Accounting Rule Upends Contract Management

A new global accounting rule that changes the way revenue is recognized and disclosed on financial statements is going to give fund management firms, financial technology shops and data providers a lot more stress. Contract management, financial reporting, IT, legal counsel and even human resource directors will have to work together more closely than ever before.

Beginning in January 2018, public companies supplying goods and services will have to follow new International Financial Reporting Standard 15 (IFRS 15) which sets up a standardized five-step process for how to revenues should be booked and documented. Private firms can wait until the following year.

IFRS 15, which represents the culmination of more than a decade of work between US and international accounting standards setters, will create a harmonized framework. It eliminates distinctions between countries and even industries on how revenues are recognized.

However, the benefits come with a hefty compliance costs related to changes in policies, procedures, and systems. A 2016 study of 700 companies conducted by PwC showed that 20 percent estimated they would need to spend at least US$500,000. Another 22 percent weren’t even sure of how to measure the costs. Even worse, only 13 percent said they had started preparing while 65 percent were at the assessment phase. Twenty-two percent hadn’t begun their preparations. Those figures aren’t encouraging considering that firms will have to eliminate their siloed approach to managing customer contracts and potentially revamp or scrap their contract management platforms.

“Financial reporting specialists already have a good understanding of the terms of each contract, but commercial contract specialists will need to have a far deeper knowledge of accounting rules,” explains Tammy Straus, an audit partner with the accounting firm of Grassi & Co. in New York. “Legal counsel will step in to help draft the expanded disclosures required for regulators and investors on how the firm will handle the new revenue recognition rule.”

Likewise, says Nicholas Chandler, a partner with KPMG in London, the biggest challenge to complying with IFRS 15 is finding sufficient internal resources to process the new rule. It happens to be one of several other related accounting changes. “Commercial managers must be integrated into the implementation team. The correct accounting treatment is contingent upon accountants understand how contract work in practice,”  he says.

As is the case with any new rule or regulation, C-level buy-in is critical for the right budget to be implemented. Advisors and auditors must also be involved. “Your auditors will need to validate your core judgments at an early stage. No one wants to spend millions of dollars transforming systems only to discover than the auditors don’t agree with the accounting treatment,” says Chandler.

The new rule does not apply to financial contracts such as swaps, insurance contracts and leasing deals. Fund management firms are affected because they are offering “a management service” to their underlying fund clients. Financial technology firms and data providers, including exchanges, are also offering goods and services such as licensed applications, terminals, and data feeds. Companies will have to choose one of two approaches to complying with IFRS 15. They must either retroactively treat all contracts as if IFRS were in place earlier and have their 2017 financial statements– income and balance sheet — reflect IFRS 15. Alternatively, the modified retrospective approach would allow them to adjust retained earnings as of January 1, 2018 for any difference in the amount of revenue that would have been reported under the old rules versus IFRS 15.

At the very least, say accounting specialists, firms can’t simply recognize revenues when the money paid by customers shows up in their bank accounts or when they have delivered their service or goods. Impacted firms will have to prove they followed a rigorous five-step process which culminates with revenue recognition or booking the revenue on the financial statements. Mistakes can easily take place along the way.

What’s Involved

Identifying the contracts affected is just the beginning. Firms must also be able to extract the important terms of the contract that relate to complying with IFRS. “They can’t rely on a army of executives to read each contract, hope they understand it and write down the relevant points,” says Jamie Wodetski, chief product officer for Exari, a Boston-based contract-management software provider. A large firm could easily have several hundred contracts to analyze and legacy contract-management systems often only with ensure the contracts are drafted and signed.

Then comes figuring out the specific performance obligation — i.e., the distinct good or service promised to a customer in the contract. “Making the identification of the performance obligation so difficult is that it could have varying timeframes, complex financial terms, multiple interconnected performance obligations and variable considerations,” says Ajay Agrawal, chief executive officer of SirionLabs, a Dublin, California-based firm which offers software-as-a-service for contract management.

IFRS 15 requires allocation of the transaction price to each performance obligation. If the supplier of the goods and service has “bundled” the price of separate deliverable obligations into a single pricetag it would have to break out each deliverable separately. The transaction price must take into account discounts, rebates, refunds, credits, penalties, and bonuses.

