Member Login
Letter to the International Accounting Standards Board (IASB) on Preliminary Views on Revenue Recognition in Contracts with Customers
Dear Sir David and Bob,
We are writing on behalf of the International Corporate Governance Network (ICGN). The ICGN isa global membership organisation of institutional and private investors, corporations and advisors from 45countries. Our investor members are responsible for global assets of U.S. $9 trillion. The mission of theICGN is to meaningfully contribute to the continuous improvement of corporate governance best practicesthrough the exchange of ideas and information across borders. Information about the ICGN, its members,and its activities is available on our website: www.icgn.org.
The purpose of the Accounting and Auditing Practices Committee is to address and comment onaccounting and auditing practices from an international investor and shareowner perspective. TheCommittee through collective comment and engagement strives to ensure the quality and integrity offinancial reporting around the world. http://www.icgn.org/advocacy/accounting-and-auditing-practices-committee/
The ICGN is pleased to provide comment to the IASB and the FASB on its joint project on revenuerecognition to clarify the principles for recognizing revenue, specifically in contracts with customers. Withperhaps overly extensive and prescriptive guidance on revenue recognition in U.S. generally acceptedaccounting principles (GAAP) and limited and somewhat fragmented guidance provided in InternationalFinancial Reporting Standards (IFRSs); the ICGN agrees that a discussion paper to obtain preliminary viewsand comments is timely and important with the current financial turmoil. ICGN represents investors andcapital providers utilizing an entity’s revenue to analyze and determine an entity’s financial position and itsfinancial performance as a basis for making economic decisions. We believe this joint project is critical andvaluable to users (investors, capital providers, preparers, auditors, and regulators) of financial statements.
With this context in mind, we provide you the following comments:
Chapter 2: A Contract-Based Revenue Recognition Principle
Question 1
Do you agree with the boards’ proposal to base a single revenue recognition principle on changes in anentity’s contract asset or contract liability? Why or why not? If not, how would you address theinconsistency in existing standards that arises from having different revenue recognition principles?
The ICGN believes that revenue recognition is a very important issue for users of financialstatements. Empirical research has clearly indicated that attempts to deceive users most often involvemanaging revenue recognition. Although we applaud the Boards’ ambition to base revenue recognition on aunified set of principles, we do not think that this is the ultimate solution. The inconsistencies that exist incurrent standards may be further resolved by adding more pragmatic means.
The apparent conflicts between IAS 11 (Construction Contracts) and IAS 18 (Revenue) do notpresent a serious problem for users although currently the rules governing the use of the percentage ofcompletion method do not always seem logical. It is also important to realize that revenue recognition is acritical issue in transactions based accounting. Although regulation should be based on principles, in thisparticular area it may be realistic to expect that a fair amount of (industry specific) guidance combined withprofessional judgment may always be necessary.
The ICGN has no particular objections to the contract assets/contract liability perspective. However,we view this perspective as a clever contrivance designed to connect revenue recognition to the conceptualframework. The key issues related to the timing of revenue recognition are not solved by this mechanism.We do not share the belief that focusing on changes in assets and liabilities could or should “bring disciplineto the earnings process approach” (see discussion paper 1.19).
Question 2
Are there any types of contracts for which the boards’ proposed principle would not provide decision-usefulinformation? Please provide examples and explain why. What alternative principle do you think is moreuseful in those examples?
Question 3
Do you agree with the boards’ definition of a contract? Why or why not?Please provide examples of jurisdictions or circumstances in which it would bedifficult to apply that definition.
We have no response to questions 2 and 3
Chapter 3: Performance Obligations
Question 4
Do you think the boards’ proposed definition of a performance obligations would help entities to identifyconsistently the deliverables in (or components of) a contract? Why or why not? If not, please provideexamples of circumstances in which applying the proposed definition would inappropriately identify or omitdeliverables in (or components of) the contract.
Question 5
Do you agree that an entity should separate the performance obligations in a contract on the basis of whenthe entity transfers the promised assets to the customer? Why or why not? If not, what principle would youspecify for separating performance obligations?
Question 6
Do you think that an entity’s obligation to accept a returned good and refund the customer’s consideration isa performance obligation? Why or why not?
