This time, we will continue our previous discussion on the revenue recognition framework in IFRS 15. We have explained in Part 1 that IFRS 15 introduces a single revenue recognition framework for entities across industries. Under this framework, entities will follow the 5-step process to determine revenue to be recognised to depict the transfer of promised goods or services to customers.
If you have missed Part 1, or would like to refresh the 5-step process, refer to Revenue Recognition in IFRS 15 (Part 1) for explanation on the first two steps of the revenue recognition framework. They are (i) identifying the contracts with a customer and (ii) identifying performance obligations.
In this Part 2 of the revenue recognition, we will discuss the remaining 3 steps of the revenue recognition framework. Let’s now go into the details.
The Revenue Recognition framework
We have discussed that entities will first need to consider whether there is a contract going on with its customers and it is performed at the contract inception. Such a conclusion will not change unless there is an indication of a significant change in facts and circumstances – for instance, a significant deterioration in the customer’s ability to pay the consideration when it is due.
Once an entity has determined that a contract exists, an entity will then need to identify the promises to transfer goods or services to the customers and these promises are identify as performance obligations. An entity will also need to determine whether each promise is distinct from other promises in the contract. If a promised good or service is not distinct, an entity will need to combine that good or service with other promised goods or services until it manages to identify a bundle of goods or services that is distinct.
Step 3: Determine the transaction price
Transaction price is determined based on the terms of the contract and entity’s customary business practice. Transaction price reflects the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. As such, amount collected on behalf of third parties is not included or considered as a transaction price.
The transaction price may be variable amounts, fixed amounts or a combination of both. One of the presumptions when determining the transaction price is that the goods or services will be transferred to the customers as promised in the contract and that the contract will not be cancelled, renewed or modified.
In determining the transaction price, an entity considers the effects of the following:
- Variable consideration
- Constraining estimates of variable consideration
- The existence of a significant financing component in the contract
- Non-cash consideration
- The consideration payable to a customer.
These are further explained below.
IFRS 15 requires an entity to estimate the amount of consideration that it will be entitled to if the consideration to be received includes a variable consideration. The amount of consideration to be received by an entity may be affected by discounts, rebates, refunds, credits and others. The amount of consideration may also be contingent on the occurrence or non-occurrence of a future event such as a right for return or performance bonus on achievement of a certain target.
In estimating the variable consideration, IFRS 15 suggests an entity to use either the following methods:
- The expected value – is the sum of probability-weighted amounts in a range of possible consideration amounts. This method may be appropriate if an entity has a large number of contracts with similar characteristics.
- The most likely amount – is the single most likely amount in a range of possible consideration amounts. This method may be appropriate if the contract has only two possible outcomes.
The method chosen should be applied consistently throughout the contract. Take note that an entity is however, required to reassess or update the estimated transaction price at the end of each reporting period. Any changes to the transaction price should be allocated to the performance obligations in the contract the same way or basis as at the contract inception – i.e. step 4.
Constraining estimates of variable consideration
IFRS 15 requires an entity to include in the transaction price some or all of the variable consideration only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is resolved. For this, an entity considers both the likelihood and the magnitude of the revenue reversal. IFRS 15 also requires an entity to update its assessment of whether an estimate of variable consideration is constrained at the end of each reporting period.
The existence of a significant financing component in the contract
An entity is required to adjust the transaction price for the effects of the time value of money if the timing of payments provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. The promise to finance may explicitly be stated in the contract or implied by the payment terms agreed by the parties to the contract.
In assessing whether there is a significant financing component, an entity considers:
- The difference between the amount of promised consideration and the cash selling price of the promised goods or services; and
- The combined effect of (a) the expected length of time between the transfers of promised goods or services and when the customer pays for it; and (b) the prevailing interest rates in the relevant market.
A significant financing component, however, does not exist in any of the following factors:
- The customer paid in advance and the timing of the transfer of goods or services is at the discretion of the customer.
- A substantial amount of consideration and the amount or timing of that consideration varies based on the occurrence or non-occurrence of a future event that is not substantially within the control of the customer or the entity.
- The difference between the promised consideration and the cash selling price arises for reasons other than the provision of finance to either the customer or the entity and the difference between those amounts is proportional to the reason for the difference.
