ON AUG. 15, 2017, the Securities and Exchange Commission approved the adoption of Philippine Financial Reporting Standards (PFRS) 15, Revenue from contracts with customers, which became effective for annual reporting periods beginning on or after Jan. 1, 2018.
Under PFRS 15, an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to. An entity must apply the five-step model to comply with the new revenue recognition standard:
Step 1: Identify the contract(s) with customers
Step 2: Define the performance obligations in each contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations in the contract
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation
Entities in varying degrees are conducting assessments on the impact of PFRS 15 and are finding that implementing PFRS 15 is challenging. It requires more effort than what was originally anticipated, as they have to reconsider not only its accounting implications, but also its impact on multiple workstreams such as processes, information technology, legal, sales, human resources and investor relations. These areas include:
PROJECT TEAM AND PLANNING
Entities need to form adequate project teams equipped and enabled with the requirements of PFRS 15, since effective project management is crucial to implementation. The assigned project team needs to obtain input from its business functions and stakeholders to plan and implement the PFRS 15 requirements to the various workstreams. Entities need to also ascertain that the conversion project team has adequate and appropriate governance to ensure that key judgments and decisions are appropriately vetted. Some entities find creating project teams to be particularly challenging as they need to confirm that project team members are: 1) competent on PFRS 15 requirements; 2) knowledgeable about the current revenue recognition policy and; 3) well-informed on the business functions and practices.
SETTING THE SCOPE
To determine the initial impact of PFRS 15, entities need to establish its effect on its revenue streams, including a review of its relevant contracts. Some entities have a large volume of non-homogenous contracts. Reviewing them takes a lot of time; thus, entities need to first agree on the scope for the review of these contracts (i.e., by selecting representative contracts for similar product and service offerings) and applying the five-step model to determine the revenue accounting for such contracts. Entities also need to consider additional factors such as geography, sales channels and customer types that could impact revenue streams and related contract provisions. Once the scope is set, entities can apply the requirements of PFRS 15 while considering its impact on their business functions. Thus, entities need to ensure that the scope is appropriate and complete as the assessment of the representative contracts will be the basis of the design and implementation of solutions across workstreams.
SIGNIFICANT JUDGMENTS AND ESTIMATES
PFRS 15 involves significant judgments and estimates since the new model uses broad principles rather than specific guidelines. Examples of areas requiring significant judgments and estimates include:
• Identifying a contract with customer
Entities need to identify when an arrangement will create enforceable rights and obligations as they cannot directly conclude that their current arrangements will pass the criteria of a contract in accordance with PFRS 15. Entities, along with their respective legal teams, will have to revisit the enforceability of other forms of arrangements (e.g., written, oral and implied contracts).
• Identifying performance obligations
Entities cannot directly assume that the deliverables identified in the current revenue standards will be the same as the performance obligations under PFRS 15.
An example of this is the recognition of bundled goods or services. Entities need to identify the promised goods or services within the contract and determine whether these goods or services should be considered collectively within the context of the contract as a single performance obligation. Otherwise, the promised goods or services will have to be treated as distinct and separate performance obligations. Typical questions considered by entities include:
• Is the entity fulfilling a single promise to the customer?
• Do one or more goods or services significantly modify or customize one or more of the other goods or services in the contract?
• Do two or more promised goods or services each significantly affect the other goods or services (i.e., two-way dependency between the promised goods or services)?
Entities will need to understand the facts and circumstances and apply significant judgment to determine whether goods or services are to be combined into one or treated as separate performance obligations.
Another example is the recognition of free goods or services, since PFRS 15 does not limit performance obligations that are explicitly stated in the contract. Implied promises from an entity’s customary business practice (e.g., free goods or services) can be considered performance obligations if these will create a valid expectation that an entity will transfer a good or service to the customer. Entities will need to evaluate whether these free goods or services which were previously treated as marketing incentives may qualify as identified performance obligations in the contract.
Examples of variable considerations are discounts, rebates, refunds, performance bonuses and penalties. Entities that simply recognized these amounts when cash is received will most likely be affected since PFRS 15 requires entities to estimate and update such estimate throughout the term of the contract. Under PFRS 15, recognizing revenue until the product is sold to the customer may no longer be acceptable if the only uncertainty is the variability in pricing; that is, the estimated variable consideration may now be recognized as part of the transaction price. However, there may be cases that the impact under PFRS 15 and legacy guidance (i.e., current revenue standards) will be the same if the estimated revenue will be constrained. Constraining variable consideration prevents over-recognition of revenue (i.e., significant reversal of cumulative revenue will not occur in future periods). Entities need to use significant judgment in constraining variable consideration by considering both the probability and materiality of revenue reversal.
ALLOCATING THE TRANSACTION PRICE
PFRS 15 requires entities to determine the stand-alone selling price of all the performance obligations and allocate the transaction price based on their standalone selling prices. Entities that determined bundled goods or services which should be treated as separate performance obligations under PFRS 15, may find allocating the transaction prices challenging, particularly when the price is not currently observable.
PROCESS FLOWS AND INTERNAL CONTROL
Entities need to revisit whether they will require new/revised process flows and adjust their transaction-level controls to make sure the information used is accurate and built around the framework of sound internal control policies. Entities also need to pinpoint significant assumptions and assess their estimation methods in applying the requirements of PFRS 15. It is also critical that the new/revised processes and controls, significant assumptions and chosen methods are appropriately documented. Documentation may provide sufficient and reliable evidence to regulators and stakeholders that the management has already taken steps to consider the impact of PFRS 15.
Where are you in the journey?
It is clear that implementing an accounting change of this magnitude is a significant challenge. Entities should already be thinking about the impact and implications of PFRS 15, as proactive implementation may overcome unwanted surprises and costly mistakes. Considering the challenges of such an accounting change, how ready are companies to meet such challenges?
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Anna Maria Rubi B. Diaz is a Senior Director of SGV & Co.