Revenue from Contracts

IFRS 15

Technical Notes

Revenue from Contracts

IFRS 15

Level Tested on CPA PEP

ExamLevel TestedImportance (low, medium, or high)
Core 1 Module Level AHigh 
Assurance ElectiveLevel AHigh 
Scope

IFRS 15 

Effective for annual periods beginning on or after January 1, 2018, the revenue recognition criteria for IFRS financial statements will be under IFRS 15. 

There is no change to revenue recognition criteria under ASPE 3400. 

The IFRS 15 focuses on a contract-based approach. As the name implies, the contract-based approach focuses on the contracts with customers. 

It is important to note that this section (IFRS 15) does NOT apply to the following customer contracts:

  • Financial instruments contracts 
  • Lease contracts 
  • Insurance contracts
  • Non-Monetary contracts between entities in the same line of business
Definition
  • IFRS 15 is called a contract-based (also known as the asset-liability) approach. 
  • Customer Contract: The IFRS 15 focuses on customer contracts. As such there has to be a customer in the contract for the IFRS 15 to be applicable. To be considered a customer entity, it has to obtain goods or services in exchange for consideration. 
  •  Contract: Contracts can be written, oral, or implied by the company’s ordinary business practices. The term contract here is for accounting purposes and doesn’t have to be same as in the legal definition. 
    • A contract doesn’t exist if each of the parties in the contract has the right to terminate an unperformed contract without an approval from another party and  without the compensation to the other party 
Revenue Recognition criteria - Steps in Revenue Model

There are 5 steps in Revenue Model:

i) Identify the contract(s) with the customer

ii) Identify the performance obligations in the contract

iii) Determine the transaction price

iv) Allocate the transaction price to performance obligations

v) Recognize revenue when each performance obligation is satisfied

 

There are individual criteria’s in each of these steps above and discussed below. 

Step #1 - Identify the contract(s) with the customer

A contract exists when all five of the following criteria are met: 

i) The contract has been approved by all parties and parties are committed to perform their obligations

ii) The rights regarding goods or services to be transferred to buying party can be identified.

iii) Can identify payment terms

iv) The contract has commercial substance.

Commercial substance = means that the risk, timing, or amount of company’s current or future cash flows is expected to change as a result of the contract. Commercial substance exists if the terms of the contract is consistent with the selling parties line of business. 

v) Collection is considered probable i.e. “More likely than not” the seller will get cash after assessing the customers creditworthiness, financial resources and intentions to pay. 

Key points:

a. If each party to the contract has the right to terminate an unperformed contract without paying any compensation to the other party, then a contract does not exist. 

b. If the criteria above is not met and there is no contract then you can still recognize revenue ONLY if one of the following two things happen.

  • All or substantially all of consideration is received from the customer and there is no further obligation to perform services or deliver goods and it’s non-refundable; or
  • Consideration is received from the customer that is non-refundable and the contract has been terminated.

c. Modifications to the original contract: Treat the modified contract as a separate contract it the two conditions are present:

  • The change in the scope of the contract is due to the addition of distinct goods or services; and
  • The price of the contract is increased by the amount of the seller’s stand-alone selling price of the additional goods or services and any appropriate adjustments to price to reflect the circumstances of the particular contract.

c.1 – If a contract modification is not considered to be a separate contract: In that case, the seller has to account for additional goods or services as below:

  • Termination approach i.e. replace the original contract with a new contract: Only if the remaining goods or services are distinct from goods or services transferred on or before modification.
  • Continuation approach i.e. treat the modification as part of the original contract and adjust revenue accordingly: Only if remaining foods or services are not distinct.
  • Combination of the above two approaches.

d. Combining two or more contracts. A seller should combine two ore more contracts at or near the same time with the same customer or someone related to the customer, if any of the following criteria are met:

  • The contracts are negotiated as a package with a single commercial objective; or
  • Amount of consideration to be paid in one contract depends on the price or performance of the other contract;
  • The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.
Step#2 - Identify the performance obligations in the contract

A performance obligation is a promise to a customer to transfer one of the following:

  1. a good or service (or a bundle of goods or services) that is distinct
  2. a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer

Good or service is considered to be distinct if both of the following criteria’s are met.       

        i) The customer can benefit from the good or services  on its own or with other readily available resources (by using, consuming, or selling it); and

       ii) The promise to transfer the good or service is separate from the other promised good or service in the contract. That is this good or service is being purchased as separate item as   opposed to be part of a larger good or service. You need to consider the following factors in assessing this point:

  • Good or service does not significantly modify another good or service promised in the contract

  • Good or service is not highly dependent on, or interrelated with, other goods or services promised in the contract

  • The entity does not provide significant integration of the good or service with other goods or services promised in the contract

If the two criteria are not met, then the goods or services are not considered to be distinct and are bundled with other goods and services to be provided under a contract until a distinct performance obligation is created.

 

Step#3 - Determine the transaction price

  • The transaction price is the amount of consideration the company expects to receive in exchange for providing the goods or services, excluding amounts collected on behalf of third parties such as sales tax.

