Revenue is undoubtedly the main element and focuses for any profit-oriented entities. IFRS 15 Revenue from Contracts with Customers governs the accounting principles for revenue recognition. IFRS 15 was introduced by the International Accounting Standards Board (“IASB”) in May 2016 to provide a single comprehensive framework for all revenue arising from contracts with customers. The introduction of IFRS 15 replaces various standards and interpretations that were previously issued to address various types of revenue as follows:
- IAS 18 Revenue
- IAS 11 Accounting for Construction Contracts
- IFRIC 13 Customer Loyalty Programmes
- IFRIC 15 Agreements for the Construction of Real Estate
- IFRIC 18 Transfers of Assets from Customers
- SIC-13 Revenue – Barter Transactions Involving Advertising Services.
IFRS 15, however, is not applied to the following type of contracts:
- Lease contracts – which is governed under IFRS 16 Leases
- Insurance contracts – which is governed under IFRS 4 Insurance Contracts
- Financial instruments and other contractual rights or obligation within the scope of IFRS 9 Financial Instruments
- Non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers.
Let us now dive deeper into how entities account for and recognise their revenue from contracts with customers.
The Revenue Recognition framework
The single revenue recognition framework introduced in IFRS 15 aims at providing a single framework for entities in all industries to recognise their revenue from contracts with customers consistently. A customer is defined by IFRS 15 as a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. For example, if the counterparty contracted with an entity to participate in an activity or process where both share in the risks and benefits, such a counterparty is not a customer.
The revenue recognition framework in IFRS 15 comes with the following 5-step process:
The objective of the 5 steps above is to ensure that revenue recognised represent or depict the transfer of promised goods or services to customers in an amount that reflects the consideration that the entities expect to be entitled to in exchange for those goods and services. Entities are required by the standard to apply the five steps for recognising revenue from contracts with customers.
We will now discuss the five steps in detail. Due to the lengthy discussion that may be involved, this article will however, discuss Step 1 and Step 2 while the remaining 3 steps will be covered in Part II of the upcoming article.
Step 1: Identifying the contracts with customers
The first step is for an entity to assess whether there is a contract with a customer. This requires an entity to determine whether a contract exists at the inception. Once determined, entities do not need to reassess this again unless there is an indication of a significant change in facts and circumstances.
A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations and for such, it is a matter of law. It is not necessary for a contract to exist merely by written agreement. This means a contract may also exist orally or implied by an entity’s customary business practices. Entities must consider their business practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations.
A contract with a customer is accounted under this standard if it meets all of the following criteria:
- Contract approval and commitment – The parties to the contract have approved the contract, either in writing, orally or in accordance with other customary business practices and are committed to performing their respective obligations
- Identification of rights – the entity can identify each party’s rights regarding the goods or services to be transferred.
- Payment terms – the payment terms can be identified for the goods and services to be transferred.
- Commercial substance – the contract has commercial substance, i.e., the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract.
- Collection of consideration is probable – It is probable that the entity will collect the consideration to which it will be entitled. For the purpose of this assessment, only the customer’s ability and intention to pay when payment is due are considered.
If the above criteria are not met, entities continue to assess whether they will be met subsequently. So, what happened if the criteria are not met? If the criteria are not met but an entity receives consideration from the customers, it recognises a liability for the consideration received until the criteria above are met or recognise as revenue in one of the following events:
- There are no remaining obligations due from the entity to transfer goods or services and all, or substantially all, of the consideration promised by the customer has been received by the entity and is non-refundable.
- The contract has been terminated and the consideration received from the customer is non-refundable.
Take note that for the purpose of applying the standard, a contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract – i.e., promised goods or services are yet to be transferred and the consideration is yet to be received – without compensating the other party.
Combination of contracts
In certain business transactions, entities may need to enter into multiple contracts at the same time or near the same time. This is common for Islamic transactions where few contracts are entered into at the same time with the same party for the purpose of meeting Shariah requirements. Nevertheless, this arrangement can also take place for conventional transactions.
The question is then, should each contract be assessed separately? Or should we combine them together? Assessing each of the contract separately may lead to a different accounting conclusion as compared to assessing them in combination.
IFRS 15 allows an entity to combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account them as a single contract if one or more of the following criteria are met:
- The contracts are negotiated as a package with a single commercial objective;
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract; or
- The goods or services promised in the contracts (or some goods or services) are a single performance obligation.
It is also common for contracts with customers to be modified subsequent to the contract inception, for example, contract modification through a change order, variation order or as an addendum to the original contract. A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties to the contract.
A contract modification can either creates new or changes existing enforceable rights and obligation of the parties to the contract. When a contract modification took place, an entity should determine whether such modification be accounted for as a separate contract. A contract modification is treated as a separate contract if both of the conditions below are present:
- The scope of the contract increases because of the addition of promised goods or services that are distinct; and
- The price of the contract increase by an amount of consideration that reflects the entity’s stand-alone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract.
Step 2: Identifying performance obligations
After an entity has determined that there is a contract with a customer, an entity is then required to determine goods or services promised in the contract and identify as a performance obligation for each promise to transfer to the customer. This determination is performed at the contract inception.
The performance obligations identified in a contract may not be limited to the goods or services that are explicitly stated in that contract. As such, a performance obligation may also include promises that are implied by the entity’s customary business practices, published policies or specific statements that create a valid expectation that the entity will transfer a good or service to the customer, assessed at the time of entering into the contract.
A performance obligation for each promise to transfer to the customer is 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.
A series of distinct goods or services have the same pattern of transfer if both of the following are met:
The next question is how do we know whether the goods or services promised in the contract are distinct? For this, IFRS 15 states that 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
This means that the good or service could be used, consumed or sold for an amount that is greater than scrap value or held in a way that generates economic benefits.
- The entity’s promise to transfer the good or service is separately identifiable from other promises in the contract
This is to determine whether the nature of the promise is to transfer each of those goods or services individually or to transfer a combined item. Factors that indicate two or more promises are not separately identifiable include the following (not exhaustive):
- A significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services is provided by the entity. The bundle of goods or services represent the combined output(s) for which the customer has contracted with the entity.
- One or more of the goods or services significantly modifies or customises, or are significantly modified or customised by one or more of the other goods or services promised in the contract.
- The goods or services are highly interdependent or highly interrelated -i.e., each of the good or service is significantly affected by one or more of the goods or services in the contract.
If the promised good or service is not distinct, that good or service is then combined with other promised goods or services until it identifies a bundle of goods or services that is distinct.
At this stage, an entity has determined whether it has a contract with a customer and the performance obligations promised to the customer in the contract. In Part II, we will further understand how an entity accounts for its performance obligations in the contract and how revenue is recognised. Meanwhile, enjoy other articles in the Financial Accounting section.