IFRS 15 – REVENUE FROM CONTRACTS WITH CUSTOMERS
IFRS 15 specifies how and when an IFRS reporter will recognise revenue.
THE FIVE-STEP MODEL FRAMEWORK
The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of promised good 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. The standard introduces a five-step model for the recognition of revenue.
The 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.
STEP 1: IDENTIFY THE CONTRACT WITH THE CUSTOMER
Step one in the five-step model requires the identification of the contract with the customer. A contract with a customer will be within the scope of IFRS 15 if all the following conditions are met:
- The contract has been approved by the parties to the contract;
- Each party‘s rights in relation to the goods or services to be transferred can be identified;
- The payment terms for the goods or services to be transferred can be identified;
- The contract has commercial substance; and
- It is probable that the consideration to which the entity is entitled to in exchange for the goods or services will be collected.
Contracts may be in different forms (written, verbal or implied). If a contract with a customer does not meet these criteria, the entity can 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 2: IDENTIFY THE PERFORMANCE OBLIGATIONS IN THE CONTRACT
Step two requires the identification of the separate performance obligations in the contract. This is often 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 a bundle of goods or services.
At the inception of the contract, the entity should assess the goods or services that have been promised to the customer, and identify as a performance obligation:
- a good or service (or bundle of goods or services) that is distinct; or
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
A series of distinct goods or services is transferred to the customer in the same pattern if both of the following criteria are met:
- Each distinct good or service in the series that the entity promises to transfer consecutively to the customer would be a performance obligation that is satisfied over time; and
- A single method of measuring progress would be used to measure the entity‘s progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.
A good or service is distinct if both of the following criteria are met:
- The customer can benefit from the good or services on its own or in conjunction with other readily available resources; and
- The entity‘s promise to transfer the good or service to the customer is separately identifiable from other promises/elements in 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.
Factors for consideration as to whether a promise to transfer the good or service to the customer is separately identifiable include, but are not limited to:
- The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract.
- The good or service does not significantly modify or customise another good or service promised in the contract.
- The good or service is not highly interrelated with or highly dependent on other goods or services promised in the contract.
STEP 3: DETERMINE THE TRANSACTION PRICE
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. When making this determination, an entity will consider past customary business practices. 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.
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 less than one year. 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.
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.
Where a contract contains elements of variable consideration, the entity will estimate the amount of variable consideration to which it will be entitled under the contract.
However, a different, more restrictive approach is applied in respect of sales or usage-based royalty revenue arising from licences of intellectual property. Such revenue is recognised only when the underlying sales or usage occur.
STEP 4: ALLOCATE THE TRANSACTION PRICE TO THE PERFORMANCE OBLIGATIONS IN THE CONTRACTS
Step four requires the allocation of the transaction price to the separate performance obligations. Where a contract has multiple performance obligations, an entity will allocate the transaction price to the performance obligations in the contract by reference to the relative standalone selling prices of the goods or services promised. This allocation is made at the inception of the contract. It is not adjusted to reflect subsequent changes in the standalone selling prices of those goods or services.
The best evidence of standalone 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 is different from the residual method that is used currently by some entities, such as software companies.
When a contract contains more than one distinct performance obligation, an entity should allocate the transaction price to each distinct performance obligation on the basis of the standalone selling price.
This will be a major practical issue 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 will require their separation.
STEP 5: RECOGNISE REVENUE WHEN (OR AS) THE ENTITY SATISFIES A PERFORMANCE OBLIGATION
Step five requires revenue to be recognised as each performance obligation is satisfied. This differs from IAS 18 where, for example, revenue in respect of goods is recognised when the significant risks and rewards of ownership of the goods are transferred to the customer.
Revenue is recognised as control is passed. 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.
Control of an asset is defined as the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. The benefits related to the asset are the potential cash flows that may be obtained directly or indirectly. These include, but are not limited to:
- Using the asset to produce goods or provide services;
- Using the asset to enhance the value of other assets;
- Using the asset to settle liabilities or to reduce expenses;
- Selling or exchanging the asset; Pledging the asset to secure a loan; and Holding 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. So, an entity recognises revenue over time if one of the following criteria is met:
- The customer simultaneously receives and consumes the benefits provided by the entity‘s performance as the entity performs.
- The entity‘s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
- The entity‘s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
Revenue is recognised in line with the pattern of transfer. Whether an entity recognises revenue over the period during which it manufactures a product or on delivery to the customer will depend on the specific terms of the contract.
If an entity does not satisfy its performance obligation over time, it satisfies it at a point in time. Revenue will therefore be recognised when control is passed at a certain point in time. Factors that may indicate the point in time at which control passes include, but are not limited to:
- The entity has a present right to payment for the asset;
- The customer has legal title to the asset;
- The entity has transferred physical possession of the asset;
- The customer has the significant risks and rewards related to the ownership of the asset; and The customer has accepted the asset.
As a consequence of the above, the timing of revenue recognition may change for some point-in-time transactions when the new standard is adopted.
The incremental costs of obtaining a contract must be recognised as an asset if the entity expects to recover those costs.
Costs incurred to fulfill a contract are recognised as an asset if and only if all of the following criteria are met:
- The costs relate directly to a contract (or a specific anticipated contract);
- The costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future; and
- The costs are expected to be recovered.
The asset recognised in respect of the costs to obtain or fulfill a contract is amortised on a systematic basis that is consistent with the pattern of transfer of the goods or services to which the asset relates.
