Two European examples of problems in presenting and disclosing revenue
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 19th edition:
- “The issuer is a biotech company that undertakes research and development projects but does not produce the products itself. It received milestone payments during the research and development process based on contracts signed with other pharmaceutical companies, which, if the projects were completed, would produce and distribute the pharmaceutical products. If the products were approved by the authorities and sold to consumers, the issuer would receive royalties.
- In 2011, the issuer acquired a development project as part of a business combination and recognized the project as an intangible asset in accordance with paragraph 33 of IAS 38. Its value amounted to more than 50% of the issuer’s total assets. At the beginning of 2012, the issuer judged that it could not complete the project on its own due to insufficient funds and attempted to form partnerships with other companies or to find external investors to be able to continue working on the project. After these initiatives failed, the issuer tried to sell the project, including all rights to future development. In the 2012 half-year report the issuer recognized an impairment loss for the full value of the intangible asset.
- After the publication of the half-year financial report, the issuer succeeded in selling the project. The gain from the sale was classified as revenue in the 2012 annual financial statements. The issuer argued that their business was medical research and development and that the sale of rights arising from the project should therefore be classified as revenue in accordance with paragraph 7 of IAS 18 since the sale of rights was part of the issuer’s ordinary business.”
The enforcer (as ESMA likes to term it) disagreed with this treatment, noting that it directly conflicts with IAS 38.113 (“gains shall not be classified as revenue”). Where the sale of rights is indeed part of the issuer’s ordinary business (which doesn’t seem to have been the case here, based on past practice), then IAS 38.3(a) specifies such assets don’t fall within its scope in the first place, but are treated instead as inventories under IAS 2. So the analysis didn’t hold together one way or another.
It’s not unusual for questions to arise about whether a particular item an entity treats as revenue truly arises in the course of its ordinary activities. In my own working life, these often arise when an entity’s “ordinary activities” haven’t really started, and the item treated as revenue represents some one-off inflow that isn’t indicative of the future. Even if one ultimately accepts the classification, the disclosure (whether in the statements or the MD&A) may not adequately emphasize the item’s non-recurring nature, and the lack of predictive value attached to it.
Talking of disclosure, the same ESMA bulletin addresses a related matter:
- “The issuer is a company that supplies products for 3D-printing. The description of the accounting policies in the financial statements referred to various components of revenue, such as sale of: machinery, spare parts, disposables and services. Also, the management report contained explanations and amounts for these revenue generating activities. However, despite the fact that the issuer generated several categories of revenue, it disaggregated the revenue in the financial statement notes into only two components, namely ‘revenue’ and ‘freight’, the latter being immaterial (less than 1% of revenue).”
Similar observations could surely often be made in Canadian practice. In this case, the enforcer concluded that the issuer “should have disclosed in its financial statements more granular information regarding its revenue,” citing IAS 18.35(b) and IFRS 8.32. As in many cases when regulators zoom in on things, it’s largely a matter of separate pieces not adding up: “The fact that the issuer describes the various accounting policies by category of revenue and in the management report discloses disaggregated amounts of several revenue generating activities confirms that more significant revenue components than disclosed in the financial statements exist and thus disaggregated information on revenue should have been provided in the financial statements.”
As revenue is often the most key of key performance measures, it’s strange how little disclosure sometimes attaches to it, relative to other areas of the statements that are far less important by any measure (the calculation of stock-based compensation for instance). No doubt the introduction of IFRS 15 will help things here, but that’s still a while away, and of course the IFRS 15 disclosures focus more on the mechanics of recognizing and measuring revenue than on the qualitative aspects of what it represents. New standard or not, there’s really no justification for a company to brag in its disclosure about the various ways it brings in business, while refusing to get specific about what that amounts to, or what it means for the future.
The opinions expressed are solely those of the author