IFRS 15, Revenue from Contracts with Customers was issued in May 2014 and replaces IAS 11 Construction Contracts, IAS 18 Revenue and various interpretations. IFRS 15 establishes a single model of accounting for revenue arising from contracts with customers. IFRS 15 requires entities to recognize revenue reflecting the transfer of goods or services to customers measured at the amounts an entity expects to be entitled to in exchange for those goods or services.
The standard requires distinct goods to be accounted for separately, which may have a significant impact on the timing of revenue and profit recognition. IFRS 15 also requires significant disclosures relating to the reporting of revenue, and entities will need to ensure that they can gather the appropriate information in a timely manner.
Insurance and investment contracts are not in the scope of this standard. IFRS 15 was effective for annual periods beginning on or after January 1, 2017. In September 2015, the IASB issued an amendment to IFRS 15 to defer the effective date by one year. As a result, IFRS 15 is now effective for annual periods beginning on or after January 1, 2018, with early adoption permitted.
Five-steps single model
The main principle of the Standard is that an entity will recognize revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for transferring promised goods or services to a customer.
The Standard introduces the following five steps model for applying the main principle:
- Identify the contract(s) with a customer
- Identify the performance obligations in the contract(s)
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when (or as) the entity satisfies each performance obligation
Identifying the Contract
Contracts and approval of contracts can be written, oral or implied by an entity’s customary business practices. IFRS 15 requires contracts to have all of the following attributes:
- The contract has been approved
- The rights and payment terms regarding goods and services to be transferred can be identified
- The contract has commercial substance
- It is probable that the consideration will be received (considering only the customer’s ability and intention to pay).
If each party to the contract has a unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties), no contract exists under IFRS 15.
The Standard provides detailed guidance on how to account for approved contract modifications. If certain conditions are met, a contract modification will be accounted for as a separate contract with the customer. If not, it will be accounted for by modifying the accounting for the current contract with the customer.
Identifying Performance obligations
The Standard determines performance obligation as a promise in a contract with a customer to transfer to the customer either:
- a good or service (or a 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.
Once an entity has identified the contract with a customer, it evaluates the contractual terms and its customary business practices to identify all the promised goods or services within the contract and determine which of those promised goods or services (or bundles of promised goods or services) will be treated as separate performance obligations.
For being distinct, a promised good or service should meet two criteria:
- The customer can ‘benefit’ from the good or service, and
- The promise to transfer a good or service is separable from other promises in the contract
The assessment requires judgment and consideration of all relevant facts and circumstances.
A good or service may not be separable from other promised goods or services in the contract, if:
- There are significant integration services with other promised goods or services
- It modifies/customizes other promised goods or services
- It is highly dependent/interrelated with other promised goods or services.
If the promised good or service is not distinct, the entity has to combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. A distinct bundle is accounted for as a single performance obligation.
Determining the transaction price
The transaction price is the amount of consideration an entity expects to be entitled to in exchange for transferring the promised goods or services.
The transaction price may be affected by the nature, timing, and amount of consideration, and includes consideration of significant financing components, variable components, amounts payable to the customer (e.g. refunds and rebates), and non-cash amounts.
Where a contract contains elements of variable consideration (e.g. Discounts, rebates, refunds, credits, concessions, incentives, performance bonuses, penalties, and contingent payments), the entity will estimate the amount of variable consideration to which it will be entitled under the contract.
Variable consideration must be estimated using either:
- Expected value method: based on probability weighted amounts within a range (i.e. for large number of similar contracts), or
- Single most likely amount: the amount within a range that is most likely to eventuate (i.e. where there are few amounts to consider).
Variable consideration is only recognized if it is highly probable that a subsequent change in its estimate would not result in a significant revenue reversal (i.e. a significant reduction in cumulative revenue recognized).
The new Standard specifies that when an entity receives or expects to receive, non-cash consideration (e.g., in the form of goods or services), the fair value of the non-cash consideration (measured in accordance with IFRS 13 Fair Value Measurement) is included in the transaction price. If an entity cannot reasonably estimate the fair value of the non-cash consideration, it is required to measure the non-cash consideration indirectly, by reference to the estimated stand-alone selling price of the goods or services promised to the customer.
The Standard also specifies situations when a contract contains significant financing component. A significant financing component may exist when the receipt of consideration does not match the timing of the transfer of goods or services to the customer (i.e., the consideration is prepaid or is paid after the services are provided). When an entity concludes that a financing component is significant to a contract, it determines the transaction price by discounting the amount of promised consideration. The entity uses the same discount rate that it would use if it were to enter into a separate financing transaction with the customer.