PRINCIPLES OF REVENUE RECOGNITION
Sale on return basis
- In case of sale on return basis, an estimate should be made of the amount of goods expected to be returned.
- The most likely amount of return can be determined by past experience or by assigning probability to estimated figures
- For the goods expected to be returned, sale is not recognized. A refund liability is recorded with the amount.
- The right to receive inventory with a corresponding adjustment to cost of sales
- If the item is ultimately not returned, then it will be recognized as sale at the point of confirmation of no return.
- In case of option to purchase warranty separately (extended), warranty is distinct and should be recognized as a separate performance obligation
- If a customer does not have the option to purchase a warranty separately, an entity shall account for the warranty in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Asset
Principal versus agent considerations
- When another party is involved in providing goods or services to a customer, the entity shall determine whether the nature of its promise is a performance obligation to provide the specified goods or services itself (ie the entity is a principal) or to arrange for the other party to provide those goods or services (ie the entity is an agent).
- An entity is a principal if the entity controls a promised good or service before the entity transfers the good or service to a customer. However, an entity is not necessarily acting as a principal if the entity obtains legal title of a product only momentarily before legal title is transferred to a customer.
- When an entity that is a principal satisfies a performance obligation, the entity recognises revenue in the gross amount of consideration to which it expects to be entitled in exchange for those goods or services transferred.
- An entity is an agent if the entity‘s performance obligation is to arrange for the provision of goods or services by another party. When an entity that is an agent satisfies a performance obligation, the entity recognises revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the other party to provide its goods or services.
Indicators that an entity is an agent are as follows:
- Another party is primarily responsible for fulfilling the contract;
- The entity does not have inventory risk before or after the goods have been ordered by a customer, during shipping or on return;
- The entity does not have discretion in establishing prices for the other party‘s goods or services and, therefore, the benefit that the entity can receive from those goods or services is limited;
- The entity‘s consideration is in the form of a commission; and
- The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the other party‘s goods or services.
A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option
(either in the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.
Repurchase agreements generally come in three forms:
- An entity‘s obligation to repurchase the asset (a forward);
- An entity‘s right to repurchase the asset (a call option); and
- An entity‘s obligation to repurchase the asset at the customer‘s request (a put option).
Forward & Call option
- In case of forward and call option, the customer does not obtain control
- If entity can or must repurchase at an amount less than original selling price of asset, then it will be accounted for as lease
- If entity can or must repurchase at an amount equal to or more than original selling price of asset, then accounting done as financing arrangement —recognize the asset and a financial liability
- If repurchase price lower than original selling price then see does customer have significant economic incentive to exercise right
- If yes then account for as lease. If no, then recognize as sale of product with right of return
- If repurchase price is equal or greater than original selling price following two options arise
- If repurchase price is more than expected market value then accounting done as financing arrangement —recognize the asset and a financial liability
- If Repurchase price is less than expected market value and no significant economic incentive to exercise right then record as sale of product with right of return
Bill and hold arrangement
- Bill-and-hold arrangements are those whereby an entity bills a customer for the sale of a particular product, but the entity retains physical possession until it is transferred to the customer at a later date.
- In assessing whether revenue can be recognized in a bill-and-hold transaction, entities must first determine whether control has transferred to the customer (as with any other sale under IFRS 15) through review of the indicators for the transfer of control. One indicator is physical possession of the asset; however, physical possession may not coincide with control in all cases (e.g., in billand-hold arrangements).
- In determining whether control has transferred in such arrangements, the specific criteria included in IFRS 15 for bill-and-hold transactions must all be met in order for revenue to be recognized.
- The reason for the bill-and-hold arrangement must be substantive (e.g., the customer has requested the arrangement).
- The product must be identified separately as belonging to the customer. o The product currently must be ready for physical transfer to the customer. o The entity cannot have the ability to use the product or to direct it to another customer.
- An entity that has transferred control of the goods and met the bill-and-hold criteria to recognize revenue will also need to consider whether it is providing other services (e.g., custodial services). If so, a portion of the transaction price should be allocated to each of the separate performance obligations (i.e., the goods and the custodial service).
Non-refundable up-front fees
Although the accounting conclusion may not change with respect to non-refundable upfront fees for retailers, the assessment process for such fees differs under IFRS 15.
Set up activities (eg retailers‘ ‗club‘ fees, health-club joining fees, set-up fees, etc.) are not generally considered to be distinct performance obligations because the customer‘s ability to benefit from them is highly dependent upon other goods or services in the contract. In such circumstances, the related upfront fees are considered to be advance payments for future goods and services and therefore comprise part of the overall transaction price. The entity allocates the overall transaction price among the identified performance obligations (as discussed above) and recognises revenue as those performance obligations are satisfied (Step 5).
When an entity delivers a product to another party (such as a dealer or a distributor) for sale to end customers, the entity shall evaluate whether that other party has obtained control of the product at that point in time. A product that has been delivered to another party may be held in a consignment arrangement if that other party has not obtained control of the product.
Accordingly, an entity shall not recognise revenue upon delivery of a product to another party if the delivered product is held on consignment.
Indicators that an arrangement is a consignment arrangement include, but are not limited to, the following:
- The product is controlled by the entity until a specified event occurs, such as the sale of the product to a customer of the dealer or until a specified period expires;
- The entity is able to require the return of the product or transfer the product to a third party
(such as another dealer); and
- The dealer does not have an unconditional obligation to pay for the product (although it might be required to pay a deposit).