Ministry of Finance announced a new PRC revenue accounting principle in 2017 (“the new principle”) and informed that the new principle shall be taken effective from January 2021 for all Chinese non-listing companies which apply the accounting standards to prepare the financial statements. The reason for issuing new principle is that due to the emerging of new sales models and way of doing businesses, the current principle cannot satisfy the revenue reporting requirement from the readers of financial statement in learning the business.
Comparing with the current one, the new principle indeed changed a lot. Almost all industries would be more or less affected by the change of the revenue principle. In this article, we will analyze the main differences.
1) One model for revenue recognition
The new one stipulates one model for all revenue categories including sales of goods, service and construction contract, requiring that revenue is recognized at a point of time or over time.
Under the current one, however, two models are available. For sales of goods, revenue is recognized after the satisfaction of all 5 conditions. For service provision and construction contract, completion stage shall be the basis for recognizing revenue.
2) Conditions for recognizing revenue
The conditions which shall be satisfied to recognize revenue are different. The new principle requires that revenue is recognized after the control on goods or service is passed. Transfer of control means that the customer can control the utilization of the goods or service and obtain almost all related benefits.
To judge the realizing of the transfer of control, the new accounting principle lists certain indications meaning that control is passed:
1) The entity has the present right to collect the amount and the customer has the present right to make payment.
2) The entity has transferred the legal ownership to the customer.
3) The entity has transferred the physical goods to the customer.
4) The entity has transferred the main risks and rewards related to the goods or services to the customer.
5) The customer has accepted the goods or services.
According to the new principle, the indications shall not be limited to the above listed. This means that the new principle admits the specific situations of different entities and industries and allows more room for the entity in deciding revenue recognition by itself.
According to the current principle, 5 conditions shall all be satisfied for revenue recognition.
a) The seller has transferred all main risks and rewards related to the goods and services to the customer;
b) The seller keeps neither the continuing management, nor substance effective control over the service and goods sold;
c) The revenue amount can be reliably measured;
d) The amount can most likely be collected; and
e) The relevant cost incurred or to be incurred can be measured reliably.
By comparing, we can see that transfer of the main risks and rewards related to the goods or services, the key condition under the old principle, is just one of indications for transfer of control under the new one.
3) More guidance in identifying performance obligation
The new principle requires identifying distinct performance obligation in the contract and recognizes revenue respectively by nature. Actually, the current one also requires recognize revenue by category such as sales of goods or service. Comparing with the current one, the new principle, however, gives more guidance in identifying the performance obligation. Therefore, revenue under the new principle is more detailed in disclosing the real nature of the business the entity does.
For payment term with financing nature, which is advance collected one year before the transfer of control or the amount to be collected one year later, the new principle requires that, interest expense/revenue shall be recognized, while no such requirement is available under the current principle.
Under the new principle, certain performances, which are not explicitly or separately described and priced in the contract, if satisfying the conditions, shall be treated as obligations under the new principle. For example, the entity which sells goods may stipulate the quality guarantee period in the sales contract. Under the new principle, if the quality guarantee period offers extra service other than the service which just ensures the goods meet quality standard promised in the contract. The extra service shall be identified as a separate performance obligation. When recognizing revenue for sales of goods, the contract amount allocated to this kind of extra service shall be recognized as liability and shall be recognized as revenue over time during the quality guarantee period.
According to the current principle, the quality guarantee term shall be treated under contingency and provision shall be made when necessary.
4) Transaction price
According to the new principle, the contract amount shall be allocated to each obligation identified. The transaction price is not simply the contract amount, but shall be the amount the entity expects to collect in return for the goods or service. If the contract stipulates terms like discounts, rebate, sales return, financing nature payment arrangement, or non-monetary consideration, the transaction price shall be accordingly adjusted when recognizing revenue.
For example, for terms such as rebate or sales return, partial sales amount shall or might be returned to customers in the future. When recognizing revenue at the point when control is passed, the amount allocated to sales return shall not be recognized as revenue, but contract liability. Of course, at this moment, the sales return shall just be an estimation made according to past experience. The entity need review the estimation and make necessary adjustment at each balance sheet date.
Under the current principle, except for the stipulation that the revenue amount is just the fair value of the consideration collected or to be collected from the customer, no further requirement is available. Sales return normally is booked as debit amount in sales of the current period when actually incurred.
5) Contract Cost
The new principle sets up guidance for two kinds of contract cost.
a) Costs to obtain a contract
This is the incremental cost that would not be incurred if the contract is not obtained. If the amortization period is more than 12 months and the amount are expected to be collectible, the incremental cost shall be recognized as an asset.
b) Costs to fulfill a contract
The cost, which directly relates to a contract and shall be borne by the customer, including the direct labor, direct materials, manufacturing expense or other similar expense, and will increase the resource to be used to fulfill the contract in the future and can be recovered, shall be capitalized as an asset.
Under the current principal, the cost to obtain a contact, such sales commission, will normally be expensed when incurred.
The impact to the entities
From above analysis, we can have some feelings about the impact of the new principle to the management of the industries. If you sell goods, under the new principle, you shall consider different accounting treatment for sales return, delay payment term, rebate paid to customers, quality guarantee. The workload for the accounting department will be obviously more than before. In many cases, the accounting system has to be revised accordingly. Further, since certain information required for applying the revenue principle, such as analyzing the nature of the revenue, the estimation made on sales return, quality guarantee service, shall probably be provided by operation or sales department, other than an update on the accounting system, a cross functional department collaboration procedure might be required.
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