By Zoey Zhang and Jess Feng
Starting January 1, 2021, several new accounting standards regarding revenue, leases, and financial instruments, will soon apply to all entities that have already adopted the Chinese Accounting Standards for Business Enterprises (CAS). These new standards include:
The issuance of new accounting standards will not only bring big challenges to the accounting work of relevant enterprises, but also make a difference to their daily business decisions, internal control, financial performance, among other aspects. It is thus advisable that enterprises make full preparations for the new CAS, in order to meet the expectations of stakeholders and the requirements of regulators.
This article will take you through the key changes and contents of the new CAS14 regarding revenue, CAS21 regarding leases, and other Chinese accounting standards regarding financial instruments, the impact brought by these new standards on businesses, and the differences among the CAS, the International Financial Reporting Standards (IFRS), and the US Generally Accepted Accounting Principles (US GAAP).
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On July 5, 2017, the Ministry of Finance (MOF) released the New Accounting Standards for Business Enterprises No.14 – Revenue (CAS14), to bring the new CAS14 in line with the International Financial Reporting Standards No.15 – Revenue from Contracts with Customers (IFRS15) published by the International Accounting Standards Board (IASB) on April 28, 2014.
The new CAS14 may lead to substantial changes to revenue recognition policies of enterprises, such as changing the timing of revenue recognition and the amount being recognized.
Two new balance sheet items – “contract assets” and “contract liabilities” – will be added into the financial statement of enterprises. Besides, the introduction of the Five-Step Model and additional disclosure requirements may also complicate the accounting work of enterprises and affect the performance of their annual financial statements.
The new CAS14 applies to the revenue recognition of most contracts with customers. Here are the major changes, which enterprises are recommended to take note of:
In July 2018, the MOF issued applicable guidelines for the CAS14, introducing a Five-Step Model framework to guide enterprises to recognize revenue step by step. The Five-Step Model reflects the core principle of revenue recognition under the CAS14 – “an entity shall recognize revenue when (or as) it satisfies a performance obligation, which is when the customer obtains control of the product”. To comply with the new principle, enterprises will need to review and modify their revenue recognition process, which is expected to involve more legal and risk assessment work in the accounting process.
Here are the key contents of the Five-Step Model framework:
An entity that first applies these standards shall, based on the cumulative effect of initially applying these standards, adjust the opening balance of retained earnings and the amount of other relevant items in financial statements of the annual reporting period, and shall not adjust the information of the comparative period.
Overall, the new CAS14 will potentially affect the timing of revenue recognition and the transaction amount being recognized in different business contracts as well as pose challenges to entities’ accounting practices. Here, we summarize some of the major challenges and impact:
On December 7, 2018, the MOF released the New Accounting Standards for Business Enterprises No.21– Leases (CAS21), to bring the new CAS21 in line with the IFRS16 published by the IASB on January 13, 2016.
The new CAS21 would bring significant changes to financial statements, especially for lessees with substantial operating leases.
Since the operating leases and finance leases will no longer be differentiated – both will be recognized in the balance sheets, relevant lessees may see notable increases in total assets and total liabilities in their balance sheet. These changes may affect the lease negotiation, therefore also influencing the lessor’s operation.
Here are the key contents of CAS21 entities should pay attention to:
Since the potential effect of the new lease standard is significant and pervasive, the standard provides a lessee with multiple choices for transitional accounting treatment.
On the first day of implementation (that is, January 1, 2020), a company may opt not to re-assess whether a contract that already exists is a lease or includes a lease. However, contracts commencing on or after the first day of implementation have to apply the new standard.
If an entity decides to re-assess existing leases, it may choose to adjust the retained earnings at the beginning of the year when implementing the new standard for the first time but shall not adjust information in the comparative period. For entities adopting this method, any lease that will be completed within 12 months after the first day of implementation (that is, January 1, 2020) may be treated as a short-term lease, thereby subject to simplified treatment.
