Revenue is one of the chief barometers by which a for-profit company is measured. That makes revenue recognition not just a topic for accountants, but also an important factor in a company’s stock performance and overall reputation. Thus, it is crucial for organizations trying to understand their profitability to have a system that works.
Until 2014, revenue recognition guidelines were somewhat blurry. The GAAP and IFRS standards disagreed on how and when revenue recognition should occur. Furthermore, both included substantial gray areas that left it up to individual finance leaders to decide how to apply the rules. The existing standards worked poorly for companies with recurring revenue models, which included nearly all SaaS companies.
The FASB and the International Accounting Standards Board (IASB) joined forces to begin a new revenue recognition project in May 2014. At the end of 2017, the new IFRS 15 standard took effect for most organizations. It is imperative that companies change their revenue recognition policies to comply with the new rules if they haven’t already done so.
IFRS 15: A five-step process for revenue recognition
IFRS 15’s core principle is, “Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” The standard establishes a five-step process:
IFRS 15 may be a significant change from companies’ current revenue recognition system. The chart below shows which industries will most likely need to make major changes to implement specific steps.
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1. Identify the contract
IFRS 15 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations and specifies that enforceability is a matter of law.” A customer contract falls under the new standard if it meets the following requirements:
- Collection of consideration is probable.
- Rates and payment terms for goods or services can be identified.
- It has commercial substance.
- It is approved, and the parties are committed to their obligations.
Note the use of the word “probable” in the first requirement. IFRS and GAAP have slightly different definitions of the term, but overall it refers to the buyer’s ability and intention to pay the agreed-upon consideration, as well as the seller’s intention of enforcing the contract should the buyer refuse to pay.
Although establishing contracts in writing is usually a good business practice, contracts don’t need to be in written down to qualify. Some businesses, such as SaaS companies that are not enterprise-focused, may not pen contracts with their customers.
For companies using a recurring revenue model, the requirements can be met in a different way:
- The “collection of consideration” isn’t just probable; it’s presumed that the customer pays when they sign up.
- Rates and payments are conveyed via publishing, sales, or otherwise.
- The commercial substance that would normally be laid out in a contract is likely detailed in the “Terms of Service.”
- The customer effectively signs the “Terms of Service” when he/she signs up. Both the organization and the customer are then obligated by these conditions.
2. Identify the performance obligations
The new standard uses “performance obligations” to determine whether or not to recognize revenue. A performance obligation can be one of two things:
- A distinct good or service or a distinct bundle of goods or services
- A series of distinct goods or services that are substantially the same and are transferred to the customer over time in a recurring pattern
A product or service qualifies as distinct if it alone benefits the customer without the need for additional goods or services and if the agreement to transfer the good or service to the customer is separately identified from any other commitments in the contract.
For SaaS companies, the performance obligation is likely the value metric. Whatever the business has promised to the customer (e.g., a certain amount of bandwidth each month, a specific number of events tracked each quarter, a particular number of videos hosted each year) is the performance that it is obligated to deliver.
3. Determine transaction price
The “transaction price” is the amount the seller expects to receive in exchange for transferring goods or services to the buyer, minus the amounts collected for third parties, such as sales tax. Sellers must estimate their transaction price at the time they generate the contract and then update that estimate as needed during each reporting period.
The following factors can all affect transaction price:
- Variable consideration: Certain factors, including discounts, refunds, bonuses, incentives, and penalties, can increase or decrease a seller’s ultimate compensation. Sellers likely won’t know which of these factors will come into play at the time they draft the contract, so they’ll need to make a reasonable estimate.
- Financing: If the contract includes a significant financing component, sellers will need to take into account the time value of money when calculating transaction price.
- Non-cash consideration: Sellers who are being partly or fully compensated by means other than cash or cash equivalents must make a reasonable estimate of the fair value of that consideration.
- Consideration payable to customers: Sellers offering coupons or other compensation to customers must determine whether the consideration counts as a reduction of transaction price, a payment for distinct goods or services, or both.
