As many accountants and finance professionals are aware, the International Accounting Standards Board (IASB) has been busy drafting revised accounting standards.
Many people have got to the stage of ‘information overload’ in relation to financial reporting and are wondering ‘do we really need more standards?’ As if that wasn’t enough, is there not supposed to be a disclosure initiative to reduce disclosures? Yes, there is but it may not necessarily reduce disclosures. Hopefully, both regulators and auditors will accept that something must be done to streamline disclosures and, at least, prioritise what are the most important issues in a set of company accounts.
Anyway, back to the new standards which are on Financial Instruments (IFRS 9), Revenue Recognition (IFRS 15) and Leases (IFRS 16). A good example is that the new Revenue standard increases the amount of disclosures nearly every entity will have to make. The IASB’s answer is that up to now disclosures relating to revenue have been lacking – mainly because IAS 18, the present standard on revenue – did not require many, and so IFRS 15 is getting us to where we should be.
Not many people would argue against the rationale for the new Leases standard. Prior to it, too many companies were using leasing as a form of off-balance sheet financing and many got into severe financial difficulty; some went bankrupt. So, there was an obvious requirement to put all leases on the balance sheet. IFRS 16 now requires that all leases of more than 12 months, from the point of view of the lessee (the entity leasing an asset and making lease payments), should go on the balance sheet as a right-of-use asset and liability. So, many companies, such as airlines, which have significant operating leases (as lessees), will now have more liabilities and, of course, this impacts on gearing ratios and debt covenants, without a change in the underlying economics of the business. It’ll be interesting to see how the banks react!
The Financial Times said that an estimate of the lease obligations that will be pushed on to balance sheets under the new rules is $2.86 trillion.
You may have noticed a little financial crisis caused, in no small measure, by irresponsible lending and then, partly because of the accounting rules in IAS 39 on financial instruments, we did not get to know the full extent of the bad loans.
This arose because, even if lenders were not sure if they would be repaid, or ultimately how much they would get, they did not have to account for the full impact. This was because we had what was called an ‘incurred loss’ model where a loan could only be written down, or impaired in IFRS-language, when there was a ‘loss event’. It meant that we needed evidence that the borrower was in financial difficulty. This was not so straightforward at the time and allowed lenders to have a lower impairment loss than there might have been.
So what will IFRS 9 now require that is so different?
We are moving to an ‘expected loss’ model. This means that from the time a loan is made, we must consider the necessity for an impairment provision, taking into account not just past information but also looking into the future. Of course, this requires more judgement but will lessen the chances of under-provisioning as occurred during the financial crisis. Initially, we will consider the likelihood of default occurring within the next 12 months and, if the financial situation deteriorates, we will have to look at the possibility of default any time in future, so requiring a higher impairment. This is going to be the biggest impact of the new standard.
The following diagram summarises and compares the impairment rules of the two standards:
Also, IFRS 9 uses a more holistic approach to the determination of impairment where we now need to look at the bigger picture in our assessment, rather than basing the assessment on individual financial assets.
Another impact will be that for certain industries, it will be easier to utilize what was called hedge accounting, where gains and losses are offset in the income statement. Ultimately, a business enters into a hedge to reduce risk. But the previous rules under IAS 39 made it difficult to qualify for this accounting causing greater volatility. As IFRS 9 will now be more flexible as to what qualifies, the results will be to better report the risk strategy.
The last of the trio of standards covers revenue, the biggest figure in most companies’ accounts. Frankly, IAS 18 was showing its age. While it was a pleasure to read compared to the language in IFRS 15, and IFRS 9 for that matter, it lacked guidance for many common business transactions.
Nowadays, in many technology-based industries, when you sign a contract, there is usually more than one transaction involved. I am sure many have signed a two-year contract and got a nice flashy mobile phone and, of course, you had to pay a subscription over 24 months. IAS 18 said very little about such transactions, so we could apply the requirements of US GAAP, as IFRS was silent. Now we have our own rules.
Let us go through how it works.
Say you sign a contract for $200 a month giving you a nice new phone and internet access. Ignore phone calls and texting, which you will get charged for as you incur them.
So IFRS 15 says you have sold two items in a bundle or as the standard says, there are two performance obligations in this contract: the phone and the subscription.
Control of the phone is transferred once the contract is signed and the customer gets it into his or her hands; but the subscription is transferred over the two years, so we say that this is transferred over time while the phone is transferred at a point in time.
So the total amount that will be paid is 24 x $200 = $4,800. This has to be allocated to each performance obligation and IFRS 15 says we must do that based on the standalone selling price of each item, i.e., how much would we get if we sold them on their own. So, assume that the subscription will still cost $4,800 but that the phone can be sold for $600.
The total consideration is $4,800 to be allocated as follows:
|Stand-alone selling price
| Mobile phone
|*4.800 x 600/5.400 = $533
**4.800 x 4.800/5.400 = $4.267
Assume that $200 is paid at the end of each month and the phone is received on signing the contract. The accounting will be as follows:
On signing the contract:
Then each month:
Over 24 months, the contract receivable will be eliminated (24 x $22 = more or less $533).
So, what is happening, once we satisfy the performance obligation, is that we can record revenue.
We now have a new five-step model to follow for all revenue transactions for all industries:
Previously, under IAS 18, we recorded the sale of goods when the risks and rewards of ownership were transferred. Now, under IFRS 15, revenue is recorded when control is transferred, which may be the same thing for many straight-forward transactions.
Conclusion: Learning to love the new standards
As one can imagine, with the introduction of new accounting standards the devil is in the detail. Even though it may be painful trying to get used to a new standard, it may be worth thinking about why a new standard was issued, as well as the possibility that the standard will make things better!