New Revenue Recognition Rules May Alter Margins, Says Fitch

The latest revenue recognition standards from the International Accounting Standards Board and the US Financial Accounting Standards Board, designed to aid consistency, may alter margins at companies where sale of goods involves a longer-term or multiple-element contract, Fitch Ratings says. But changing business practices, including restructuring of sale agreements, is likely to reduce the new rules' impact by their adoption in 2017.

The new standard, IFRS 15: Revenue from contract with customers, comes more than five years after the standard setters published the first version of their joint revenue proposals. It replaces most of the detailed guidance on revenue recognition that currently exists under the US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

The rules will affect the timing of revenue recognition, but not overall contract profitability or timing of contract-related cash flows - unless contract terms are altered in response to them. The standard will base all revenue recognition on when the customer gets control over the good or service provided. Control may pass all at once, for example on delivery, or over time. The standard's five-step model will apply to sales contracts to allow the timing and amount of revenue recognition to be deduced.

The new rules should not materially change the credit profile of companies, so ratings are likely to be unaffected. However, some companies may use the transition period as an opportunity to restructure future sales contracts to receive the most favourable revenue recognition. Companies may restructure agreements in a more intuitive way, as terms and conditions linked to existing revenue recognition rules may no longer be required.

The new rules may also provide fresh incentives to structure contracts to accelerate revenue recognition. For example, greater customer specificity might be built into a product so that it has no alternative use for the manufacturer. This may enable some contract manufacturers to recognise revenue over time, as production progresses, rather than on delivery. Conversely, in revenue recognition for long-term production contracts, companies may change how they measure revenue, and costs incurred, as work progresses. This will be particularly applicable for bespoke, complex goods with long production times.

The rules may also affect "bill and hold" arrangements, where a supplier holds onto the customers' goods after invoicing. The new rules look at when control of the goods passes to the customer, rather than delivery. Nevertheless, booking revenues earlier would not materially affect our credit analysis because we focus on sustainable operating cash flow.

Business practice changes already taking place may mute the impact of the new accounting standard. For example, under new accounting rules a handset sale bundled with line rental would lead to more revenue booked up front. Last year, US wireless carriers introduced equipment instalment plans that separated the cost of line rental from the cost of the handset. This unbundling of products ahead of the new standard's implementation is likely to reduce the accounting impact on revenue and margins.

New standard likely to be welcomed by real estate developers
Real estate developers in Asia, in particular, may lead the pack in early adoption of the new revenue standard.

“Revenue and profits are currently recognised only upon completion of their developments overseas. This causes significant earnings volatility," says Gerald Low, Audit Partner, KPMG in Singapore.

“Applying the new standard is expected to allow revenue and profits for some overseas building projects with non-refundable progress payments to be recognised progressively. Many developers in Singapore are already eagerly waiting for the Accounting Standards Council to issue the new standard here.”

Changes to headline revenue numbers for the telecommunication, offshore and marine sectors
Companies that bundle their products and services or who engage in major long-term projects spanning more than one year are likely to see the most impact from the new standard. This is mainly due to changes to the timing of revenue recognition.

Globally, there are telecommunication companies that do not currently recognise the allocated sale value of a handset as revenue when the handset is given to the customers under a bundled arrangement. What they currently practice is limiting the revenue to the actual cash received, or to recognise the cost of the handset as a marketing expense.

Under the new standard, revenue is allocated to the handset based on the standalone selling prices of the handset and the ongoing service. This means that in many cases, more revenue will be allocated to the handset.

Said Low: “The unbundling of different elements in the contract, including handset revenue, would result in an acceleration of revenue recognition while the timing of cash inflows remain unchanged. This new revenue model will result in a significant difference between when revenue is recorded and when actual cash is received from customers.”

Ship and oil rig builders may experience significant earnings volatility from adopting the new standard.

Low said: “The current practice for ship and oil rig builders is to recognise revenue over time. Some arrangements may no longer meet the criteria for doing so. This means that adopting the new standard will delay how revenue is recognised.

“For affected companies, the new standard may change their earnings pattern by deferring revenue until delivery of the vessels in some cases.”

The new standard takes effect in January 2017, although IFRS preparers can choose to apply it earlier. While the effective date may seem a long way off, affected companies need to make important decisions on when and how to transition to the new standard soon.

All companies should also assess the extent of the impact, so that they can address the wider business implications, including communications with investors and analysts. Low said: “An early decision will allow companies to develop an efficient implementation plan and inform their key stakeholders.”

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