A year on from IFRS 9 and 15
A year on from IFRS 9 and 15
Construction industry is expected to be significantly impacted as the scope of services varies from contract to contract and there is a high amount of judgement required to establish the level of transfer of performance obligations.
Companies in Qatar will have completed their first year of financial reporting using the latest International Financial Reporting Standards (IFRS). IFRS 9 – Financial Instruments and IFRS 15 – Revenue from Contracts with Customers, both became effective on 1 January 2018 and have changed the way we must read a company’s financial statements from now on. Implementing these accounting standards required different levels of efforts for companies in different industries. The banking industry, for example, had to put significant amount of efforts in implementing IFRS 9 under Qatar Central Bank guidance, which played a pivotal role. Another example is construction companies, which have been implementing IFRS 15, will have had to make significant changes in how they recognise revenue from sales. First, let us look at the impact of IFRS 9 – Financial Instruments. This standard has three aspects Classification & Measurement (C&M), Expected Credit Loss (ECL) and hedge accounting, which is not discussed in this article as Companies in Qatar have opted to continue to follow IAS 39 rules.
CLASSIFICATION & MEASUREMENT
Companies invest in equity instruments, both listed and unlisted. In the past, and these investments were generally classified as “Available for Sale” investments using the former IAS 39 principal. However, this classification eventually led to volatility to the bottom line either through impairment charges or upon disposal. IFRS 9 offers a solution to volatility issues by introducing Fair Value through Other Comprehensive Income (FVOCI) classification for equity investment, as the related gain/loss on equity investments are not recycled to the income statement. Companies in Qatar have widely opted for FVOCI classification. The downside of FVOCI classification is that gain/loss on equity investments are not reflected in the bottom line, earnings per share and there is ambiguity on transfer to legal reserves/ sports fund. Readers of the financial statements are expected to be mindful of such adjustments for a better understanding of the distributable profits. IFRS 9 has removed cost exemption basis as available previously under IAS 39 and requires the use of fair valuation for investments measurement in the balance sheet. There are obvious benefits as stakeholders will be able to take timely investment decisions. Companies in Qatar that are impacted have introduced fair valuation process.
EXPECTED CREDIT LOSS
ECL uses a forward-looking approach that takes into consideration expected future economic events and their impact on debtors’ ability to pay. This technique requires robust projection process. Qatar Central Bank provides appropriate guidance to banks for a consistent approach across the banking industry. This technique presumes that all debt instruments have some credit risk and depending upon the quality of the debtors’ credit risk, that is staging and available security cover an appropriate ECL is recognised. As we know, interest includes an element of credit risk compensation; therefore, it is likely that the banks may pass on additional ECL to the borrower leading to increased finance cost for the borrower who may offer acceptable and appropriate amount of security to mitigate such scenario. Borrowers will also need to continue to monitor economic cycle in general and the related industry in particular for projected trend in finance costs. For non-banking industry, trade receivable including contract assets (unbilled revenue), due from related parties, retention receivable, bank balances etc. are some of the typical assets that require ECL calculation. Companies should consider segmenting them, that is Government, non-Government etc. to arrive at appropriate ECLs. This is more important for companies which have majority of transactions with Government or related entities where duration for processing of invoices is different from non-Government sector. Going forward companies will need to ensure timely collection of their receivable balances as it impacts ECL. IFRS 9 will lead to expected credit losses that will reflect the quality of the customer base, the expected economic trend and the level of security available to safeguard losses on actual default. This may also have indirect impact of increasing the cost of borrowing. IFRS 15, the Revenue from Contracts with Customers, introduces new 5-step model for revenue recognition. The underlying principal is that the company should recognise revenue to the extent control over related performance obligation has been transferred to the customer. The highlights for each of the step are:
IDENTIFY THE CONTRACT
Legal enforceability is the criteria for this step and therefore there is no specific requirement on the form of the contract, that is written, verbal or by action as long as enforceable under the law. Generally, companies in Qatar have appropriate process that ensures the compliance of this step. In the construction industry, where variation orders and claims are normal activity, the standard has specific guidance for such instances that requires variations to be approved. In case of claims, only when it is highly probable that revenue will not reverse in the future, revenue may be recognised. This requires an appropriate assessment including status of the claim, level at which discussions are ongoing, legal opinion etc.
IDENTIFY THE PERFORMANCE OBLIGATIONS
This applies to a contract where the seller is making more than one promise to the customer. Performance obligation is defined from the customer’s perspective and overall promise of the seller. At times, this could be highly judgmental and therefore companies may want to discuss and agree in advance with the auditors.
DETERMINE THE TRANSACTION PRICE
One need to consider transaction price that is not variable and there is no probability of reversal in future. Construction contracts with penalty clauses, retail contracts with right to return, loyalty programme etc. are some of the examples that should be considered at the beginning of the contract and regularly updated to reflect expected transaction price. This requires an appropriate analysis of historical data and projections until the variability scenario ends. There are two techniques available to estimate transaction price i.e. expected value and most likely value. Probability weighted analysis that is widely used for expected value technique by companies is one of the simplest method of calculating the variable amount. Step 4: Allocate the transaction price to the performance obligations in the contract This step applies if multiple performance obligations are identified in step 2. In this step, transaction price (as determined in step 3) is allocated to performance obligations. Stand-alone selling price is the most preferable method to allocate the transaction price however, this may not be available in all cases due to customer specific requirements, alternatives like adjusted market assessment, expected cost plus margin and residual approach (limited cases). In case stand-alone selling price is not available, companies have preferred to use expected cost plus margin approach as the information is readily available within the company and it is relatively easier to estimate. Whatever method is used, the underlying principal is that the revenue should reflect the reasonable commercial value of the related performance obligation.
The standard requires revenue recognition to align with transfer of control over performance obligation i.e. over time or point in time. Over time, approach is qualifying in nature and is applied if one of the three criteria given in the standard is met failing which point in time approach is used. This step has complexities for sale of residential apartments where delivery takes place upon completion. The assessment of whether control is passed during the construction phase is a typical legal question where companies need to rely heavily on the national judicial system and how the courts have concluded in case there is a dispute between the contractor and homebuyer. The standard although allows companies to follow cost-to-cost approach to measure revenue, which is similar to percentage of completion. However, there is guidance on uninstalled material, wastage and inefficiencies. Construction companies will need to consider these aspects, as it will lead to either lower revenue and / or lower profitability during the construction phase. A well-defined policy and procedure will help immensely in identifying such factors on a timely basis. IFRS 15 will have minimal impact to the Banking industry as most of its revenues streams are outside its scope. Construction industry is expected to be significantly impacted as the scope of services varies from contract to contract and there is a high amount of judgement required to establish the level of transfer of performance obligations.
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