As we’ve discussed many times in the past, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2018.
Canada’s IFRS Discussion Group recently considered the following issue relating to the application of IFRS 15:
- Entity A develops, manufactures and distributes innovative products. Product X was launched in mid-2018 and there is no other similar product on the market.
- On November 30, 2018, Entity A enters into a contract with Entity B (a retail company) to sell 100 units of Product X for $10,000.
- Entity A has a written policy allowing its retail customers to return any unsold products within 90 days. Entity A agrees to pay the shipping costs of any units returned by Entity B and estimates that the cost to ship each unit is $10.
- The cost to produce each unit of Product X is $70 and Entity A thinks that the product can be resold at a profit.
- At Entity A’s year end, December 31, 2018, Entity B has not returned any units of Product X. Entity A’s financial statements are issued on February 18, 2019.
As we discussed here, IFRS 15 contains new requirements for identifying and measuring variable consideration – amounts of consideration that can vary due to the effect of discounts, rebates, refunds, returns, penalties, or other items. Before an entity can recognize any revenue on a contract, the standard requires estimating the amount of such consideration to which it will be entitled, taking all of this into account, in exchange for transferring the promised goods or services to a customer. The entity makes the estimate by using either an expected value method (the sum of probability-weighted amounts) or the most likely amount, depending on which method it expects to better predict the amount of consideration to which it’ll be entitled. It updates the estimated transaction price at the end of each reporting period.
In some cases, the variability attached to an element of consideration may be so great that the standard precludes the entity from recognizing any revenue. An entity doesn’t include any amount of variable consideration in the transaction price unless “it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.” This might apply for instance when the entity only has limited experience with a particular product, or where the range of concessions that might be offered to customers is unusually wide or unpredictable.
The group discussed this requirement relative to the fact pattern above, noting that relevant factors might include historical resale data (for example, sales, returns and gross margin of Product X and of similar products) both during the year, and in between the year end and the issuance date of the financial statements; the payment terms set out in the contract; and any uncertainties associated with the transaction (for example, whether the retailer will be able to sell the product with a margin to another customer and would record the inventory at its net realizable value).
Where a sale includes a right of return, then as we discussed here, in addition to recognizing revenue, the vendor recognizes a refund liability, and an asset for its right to recover products from customers on settling that liability. The group discussed how to measure this “right of recovery asset” in the situation above (assuming for the sake of argument that control of the product has passed to the customer and that the transaction constitutes a sale). IFRS 15.B25 says the asset is initially measured “by reference to the former carrying amount of the product (for example, inventory) less any expected costs to recover those products (including potential decreases in the value to the entity of returned products).” In a situation where the vendor hasn’t recognized any revenue, because of the constraint on recognizing variable consideration, then recognizing an expense for expected costs to recover the products would generate a negative margin on the transaction in the income statement. It might seem strange and inappropriate, as it did to some members, that a vendor is precluded from recognizing revenue at the outset of a particular contract, and yet has to recognize an estimate of recovery costs.
One might reject that outcome just based on the substance of the transaction, and yet paragraph B25 seems entirely clear on the matter. Perhaps one could reason in some way that if the consideration isn’t sufficiently determinable, then recovery costs can’t truly be so either. Or perhaps the oddity of the accounting outcome might cause the vendor to reconsider whether a sale has truly taken place, for example, whether the customer has in reality accepted the products only for “trial or evaluation purposes” – in such circumstances, IFRS 15.B86 specifies that control of the product isn’t transferred until either the customer accepts the product or the trial period lapses. Whether that applies here would depend of course on the specific facts and circumstances.
Overall, the discussion certainly illustrates what one of the participants expressed – that IFRS 15 is a whole new model for recognizing and measuring revenue, which requires thinking about the underlying contracts in a significant new light…
The opinions expressed are solely those of the author