Allocating the transaction price to the performance obligations
Once the performance obligations have been identified and the transaction price has been determined, an entity is required to allocate the transaction price to the performance obligations, generally in proportion to their stand-alone selling prices (i.e., on a relative stand-alone selling price basis). The transaction price is not reallocated to reflect changes in stand-alone selling prices after contract inception.
To allocate the transaction price on a relative selling price basis, an entity must first determine the stand-alone selling price (i.e., the price at which an entity would sell a good or service on a stand-alone basis at contract inception) for each performance obligation.
If a standalone selling price is not directly observable, the entity will need to estimate it. IFRS 15 suggests various methods that might be used, including:
- Adjusted market assessment approach
- Expected cost plus a margin approach
- Residual approach (only permissible in limited circumstances).
After standalone selling prices of all performance obligations are determined, the sum of all the standalone selling prices is compared with the consideration payable, and the excess represents an overall discount. Any overall discount is allocated between performance obligations on a relative standalone selling price basis. In certain circumstances, it may be appropriate to allocate such a discount to some but not all of the performance obligations.
Recognizing revenue when performance obligations are satisfied
The transaction price allocated to each performance obligation (determined in Step 4) is recognized as/when the performance obligation is satisfied, either over time or at a point in time.
Satisfaction occurs when control of the promised good or service is transferred to the customer. 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. This includes the ability to prevent others from directing the use of and obtaining the benefits from the asset.
An entity recognizes revenue over time if one of the following criteria is met:
- the customer simultaneously receives and consumes all of the benefits provided by the entity as the entity performs;
- the entity’s performance creates or enhances an asset that the customer controls as the asset is created; or
- 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.
If an entity does not satisfy its performance obligation over time, it satisfies it at a point in time, when control is passed.
Factors to consider when assessing transfer of control:
- Entity has present right to payment for the asset
- Entity has physically transferred the asset
- Legal title of the asset
- Risks and rewards of ownership
- Acceptance of the asset by the customer.
IFRS 15 requirements should be applied consistently to contracts with similar characteristics and in similar circumstances. Below are the examples of the industry context of the reporting implications under the standard:
- Entities that ship consumer goods FOB shipping point but retain some form of risk during shipment may be able to recognize revenue earlier if control passes to the customer at the point of shipment;
- The new model provides for recognition of revenue as customized industrial products are produced, depending on the terms of the contract with the customer, and specifically, the termination provisions. Organizations may determine that revenue should be recognized earlier as compared to current practice;
- An entity in the retail sector will have to consider if a warranty provides assurance that a product meets agreed-upon specifications only, or if it provides for additional maintenance service. The latter will require accounting for a separate performance obligation;
- Some entities in the real estate sector will find that revenue previously recognized at a point in time should now be recognized over time, or vice versa;
- Media companies often offer bundles of goods and services to their customers. For example, a multimedia advertising campaign may include more than one type of advertising placement such as print, online and television. Entities will need to assess whether the advertising services represent separate performance obligations, to which the transaction price will have to be appropriately allocated, or whether they should be accounted for as one obligation;
- IFRS 15 distinguishes between licenses that represent the transfer of a right to use an entity’s intellectual property (recognized at a point in time) and licenses that represent the provision of access, over a period of time, to an entity’s intellectual property (recognized over the period of access). Entities within the technology sector will need to examine license arrangements in light of this new guidance, and may need to change their existing accounting;
- Telecommunication service providers will now be required to recognize more revenue associated with a subsidized handset at the start of the contract and less revenue as the contract continues regardless of the pattern of billings;
- Entities in the mining sector may have to recognize revenue at a different point in time depending on its assessment of the transfer of control of goods and/or may have to allocate a portion of the transaction price to a distinct ‘shipping and insurance’ service for certain CIF contracts.
Other topics covered by the Standard
IFRS 15 contains application guidance for:
- Contract costs
- Sale with a right of return
- Principal versus agent considerations
- Customer options for additional goods or services
- Customers’ unexercised rights
- Non-refundable upfront fees (and some related costs)
- Repurchase agreements
- Consignment arrangements
- Bill-and-hold arrangements
- Customer acceptance.
On both an interim and annual basis, companies will generally need to disclose more information than it does under current IFRS. Annual disclosures will include qualitative and quantitative information about the entity’s contracts with customers, significant judgments made (and changes in those judgments) and contract cost assets.