The impact of the coming rule changes under IFRS and us GAAP adds to the already complex environment for a foreign firm doing business in China.
Foreign firms doing business in China generally recognise revenues and track their results of operations under multiple types of accounting principle bases; PRC tax/GAAP basis (which is a statutory requirement for the annual Corporate Income Tax (CIT) filing), US GAAP or IFRS or other foreign GAAP (the reporting accounting principles used by the parent company or foreign entity operating in China) and other tax revenue recognition bases such as reporting under the VAT regime.
To add to the complexity of the above, on May 28, 2014, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) jointly developed and issued a comprehensive new revenue recognition standard that will supersede nearly all current revenue recognition rules under both IFRS and US GAAP. This standard is – Revenue From Contracts with Customers Topic 606 under US GAAP and IFRS 15 under IFRS standards.
The effect of these changes on entities operating both in China and abroad will vary, and some may find the new standard brings benefits to financial reporting as well as significant changes in the way the entities recognise revenue. The guidance was designed to align US GAAP and IFRS revenue recognition standards as well as “enhance the comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.” The new principles- based guidance provides a framework that can be applied to “all contracts with customers regardless of industry-specific or transaction-specific fact patterns.” Additionally, the disclosure requirements will also improve an entity’s financial statements description of its revenues.
The standard is effective for annual and interim periods beginning after 15 December 2016 for US listed (public) entities reporting under US GAAP and for annual periods beginning on or after 1 January 2017 under IFRS.
Early adoption is not permitted under US GAAP but is permitted under IFRS. Because the cumulative effective of the change will be required to be presented at the beginning of the adoption period under both US GAAP and IFRS standards, entities should immediately begin assessing how the affect on their current revenue recognition practices and prepare an implementation plan for the new standard.
Main differences from current U.S GAAP and IFRS
The previous guidance on revenue recognition in U.S. GAAP was initially limited to the general guidance specifying that an entity should recognise revenue only when realised or realisable and earned. Additional interpretive guidance on how to apply the realised or realisable and earned criteria was developed as well as other specific authoritative literature on revenue recognition which required an entity to satisfy specific criteria before recognising revenue. Additional industry and transaction specific guidance for recognising revenue were developed and as the guidance became more complex issues about recognising revenue resulted and sometimes similar transactions resulted in entities using different revenue recognition methods.
IFRS revenue recognition standards were not as fully developed and were based on fundamental principles different than those used in US GAAP. Because IFRS lacked specific guidance on certain complex topics, many times entities used or emulated US GAAP over those topics.
Previous disclosure requirements about revenue under both sets of standards have been considered insufficient for allowing financial statement users the ability to meaningfully analyse an entity’s revenue.
Other considerations – revenue recognition and reporting under the VAT regime and under PRC GAAP or tax basis
In additional to the external reporting requirements to their MNC or foreign located parents, foreign invested and/or listed entities in China must report revenues according to statutory requirements. For annual CIT filings, PRC GAAP or PRC tax basis must be used. Each entity is required by law to maintain a set of books on the PRC basis. There are various rules under this guidance relating to revenue recognition, such as for the sale of goods – certain conditions must be met simultaneously. Those conditions are in alignment with the IFRS guidance over revenue recognition.
Under the VAT regime, which is a turnover tax levied on income rather than profit, the timing at which the tax liability on the sales of goods or taxable services arises is specified according to different methods of settlement. For example, for sales of goods where a direct payment is made, it shall be the date on which the sales sum is received or the documented evidence of the right to collect the sales sum is obtained, and the bills of lading are delivered to purchasers, whether or not the goods are delivered. Other methods apply to other situations, such as when the sales amount is entrusted for collection or the sale of goods on credit or by instalment payments.
The New Revenue Standard – revenue from contracts with customers
The Standard applies to revenues or income from ordinary activities relating to a contractual arrangement with a customer. Leases, insurance, financial instruments and a limited number of other types of transactions are excluded from the scope.
According to the guidance “The core principles of the guidance is that an entity should recognise 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 in exchange for those goods or services.” In the guidance, there are five steps for an entity to undertake in the process of determine if it is appropriate to recognise revenue:
Step 1: Identify the contract(s), which represents an agreement creating enforceable rights and obligations with a customer:
- Contract has been approved and can be written, oral, implied
- Has commercial substance
- Entity can identify each parties rights and obligations regarding the goods/services
- Payment terms can be identified
- Collectability must be “probable”
- Contracts entered into at or near same time which are negotiated as a package, payment of one depends on the other and there is a single performance obligation should be combined
Step 2: Define and separate the performance obligations in the contract:
- Distinct good or service
- Series or stream of goods or services which are substantially the same and have same pattern of transfer to the customer
Step 3: Determine the transaction price:
- Amount of consideration entity expects to receive, excluding amounts collected on behalf of third parties
- May be fixed, variable or both
- The estimate of the transaction price will be affected by the nature, timing, and amount of consideration
Step 4: Allocate the transaction price to each specific performance obligation in the contract:
- Transaction price allocated on a relative standalone selling price basis for each performance obligation
- Best standalone selling price is an observable price of a good or service
- If selling price is highly variable or uncertain than ‘residual approach’ should be used
Step 5: Recognise revenue when each performance obligation is satisfied:
- Determine if performance obligation is satisfied at a point in time or over time
- If over time, then based on pattern of transfer to customer
- If not point in time, recognise revenue when control transfers
Other aspects of the new standard address certain specific concepts such as principal vs. agencies, warranties, sale with right of return, repurchase agreements, consignment arrangements and various other issues.