“The guidance from the IASB on IFRS 15 does include criteria and a list of indicators to help companies determine when goods and services are distinct and should be accounted for separately or whether they should be combined into a single obligation,” says Agrawal. “Companies may end up having either fewer or more performance obligations than they did in the past.”

Case in point: a financial technology firm may end up having four obligations when it comes to a licensing contract. Those are the licensing contract itself, the installation service, the software update and the tech support contract. Why? The promise to deliver each good and service to the customer is identified separate from the other. The installation service does not significantly modify or customize the software itself and as such are considered to be multiple separate outputs. They are not multiple inputs used to produce a single combined output. Or so says the IASB.

Last but not least, comes revenue recognition. IFRS says that revenues can only be recognized when the obligation is completed. That means the promised good or service has been delivered or transferred to the customer. That could be either one time or on several occasions over the course of the contract. Hopefully, the contract management system will have generated the correct invoice for the correct service and can keep track that the customer received the good or service.

What to Do

Given the complexity of complying with IFRS 15, what’s a “supplier” of goods and services to do? For starters, recommends Exari’s Wodetzki, the firm must determine which customer contracts, performance metrics and compensation plans are affected. “Consider how existing contracts and employee bonuses might be changed under the new accounting standard,” he says. “The company may have to rethink its business strategies such as how it prices products or structures compensation plans.” Therefore, sales and human resource executives may ultimately be called upon to work with contract and financial reporting experts.

Fund managers, in particular, will have a hard time recognizing performance fees, which are contingent upon exceeding an agreed-upon investment return, according to Straus. The reason: fund managers often book performance fees as revenue each quarter. Under current US accounting rules, if there is a market downturn and the fund manager doesn’t achieve the promised investment return, it will reverse that revenue in the subsequent quarter.

By contrast, the new IFRS 15 requires fund managers to forecast whether they can achieve the promised return on investment over the entire term of the contract. “Fund managers can only book the full amount of the performance fee if they believe it is highly likely a market change will not cause the performance fee to be reversed,” says Straus. “If the market is highly volatile or there is a long period before the performance fee ends, fund managers will have to reduce the revenues recorded from performance fees to reflect the uncertainty.”

Legal counsel will eventually also have to step up to the plate. Complying with the new rule’s disclosure requirements will spell changes to financial and investor statements to include far more language to explain how revenues will be recognized. Under current rules, disclosure is limited to a brief explanation of how revenue is recognized. The new IFRS will require firms to disclose the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. Firms will also have to describe their performance obligations, when they typically satisfy them and how they allocate a transaction price to a performance obligation. Last but not least, firms must explain the judgments or any change to the judgments made in applying IFRS to their customer contracts.

Where do technologists fit into the equation? The answer to that question is in evaluating the firm’s contract management system and making the necessary changes. Can it interpret the terms of a contract with enough granularity to understand whether IFRS 15 is applicable and find the relevant data? Current contract management systems probably don’t have functionality, says Wodetzki.

Next question: can the contract-management system come up with the transaction price allocated to each performance obligation? Likewise, it’s questionable right now.  “An intelligent and dynamic computational logic is required that can sense when the applicable discounts should kick in, when the price needs to be adjusted for volume discounts and when performance based adjustments to revenues need to be made,” says Agrawal. “The technology set-up most firms have does not support this. It does not manage individual obligations because payment systems are not integrated to contract data or performance data.”

Exari and SirionLab executives say their platforms help firms handle the five steps required under IFRS 15 by extracting the information into contracts into usable data. That data includes performance and payment obligations as well as transaction prices.

Straus predicts that, for most firms, the new IFRS 15 ultimately won’t change much about how revenues are recognized over an extended period of time. However, there could be fluctuations in the short term. Case in point: instead of deferring variable fees until they are received, firms will have to take them into account in the transaction price. In some cases, that means booking those fees as revenues earlier than is currently the case. Variable fees include price concessions, rebates, performance bonuses and contingent fees.

Because identifying performance obligations and recording variable fees does requires some subjectivity, companies are left wide open to second-guessing by regulatory bodies. Fortunately, they won’t face any regulatory fines, but they may have to rework their financials. In the case of public firms, earnings adjustments can result in a plunge in stock price. In the case of a privately-held firm, investors could decide to pull out. The bottom line; a new accounting rule has created a brand new business risk.