The IASB and FASB are developing a new model for recognizing revenue. Dennis Deutmeyer outlines its potential impact on accounting for energy sales contracts.
Revenue recognition: the proposed changes
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (the Boards) released an updated exposure draft (ED) in November 2011. This proposes a new revenue model that could change the way power and utilities companies recognize revenue – both in terms of timing and amount.
The ED applies to all entities entering into contracts to supply goods and services – which of course includes energy sales contracts. It 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
Many transactions in the power and utilities sector won't be greatly affected by the changes. Challenges may arise, though, when accounting for contract modifications, identifying performance obligations and determining standalone selling prices. Companies will need to understand the changes and make sure they can address them.
When is a modified contract a new contract?
Under the Boards' model, accounting for contract modifications may change significantly.
Under the new standard, a contract extension may be considered a separate contract. This would mean, for example, that a seller with a 10 year fixed price contract who extends it for a further five years at an updated price may have to consider those five additional years as a separate contract. Currently, revenue would generally be recognized ratably over the combined existing and extended terms of the contract.
Companies must consider each contract modification carefully to decide whether changes constitute a separate contract or are part of the existing one.
How do you identify performance obligations?
Under the proposed model, entities must 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.
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Companies will need to exercise careful judgment here (e.g., is the performance obligation an individual MWh of energy; the energy delivered during a day, a month, a year; or the term of the contract). Making the right decision is crucial as it will decide how much revenue is recognized, and when.
Will the standalone price change timing of revenue recognition?
How standalone selling prices are determined under the new ED may affect the timing of revenue recognition. It states that the amount of revenue to be recognized would be determined by allocating 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.
Complexities arise when determining the standalone price in a multi-year fixed price contract. The current ED is not clear on how to determine the standalone price of performance obligations for energy sales contracts, depending on whether the spot price or the forecasted future price is used. The method used will determine the timing and amount of revenue recognized.
Act now and be ready
The proposed revenue recognition model may change the amount and timing of revenue reported by an entity in its financial statements. The best preparation is to act early to understand the changes' potential impact, and take advice on areas that are unclear.
Key areas of focus:
- Contract modifications
- Identifying performance obligations
- Determining standalone price
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