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When do you recognise revenue?
This is a controversial issue in the world of accounting and is one that is
very important. Revenue is an extremely relevant metric in assessing a
company’s performance and prospects for the future. It doesn’t only play an important
part in measuring the profitability of a company, but also impacts
stakeholders, tax authorities, banks, credit ratings, and other investors. With
this in mind, it is crucial that the way revenue is accounted for is
consistent, up-to-date and fairly portrays the revenue stream of companies. As
of the 1st of January 2018, companies will be required to implement
the new standard, IFRS 15, proposed by the IASB in order to give investors and
other users of financial statements more confidence that revenue is being
recognised consistently even in new and developing industries. This report aims
to discuss whether the previous standard, IAS 18, is no longer adequate in the
modern day and whether the new IFRS 15 is more suitable. This will be done by
initially analysing the requirements of both of the standards and then applying
them in a real-world context using Vodafone plc. and the mobile
telecommunications market.



Nature of
the problem

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The need for a new standard is due
to the emergence of increasingly complex business transactions as well
inconsistent treatments in revenue recognition among companies for very economically
similar transactions. These inconsistent treatments make it difficult for
stakeholders and investors to accurately compare revenue figures between
companies and industries. The reason for this is that unlike the new standard, IAS
18 leaves a lot more room for judgement from accountants as it primarily bases
revenue recognition on the transfer of ‘significant risks and rewards’ and also
lacks specific guidance on how to deal with the more niche and sophisticated treatments.

IFRS 15 aims to improve the consistency in revenue recognition as well as
keep-up with the complex business transactions of today by introducing a 5-step
process that bases revenue recognition on ‘control’ instead. This new method
will require entities to identify specific performance obligations in each
contract and allocate the overall transaction price to each one based on the
fair values of each obligation. Only when these obligations are met, will
revenue be recognised. The idea of this is for revenue to be recognised in a
way that depicts the transfer of promised goods or services to the seller in an
amount that reflects the consideration to which the entity expects to receive
in exchange for the goods or services (ICAEW,



How is IFRS
15 tackling the issues within IAS 18?



Now, looking at the criteria
under IAS 18 for recognising revenue, it is clear to see how there can be discrepancies
in the recognition of revenue across industries. As previously mentioned, in
the case of selling goods, the transfer of ‘significant risks and rewards’ to
the buyer can be very subjective and can lead to some companies recognising
revenue in their financial statements in a way that does not faithfully
represent their business activities. For example, an entity might treat a good as
inventory if they feel the significant risks and rewards have not yet been
transferred to the buyer even though the buyer has control over the good. This
treatment is inconsistent with IASB’s definition of an asset, which is based on
the control of the good and not the risks and rewards and illustrates the
inconsistency of IAS 18 (IASB, 2015).

IFRS 15 aims to eradicate this ‘grey area’ by focusing on when the seller gives
‘control’ of the asset to the buyer, which is a lot clearer than using risks
and rewards. The new standard dictates that an entity has control of an asset
when they are able to direct the use of, and obtain majority of all of the
remaining benefits of the asset (Deloitte,
2015). This use of control as supposed to risks and rewards provides a lot
more consistency, as less personal judgement will be required from entities.


Multiple Components

IAS 18 also lacks specific
guidance on the treatment of multiple-deliverable arrangements. While the
standard mentions that it might be necessary to apply recognition criteria to
the separately identifiable components in a transaction, there is no specific
instruction as to how to allocate revenue to each item (KPMG, 2016). As a result, the timing of revenue recognition in some
companies might not accurately portray the nature of the transaction and can
lead to companies’ financial statements being unfaithfully represented as some
accounting periods might show too little or too much revenue. IFRS 15 tackles
this by requiring the entity to identify performance obligations and allocate
the transaction price to each one. This means that in the case of
multiple-deliverable arrangements, entities will be able to, and must identify
each separate component and allocate part of the transaction price to it based
on its stand-alone selling price. 


Additional Guidance

IFRS 15 provides a lot more
guidance for complex business transactions that IAS 18 and other old IFRS
standards lack such as the treatment of variable consideration and contracts
costs. With limited guidance on how to deal with such complicated aspects of
business activity in IAS 18, many telecom providers vary in how they account
for contracts where the transaction price may be variable (Ernst & Young, 2015). Furthermore, many providers vary in the
standard they use for treating incremental costs to obtain customers with some
using IAS 38 and others following similar procedure to IAS 11.



