Article:

Triple Whammy – Upcoming changes to AASB 9, 15 & 16

10 January 2017

Wayne Basford , Asia Pacific Leader, IFRS
Partner, Audit & Assurance
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Directors and management may be forgiven for thinking that accounting is a very staid and stable issue, however all Australian companies need to be aware of the " triple whammy " that is about to hit Australian financial reporting. This “triple whammy” involves the update of three accounting standards (AASB 9, 15 and 16) which will fundamentally change the accounting for financial instruments, revenue, and leases.

These three updates are the most significant changes to accounting in recent history and represents a significant challenge to Australian companies.

The Importance of Adequate Planning and Resourcing:

These new standards, will change the pattern of revenue recognition, will bring most leases onto the balance sheet and will improve an entity's EBITDA. This in turn will require significant changes to both processes and systems.

Think of it as the “Y2K” of accounting, and like Y2K, if it is planned for properly and adequate resources are allocated to the project, transition to the new rules will pass smoothly. On the other hand, a lack of planning could well see companies receiving qualified audit opinions, delays in lodging financial statements, loss of investor confidence, a fall in share price and potentially a number of CFO's seeking alternate employment!

This could also see disputes as to whether bonuses based on revenue or EBITDA targets have been met, disputes on any earn out payments based on EBITDA and the breach of banking covenants also, name but a few.

The relative impact of each of the new standards varies depending on the industry sector an entity operates in.

Impact of AASB 9 Financial Instruments

For organisations involved in lending:
AASB 9 Financial Instruments will have the greatest impact on entities whose primary business is lending (i.e. banks, credit unions, leasing companies etc.). New models and processes will have to be developed in order to determine loan loss provisions using a complex predictive loss model. This new model will result in losses on loan defaults being recognised far earlier than they are under the current standard. The new standard also requires far more disclosure about the credit deterioration of a lender’s loan book, even if loan losses are not expected to eventuate.

For organisations not primarily involved in lending:
Those entities not involved in lending, do not escape the impacts of the new management AASB 9.

Hedge Accounting:
AASB 9 introduces far simpler rules for an entity to be able to qualify for hedge accounting. Making it easier under this new standard for the recognition of gains and losses in respect of derivatives to be deferred until the transaction they were intended to hedge actually occurs.

Although accounting rules should never drive accounting practice, the application of the current restrictive rules on being able to apply hedge accounting, has seen the prevalence of hedging in the listed sector being far less than in the private sector. Largely due to listed companies not wanting to be subject to the income statement volatility resulting from the movement in the fair value of the derivative products if hedge accounting has not been achieved.

The introduction of AASB 9, should be a catalyst for all entities exposed to interest rate risk, FX risk and commodity risk to reconsider their risk management policies for these market risks, not only using simple swap productions, but also to investigate the use of options, swaptions, zero cost collars etc. This obviously corresponds to record low interest rates and greater volatility on the world markets in respect to currency and commodities.

Impact of AASB 15 Revenue from Customers

AASB 15 Revenue from Customers, is likely to have the most wide reaching impact particularly in the telecommunications, software, technology and construction sectors. Though it is likely to impact all sectors in one form or another.

Revenue recognition for ‘free’ goods and services:
AASB 15 will require entities to unbundle all distinct goods and services they provide to a customer. The identification of these goods and services is likely to include items that may have in the past been treated as marketing costs, for example free vouchers, free help desk, free extended warranty, free training, free hosting, free updates etc. Under AASB15 all of these items will now represent a separate element of revenue, with such revenue only being recognised when the free voucher is used or the free help desk service is provided.

Companies will need processes in place to identify these bundled goods and services and then have systems in place to allocate consideration to these separate items and accordingly recognise revenue over the period the service is delivered. This requirement will mean that the timing of revenue recognition will differ significantly between the customer being invoiced and paying for the goods and the corresponding revenue actually being recognised in respect of these free goods and services.

Combining goods and services provided to a customer if not distinct within the context of the promise to the customer:
The best way to illustrate this change is via an example:

A company agrees to construct a wall for a customer, but instead of raising a single invoice, it raises an invoice for the supply of bricks, which are delivered to the customer on 30th June and an invoice for bricklaying services that are subsequently performed in the first week of July. Under AASB 15 the company’s promise to the customer was to construct a wall, rather than to supply bricks, therefore revenue would be recognised as the wall is constructed.

This principle is likely to have most impact in the software sector where the supplier supplies a software licences and then provides hosting services, integration services, updates, etc. If the software will not function as promised to the customer without these additional services, the revenue will not be recognised when the software licence is supplied to the customer, but instead over the period in which the service is provided to the customer. This could in a number of cases significantly defer revenue compared with current practice and will require extensive changes to systems.

Variable Consideration:
The third major impact area of AAB 15 is its very strict rules on variable consideration, in particular the “reversal constraint”. The reversal constraint states that revenue can only be recognised if it is highly probable that the revenue will not reverse. This concept is of particular relevance to those entities that are subject to bonuses, awards, penalties and volume rebates or have a practice of issuing credit notes (price concessions to their customers).

