IFRS 15 – revenue recognition steps

IFRS 15 became mandatory for accounting periods beginning on or after 1 January 2018. As entities and groups using the international accounting framework leave the old regime behind, let’s look at the more prescriptive new standard.

Changes, which include replacing the concept of transfer of ‘risks and rewards’ with ‘control’ and the introduction of ‘performance obligations’ alongside extensive disclosures, are likely to put more pressure on accountants and auditors to closely evaluate client contracts and challenge directors' judgements.

Here, we summarise the following five steps of revenue recognition and illustrative practical application for the most common scenarios: 

1. Identify the contract
2. Identify separate performance obligations
3. Determine the transaction price
4. Allocate transaction price to performance obligations
5. Recognise revenue when each performance obligation is satisfied.

• Contract can have a written and non-written form or be implied (contract may not be limited to goods or services explicitly mentioned in a contract, but also include those expected to be delivered due to business practices or statements made)
• Should be approved by parties, and have a commercial basis
• Should create enforceable rights and obligations between parties
• Should have a consideration established taking into account ability and intention to pay

New contracts may arise when terms of existing contracts are modified. Contract modifications:

• Could result in retrospective or prospective adjustments to an existing contract, creation of a new contract alongside the old contract, or a termination of the original contract and creation of a new contract
• New contract arises as a result of modifications if:
  • a new performance obligation is added to a contract. If a customer orders additional units at a later date, the additional order is considered distinct, even if the order is for identical goods
  • the price at which the additional units are sold represents a standalone selling price at the time of modification. This is a price at which the product would be sold on the market, rather than a significantly different price, for example heavily discounted despite the product being the same and of the same quality (for example to entice more future business from that customer)
• Continuation of an existing contract arises when:
  • no distinct goods or services are provided as part of the modification
  • performance obligation can be satisfied at modification date – for example, a customer negotiates a discount in relation to units already delivered, for example due to unsatisfactory quality or service relating to the delivered units only

• A performance obligation is a distinct promise to transfer specific goods or services, distinct from other goods or services
• Performance obligation is distinct when its fulfilment:
  • provides specific benefits associated with it, in its own right or together with other fulfilled obligations
  • is separable from other obligations in the contract – goods or services offered are not integrated or dependent on other goods or services provided already under the contract; the obligation provides goods or services rather than only modifies goods or services already provided

The following are examples of circumstances which do not give rise to a performance obligation:

• providing goods at scrap value
• activities relating to internal administrative contract set-up

Identifying performance obligations may result in unbundling contracts into performance obligations, or combining contracts into a performance obligation, to recognise revenue correctly.

Unbundling a contract may apply when incentives are offered at the time of sale, such as free servicing or enhanced warranties. In this case servicing and warranties are performance obligations that are distinct and revenue relating to them needs to be recognised separately from the goods or services promised on the contract to which they relate.

Circumstances which could result in contracts being combined:

• it is negotiated as a package with a single commercial objective
• consideration for one contract depends on the price or performance of the other contract

• Transaction price is the most likely value the entity expects to be entitled to in exchange for the promised goods or services supplied under a contract
• May include significant financing components and incentives and non-cash amounts offered, which affect how revenue is recognised (see below)

Variable amounts of consideration:

• may arise as a result of discounts, rebates, refunds, credits, concessions, incentives, performance bonuses, penalties, and contingent payments
• variable consideration is only recognised when it is highly probable that there will not be a significant reversal in the cumulative amount of revenue recognised to date
• no revenue is recognised if the vendor expects goods to be returned
  • instead a provision matching the asset is recognised at the same time as the asset, with an adjustment to cost of sales
  • the restriction results in a later recognition of revenue and profit (once there is certainly the goods will not be returned) in comparison with current accounting
• variable consideration is measured by reference to two methods
  • expected value for the contract portfolio (for a large number of contracts), or
  • single most likely outcome amount (if there are only two potential outcomes)

Adjustments for the effects of the time value of money (a ‘financing component’):

