Seal SoftWare Helping Organizations Achieve Compliance with the New Rules for Revenue Recognition

OVERVIEW

In May 2014, the FASB and IASB issued a new standard on revenue recognition called IFRS 15 - Revenue from Contracts with Customers. The new standard contains principles an organization will use to determine the application of revenue to a transaction, or set of transactions, and the timing of when that revenue is recognized. IFRS 15 supersedes IAS 18, IAS 11, and all other IASB, FASB, and US GAAP rules on reporting of payments received in customer transactions.

The new mandate guides the recognition of revenue to more accurately depict the transfer of goods or services to customers, and maps that to the amount the entity expects to be entitled to in exchange for those goods or services. It is intended to prevent the lack of clarity or consistency in financial reporting for organizations that bundle goods or services, for those delivered over time, for deal structures that are conditional and revocable, and to guide the reporting of goods being sold into partner channels before the ownership of the good or services are consumed by the end user customer.

The new standard has a compliance date of Jan 2017, at which time the IASB can conduct audits on any organization it deems may be in non-compliance. At that time, organizations must be able to prove (in audit) that for each customer, in its simplest form:

  • The client is being billed for the appropriate amount
  • At the appropriate time
  • For the appropriate delivery of a good or service

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The standard will also result in a significant increase in the volume of disclosures to regulators associated with revenue, and those who are found to be out of compliance with IFRS 15 may be fined according to the degree of non-compliance.

IFRS 15 will likely be a significant change in how most entities recognize revenue, especially those that currently apply industry-specific guidance. It also has the potential to directly impact an organization’s financial ratios (and stakeholder perception) and tax liabilities. For this reason, organizations must take an aggressive approach to compliance, in particular when it comes to managing three aspects:

  • Data Capture and Analytics: The terms and conditions of customer transactions are found in contracts, and organizations have a big task with all the work locating contracts across divisions, entities, systems, , and then manually reviewing the documents and extracting the data needed to recognize revenue according to the new principles.
  • Assessing the Impact: It is important that organizations analyze the data coming from contracts and model the changes on financial reporting prior to the deadline. This can provide the time to renegotiate or novate customer contracts before the compliance dates to better manage the impacts to public
  • Managing the Compliance Initiative: Organizations must also look to minimize the cost and 
THE NEW MODELS

With IFRS 15, the IASB has taken an asset and liability approach to revenue recognition, as opposed to the earnings approach, to better align with the basic tenants of the FASB’s and IASB’s frameworks. The boards believe a more consistent methodology can be achieved by using a contract-based model where revenue recognition is based on changes in contract assets, starting with the rights to receive consideration (payment), and then changes in liabilities, which are the obligations to provide a good or perform a service.The current earnings approach is based on the timing of revenues that are realized, realizable or earned. The approach has been considered too ambiguous, and has resulted in over 200 pieces of guidance specifying when revenue is earned for specific transactions, which is frequently industry-based, inconsistent, and often conflicting.

The earnings approach has also been challenging when the delivery of goods is structured over time, and/or there is a high degree of services or renewable supplies. Many organizations bundle goods and services, intended to be consumed over time into a single transaction to accelerate revenue.

"Information about revenue is used to assess a company's financial performance and position and to compare that company with other companies. However, previous revenue requirements in IFRS and US GAAP made it difficult for investors and analysts ('investors') to understand and compare a company's revenue."

IFRS - May 2014

A challenge also lies in conditional transactions, where bundled goods or services are sold as a unit and certain components of the transaction are dependent on certain outcomes or other variables, with a right to cancel or roll back any component of the transaction.

The result of the earnings approach was companies could recognize revenue for goods or services that were not yet being consumed by customers, may not actually occur and need to be restated, or may end up being at a different revenue levels than originally reported. This created inconsistency and a lack of clarity into revenues, resulting in a potentially inaccurate picture of a company’s true financial state.