The likely impact of this is a more conservative approach to recognising revenue, not only in respect of when to recognise revenue relating to bonuses but also in respect of the timing around the likelihood of an entity incurring penalties. This requirement will have the greatest impact on start-up companies or companies without a track record of delivering on projects. Start-up companies or those entering into new markets are most likely going to have to adopt a more conservative approach to recognising revenue, when compared to those companies with an established track record of delivering on that type of project.

Questions to consider in respect to AASB15 Revenue:

  • What is the impact? defer? accelerate? increase revenue? decrease revenue?
  • What is our plan for transition?
  • Will we "lose’ revenue?
  • Will we be double counting revenue?
  • How will it impact EBITDA?
  • Will it impact bonus payment, ESOPs?
  • Will it impact the dividend policy?
  • Will it impact banking covenants?
  • How will analysts react?
  • Do we need to change sales contracts? Sales and marketing methods?
  • Have we the resources available for adoption?
  • Who is in charge of the project?

Impact of AASB 16 Leases

AASB 16 Leases will have very wide ranging impacts for any entity entering into operating leases, whether that be leasing buildings, transport equipment, heavy plant or computer equipment.

The key take away for management is that in most cases a lease arrangement will now result in an asset (i.e. the right to use a piece of equipment) and a corresponding lease liability being recognised on a company’s balance sheet, this will subsequently impact gearing ratios, ROI calculations and has the potential to impact banking covenants.

The positive aspects of the introduction that Management need to be aware of is that the new lease standard effectively changes a rent expense into two elements, namely an amortisation charge on the right to use the asset and an interest charge on the lease liability, this change automatically improves an entity’s reported EBITDA.

Questions to be consider in respect to AASB 16 Leases:

  • How much will the EBITDA improve by?
  • Will it impact bonuses based on EBITDA?
  • What will it do to our gearing / borrowing levels?
  • What leases will be recorded on the balance sheet?
  • Which of our service contracts constitute a lease?
  • Should we adopt AASB 16 at the same time as AASB 9 & 15?

Impacts on other contracts and arrangements

It is very unlikely that an entity’s reported profit number will not be impacted by at least one of these three new standards, management therefore need to consider what changes to contracts need to take place where there is a defined reference to revenue, profit, EBIT or EBITDA. The type of contracts involved are likely to include:

  • bonus schemes
  • share option plans
  • deferred payment arrangements for either the sale or purchase of assets; and
  • banking covenants.

A key action element of an entity’s transition plan is to prepare an inventory count of potentially impacted agreements and then to undertake an exercise to ensure they are “IFRS proof”.

What transition route are you planning on adopting?

A key decision Management need to make is which transition route they are planning to adopt, including an understanding of the method their peers and competitors are likely to follow. This is in addition to ascertaining the impact on reported revenue and earnings post adoption of the new standard.

Full Retrospective Transition Method:
Preparers have the choice of adopting a full retrospective transition method where they will restate comparatives. In the case of a company with a 31 December year end, this would mean the first year of adoption would be the year ended 31 December 2018, however the results and balance sheet for the year ended 31 December 2017 would be restated, with the date of initial adoption being 1 January 2017. 

Partial Retrospective Approach:
As an alternative to the full retrospective method, preparers may adopt a partial retrospective approach, that involves not restating comparatives and instead having a “catch up” up through retained earnings at the date of initial adoption. In the case of a company with a December year end this would mean the first year of adoption would be the year ended 31 December 2018, but the results and balance sheet for the year ended 31 December 2017 would not be restated in the comparatives, with the date of initial adoption being 1 January 2018.

The Pro’s and Con’s:
At first glance it would appear to be a “no brainer” to elect for the partial retrospective method - ‘why do today, what can be put off until tomorrow’, however this decision does come with its draw backs. In this first instance it does not give users a true set of numbers to make comparisons and see trends, therefore it does require the company to effectively maintain two sets of books in 2018, so the entity can disclose its results under the old rules. The question as to which transition method to use also needs to take into account investor relations, namely, what will be the market reaction if competitors are adopting the full retrospective method or vice-versa? Further how will this impact analysts’ views of results?
In the case of revenue, it is likely that adoption of AASB 15 will see revenue being deferred compared with current practice, this is likely to mean that revenue will be reported twice (double counted) i.e. revenue will be recorded in 2017 under the current rules and then again in 2018 and beyond under the new rules.

Key questions Management should ask of their finance teams and auditors:

  • Are we on top of adoption?
  • Have we got sufficient resources/or access to resources to handle a project of this nature? (given that this is a once in a generation change it is unlikely that a well structured finance team will have sufficient resources to handle the transition required)
  • What is the timeline to be able to determine the impacts?
  • What processes and systems will need changing?
  • What resources are required to change processes and systems?
  • When will the project be finished?
  • Who will be in charge and accountable for this project?

This article has been carefully prepared, but has been written in general terms and should be seen as broad guidance only. The article cannot be relied upon to cover specific situations, and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact the BDO member firms in Australia to discuss these matters in the context of your particular circumstances. BDO (Australia) Limited and each BDO member firm in Australia,  their partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.