Moves toward a new model of recognizing revenue may impact some common power and utilities arrangements.
In November 2011, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) (the Boards) issued an updated exposure draft of their converged revenue model. The proposal specifies accounting guidelines for all revenue arising from contracts with customers, so it will affect almost all entities.
The proposed model would be applied using five steps:
- Identify the contract(s) with a customer
- Identify the separate performance obligations in the contract(s)
- Determine the transaction price
- Allocate the transaction price to the separate performance obligations
- Recognize revenue when, or as, the entity satisfies each performance obligation
While the standard will have minimal impact on many transactions within the industry, challenges may arise on certain common transactions such as the accounting for contract modifications, identifying performance obligations and determining standalone selling prices.
Timing of revenue recognized from contract modifications may change
Under the Boards’ proposed model, accounting for contract modifications may change significantly from today’s practice. The following example demonstrates the potential impact.
Assume Seller has a ten year contract to supply 100,000 MWh of energy per year to Customer at a fixed price of CU55/MWh. After five years, both Seller and Customer agree to extend the contract for an additional five years at a revised fixed price of CU65/MWh for the remaining ten years of the modified contract. The updated pricing is determined by blending the original CU55/MWh price with the market price at the time of the modification (i.e., CU75/MWh).
Currently, Seller would recognize CU6,500,000 of revenue during each of the ten years of the extended contract. Under the proposed model, Seller would generally consider the five additional years to be a separate contract. Thus, Seller would then recognize CU5,500,000 of revenue during each of the first five years of the extended contract and CU7,500,000 of revenue during the last five years of the extended contact.
Identifying performance obligations will be important
The proposed model requires entities to identify separate performance obligations (i.e., deliverables) within a contract. This is important because performance obligations are used in several steps of the model — allocation of the transaction price, timing of revenue recognition and determining onerous contracts.
The proposed model’s assessment of what is a distinct performance obligation, and when these may be bundled together, could result in similar contracts being dealt with differently. For example, applying this step of the model to an energy contract may result in the identification of separate performance obligations based on either the unit of measure (e.g., the individual MWh) or a delivery period (e.g., the energy delivered during a day, a month, a year or the entire term of the contract). These different assessments of performance obligations may change the amount of revenue recognized within a period. A lack of consistency in identifying performance obligations would impact the comparability of financial information within the industry.
Standalone selling price may change timing of revenue recognized
The proposed model requires revenue to be recognized when the performance obligation is transferred to the customer. The amount of revenue recognized would be determined by allocating part of the total transaction price to each performance obligation, based on its respective standalone selling price. This is the price at which an entity sells a good or service on a standalone basis at contract inception.
The proposed model is unclear on how to determine the standalone selling price in a multi-year fixed price contract.
For example, assume Seller has a two year contract to supply 100,000 MWh of energy per year to Customer at a fixed price of CU65/MWh. As is usually the case, the CU65/MWh price is negotiated based on the unit prices reflected in the forward curve for the respective energy.
When determining the standalone selling price of the performance obligations (assumed to be the energy provided in each month during the contract term), Seller may apply the current spot rate to each month’s volume, resulting in revenue being recognized evenly throughout the contract.
Alternatively, if Seller determines that the standalone selling price of energy is best reflected by the prices included on the forward curve, this will usually result in increasing standalone selling prices over the contract. As the standalone selling prices determine the allocation of the transaction price to performance obligations, this would impact the revenue profile with less revenue being recognized in the earlier periods, and more in later periods of the contract.
We encourage companies to consider the impact these changes may have on their financial statements and discuss the implications with the Audit Committee, the Board and, if necessary, industry analysts.
For more information, contact:
Dennis J. Deutmeyer
Leader, Power & Utilities Sector
Global IFRS Services
+ 1 212 773 9199
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