FIVE STEPS TO COMPLIANCE

To help organizations understand and work toward compliance with IFRS 15, the IASB has provided a five-step plan for companies for recognizing revenue within a transaction. The five steps include:

Step 1: Identify the contract with a customer
Step 2: Identify the separate performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the separate performance obligations
Step 5: Recognize revenue when (or as) each performance obligation is satisfied

 

Step 1:  Identify the Contract with the Customer

The five steps start with identifying the contract with the customer to understand what delivery obligations the organization has, and if they are in alignment with IFRS 15. This is also when it must locate and determine if they need to combine contracts, and consider any updates, addenda, exhibits, revocations, or any other elements that may impact the transaction.

Any transaction not covered by an existing contract will require a new contract. When creating a new contract, the guidance from US GAAP and IASB/FASB is that an entity will need to assess and determine that it is reasonably “probable” they will collect consideration in direct exchange for the goods or services being transferred to the customer in order for a contract to be in the scope of the revenue standard. The term 'probable' has a different meaning under US GAAP, where it is generally interpreted as a 75-80% likelihood, and the IFRS, where it means more likely than not -- that is, greater than a 50% likelihood.

This aspect of the first step sounds like it should be much easier than it often is. Just the task of locating all customer contracts and their extensions and attachments can be extremely challenging if done manually. Contracts can be stored on various repositories, across divisions and locations, and be in various formats, including non-searchable image files.

STEP 2:  Identify the Contract with the Customer

The next step is to identify and extract all performance obligations in each customer contract, which are essentially the promises to transfer goods or services to a customer. They may be stated explicitly in a contract, they may be componentized as different deliverables in the same contract, such as asset deliverables, maintenance, support, or renewable supplies, or they may not be explicit at all but assumed. All of these things will affect the timing of the receipt of revenue and when it can be recognized.The next step is to identify and extract all performance obligations in each customer contract, which are essentially the promises to transfer goods or services to a customer.

"IFRS 15 addresses deficiencies by specifying a comprehensive and robust framework for the recognition measurement and disclosure of revenue. In particular, IFRS 15 improves the comparability of revenue from contracts with customers; reduces the need for interpretive guidance to be developed on a case-by-case basis to address emerging revenue recognition issues; and provides more useful information through improved disclosure requirements."

IFRS - May 2014

To meet compliance, an entity must account for each promised good or service as a separate performance obligation if the good or service is distinct, meaning the customer can benefit from the good or service on its own or together with other resources readily available. It may be bundled only when the value of the good or service is highly dependent or interrelated with other promised goods or services in the contract.

Sales incentives such as the very popular customer loyalty programs or free products as part of a promotion are currently recognized as marketing expense under US GAAP. These types of incentives may be considered performance obligations under the new model. This means revenue will be deferred until obligations are satisfied, such as when a customer books a flight with the redemption of loyalty points.

As described above, the definition of performance obligations can be quite complicated and confusing. The act of reviewing customer contracts to spot and define the specific language that would, through its explicit or implicit intent, describe delivery obligations by a vendor, would be difficult in the best circumstances.

step 3:  Determine the Transaction Price

The third step is the mapping of the performance obligations identified in step two, to the transaction price also identified in the contract. This transaction price reflects the amount of consideration an entity expects to be entitled to in exchange for goods or services delivered.

As some transactions are conditional (or variable) in nature as described above, the amount of consideration is measured using either a probability-weighted or most- likely-amount approach - whichever is most predictive. The determination uses the concept of probability that the amount will not result in a significant reversal in revenue if estimates change due to various circumstances. These include the factor of time, and the time value of money in the calculation, the recognition of non-cash consideration, and if there is any consideration paid to customers in the transaction (e.g. rebates or “cash back” incentives) just to name a few.

STEP 4:  Allocate the transaction price to the separate performance obligations

The fourth step in the process is to clearly assess the performance obligations in each contract, and separate those that have different patterns for the transfer of goods and services. Once separated and distinct, the transaction price is allocated directly to these separate performance obligations based on relative standalone selling prices.

The determination of standalone selling price is the observable price of a good or service when it is sold separately. But sometimes that is not available, and then it can be estimated using cost plus margin or the standalone price of similar products.