We do not think that a right of return is a performance obligation. In a sale with right of return the“buyer” may have very little intention of actually acquiring the good in question. It may actually be a trialperiod based on a Memorandum of Understanding. The probability of an actual transaction may be quitelow. The ICGN believes the current regulations regarding rights of return should not be relaxed. For asingle transaction, revenue should not be recognized unless the customer has accepted the good inquestion. In case of a large number of similar transactions the revenue may be recognized provided returnsmay be reliably estimated based on available data.
Question 7
Do you think that sales incentives (e.g. discounts on future sales, customer loyalty points and ‘free’ goodsand services) give rise to performance obligations if they are provided in a contract with a customer? Why orwhy not?
We do believe that sales incentives give rise to performance obligations. Clearly, the seller has giventhe buyer rights to future goods or services. How to measure this obligation seems to be the difficultquestion. However, in principle such a promise has a fair value.
Chapter 4: Satisfaction of Performance Obligations
Question 8
Do you agree that an entity transfers an asset to a customer (and satisfies a performance obligation) when thecustomer controls the promised good or when the customer receives the promised service? Why or why not?If not, please suggest an alternative for determining when a promised good or serviceis transferred.
The ICGN believes that the focus on delivery and control here is too narrow. Existing standards takethe distribution of risk and return into account as well. We believe the substance of an economic good isrelated to risk and return. In practice it may sometimes be difficult to describe the distribution of risk andreturn. However, in most cases the parties involved should have a pretty good idea of the risks and returnsthat have been retained or transferred. The control concept, on the other hand, is very much a matter ofform. Moreover in practice it seems no less challenging to determine who has control.
The ICGN believes both risk and return and control should be taken into account. In most casesthese characteristics will reside with the same party. If not, perverse incentives are likely to exist. Suchcases should be handled with due care by preparers and auditors alike; the presumptions should be thatthere are hidden arrangements which should be uncovered and taken into account. We believe that no salehas occurred unless most risks and returns have been transferred to the buyer. Delivery and legal transfer oftitle is not sufficient if risks and rewards are retained. Conversely, legal control is less important when riskand return have been transferred.
Consider the following example: A shipping company sells a ship to a customer with very littlecapital. It is agreed that the price will be paid in installments over a number of years and it is obvious thatthe seller will only receive payment if the market allows the buyer to generate sufficient cash flow. In thiscase the buyer clearly controls the asset, but all of the downside risk is retained by the seller. Thus according to the traditional risk and return criterion, revenue is not realized or realizable and may not berecognized. On the other hand, the proposed control criterion would allow revenue to be recognized. Webelieve the traditional solution (requiring transfer of risk and return) is the correct one, and in cases such asthis payment is necessary as an indicator of risk transfer. The claim by the seller is not a financial asset, butan operational one.
Question 9
The boards propose that an entity should recognise revenue only when a performance obligation is satisfied.Are there contracts for which that proposal would not provide decision-useful information? If so, pleaseprovide examples.
The Boards propose limitations on the use of the percentage of completion method for revenuerecognition. This method may no longer be used for long term production contracts and provision ofservices unless ownership and control are continuously transferred to the customer. We tend to disagreewith this position for several reasons. First of all, we think that instead of the percentage of completionmethod, it would be an improvement to distinct objectively identifiable stages in the process of completionof a contract for revenue recognition purposes. Secondly, it is far from clear that the criterion proposed bythe Boards is operational; we fear that it may lead to extensive legal hair-splitting. Thirdly, whether controlis transferred appears to have very little to do with risk and return in these cases. Thus the proposeddistinction between the two kinds of long term contracts may have little substance. Fourthly, thepercentage of completion method is familiar to users and may provide relevant information aboutcompanies earnings power. The Boards do not provide any substantive reason for limiting its use. Finally,we believe that when prices are fixed and costs are reasonably predictable, it makes sense to say thatperformance is tied to production whether or not this has a legal basis. The performance obligation isextinguished gradually, and it follows that revenue may be recognized continuously. Shareowners andother users of financial reports have sometimes questioned the reliability of revenues and profits derivedfrom incomplete contracts. The ICGN believes the Boards should consider ways of improving thereliability of the percentage of completion method for example by requiring added dislosures.
Chapter 5: Measurement of Performance Obligations
Question 10
In the boards’ proposed model, performance obligations are measured initially at the original transactionprice. Subsequently, the measurement of a performance obligation is updated only if it is deemed onerous.