An entity should not adjust the promised amount of consideration for the effects of a significant financing component if the period between transfers of goods or services and its payment is 12 months or less. The discount rate used must also reflect the credit characteristics of the party receiving financing in the contract as well as the collateral or security provided, including assets transferred in the contract. Such a rate should not be updated or adjusted after the contract inception.
IFRS 15 requires an entity to measure the non-cash consideration (or promise of non-cash consideration) at fair value. However, if the fair value cannot be reasonably estimated, an entity should measure the consideration indirectly by reference to the stand-alone selling price of the goods or services promised to the customer.
The consideration payable to a customer
This amount includes the cash amount that an entity pays or expects to pay to the customer. The consideration payable also includes credit or other items that can be applied against the amount owed to the entity. It should be treated as a reduction of the transaction price or revenue unless the payment is in exchange for a distinct good or service that the customer transfers to the entity.
Step 4: Allocating the transaction price to performance obligations
Once the transaction price of the contract with customers has been determined, an entity will then need to allocate the transaction price to each performance obligation or distinct good or service in an amount that reflects the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. This allocation is made on a relative stand-alone selling price basis.
What is a stand-alone selling price and what does it mean by allocation based on stand-alone selling prices? The stand-alone selling price represents the price at which an entity would sell a promised good or service separately to a customer. After determining the stand-alone selling price of goods or services underlying each performance obligation in the contract, the entity will then allocate the transaction price to each performance obligation in proportion to their stand-alone selling price.
The stand-alone selling price is generally the observable price of a good or service when it is sold separately in similar circumstances to similar customers. Take note that a contractually stated price or a price list may be the stand-alone selling price but this may not necessarily be the case. When the stand-alone selling price is not directly observable, IFRS 15 requires an entity to estimate it by maximising the use of observable inputs and apply estimation methods consistently. IFRS 15 also states that the suitable methods for estimating the stand-alone selling price include:
- Adjusted market assessment approach – evaluating the market in which it sells goods or services and estimates the price that a customer in that market would be willing to pay.
- Expected cost plus a margin approach – forecast its expected costs and then add an appropriate margin for that good or service.
- Residual approach – estimate the stand-alone selling price by reference to the total transaction price less the sum of the observable stand-alone prices of other goods or services. There is condition to be met however if an entity wants to use this approach.
Can we combine the methods above to estimate the stand-alone selling price? The answer is a yes. A combination of methods may need to be used to estimate the stand-alone selling price.
Step 5: Satisfaction of performance obligations
After the transaction has been allocated to the performance obligations, an entity will only recognise revenue when or as an entity satisfies a performance obligation. A performance obligation is satisfied when or as an entity transferring a promised good or service to a customer and the customer obtains control of the asset.
Control of an asset refers to the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. It also includes the ability to prevent other entities from directing the use of and obtaining the benefits from an asset.
Each performance obligation can either be satisfied over time or at a point in time. An entity transfers control over time (and recognise revenue over time) only if one of the following criteria is met:
- 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 it 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.
If none of the criteria is met, the performance obligation is satisfied at a point in time. In determining at which point in time the control is transferred, an entity also considers the following indicators:
- The entity has a present right to payment for the asset.
- The entity has transferred physical possession of the asset.
- The customer has legal title to the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
The next question is if a performance obligation is satisfied over time, how do we measure an entity’s progress towards complete satisfaction of the performance obligation? IFRS 15 requires an entity to measure the progress using either the input method or the output method for each performance obligation satisfied over time.
|Input method||Output method|
|Recognise revenue based on the entity’s efforts or inputs to the satisfaction of a performance obligation||Revenue is recognised based on the direct measurement of the value to the customer of the goods or services transferred to date relating to the remaining goods or services promised in the contract|
– Resources consumed
– Labour hours expended
– Cost incurred
– Time elapsed
– Machine hours used
– Survey of performance completed to date
– Milestones reached
– Time elapsed
– Units produced or delivered
– Appraisals of results achieved
The method chosen is to be applied consistently to similar performance obligation in similar circumstances. At the end of each reporting period, an entity re-measures its progress again.
With this, we have now concluded the key principles in the revenue recognition principles in IFRS 15. More detailed guidance on revenue recognition is available in IFRS 15 for further guidance on the 5-step above. In addition to revenue recognition principles, IFRS 15 also provides guidance on the accounting for contract costs and presentation of revenue and its related items in the financial statements. We will continue our discussion on other financial reporting requirements in our future articles. Meantime, enjoy other articles in the Financial Accounting Section.