Qualitative and quantitative disclosures are required regarding the nature, amount, timing, and uncertainty, if any, of revenues and cash flows arising from contracts with customers. This information includes revenue from customers and any impairment recognised, disaggregation of revenue, and detailed information about contract balances and performance obligations. Another additional disclosure that is required involves what significant judgments and changes in judgments were made in determining the timing of completion of the performance obligations how management determined the appropriate transaction price and how amounts were allocated to performance obligations. Also, any assets recognised from the costs to obtain or fulfil a contract should be disclosed.
Consequences of the change and a plan to minimise risk
The new revenue standard requires retrospective application by one of two choices; ’full retrospective’ adoption in which the standard is applied retrospectively to all of the periods presented or a ‘modified retrospective’ adoption in which the standard is applied prospectively with the cumulative effect of applying the standard recognised at the first date of the initial application, with disclosure of the old GAAP relating to the initial application period for comparability.
The guidance allows some practical expedients when applying this standard retrospectively such as an entity not needing to restate contracts that begin and end within the same annual period and allowing the use of hindsight on variable consideration contracts.
The upcoming changes in revenue recognition under US GAAP and IFRS and likely changes many entities will make in response to the new standard are expected to impact not only financial reporting, but many other areas of an entity, such as business operations, system development and have potential tax implications as well. Entities are well advised to begin an analysis of how the standard will affect them. An implementation plan for the new standard is further recommended and that plan will vary from entity to entity, depending on the breadth and depth of impact expected.
As noted in Part I of this Two Part Series, on May 28, 2014, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) jointly developed and issued a new revenue recognition standard that will supersede most current revenue recognition rules under both IFRS and US GAAP. This standard is – Revenue From Contracts with Customers Topic 606 under US GAAP and IFRS 15 under IFRS standards.
The effect of these changes on entities operating both in China and abroad will vary, and some may find the new standard brings benefits to financial reporting as well as significant changes in the way the entities recognise revenue. As the upcoming changes in revenue recognition and the changes many entities will need to make to comply with the new standard are expected to impact many areas of an entity, including financial reporting, business operations, IT and controls systems development and have potential tax implications as well, companies are beginning their implementation plans, which begins with an analysis of how the standard will affect them. An implementation will vary from entity to entity, depending on the breadth and depth of impact expected.
In Part II of our two part series on the change in the revenue recognition standard, we will examine suggestions for how to transition to compliance with the new accounting standard.
Set up a project team and conduct an impact analysis
Assign a team leader or team the responsibility to evaluate how the changes to the new revenue recognition standard will impact on how your company accounts for existing revenue and the results of operations, including evaluating how the new guidance affects your systems, processes, and internal controls. Project scoping may include or necessitate involvement from personnel involved in operations, internal controls, information technology, finance and tax. The company should consider compensation plans, debt agreements, tax matters and other areas in addition to company revenue contracts and business models.
In addition to the above, companies need to analyse where any changes will need to be made to IT system, software applications or processes in order to implement the new revenue recognition standard, including the retrospective adoption of the guidance. A full project plan including implementation of the standard and training of staff will need to be developed to manage the process, including plans for educating stakeholders such as the board of directors and investors. The team will need to determine the nature, timing and extent of work involved over the implementation transition timeline.
It is well advised to communicate frequently with your external auditor to ensure that your scoping is complete, and your implementation approach and the changes in accounting for revenue recognition are appropriate, and documented completely and accurately.
Interim disclosures will need to be made including additional qualitative and quantitative disclosures over the impact of the retrospective adoption on the company’s financial statements, operations, how the company is doing the implementation and what, if any, significant changes to the internal control structure and reporting processes need to be made in order to implement the standard.
Implementation and education
Initiate a performance monitoring scheme to collect the information needed to measure progress of implementation against the plan which was set. Training, education and follow up of implementation changes relating to the new revenue recognition standard will be key activities to ensure the adoption of the standard is successful. The project team should report to management, the audit committee and the board of directors periodically on progress to plan, issues encountered and solutions provided. The key stakeholders will need to understand what changes have been made in the timing of revenue recognition, the systems and processes surrounding revenue recognition and other changes resulting from the implementation of the new standard. Management should ensure open communication and information flow with the project team, management, key stakeholders, internal auditors, and external auditors in order to ensure a successful transition to the new revenue recognition standard.
Acclime can assist your company in the project management of implementing the new revenue recognition standard, whether it is under US GAAP or IFRS. Our team members have professional expertise in US GAAP, IFRS and PRC GAAP Accounting, as well as extensive experience in project management and compliance implementation projects.