In May 2014, the IASB and FASB issued their converged standard on revenue recognition – IFRS 15 and ASC 606, Revenue from Contracts with Customers. The standard contains principles that an entity will apply to determine the measurement of revenue and the timing of when it is recognised. The underlying principle is that an entity will recognise revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. The standard could significantly change how many entities recognise revenue. The standard will also result in a significant increase in the volume of disclosures related to revenue recognition.
Under IFRS 15, revenue is recognised based on the satisfaction of performance obligations. In applying IFRS 15, entities would follow this five-step process:
- Identify the contract with a customer.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations.
- Recognise revenue when (or as) each performance obligation is satisfied.
1. Identify the contract with a customer
The model starts with identifying the contract with the customer, and whether an entity should combine, for accounting purposes, two or more contracts, to properly reflect the economics of the underlying transaction. An entity will need to conclude that it is ‘probable’, at the inception of the contract, that the entity will collect the consideration to which it will ultimately be entitled in exchange for the goods or services that are transferred to the customer in order for a contract to be within the scope of the revenue standard. The term ‘probable’ has a different meaning under IFRS (where it means ‘more likely than not’ – that is, greater than 50% likelihood) and US GAAP (where it is generally interpreted as 75–80% likelihood). This could result in a difference in the accounting for a contract if there is a likelihood of non-payment at inception. However, the Boards decided that there would not be a significant practical effect of the different meaning of the same term, because the population of transactions that would fail to meet the criterion in paragraph 9(e) of IFRS 15 would be small.
Two or more contracts (including contracts with related parties of the customers) should be combined if: the contracts are entered into at or near the same time and the contracts are negotiated with a single commercial objective; the amount of consideration in one contract depends on the other contract; or the goods or services in the contracts are interrelated. A contract modification is treated as a separate contract only if it results in the addition of a separate performance obligation and the price reflects the stand-alone selling price (that is, the price at which the good or service would be sold on a stand-alone basis) of the additional performance obligation. The modification is otherwise accounted for as an adjustment to the original contract, either through a cumulative catchup adjustment to revenue or a prospective adjustment to revenue when future performance obligations are satisfied, depending on whether the remaining goods and services are distinct.
2. Identify the separate performance obligations in the contract
An entity will be required to identify all performance obligations in a contract. Performance obligations are promises to transfer goods or services to a customer, and they are similar to what we know today as ‘elements’ or ‘deliverables’. Performance obligations might be explicitly stated in the contract, but they might also arise in other ways. Legal or statutory requirements to deliver a good or perform a service might create performance obligations, even though such obligations are not explicit in the contract. A performance obligation could also be created through customary business practices, such as an entity’s practice of providing customer support, or by published policies or specific company statements. This could result in an increased number of performance obligations within an arrangement, possibly changing the timing of revenue recognition.
An entity accounts for each promised good or service as a separate performance obligation if the good or service is distinct. Such a good or service is distinct if both of the following criteria are met:
- The customer can benefit from the good or service, either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct); and
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).
Sales-type incentives (such as free products or customer loyalty programmes) are currently recognised as marketing expense under US GAAP in some circumstances. These incentives might be performance obligations under IFRS 15; if so, revenue will be deferred until such obligations are satisfied, such as when a customer redeems loyalty points. Other potential changes in this area include accounting for return rights, licences and options.
3. Determine the transaction price
Once an entity identifies the performance obligations in a contract, the obligations will be measured by reference to the transaction price. The transaction price reflects the amount of consideration that an entity expects to be entitled to in exchange for goods or services transferred. The amount of expected consideration captures: (1) variable consideration if it is ‘highly probable’ (IFRS) or ‘probable’ (US GAAP) that the amount will not result in a significant revenue reversal if estimates change; (2) an assessment of time value of money (as a practical expedient, an entity need not make this assessment where the period between payment and the transfer of goods or services is less than one year); (3) non-cash consideration, generally at fair value; and (4) less any consideration paid to customers.
Variable consideration is measured using either a ‘probability weighted’ or ‘most likely amount’ approach, whichever is most predictive of the final outcome. Inclusion of variable consideration in the initial measurement of the transaction price might result in a significant change in the timing of revenue recognition. Such consideration is recognised as the entity satisfies its related performance obligations, provided that (1) the entity has relevant experience with similar performance obligations (or other valid evidence) that allows it to estimate the cumulative amount of revenue for a satisfied performance obligation, and (2) based on that experience, the entity does not expect a significant reversal in future periods in the cumulative amount of revenue recognised for that performance obligation. Judgement will be needed to assess whether the entity has predictive experience about the outcome of a contract. The following indicators might suggest that the entity’s experience is not predictive of the outcome of a contract: (1) the amount of consideration is highly susceptible to factors outside the influence of the entity; (2) the uncertainty about the amount of consideration is not expected to be resolved for a long period of time; (3) the entity’s experience with similar types of contract is limited; and (4) the contract has a large number and broad range of possible consideration amounts.
4. Allocate the transaction price to the separate performance obligations
For contracts with multiple performance obligations (deliverables), the performance obligations should be separately accounted for, to the extent that the pattern of transfer of goods and services is different. Once an entity identifies and determines whether to separately account for all of the performance obligations in a contract, the transaction price is allocated to these separate performance obligations, based on relative stand-alone selling prices.