Transaction price estimates should assume that both buyer and seller will be upholding all contract terms. They should not factor in the possibility that a contract might be modified, renewed, or canceled, even if it’s likely to happen.
For most SaaS companies, determining the transaction price should be simple because the pricing is already defined. If using a sales model other than self-serve with discounting allowed, or if refunds must be given to customers for unused services, it can become more complicated.
4. Allocate transaction price
Once a reasonable estimate of transaction price has been made, it is time to allocate that transaction price between each distinct product or service included in the contract. In most cases, that means allocating the transaction price proportional to the stand-alone price of each product or service.
If there is no easy way to determine stand-alone prices for some or all of the relevant goods or services, it is necessary to come up with an estimate using one of the following approaches:
- Adjusted market assessment: Evaluate the market and estimate the price that customers in that market would be willing to pay for the relevant goods or services.
- Expected cost plus margin: Forecast the expected costs of providing the goods or services and then add an appropriate profit margin.
- Residual approach: Subtract the prices of the goods or services for which you do have stand-alone prices from the total transaction price. Use the remainder as the price for the goods and services for which you do not have stand-alone prices. This last approach is only permitted if the stand-alone selling price for certain relevant goods or services is highly variable and/or uncertain, while the other relevant goods or services have clearly established stand-alone prices.
In some cases, the total stand-alone prices for a contract’s goods or services will be out of line with the contract’s transaction price. A contract may offer a considerable discount over ordinary stand-alone prices for longtime customers or customers buying in bulk, for example. In that instance, sellers must develop a consistent policy for determining stand-alone prices. One such strategy might be always using the midpoint of stand-alone prices when allocating transaction price.
Compared to determining the transaction price, the difficulty in allocating transaction price can vary widely for SaaS companies. If there is a flat monthly fee, it can be easy. If the pricing structure depends on usage or tiers, it is much more difficult.
5. Recognize revenue after satisfying a performance obligation
IFRS 15 says revenue can be recognized only when or as a company satisfies a performance obligation. To satisfy a performance obligation, the company must transfer a product or service to the customer. It’s considered “transferred” the moment the customer gains control of it.
For performance obligations satisfied over time, such as recurring services, sellers may also recognize revenue over time. In that case, sellers must apply a single, consistent method of measuring progress to determine when a performance obligation has been completely satisfied.
Sellers can choose either an input method (e.g., resources consumed, costs incurred, or expended labor hours) or an output method (e.g., performance surveys, predetermined milestones, or elapsed time), which must align reasonably well with the nature of the performance obligation. For example, it wouldn’t make sense for most SaaS companies to use labor hours as a method because labor is rarely a major factor in their services. Recognizing revenue linearly over the month or year of the agreement, however, could work well.
As a rule of thumb, any time a seller has the right to invoice a customer for an amount directly corresponding to what it has already done for that customer, it can recognize that much revenue.
Is your company affected by IFRS 15?
Any organization that enters into contracts with customers to deliver products or services, or to transfer nonfinancial assets, must adopt the new standard. Public organizations were required to use IFRS 15 beginning December 15, 2017. Nonpublic organizations have until December 15, 2018. There is an exception for companies that have other standards that supersede IFRS 15 (for example, insurance companies).
The above are just guidelines; they do not constitute financial advice. To determine how you are affected by IFRS 15, talk to your accounting team. The sooner you do, the more ready you will be for the change.
Long-term benefits of IFRS 15
IFRS 15 requires detailed contract tracking and forecasting, which will lead to more-accurate budgeting and reporting. Although changing revenue recognition policies will likely be a hassle in the short term, the long-term benefits may be considerable. If all companies use the same approach for revenue recognition, sizing up annual revenues and financial statements between companies becomes an “apples to apples” comparison.
This joint project between FASB and IASB is an important first step toward combining GAAP and IFRS standards into a single system, which would greatly reduce international differences in financial reporting. All in all, IFRS 15 is a step forward for the entire finance industry.