Some issues around the second 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, and we discussed the first of these steps here. In this article we’ll take a brief look at some of the issues attaching to the second step – to identify the performance obligations contained in the contract.
A performance obligation is:
A promise in a contract with a customer to transfer to the customer either:
(a) a good or service (or a bundle of goods or services) that is distinct; or
(b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
In many situations, of course, it’s easy to identify the promises made to a customer (even if, as later articles will discuss, it may not be as straightforward to conclude when those promises have been entirely fulfilled, or how this should affect the pattern of recognizing revenue). For example, in an everyday retail transaction, the promise is to transfer a particular item to the customer in return for receiving payment, and this promise can be rapidly fulfilled once the customer initiates the transaction. In other cases, a contract may encompass a number of different goods and services: some of them delivered at or near to the time of intercepting the contract, others in the future, or over a period of time.
IFRS 15 observes that an entity’s contract with a customer will usually explicitly state the goods or services that it promises to transfer. However, it goes on: “the performance obligations identified in a contract with a customer may not be limited to the goods or services that are explicitly stated in that contract. This is because a contract with a customer may also include promises that are implied by an entity’s customary business practices, published policies or specific statements if, at the time of entering into the contract, those promises create a valid expectation of the customer that the entity will transfer a good or service to the customer.” For example, a customer who purchases particular goods may have a valid expectation of receiving various forms of maintenance or other support over a period of time following the purchase, even if the contract doesn’t confirm this in so many words. The significance of this is that the entity typically allocates the overall transaction price to each performance obligation on the basis of the relative stand-alone selling prices of each distinct good or service; consequently, such non-contractual “valid expectations” on the part of the customer may entail that the entity doesn’t recognize a portion of contract revenue until the related performance obligation can be considered to be satisfied (perhaps simply through the passage of time).
However, performance obligations don’t include other activities necessary to fulfilling a contract that don’t transfer a good or service to a customer. For example, the standard specifies that “various administrative tasks to set up a contract” don’t constitute a performance obligation if the customer doesn’t directly receive a service as the tasks are performed.
A good or service promised to a customer is distinct if the customer can benefit from the good or service either on its own or together with other resources that are readily available to it (i.e. 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 (i.e. the good or service is distinct within the context of the contract). This assessment will clearly often be key to determining whether a particular aspect of a contract can be regarded as a distinct performance obligation.
For example, suppose a technology company transfers a device to a customer at the outset of entering into a multi-year contract. The device may be capable of being distinct in that, if the customer hadn’t purchased it as part of a “bundled” contract, he or she could have acquired the device and other services provided by the contract separately, either from that same company or from its competitors. On the other hand, the device may be highly application-specific and incapable of being acquired or meaningfully used except in conjunction with the other services in the contract. In the latter case, it’s less likely that the entity will recognize any portion of contract revenue simply as a result of transferring the device to the customer. As the Standard summarizes it: “If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation.”
IFRS 15 addresses this area in much greater detail than the current IAS 18, and may certainly affect the pattern of revenue recognition for contracts containing multiple elements. Because the Standard focuses on the substance of what’s promised to the customer rather than on the form in which the promise is made, it may be difficult to affect its application by changing the content of contracts alone. Still, given the significance of revenue as a performance measure, any entities subject to potential complexities and differences should certainly be assessing these matters sooner rather than later.
The opinions expressed are solely those of the author