The best evidence of stand-alone selling price is the observable price of a good or service where the entity sells that good or service separately. The selling price is estimated if a stand-alone selling price is not available. Some possible estimation methods include (1) cost plus a reasonable margin, and (2) evaluation of stand-alone sales prices of the same or similar products, if available. If the stand-alone selling price is highly variable or uncertain, entities could use a residual approach to aid in estimating the stand-alone selling price (that is, total transaction price less the stand-alone selling prices of other goods or services in the contract). An entity could also allocate discounts and variable amounts entirely to one (or more) performance obligations if certain conditions are met.
5. Recognise revenue when (or as) each performance obligation is satisfied
Revenue should be recognised when a promised good or service is transferred to the customer. This occurs when the customer obtains control of that good or service. Control can transfer at a point in time or continuously over time. Determining when control transfers will require significant judgement. An entity satisfies a performance obligation over time if: (1) the customer is receiving and consuming the benefits of the entity’s performance as the entity performs (that is, another entity would not need to substantially re-perform the work completed to date); (2) the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or (3) the entity’s performance does not create an asset with an alternative use to the entity, the entity has a right to payment for performance completed to date that includes compensation for a reasonable profit margin, and it expects to fulfil the contract. A good or service not satisfied over time is satisfied at a point in time. Indicators to consider, in determining when the customer obtains control of a promised asset, include: (1) the customer has an unconditional obligation to pay; (2) the customer has legal title; (3) the customer has physical possession; (4) the customer has the risks and rewards of ownership of the good; and (5) the customer has accepted the asset. These indicators are not a checklist, nor are they all-inclusive. All relevant factors should be considered, to determine whether the customer has obtained control of a good.
If control is transferred continuously over time, an entity could use output methods (for example, units delivered) or input methods (for example, costs incurred or passage of time) to measure the amount of revenue to be recognised. The method that best depicts the transfer of goods or services to the customer should be applied consistently throughout the contract and to similar contracts with customers.
Contract cost guidance
IFRS 15 also includes guidance related to contract costs. Costs relating to satisfied performance obligations and costs related to inefficiencies should be expensed as incurred. Incremental costs of obtaining a contract (for example, a sales commission) should be recognised as an asset if they are expected to be recovered. An entity can expense the cost of obtaining a contract if the amortisation period would be less than one year. Entities should evaluate whether direct costs incurred in fulfilling a contract are within the scope of other standards (for example, inventory, intangibles, or property, plant and equipment). If so, the entity should account for such costs in accordance with those standards. If not, the entity should capitalise those costs only if the costs relate directly to a contract, relate to future performance, and are expected to be recovered under a contract. An example of such costs might be certain mobilisation, design or testing costs. These costs would then be amortised as control of the goods or services to which the asset relates is transferred to the customer. The amortisation period could extend beyond the length of the contract, where the economic benefit will be received over a longer period. An example might include set-up costs related to contracts likely to be renewed.
IFRS 15 includes specific implementation guidance on accounting for licences of IP. The first step is to determine whether the licence is distinct or combined with other goods or services. The revenue recognition pattern for distinct licences is based on whether the licence is a right to access IP (revenue recognised over time) or a right to use IP (revenue recognised at a point in time). For licences that are bundled with other goods or services, management will apply judgement to assess the nature of the combined item and determine whether the combined performance obligation is satisfied at a point in time or over time. In addition, the revenue standard includes an exception to variable consideration guidance for the recognition of sales – or usage-based royalties promised in exchange for a licence of IP.
Principal versus agent considerations
Where an arrangement involves two or more unrelated parties that contribute to providing a specified good or service to a customer, management will need to determine whether the entity has promised to provide the specified good or service itself (as a principal) or to arrange for those specified goods or services to be provided by another party (as an agent). Determining whether an entity is the principal or an agent is not a policy choice. IFRS 15 includes indicators that an entity controls a specified good or service before it is transferred to the customer, to help entities to apply the concept of control to the principal versus agent assessment. The assessment should be made separately for each specified good or service. An entity could be the principal for some goods or services, and an agent for others, in contracts with multiple distinct goods or services.
Summary observations and anticipated timing
The above commentary is not all-inclusive. The effect of IFRS 15 is extensive, and all industries could be affected. Some will see pervasive changes, because the new model will replace all existing IFRS and US GAAP revenue recognition guidance, including industry-specific guidance with limited exceptions (for example, certain guidance on rate-regulated activities in US GAAP). Under IFRS, the final standard is effective for the first interim period within annual reporting periods beginning on or after 1 January 2018.
Entities should continue to evaluate how the model might affect current business activities, including contract negotiations, key metrics (including debt covenants and compensation arrangements), budgeting, controls and processes, information technology requirements, and accounting. IFRS 15 will permit an entity to apply it either retrospectively in accordance with IAS 8 or modified retrospectively (that is, including the cumulative effect at initial application date in opening retained earnings – or other equity components, as appropriate). IFRS 15 also provides certain practical expedients that an entity could elect to apply, to simplify transition.