Is IFRS 15 completely better than IAS 18?

Whilst the new standard will improve the quality of accounting worldwide,
it will still require significant resources and effort to implement. Compared
with IAS 18, the new standard will require entities to obtain much larger
amounts of information such as variable consideration estimates, stand–alone
costs as well account for the time value of money depending on the length of
the contract, all of which will cost money and time. This will be even more
prevalent in industries such as telecoms and real-estate which will be heavily
affected. IAS 18, though not being as consistent as IFRS 15, is at least much
more straight-forward for accountants to understand as well as cheaper to
implement. In fact, in the case of simple transactions, IAS 18 is just as
consistent in revenue recognition as IFRS 15 which is why many industries won’t
be experiencing noticeable changes in how they recognise revenue. Whilst IFRS
15 will improve overall accounting consistency and provide guidance for the
more complex transactions, it will still be extremely costly for the entities
significantly affected by the new standard.




us apply both IAS 18 and IFRS 15 to a typical transaction between Vodafone and
a customer and evaluate both treatments:



Terms of Contract:


IAS 18 – Accounting

Under IAS 18, Vodafone and indeed majority
of other mobile phone operators restrict the recognition of revenue on the sale
of handsets to the amount which is not dependent on the delivery of future
services – i.e. the cash they receive for the handset (Deloitte, 2014; Vodafone, 2016). This is because the recovery of
the handset subsidy is priced into the monthly billing. This is referred
to as the ‘contingent revenue cap’ approach as the amount of revenue recorded
is limited to the amount billable at the point of handing the handset to the
customer (PwC, 2015). Here, Vodafone will not
recognise any revenue from selling the handset as it gives the handset to the
customer for free as there is no upfront cost. Revenue will only be recognised
once the first monthly fee of £38 is paid. This is an example of IAS 18 being
unfit for purpose in a complex business transaction, as there is a lack of
guidance on how to separately identify components in the transaction. Due to
this lack of specific guidance, many companies apply their own judgement on
when and how to recognise revenue for multiple-deliverable arrangements and has
led to there being discrepancies in revenue timings. Here, Vodafone incurs a
loss at inception of the transaction and treats it as an expense in their
income statement as a cost of acquiring a new customer, as they are not a
handset retailer.



IFRS 15 –
Accounting Treatment:

IFRS 15 leaves little room for judgement in deciding when to
recognise revenue. Under IFRS 15, Vodafone will need to allocate the whole
transaction price (£912) to specific performance obligations. In this example,
Vodafone’s performance obligations are to provide the handset for free, and
provide the agreed network services over the 24 months as the customer can
benefit from them either of them together or on their own in accordance with
the criterion in IFRS 15. This means that Vodafone will need to allocate part
of the overall transaction price (£912) to the provision of the handset and
part of it to the provision of the services. This is done based on their
respective stand-alone prices. The stand-alone selling price for the iPhone 6s
is £640 and stand-alone price for the same network services would be £15 per
month. The table below illustrates how to allocate the transaction price to the
performance obligations:

As supposed to recognising no revenue upon giving control of the handset
to the customer, under IFRS 15, £583.68 will be recognised as a debit entry in
accrued revenue as the first performance obligation has been satisfied.

Subsequently, £13.68 will be recognised each month once the monthly obligation
of providing the network services have been met. This treatment is a lot more
adequate as not only does it more accurately reflect the timeliness of revenue
generation, but is also a much more clear-cut approach that leaves no room for
judgement by the mobile operators.



Impact of Revenue Timing on

This change in timing of revenue will have a
significant impact on Vodafone. Let’s say for instance that this contract commenced
on 1 July 20X1 and Vodafone’s financial year end’s 31 December 20X1. Although
Vodafone will ultimately generate the same revenue under both standards, during
the first six months there will be a very large difference in the quantity of
revenue recognised as can be seen in the table below:


There will be a significant difference in revenue recognised of £439.76
during the first six months between both standards. To contextulaise this, according
to Vodafone’s 2016 annual report, there are currently roughly 462 million mobile
users subscribed to their services and revenue accruing from their mobile
services take up 74% of their total annual revenue (Vodafone, 2016). This means that Vodafone’s annual revenue figure
will increase dramatically depending on the commencing date of most of it’s
mobile contracts. The closer the starting dates are to the end of the financial
year for Vodafone, the higher the revenue that will be recognised.





