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In a Discussion Paper that is being issued jointly with the FASB later this year, the International Accounting Standards Board will propose changes in how companies account for earnings from their sales process.

In recent years there have been manycomments about the quantity of new literature issued by the International Accounting Standards Board (IASB). What is more surprising, however, is the lack of guidance in certain areas. Revenue recognition, for example, affects all companies across all industry sectors and yet up to now little attempt has been made to address the weakness in the two existing standards, IAS 11 Construction Contracts and IAS 18 Revenue.

By its own admission, revenue recognition has been on the IASB’s agenda for six years. The recent refocusing of effort is driven by the ongoing goal of convergence with US GAAP and the deliberations currently underway at the SEC regarding whether US Domestic Registrants should be permitted to use IFRS as their primary GAAP. A switch to IFRS without the existence of a robust revenue recognition standard is inconceivable for many US entities, and their regulators.

Current Practice Since there is limited revenue recognition guidance available for IFRS, many companies are following the current provisions of US GAAP. That, however, provides more than 200 pieces of revenue recognition related literature, much of which is industry focused, so bigger isn’t necessarily better. Strict application of the US requirements may mean thatan entity is unlikely to overstate revenue, but earnings management may equally be about deferring revenue to future periods.

At the IASB conference in Amsterdam in June 2008, Henry Rees, the IASB project manager with responsibility for the revenue recognition, outlined the Board’s preliminary views about how it believes companies should account for earnings from their sales process. The proposed model involves a shift in perspective from a performance or critical events model to one which focuses on recognising the rights (to receive consideration) and obligations (to perform services or transfer assets) that arise from a company’s contractual arrangements with its customers. The approach is somewhat similar to the current Irish and UK GAAP principles outlined in Application Note G to FRS 5 Reporting the Substance of Transactions.

Which Assets and Liabilities? Figure 1 (Chart omitted from internet) above demonstrates that the assets to be identified are not those which might be delivered to the customer under the contract – for example, inventory of goods – but rather the initial asset to identify is the right to be paid as a result of the contract. A net contract asset is recognised where the value of rights received under the contract exceed the obligations assumed. A net liability is the result of the reverse scenario.

Performance Obligations Having established the assets and liabilities arising as a result of a customer contract, revenue will be recognised when a performance obligation is satisfied. Currently a performance obligation is to be defined as a promise in a contract to transfer economic resources to a customer. This again represents a shift in emphasis. The transfer to the customer is not based on the transfer of risks and rewards. Rather it occurs when the customer gets an enforceable right or other means of limiting access to the resource. For example, with respect to the sale of goods, the transfer will typically occur when the goods are delivered to the customer. In theory at least, this would mean that a company could recognise revenue when a product is delivered to a customer even where the customer has a right of return that is reasonably likely to be exercised.

Such principles of revenue recognition contain an obvious risk: an entity might ship goods close to any reporting date in order to recognise revenue albeit that the goods may well be returned. It is likely, then, that rights of refund will become an increasingly important feature of service contracts if the current proposals are eventually adopted.

Another obvious challenge for the IASB’s proposed approach is the question of how to recognise revenue on a contract that involves the delivery of both goods and services. To illustrate the point, the IASB provide the example of a painting company, where the entity provides the paint, say on March 31, but does not provide the painting service until April. The guidance will contain a rebuttable presumption that if the goods are used to satisfy another performance obligation, then the revenue is not recognised until such time as the second performance obligation is extinguished.

Measurement of Performance Obligations Undoubtedly the most difficult piece of this project for the IASB is the measurement aspect. There are two potential methods: - the current exit price approach, and - the transaction price method

Exit Price Approach Under the current exit price approach the performance obligation is measured at the price that a third party would charge to assume the remaining obligations. For example, in the case of a software provider the performance obligation associated with fulfilling a support and maintenance contract might be the cost of fulfilment plus a reasonable margin. Such costs must exclude any direct or indirect costs of obtaining a customer contract. Using this type of layoff price creates the potential for Day 1 revenues or losses to arise. After contract inception, the remaining rights and performance obligations are remeasured at each balance. Any changes not related to fulfilment of performance obligations are reported outside the revenue line as gains or losses. This may arise, for example, where a change in the price of goods not yet provided to a customer occurs. The inherent difficultly in the current exit price approach is the assumption that an exit or lay-off price exists for performance obligations. Whilst it is consistent with the measurement method proposed in the IASB’s Fair Value Measurement Discussion Paper and Phase II of its Insurance Project, one has to ask whether the proposition represents commercial reality. How many insurance providers, for example, sell their insurance liabilities rather than run off the obligation?

Transaction Price Approach The transaction price approach (also known as the customer consideration approach) suggests that the rights and obligations arising are measured at prices set out in the contract. This method assumes that the transaction price only represents the price of goods and services yet to be provided.

At the inception of a deal, the contract asset and liability are a net nil position and effectively the contract is not booked in the financial statements until the asset is realised or the value of the performanceobligation changes.

The IASB plans to issue a Discussion Paper (jointly with the FASB) for consultation in the second half of 2008. This will indicate that the Board’s preliminary view favours the transaction price method which has the significant advantage that, at inception, values are measured by reference to a contract price which is observable and verifiable. It also means the revenue cannot be recognised at the inception of the contract. This is of course consistent with the rules of IAS 39 Financial Instruments: Recognition and Measurement concerning Day 1 profits.

Multiple element contracts Where the transaction price method is used, the price in the contract is assumed to be the price for purchasing a bundle of goods or services. The seller must then allocate a portion of the contract price to each performance obligation on the basis of a stand-alone sales price of the underlying product or services. The IASB have indicated that this will involve estimating what the standalone price would be even if such a price is not observable in the market.

For example, where a software provider sells a licence with a support and maintenance bundle, the seller must estimate the sales proceeds attributable to the licence even where it is not currently available for sale on a stand-alone basis. This is very different from current US GAAP where the concept of Vendor Specific Objective Evidence (VSOE) is required to achieve unbundling. Many might argue that the introduction of such estimation reduces the reliability of information in financial reporting, but it is, however, consistent with the characteristics of financial information identified in the Board’s conceptual framework projects.

Fergus Condon is Director of the Financial Reporting Advisory Group at Ernst & Young.