• if a financing component is significant, IFRS 15 requires an adjustment to be made for the effect of implicit financing
  • cash received in advance from buyer – vendor to recognise finance cost and increase in deferred revenue
  • cash received in arrears from buyer – vendor to recognise finance income and reduction in revenue
• no adjustment for a financing component is needed if payment is settled within one year of goods or services transferred
• the following do not give rise to a financing component (and hence no adjustment is needed):
  • customer has discretion over the timing of the transfer of control of the goods or services
  • consideration is variable and the amount or timing depends on factors outside of parties’ control
  • the difference between the consideration and cash selling price arises for other non-financing reasons (ie performance protection)

• Allocation is based on the standalone selling price of goods or services forming that performance obligation

Allocation of transaction price may include allocation of discounts, which are applied:

• on a proportionate basis to all performance obligations based on the stand-alone selling price of each performance obligation (observable or estimated), or
• to specific performance obligations only, if
  • observable evidence exists evidencing that the discount relates to those specific obligations only; and
  • goods / services stipulated in the performance obligation are regularly sold as stand-alone and at a discount; and
  • discount is substantially the same as the discount usually given when goods / services are sold on a stand-alone basis

Variable consideration is applied to a specific performance obligation if:

• terms relating to varying the consideration relate to satisfying that specific performance obligation
• amount of variable consideration allocated is what the entity expects to receive for satisfying the performance obligation

Contract modifications may require reassessment how consideration is allocated to performance obligations.

• The point of revenue recognition is the point when performance obligation is satisfied, per each distinctive obligation
• May result in revenue recognition at a point in time or over time

Recognition over time applies when:

• the customer simultaneously receives and consumes the asset/service as the vendor performs the service, or
• the vendor’s performance creates or enhances an asset (for example, work in progress) that is controlled by the customer as the work progresses.

The vendor’s performance creates an asset, when:

• the asset has no alternative use to the vendor:
  • the vendor is restricted from using the asset for any other purpose other than selling it to that specific customer, for example
  • the asset is manufactured to specific specifications or delivery time, meaning that from the point of commencement of asset creation, it is clear the asset is for a specific customer
  • the entity cannot practically or contractually sell the asset to a different customer as it would be practically and contractually prohibitive (for example would require a costly rework, selling at a reduced price, or if customer can prohibit redirection)
  • no such practical or contractual limitations would apply if the entity production is that of identical assets in bulk, and those assets are interchangeable
• the vendor has an enforceable right to be paid for work completed to date
• the vendor does not have an enforceable right to pay when, for example:
  • terms of contract allow customer to cancel or modify the contract
  • the contract allows for circumstances where customer does not have to pay at all
  • the customer can pay an amount other than the value of the asset or service created to date (ie compensation only)
  • for a compensation to be treated as consideration and fulfil the condition of enforceable right to be paid, the compensation would have to approximate the selling price for the asset, or part of it equal to the proportion of work completed

How to recognise revenue over time:

• To the extent that each of the performance obligations has been satisfied. This can be established using two methods:
  • output method - direct measurement of the value of goods or services transferred to date for example per surveys of completion to date, appraisals of results achieved, milestones reached, units produced/delivered; or
  • input method - based on measures such as resources consumed, costs incurred (but see below re contract set up costs), number of hours per time sheets or machine hours, which are directly related to the vendor's performance
• Contract set up activities and preparatory tasks necessary to fulfil a contract do not form part of revenue, and may meet capital recognition asset requirements (see below)

Capitalisation of costs associated with a sale contract (for example bidding costs, sales commission)

• Only incremental costs of obtaining a contract (which would not have been incurred if the contract had not been obtained) to be considered, for example:
  • direct sales commissions payable if contract is awarded - include
  • costs of running a legal department proving an across-business legal support function - exclude
• Capitalise – if expected to be recovered (contract will generate profits)
• Amortise on a basis that is consistent with the transfer of the goods or services specified in the contract