    • The transaction price must reflect any variable consideration if it is “highly probable” that it won’t be revised or reversed in the future.
      • Variable consideration can result if there are discounts, refunds, rebates, penalties or other similar items.
      • 2/10, n/30, means a customer will get a 2% discussion if they pay within 10 days of purchase but the regular due date is 30 days
    • Refunds or  sale with a right of return: The expected amount is set up when sale is  recognized as a reduction in revenue with an offsetting liability and is reassessed at the end of each year.

    Other points:

    • The non-cash consideration is measured at fair value and included in the transaction price.
    • If the payment and date of transfer of the goods or services is more than one year apart then you should discount the payment and recognize interest revenue separately.
Step#4 - Allocate the transaction price to performance obligations
  • If in step#2, only a single performance obligation was identified, then this step is not required.
  • Otherwise the transaction price is allocated among multiple produces based on their relative stand alone selling price.
  • If a stand-alone selling price is not directly available from other sales, the seller will need to estimate an appropriate allocation considering all available information that is available.
    • The following methods can be used to estimate the stand-alone price:
      • Adjusted market assessment approach: The seller will evaluate the same price for similar good or service sold in the market. This may include referring to competitor’s prices and adjusting as necessary.
      • Expected cost + margin approach: The seller will estimate its costs and then ads an appropriate margin.
      • Residual approach: – total transaction price less the total of available standalone selling prices. The approach can only be used if one of following criteria is met:
        • The entity sells the same good or service to different customers for a wide range of amounts; or
        • The entity has not yet established a price for that good or service and it hasn’t previously been sold on a stand-alone basis

  • Transaction price involves a discount:

    The bundles are usually at a lower price that the individual standalone selling prices. The general rule is to allocate the discount proportionately to all performance obligations unless the following criteria are met, in which case the discount is allocated entirely to one or more, but not all, performance obligations:

    • Each good or service is distinct and sold regularly on a standalone basis;
    • The seller also regularly sells some of those distinct goods or services at a discount;
    • The discount being attributed to the goods or services is substantially the same as what the seller regularly offers on the good or service.

  • Treatment of variable consideration:

    Allocate only to the performance obligation(s) to which the variable consideration is attributable i.e.  it is attributable to one or more, but not all, performance obligations.

  • Changes in the transaction price:

    • The change in the transaction price should be adjusted to the performance obligations on the same basis as at contract inception. This means that the seller should not update or reallocate the transaction price to reflect changes in standalone selling prices after contract inception.
    • If allocated to a performance obligation that is already completed, recognize in period in which the transaction price change occurred and do not have to adjust retrospectively.
Step#5 - Recognize revenue when each performance obligation is satisfied
  • The seller should recognize revenue when it has satisfied its performance obligation. This could be satisfied over time or at a point in time. 
  • Performance obligation is satisfied when control of the goods or services are transferred to the customer.

Performance obligation satisfied over time

Performance obligations are satisfied over time if the any one of the criteria is met:

  • The customer receives or consumes the benefits provided by the seller simultaneously for e.g. monthly subscription of netflix
  • The sellers performance enhances or creates an asset that the customer controls as the asset is created or enhanced for e.g. work-in-progress
  • The sellers performance does not create an asset with an alternative use to the seller and the seller has an enforceable right to payment for performance completed to date for e.g. a custom equipment that is in work in progress and the seller cannot sell to a third party because it is customized. 

Once any of the criteria above is met, the revenue needs to be recognized over time. 

The seller need to recognize revenue at the end of each period by comparing how much work has been completed in relation to the total amount of work to be performed under the contract. The calculation is is same as % of completion method in the old IAS11. Refer to our notes in IAS 11 for example on % of completion. 

IFRS 15 allows for the following two methods.  Once the method is chosen then the seller must use the same method of measuring progress consistently.

  1. Output method:
  • Recognize revenue by prorating the value of the goods or services transferred to date relative to the remaining goods or services promised under the contract i.e. the proportion of the good or service that has been delivered compared with the proportion that still has to be delivered.
  1. Input method:
  • Recognize revenue by prorating the total inputs used relative to the total expected input.

If the seller is unable to use one of the two methods because you can’t reasonably measure progress to completion, then seller should only recognize revenue to the extent of costs incurred until you can reasonably measure.

Performance obligation satisfied at a point in time

  • If a performance obligation is not satisfied over time, then the seller satisfies the performance obligation at a point in time.
  • Indicators that performance obligation is satisfied at a point in time includes the customer having:
    • Physical possession of goods or
    • Legal title or
    • The risk and rewards of ownership or
    • Accepted the goods or received the services
    • Sellers right to payment
Other Issues under IFRS 15

The IFRS 15 also addresses the following topics

  • Sale with a right of return 
  • Warranties 
  • Principal versus agent considerations 
  • Customer options for additional goods or services 
  • Customers’ unexercised rights 
  • Non-refundable upfront fees 
  • Licensing 
  • Repurchase arrangements 
  • Consignment arrangements 
  • Bill-and-hold arrangements 
  • Customer acceptance
Changes to ASPE
  • There is no change to ASPE Section 3400. 

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