Variable Consideration

IFRS 15 will also be more adequate when it comes to contracts with
variable consideration. As with many of Vodafone’s contracts, the transaction
price has a possiblity of changing due to a range of factors such as discounts or
refunds. According to Ernst & Young (2015), IAS 18 currently allows the recognition
of variable consideration as long as the revenue can be measured reliably and
the economic benefits are likley to flow to the entity. As a result, many
telecom providers vary in their treatment of volume discounts and tiered
pricing depending on their ability to make a reliable estimate. Ernst &
Young also discovered that some entities have concluded that there is
significant uncertainty in their estimates and so do not recognise any revenue
until the amounts become known to them (Ernst
& Young, 2015). This leads to revenue not being recognised by entities
in the correct accounting period and is proof of IAS 18 not being fit for
purpose. IFRS 15 now provides more comprehensive guidance on the treatment of
variable consideration. Variable amounts are to be estimated using either the
expected value or most likely method and the entity should apply the selected
method consistently throughout the contract and update the estimated price at
the end of each reporting period. IFRS 15 limits the amount of variable
consideration to the amount for which it is highly probably that a subsequent
change in estimated variable consideration will not result in a significant
revenue reversal, i.e. a constaint (Ernst
& Young, 2015). This adds more consistency to the use of variable
consideration and will lower the amount of telecom providers that are using
different treatments for the same transaction.



Incremental Costs

Incremental costs are costs that would not have been incurred had the
contract with the customer not been reached, such as sales commission through a
third party. Due to a lack of guidance in IAS 18, mobile providers either
expense these incremental costs as incurred, treat them as part of the contract
costs under IAS 11, or capitalise them under IAS 38 (BDO, 2017). Regardless, there are varying treatments for such costs
across telecom providers under current IFRS, which makes it less reliable in
comparing financial statements. IFRS 15 provides stricter guidance on
incremental costs to improve consistency. Under IFRS 15, managers must assess
whether the costs incurred would not have arised if the contract was not
obtained and whether the costs are recoverable. If both these criteria are met,
the company shall recognise the costs as an asset but have the option to treat
these costs as expenses if the amortisation period of the asset is within one
year (KPMG, 2016). The standard
requires the amrotisation of such costs on a systematic basis that reflects the
pattern of transfer of goods and services. This change will help in lowering
incosistencies with costs relating to revenue and will significantly impact
entities that currently expense such costs (Ernst
& Young, 2015). Vodafone will now recognise more assets as they are
obliged to captialize costs if they are incremental (PwC, 2017).



Activation Costs

Activation or set-up fees are very common with mobile operators. From a
survey of accounting policies of 25 operators, 18 spread such fees over the
expected customer life, 5 recognised the fees upon connection and 2 spread them
over the contract period (Deloitte, 2014).

It is clear that IAS 18 is not prescriptive enough in this area and has lead to
there being different treatments. IFRS 15 tackles this by requiring the entity
to assess whether the activation fees represent a separate performance
obligation in which case they must allocate part of the transaction price to
it. If it doesn’t represent a separate obligation, then it must assess whether
it gives rise to a material right to determine the timing of revenue
recognition (KPMG, 2016)



Conclusion and

It is unquestionable that a new revenue recognition standard
is needed to keep up with the ever-changing business models and transactions of
today. It is evident from the difference in practise among telecom providers
that IAS 18 is no longer adequate in providing consistency and reliability when
comparing the revenue figures of companies. Lack of specific guidance has led
to many companies interpreting the standard differently for economically
similar transactions, which is why there is a need for a more robust standard.

IFRS 15 aims to resolve this by bringing a larger element of standardisation to
revenue recognition and giving companies more prescriptive guidance on how to
deal with the niche and complex issues. By applying the same 5-step method to
any contract, the new standard leaves a lot less room for judgement and should
lower the variations in revenue treatment for similar transactions. In the
short-term, Vodafone will recognise much more revenue, however they will need
to re-design current I.T systems to be able to estimate stand-alone selling
prices and support the price allocation mechanism. They will also need to
collate vast data from previous contracts in order to make these consideration
estimations as well as re-evaluate the nature of their contract modifications
with customers. Vodafone will need to assess what constitutes as performance
obligations and may wish to implement additional controls to ensure
effectiveness in reporting. The company will in addition need to decide whether
they will use a full retrospective approach or a modified retrospective
approach come January 1st. In the long-term, the company might want to
identify potential commercial opportunities that can be made by re-assessing
and moulding its business models around the new revenue recognition