In May 2014, the International Accounting Standards Board (the Board), issued International Financial Reporting Standard (IFRS®) 15, Revenue from Contracts with Customers. Application became mandatory for annual reporting periods starting from 1 January 2018, although earlier application was permitted.
Historically, there had been a significant divergence in practice over the recognition of revenue, mainly because IFRS Standards had contained limited guidance in certain areas. The original standard, IAS® 18, Revenue, was issued in 1982 with a significant revision in 1993. However, IAS 18 was not fit for purpose in today’s corporate world as the guidance available was difficult to apply to many transactions. IFRS 15 replaced the following standards and interpretations:
The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of promised goods or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services.
This article considers the application of IFRS 15 using a ‘five-step model’. This five-step model applies to revenue earned from a contract with a customer with limited exceptions, regardless of the type of revenue transaction or the industry:
We will consider each of these steps in more detail below.
Step one requires the identification of the contract(s) with the customer. Contracts may be in different forms (written, verbal or implied), but must be enforceable, have commercial substance and be approved by the parties to the contract. The model applies once the payment terms for the goods or services are identified and it is probable that the entity will collect the consideration. Each party’s rights in relation to the goods or services must be capable of identification. If a contract with a customer does not meet these criteria, the entity should continually reassess the contract to determine whether it subsequently meets the criteria.
Two or more contracts that are entered into around the same time, with the same customer, may be combined and accounted for as a single contract if they meet the specified criteria. The standard provides detailed requirements for contract modifications. A modification may be accounted for as a separate contract or as a modification of the original contract, depending upon the circumstances of the case.
Step two requires the identification of the performance obligations in the contract. Contracts can have more than one performance obligation and each one must be identified separately. This is sometimes referred to as ‘unbundling’ and is done at the beginning of a contract. The key factor in identifying a separate performance obligation is the distinctiveness of the good or service, or bundle of goods or services. A good or service is distinct if the customer can benefit from the good or service on its own or together with other readily available resources and it is separately identifiable from other elements of the contract.
IFRS 15 requires that a series of distinct goods or services that are substantially the same with the same pattern of transfer, to be regarded as a single performance obligation. A good or service which has been delivered may not be distinct if it cannot be used without another good or service that has not yet been delivered. Similarly, goods or services that are not distinct should be combined with other goods or services until the entity identifies a bundle of goods or services that is distinct. IFRS 15 provides indicators rather than criteria to determine when a good or service is distinct within the context of the contract. This allows management to apply judgment to determine the separate performance obligations that best reflect the economic substance of a transaction.
Step three requires the entity to determine the transaction price, which is the amount of consideration that an entity expects to be entitled to in exchange for the promised goods or services. This amount excludes amounts collected on behalf of a third party – for example, government taxes. An entity must determine the amount of consideration to which it expects to be entitled in order to recognise revenue.
The transaction price might include variable or contingent consideration. Variable consideration should be estimated as either the expected value or the most likely amount. The expected value approach represents the sum of probability-weighted amounts for various possible outcomes. The most likely amount represents the most likely amount in a range of possible amounts.
Management should use the approach that it expects will best predict the amount of consideration and it should be applied consistently throughout the contract. An entity can only include variable consideration in the transaction price to the extent that it is highly probable that a subsequent change in the estimated variable consideration will not result in a significant revenue reversal. If it is not appropriate to include all of the variable consideration in the transaction price, the entity should assess whether it should include part of the variable consideration. However, this latter amount must still pass the ‘revenue reversal’ test.
Variable consideration is wider than simply contingent consideration as it includes any amount that is variable under a contract, such as performance bonuses or penalties.
If an entity anticipates that it may ultimately accept an amount lower than that initially promised in the contract due to, for example, past experience of discounts given, then revenue would be estimated at the lower amount with the collectability of that lower amount being assessed. Subsequently, if revenue already recognised is not collectable, impairment losses should be taken to profit or loss.
Additionally, an entity should estimate the transaction price, taking into account non-cash consideration, consideration payable to the customer and the time value of money if a significant financing component is present. The latter is not required if the time period between the transfer of goods or services and payment is one year or less. In some cases, it will be clear that a significant financing component exists due to the terms of the arrangement.
In other cases, it could be difficult to determine whether a significant financing component exists. This is likely to be the case where there are long-term arrangements with multiple performance obligations such that goods or services are delivered and cash payments received throughout the arrangement. For example, if an advance payment is required for business purposes to obtain a longer-term contract, then the entity may conclude that a significant financing obligation does not exist.
Step four requires the allocation of the transaction price to the separate performance obligations. The allocation is based on the relative stand-alone selling prices of the goods or services promised and is made at the inception of the contract. It is not adjusted to reflect subsequent changes in the stand-alone selling prices of those goods or services.
The best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately. If that is not available, an estimate is made by using an approach that maximises the use of observable inputs – for example, expected cost plus an appropriate margin or the assessment of market prices for similar goods or services adjusted for entity-specific costs and margins or, in limited circumstances, a residual approach. The residual approach involves the entity estimating the stand-alone selling price by reference to the total transaction price less the sum of observable stand-alone selling prices of other goods or services promised in the contract. This is only allowed if certain criteria are met.
When a contract contains more than one distinct performance obligation, an entity should allocate the transaction price to each distinct performance obligation based on the stand-alone selling price.
Where the transaction price includes a variable amount and discounts, it is necessary to establish whether these amounts relate to all or only some of the performance obligations in the contract. Discounts and variable consideration will typically be allocated proportionately to all of the performance obligations in the contract. However, if certain conditions are met, they can be allocated to one or more separate performance obligations.
This can be a major practical issue for some entities as it may require a separate calculation and allocation exercise to be performed for each contract. For example, a mobile telephone contract typically bundles together the handset and network connection and IFRS 15 requires their separation.
Step five requires revenue to be recognised when (or as) each performance obligation is satisfied. An entity satisfies a performance obligation by transferring control of a promised good or service to the customer, which could occur over time or at a point in time. The definition of control includes the ability to prevent others from directing the use of and obtaining the benefits from the asset. A performance obligation is satisfied at a point in time unless it meets one of the following criteria, in which case, it is deemed to be satisfied over time:
For each performance obligation satisfied over time, an entity must recognise revenue over time by measuring the progress towards complete satisfaction of that performance obligation. Progress measurement can be done through using input methods or output methods. Input methods are based on the entity’s own efforts (eg resources consumed or machine hours used) whereas output methods are based on the value to the customer (eg surveys of performance completed to date or milestones reached).
If an entity does not satisfy a performance obligation over time, it satisfies it at a point in time and revenue will be recognised when control is passed at that point in time. Factors that may indicate the passing of control include the present right to payment for the asset, the customer has legal title to the asset or the entity has transferred physical possession of the asset.
IFRS 15 also sets out how to account for the incremental costs of obtaining a contract and the costs directly related to fulfilling a contract and provides guidance to assist entities in applying the model to licences, warranties, rights of return, principal-versus-agent considerations, options for additional goods or services and breakage.
For exam purposes, you should focus on understanding the principles of the five-step model so that you can apply them to practical questions.
Written by a member of the Financial Reporting examining team