Wayne Basford explains three significant upcoming changes to Australian financial reporting standards and outlines the questions directors should be asking.
Directors may be forgiven for thinking that accounting is staid and stable, however all Australian directors need to be aware of the “triple whammy” about to hit Australian financial reporting. This “triple whammy” involves the introduction of three new accounting standards (AASB 9, 15 and 16) which fundamentally change the accounting for revenue, leases and financial instruments.
These new standards are the most significant changes to accounting this century and represent a fundamental challenge to Australian companies in being able to prepare financial reports on time and in accordance with accounting standards. They will change the pattern of revenue recognition, bring most leases onto the balance sheet and will improve an entity’s earnings before interest, tax, depreciation and amortisation (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 properly and resourced adequately, 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 some chief financial officers seeking alternate employment. Disputes could also arise as to whether bonuses based on revenue or EBITDA targets have been met, regarding earn out payments based on EBITDA and the breach of banking covenants to name but a few.
The relative impact of each of the new standards varies depending on the industry sector.
AASB 9, effective from 1 January 2018, will have the most impact on entities whose business is lending (i.e. banks, credit unions and leasing companies). Models and processes need to be developed to determine loan loss provisions using a complex predictive loss model. This will result in losses on loan defaults being recognised far earlier than they are under the current standard. Those entities not involved in lending, however, do not escape the impacts of the new AASB 9.
AASB 9 also introduces far simpler rules for an entity to be able to qualify for hedge accounting. Under this new standard, it is easier to defer the recognition of gains and losses in respect of derivatives 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 hedging in the listed sector being far less prevalent than in the private sector. This is largely due to listed companies not wanting to be subject to income statement volatility. 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.
Revenue from customers
AASB 15, effective from 1 January 2018, is likely to have the most wide-reaching impact in the telecommunications, software, technology and construction sectors – though it is likely to impact all sectors in one form or another.
“Free” goods and services
AASB 15 will require entities to unbundle all distinct goods and services they provide to a customer. Goods and services that may require identification include items that have in the past been treated as marketing costs, for example “free” vouchers, help desk, extended warranty, training, hosting and updates. These items will now represent a separate element of revenue, with such revenue only being recognised when the free voucher/help desk/update is used or provided.
Companies will need processes in place to identify these bundled arrangements and systems in place to allocate consideration to these separate items and accordingly recognise revenue over the period the service is delivered. This requirement will likely impact the timing of revenue recognition.
Combining goods and services
In circumstances where a contract combines goods and services, the new standard requires revenue to be recognised as the services are provided. This principle is likely to have most impact in the software sector, where contracts include software licences, hosting services, integration services and updates. If the software will not function without these additional services, the revenue will be recognised not when the software licence is supplied to the customer, but instead over the period in which the service is provided. This could significantly defer revenue and will require changes to systems.
The third major impact area of AASB 15 is its strict rules on variable consideration. Revenue can only be recognised if it is highly probable that it 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.
This will likely result in a more conservative approach to recognising revenue. The greatest impact will be noticed in start-up companies or companies without a track record of delivering on projects.
Questions directors should ask:
- 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 payments, employee share and option plans?
- 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?
- What additional processes do we need?
- What systems need to be changed?
AASB 16, effective from 1 January 2019, 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.
Key points of note for directors:
- Identifying a lease is not as simple as looking for contracts called “leases”. A lease arrangement may be hidden in service or shipping contracts, among others.
- In most cases, a lease arrangement will now result in an asset and a corresponding lease liability being recognised on a company’s balance sheet. This will subsequently impact gearing ratios, return on investment calculations and has the potential to impact banking covenants.
- One positive aspect is that the new lease standard will automatically improve an entity’s reported EBITDA.
Questions directors should ask:
- What leases do we have?
- How will we identify all lease arrangements?
- By how much will the EBITDA improve?
- Will it impact bonuses based on EBITDA?
- What will it do to our gearing/borrowing levels?
- What leases will be brought on balance sheet?
A key decision directors need to make is which transition route they will adopt and the method their competitors are likely to follow.
Options exist on whether to apply the new standards fully retrospective, or partially retrospective. Determining this will require detailed management analysis of the merits of each method, including the impact of market reaction to these changes.
Key questions directors should ask management:
- Are we prepared for the new standards?
- Do we have sufficient resources or access to resources to handle a project of this nature?
- 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?
- What contracts (e.g. bonus schemes) are impacted by these changes?
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