(a) Do you agree that performance obligations should be measured initially at the transaction price? Why orwhy not?
(b) Do you agree that a performance obligation should be deemed onerous and remeasured to the entity’sexpected cost of satisfying the performance obligation if that cost exceeds the carrying amount of theperformance obligation? Why or why not?
(c) Do you think that there are some performance obligations for which the proposed measurement approachwould not provide decision-useful information at each financial statement date? Why or why not? If so, whatcharacteristic of the obligations makes that approach unsuitable?Please provide examples.
(d) Do you think that some performance obligations in a revenue recognition standard should be subject toanother measurement approach? Why or why not? If so, please provide examples and describe themeasurement approach you would use.
The ICGN agrees that performance obligations should be measured initially at the transactions price.We also agree that a performance obligation should be deemed onerous and remeasured to the entity’sexpected cost if that cost exceeds the carrying amount of the performance obligation. This approachprovides investors with relevant and reliable information that is well understood.
We also believe that very few contracts for sale of goods or rendering of services should be excludedfrom the scope of the standard. In particular, any contract for delivery of non-financial items in accordancewith the entity’s expected sale of the items should be included. However, we believe the current projectson the insurance industry should be completed as planned.
Question 11
The boards propose that an entity should allocate the transaction price at contract inception to theperformance obligations. Therefore, any amounts that an entity charges customers to recover any costs ofobtaining the contract (e.g. selling costs) are included in the initial measurement of the performanceobligations. The boards propose that an entity should recognise those costs as expenses, unless they qualifyfor recognition as an asset in accordance with other standards.
(a) Do you agree that any amounts an entity charges a customer to recover the costs of obtaining the contractshould be included in the initial measurement of an entity’s performance obligations? Why or why not?
(b) In what cases would recognising contract origination costs as expenses as they are incurred not providedecision-useful information about an entity’s financial position and financial performance? Please provideexamples and explain why.
We do agree that any costs not directly attributable to a contract, such as marketing costs, should berecognized as expenses even though the price charged from customers would cover these costs. On the otherhand such marketing costs should be distinguished from similar costs that are directly attributable to thecustomer relationship. The costs of establising a mobile phone account for example are significant. The feescharged to cover these costs should be recognized as revenue up front. This could be justified by defining thesetting up of the account as a separate performance obligation. In other cases such costs should becapitalized and deferred. This would include commissions. As a valid contract exists there should be noobjections to capitalizing such costs. Whether the contract is bought from a dealer or commissions are paidto an agents should make no difference.
Question 12
Do you agree that the transaction price should be allocated to the performance obligations on the basis of theentity’s stand-alone selling prices of the goods or services underlying those performance obligations? Whyor why not? If not, on what basis would you allocate the transaction price?
Question 13
Do you agree that if an entity does not sell a good or service separately, it should estimate the stand-aloneselling price of that good or service for purposes of allocating the transaction price? Why or why not? When,if ever, should the use of estimates be constrained?
The ICGN supports the allocation of transactions prices on the basis of stand-alone selling prices. Ifsuch stand-alone selling prices are not available in the market, estimates must be made. Although allocationsschemes may offer opportunities for earnings management, there does not appear to be any realistic alternatives. In many jurisdictions standard warranties are extensive, and hence there is no market. Still webelieve it should be possible to estimate fair values.
The ICGN thanks both Boards for its diligence on this discussion paper, as revenue recognition is anarea of accounting which is difficult to record accurately. A recent paper written by Glass Lewis &Company, ‘Revenue Recognition for Collaborative Arrangements in the Biotechnology Industry’ 1 reflectsthe need for this project since revenue recognition errors are a leading cause of restatements year after year.
Thank you for the opportunity to provide our comments. If you would like to discuss any of thesepoints, please do not hesitate to contact Kerrie Waring, our Chief Operating Officer, at +44 207 612 7079 or kerrie.waring@icgn.org. Thank you for your attention and we look forward to your response on the pointsabove.
Yours sincerely,
Frederic Gielen
Co-Chair, ICGN Accounting and
Auditing Practices Committee
Lou Moret
Co-Chair, ICGN Accounting and
Auditing Practices Committee