This second article on IFRS 15,
Revenue from Contracts with Customers, will look at the application of the
standard using the five-step model. 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 one in the five-step model
requires the identification of the contract 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 have to be capable of identification. 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 a modification of
the original contract, depending upon the circumstances of the case.
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. 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 is separately identifiable
from other elements of the contract.
IFRS 15 requires 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 still has to 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.
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.
Step four requires the allocation of
the transaction price to the separate performance obligations. The allocation
is based on the relative standalone selling prices of the goods or services
promised and is made at 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 allocates the transaction price
to each distinct performance obligation on the basis of the standalone selling
price.
Where the transaction price includes
a variable amount and discounts, consideration needs to be given as to 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 will be a major practical issue
as it may require a separate calculation and allocation exercise to be
performed for each contract. A mobile telephone contract typically bundles
together the handset and network connection. IFRS 15 will require their
separation.
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. 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:
- 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 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 or the customer has legal title to the asset or the
entity has transferred physical possession of 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.
In addition to the five-step model,
IFRS 15 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.
IFRS 15 is a significant change from
IAS 18, Revenue, and even though it provides more detailed application
guidance, judgment will be required in applying it because the use of estimates
is more prevalent.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School
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