STEP 5:  Recognize revenue when each performance obligation is satisfied

The final step is the recognition of revenue when the customer obtains control of a good or service. Control can transfer at a point in time or continuously over time, and may require judgment.

An organization satisfies a performance obligation over time if the customer is receiving and consuming the benefits of a vendor’s performance (service delivery) as its being delivered, or if an entity creates or enhances an asset that the customer currently controls. Another determination of revenue against performance is when an entity’s performance does not create an asset, but the entity will have a right to payment for performance completed to date with expectation of completing the contract in the future.

Determination of when the customer gets control of a promised asset includes when there is an understood and unconditional obligation for payment, the customer has legal title or physical possession, or if the customer has accepted the assets and have the risks and rewards of ownership. If control is transferred over time, one approach is using output methods, such as units delivered, or input methods such as costs incurred or passage of time to measure the amount of revenue to be recognized.

THE CHALLENGE OF IFRS 15

The first two steps in IFRS 15 compliance may be the hardest and most expensive. That is, how an organization can initially find, centralize, and extract needed data from customer contracts before moving to the analysis and mapping of transaction price to the performance obligations.

In many cases, organizations do not have a centralized repository of all of their customer’s contracts. They may have contracts on file shares, SharePoint or other repositories, or on a network drive somewhere. The challenge is reducing the time and effort to get those contracts in a centralized location and ensure they are all in a searchable format.

The second significant challenge is reviewing them to extract the terms needed for compliance. This includes a host of information from contracts that may include the terms shown below:

  • Active agreements vs non-active
  • Contracting parties
  • Delivery terms
  • Payment terms
  • Discounts
  • Extraction of costs associated with services,
  • warranties, maintenance, and supplies
  • Additional charges
  • SLAs
  • Payments tied to acceptance
  • Payment tied to conditions
  • Payment tied to work in progress
  • General acceptance clauses
  • Payment or obligation information found in addenda and exhibits
  • Etc. etc.
MANUAL REVIEWS

The traditional way to extract data from a portfolio of contracts or agreements is to pay a legal services firm to review them. They take the contracts and arrange for rooms of trained reviewers to go through each one, recording the needed data elements on spreadsheets.

The full manual review has many drawbacks, including the following:

  • The Cost of Labor: Trained reviewers often require legal backgrounds to fully understand contracts and these can be $75 per hour or Depending on the number of contracts processed, this could be in the $100,000s of dollars.
  • The Time for Review: With the deadline looming, there may not be sufficient time for a full manual review of all customer Manual reviews can take many months to years to complete depending on the numbers of contracts.
  • It is Subjective: A manual review means that the results differ by reviewer. Their training, experience, and perception all influence if they will see everything the same way – consistently.
  • The Extensive Nature of the Data: With IFRS 15, large amounts of detail associated with each customer is needed for appropriate action, including everything associated with consideration and Tracking that level of information significantly drives up the cost and time.
  • Can you “Future Proof” the Review? Obviously, there would be a set of predetermined data that would be sought within customer contracts. But, what if IFRS 15 changes, there are new stipulations, or there is the need for additional information from customer contracts? With a manual review, they must be started
THE SOLUTION: DISCOVERY AND ANALYTICS

Fortunately, for companies developing IFRS 15 compliance programs, there is an alternative to manual reviews for the critical steps of finding all their customer agreements and extracting the needed data to meet compliance.

There is a class of software called Contract Discovery and Analytics which automates the discovery and review of contractual documents wherever they may be on the network. It is faster, less costly, and can extract various data elements to ensure organizations can identify customer contracts vs other types of agreements, and then get a very clear picture of the consideration (e.g. payment types, terms, schedules, conditions, adjustments, etc.) and product or service obligation data buried inside each document.

Seal is a robust system that starts with a combination of natural language processing and machine learning technologies, and then is highly trained and tuned to fully understand contract documents and the provisions they hold.

