Some issues around the first step in the IASB’s new framework for recognizing revenue
As we summarized here, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2017 (NB this was subsequently amended to January 1, 2018). The new standard is built around a five-step framework, the first step being to identify the contract(s) with the customer. In this article, we’ll take a brief look at some of the issues attaching to this key step.
The Standard specifies that an entity accounts for a contract within the scope of IFRS 15 only when all the following criteria are met:
- (a) the parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;
- (b) the entity can identify each party’s rights regarding the goods or services to be transferred;
- (c) the entity can identify the payment terms for the goods or services to be transferred;
- (d) 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); and
- (e) it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession.
In contrast, the current standards don’t have the same focus on identifying a contract that meets specific criteria; instead they set out in more general terms the need to examine the circumstances of the transaction to assess when an entity has transferred the significant risks and rewards of ownership to the buyer. In many cases, such as a simple retail sale, the conditions set out above will be easily met by virtue of the common and recurring nature of the transaction stream. In other cases though, implementing IFRS 15 may require reassessing current business practices, to ensure that revenue recognition isn’t delayed or otherwise affected solely due to definitional or procedural matters attaching to the contract. For example, the first criterion set out above might entail that revenue can’t be recognized where a form of explicit approval is required by both parties and this approval hasn’t been promptly obtained (for instance, because of familiarity between the parties).
When a contract with a customer doesn’t meet all these criteria and an entity receives consideration from the customer, it recognizes this as revenue only when it has no remaining obligations to transfer goods or services to the customer and it’s received (on a non-refundable basis) all, or substantially all, of the consideration promised by the customer; or else when the contract has been terminated (assuming again that the consideration is non-refundable). Any consideration received from the customer before this point is recognized as a liability (in present terminology, many will think of this liability as “deferred revenue,” although this label wouldn’t reflect the wording of IFRS 15 particularly well).
An entity combines two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and accounts for the contracts as a single contract if:
- the contracts are negotiated as a package with a single commercial objective; and/or
- the amount of consideration to be paid in one contract depends on the price or performance of the other contract; and/or
- the goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation in accordance with the guidance in the standard (we’ll address this concept in the near future).
This entails that an entity can’t influence the pattern of revenue recognition from its involvement with a customer simply by dividing the work to be done between different contracts or different legal entities. For example, if the entity is supplying a package of intertwined technological goods and services, all documented and priced separately, the separate documents will be regarded as one for purposes of IFRS 15, assessing matters such as the separate performance obligations promised by the entity, and their stand-alone selling prices, without regard to the form of the documentation.
IFRS 15 also includes detailed guidance on accounting for contract modifications – changes in the scope or price (or both) of a contract that are approved by the parties to the contract. An entity accounts for such a modification as a separate contract if the scope of the contract increases because of adding promised goods or services that are distinct and the price of the contract increases by an amount of consideration reflecting 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. The standard also sets out detailed accounting requirements for contract modifications when they’re not accounted for as separate contracts.
Of course, the above doesn’t tell you anything about the actual accounting mechanics, only about the groundwork to be laid before even starting to assess those mechanics. We’ll follow the trail further in future posts.
The opinions expressed are solely those of the author