Some issues around the fifth 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 already discussed the first four of these steps (most recently here). In this article we’ll take a brief look at some of the issues attaching to the fifth step – to recognize revenue when a performance obligation is satisfied.
We discussed in previous articles how to identify all the performance obligations in a contract and to allocate the transaction price between those obligations. With that done, an entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). The amount of revenue recognized is the amount allocated to the satisfied performance obligation. Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset (including the ability to prevent other entities from directing its use and obtaining the benefits from it).
A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer). In many cases, such as in a straightforward retail sale, it will be easy to determine this point in time. In other cases (for example when an item is delivered to the customer through intermediaries) it may be necessary to look at such matters as the point at which legal title to the item is transferred, at customer acceptance provisions, or at other issues relevant to assessing ownership and control.
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if it meets one of the following criteria:
- (a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs – this might apply, for example, where the entity provides sub-contracting services to the customer as part of a larger project for which the customer is responsible;
- (b) the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced – the assessment of control for this purpose is consistent with that described above;
- (c) the entity’s performance doesn’t create an asset with an alternative use to the entity, and it has an enforceable right to payment for performance completed to date. For example, if the service provided by the entity consists of developing a certain kind of machine for the customer, and the customer doesn’t control that asset as it’s created, then the entity doesn’t recognize revenue over the development period if the machine is largely interchangeable with other assets that it could transfer to another customer without breaching the contract and without incurring significant costs it otherwise wouldn’t have incurred in relation to that contract. In contrast, if the machine is sufficiently unique in its design specifications that the entity would incur significant costs in reworking it for another customer, then the entity will likely recognize revenue over the development period (assuming that, at all times throughout the duration of the contract, it’s entitled to an amount that at least compensates it for performance completed to date, if the customer or another party terminates the contract for reasons other than the entity’s failure to perform as promised).
For performance obligations satisfied over time, an entity recognizes revenue over that period by selecting an appropriate method for measuring its progress towards completely satisfying that performance obligation. It applies a single method of measuring progress for each performance obligation satisfied over time and applies that method consistently to similar performance obligations and in similar circumstances. Possible methods include both output and input methods.
Output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract; these methods include surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed and units produced or units delivered. Input methods recognize revenue on the basis of the entity’s efforts or inputs to satisfying a performance obligation (for example, resources consumed, labour hours expended, costs incurred, time elapsed or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation.
Input methods are often easier to apply in practice, but may require careful application and adjustment where (as often) no direct relationship exists between an entity’s inputs and its transfer of control of goods or services to a customer. If an entity lacks any appropriate basis for reasonably measuring its progress toward satisfying the performance obligation, then it doesn’t recognize revenue over time. This inability may sometimes apply only in the early stages of a contract – in this case, the entity recognizes revenue only to the extent of the costs it’s incurred in satisfying the performance obligation (assuming it expects to recover those costs), until it can start reasonably measuring the outcome of the obligation.
Many of the major changes from applying IFRS 15 may, strictly speaking, relate more to the first four steps of the steps in the framework; entities will often find that the new standard doesn’t affect the point in time at which they appropriately recognize revenue, or the adequacy of their existing processes for measuring progress of a contract. However, every entity will need to assess this against its own specific circumstances. Again, the assessment should likely be made sooner rather than later, as (for example) it may be challenging to develop new measurement systems, whether input- or output-based, in cases where this is required.
The opinions expressed are solely those of the author