For IFRS 15, Seal can perform the following functions:

  • Seal will find all documents from across the It can look in file shares, shared drives, and document repositories for all document file types.
  • It converts non-searchable document types, such as TIFF images and image PDF formats to a searchable format using its Optical Character Recognition (OCR) engine
  • Now that the documents are in a “readable” format, Seal will review each one and identify if it is a customer contract or If it is, it will copy the document into a secure repository.
  • Seal will then do term extraction. This entails finding and extracting key terms, conditions and provisions from the agreement, enhancing the data, indexing the data and presenting it to users in an intuitive interface. Seal finds numerous contract terms out-of-the-box, including the payment information needed for
  • Seal allows business users to create customized search queries or policies that can be used to extract data from the contracts within the portfolio specific to the organization. This is where reviewers can go deep into customer contracts, and tease out all needed information for IFRS 15 compliance, taking into consideration their organization’s nuances, language, terms, products, services, warranties,

Seal also includes a robust reporting and data visualization tool, so stats and metrics from across the entire set of customer contracts can be shared and used to make business decisions on approaches to IFRS 15 compliance.

Finally, Seal can perform an extraction and load function if desired. This includes taking the data from customer contracts and facilitating the loading of that data into Customer Resource Management systems such as Salesforce, or into AR (ERP), custom applications, or legacy systems.

SEAL WITH PARTNERS

This paper began with the three steps to a IFRS 15 compliance initiative, and for convenience, those items were:

  1. Data capture and analytics
  2. Assessing the impact
  3. Managing the compliance initiative

This means to be truly compliant, it takes planning and analysis to work efficiently through the five steps, and minimize the disruption to the organization.

Contract Discovery and Analytics is an effective way to kick off the five steps, but what about knowing the impact of compliance on the business? This includes the effect on financial reports and key ratios, and their impact on public disclosures and the perception of stakeholders on the state of the company.

Seal has chosen a set of tier 1 consulting partners that fully understand both the new mandate but also the application of Seal technology. Using the data coming from Seal, they can run financial models to help organizations understand the impact on financial reporting, well before the dates for compliance and public disclosures. They can help organizations make decisions on possible restructuring or novation of contracts, and managing customer relationships to create the optimal outcome of both compliance and public disclosures.

These partners can also work directly with organizations to guide them through the steps to IFRS 15 compliance, helping them meet the deadline, but doing it faster, at a lower cost, and minimizing the disruption and distraction to the business of making the change. This takes a significant burden from organizations trying to go it alone.

Seal’s services partners are well equipped to “wrap” Seal with several offerings, including:

  • Overall program design
  • Pre-developed IFRS 15 specific contract policy playbooks
  • Contract review and triage
  • Impact analysis and reporting
  • Remediation advice and consultancy
  • Wider IFRS 15 understanding and integration work

These partners can also be used to ensure key reporting requirements are met, and can work with customers in the capacity that makes the most sense for their business. 

CONCLUSION

The impact of the new revenue recognition guidance is extensive, and all industries will be affected when the deadline hits for companies during the first interim period within annual reporting periods beginning on or after 1 January 2017. Organizations will see pervasive changes as the new model replaces all existing US GAAP and IFRS revenue recognition guidance, including industry- specific guidance.

The broad reach and impact of IFRS 15 means organizations must quickly evaluate how the model will affect current business activities, including contract negotiations, key metrics (including debt covenants and compensation arrangements), budgeting, controls and processes, information technology requirements, and accounting.

The first steps of the five step plan mean that entities must find all of their customer contracts, and their addenda, exhibits, and changes, and then extract all data needed to map the consideration aspects of all customer relationships to performance obligations. This is a huge job, and if not approached with technology in the form of contract discovery and analytics software, could take many months at high costs, depending on the number of contracts and nature of transactions.

Manual contract reviews will likely not be sufficient with the short timeframe, especially when organizations will also require the time to analyze the data and run financial models to determine the impact on the financial state and disclosures of the company before they are provided to stakeholders.

Seal and its partners are the right choice for IFRS 15. Together, we can automate the laborious and costly tasks of IFRS 15 compliance, and ensure our customers’ compliance initiatives achieve the expected and optimal outcomes.

To Learn More, visit: seal-software.com/solutions/