Alternatively, an entity may choose to adopt the retrospective adjustment method in accordance with CAS28 – Changes in Accounting Policies and Estimates and Correction of Errors.
For a lessee under operating lease, both total assets and total liabilities will increase due to the right-of-use assets and lease liabilities recognized in the balance sheet. This will have a significant impact on various financial indicators (that is, return on assets, gearing ratio). The impact will be particularly significant for industries that heavily adopt the current operating lease model, such as manufacturing, transportation, airlines, etc.
Besides, for lessees, the new standard will affect the income statement by recognizing interest expense in the finance expense category, thereby influencing Earnings Before Interest and Taxes (EBIT) and Earnings Before Interest Taxes and Amortization (EBITA).
Also, total expense recognized in the income statement will be front-loaded, meaning that the total expense for the first few periods after the inception of the lease will be larger than the amount that would have been reported under the old standard. In addition, the difference between lease expense and lease payment will give rise to deferred taxation.
For lessees, not all of the lease payment will be presented under cash outflows from operating activities. Instead, repayment of the principal and interest of lease liability will be included in cash outflows from financing activities.
For both lessees and lessors, when assessing the lease term, significant judgement is involved in determining whether the option to renew or terminate lease will be exercised.
On March 31, 2017, the MOF released the new CAS22 – Recognition and Measurement of Financial Instruments, CAS23 – Transfer of Financial Assets, and CAS24 – Hedge Accounting. These new CAS regarding financial instruments are consistent with the IFRS9 published by the IASB on July 24, 2014 in material aspects.
The major changes in these accounting standards regarding financial instruments include:
The CAS regarding financial instruments requires financial assets to be measured at amortized cost or fair value. Depending on the business model of an entity’s management of financial assets, accounts receivable and bills receivable might be reclassified as financial assets at fair value through other comprehensive income or fair value through profit and loss. Bank’s structured deposits, wealth investment products, or other financial instruments that do not satisfy the test of “solely payments of principal and interest on the principal amount outstanding” might be reclassified as financial assets at fair value through profit and loss. Also, under the new standard, all the non-trading equity instruments shall be measured at fair value.
In addition, moving to an expected credit loss model can be a major challenge, particularly for banks and other lenders. Since reasonable and well-grounded forward-looking information needs to be obtained when evaluating impairment, more accounting judgement will be involved in assessing the credit risks of the financial instruments, potentially resulting in fluctuated provision recognized in income statement. The expected credit loss method in impairment assessment of financial instruments may result in more impairment being recognized earlier in income statements than it used to be. Besides, the expected credit loss model is also applicable to lease receivables and contract assets.
There is no material difference between the CAS14, IFRS15, and ASC606 (Accounting Standard Committee 606 – Revenue from Contracts with Customers).
However, entities should be aware of the subtle differences when preparing for GAAP adjustments. For example, both CAS14 and ASC606 specifically state that shipping and handling activities before the customer obtains control of the product are fulfilment activities, which should not be identified as separate performance obligations. However, no similar requirement is noted under IFRS15.
There are several notable differences to keep in mind when preparing for GAAP adjustments.
Due to the specific circumstances of Mainland China, the land use rights are classified as intangible assets, thus not subject to CAS21. Under IFRS, however, the land use rights are regarded as property, plant, and equipment and are subject to IFRS16.
One of the notable differences between CAS21 and ASC842 is that for lessee accounting, US GAAP differentiates operating lease from finance lease. For operating lease, the lessee recognizes right-of-use assets and lease liabilities in the balance sheet. However, under ASC842, the overall impact on income statement remain constant for each period. On the contrary, the impact of CAS21 on the income statement is frontloaded.
There is no material difference between CAS22 and IFRS9, but only subtle differences. For example, while CAS22 specifies the treatment regarding the change in principal during the existence of the financial assets, IFRS 9 uses the term the expected life of the financial instruments.
All enterprises are required to adopt the new accounting standards starting January 1, 2021. Thus, relevant enterprises are recommended to:
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China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at firstname.lastname@example.org.
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