The New Revenue Standard
The new revenue standard, Revenue from Contracts with Customers (the Standard), significantly changes accounting for revenue. Potentially impacting on your remuneration/bonus amounts, reported business profits, timing of income tax, revenue systems and contracts. The Standard applies for reporting periods beginning on or after 1 January, 2018 and is particularly relevant for service providers with financial compliance obligations.
The Standard requires us to consider a ‘Five Step Process’ to assess when revenue arising from contracts with customers is to be recognised:
(1) Determine whether a contract exists with your customers
(2) Identify which distinct goods and services have been promised
(3) Stipulate when to recognise revenue
(4) Determine the transaction price
(5) Allocate the transaction price to the distinct goods and services promised.
The Standard is complex and may fundamentally change the timing that revenue is booked. In some situations, revenue will be recognised at the end of a contract where previously it was recognised upfront and vice versa. The changes could impact:
- Income measures such as EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization)
- Receivable and liability accounts on the balance sheet
- A range of financial ratios used by regulators, financiers and the investors.
Responsible entities, builders and other service providers subject to regulatory oversight, will need to carefully consider the impact of the new standard and how it will impact your regulatory and other performance measures such as current asset ratios, net tangible assets, earning multiples and coverage ratios.
Some examples of changes include:
Upfront fees – Some upfront fees which were previously recognised at the start of the contract, will need to be deferred even if they have been collected. An investment manager that charges an upfront establishment fee to a managed fund, will likely not meet revenue recognition requirements of the new standard, unless a distinct service is contracted for. The financial impact will be a decrease in earnings, increase in liabilities, decrease in net assets and decrease in current ratio.
Performance fees – Performance fees may be based on a fund’s performance relative to a benchmark such as the fair value of net assets. Such benchmarks are generally susceptible to factors outside the entity’s influence (for example, market volatility). Such fees will mostly not be recognised as revenue until they have been realised. That is because it is not highly probable that gains are locked in and will not be reversed until they are realised.
Awards and penalties (e.g. delays past a deadline) – Revenue is more likely to be delayed out of requirements to be more conservative.
Other promises – Building contracts which include extended warranties and shared facilities such as a club house, will now be required to allocate a portion of their revenue to these performance obligations. They may have previously been considered free incentives and revenue need not have been separately allocated to these performance obligations.
Variations - Complex rules contained in the Standard, which determine when a contract variation is to be accounted for as a new contract or a modification of an existing contract.
There are many other facets of the new revenue standards which may impact fund managers, responsible entities, builders and other service providers. The first step is to gain an understanding of the new standard, undertake an evaluation of customer relationships and create an inventory of all promises and undertakings to customers and cross check to your existing customers’ contracts.