IFRS 15 – issues in identifying transfer of control, or: you had an alternative sir!

Returning to a key element of IFRS 15…

We looked in the past at the following principle:

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;
  • (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.

On that last point, I wrote that 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).

It would be easy to get tangled up in the technicalities of this “no alternative use” criterion and to forget what it’s all for. The point really is about being able to demonstrate that the entity’s customer controls the asset, in that it has the ability to restrict the entity from directing it to another customer. Where that ability doesn’t exist as a matter of contract, it may be deducible from (for instance) the degree of customization inherent in the asset (i.e. there’s little or no chance it could or would be sold to anyone else). But it’s perhaps more straightforward when it is set out by contract. As the basis for conclusions puts it:

  • If a contract precludes an entity from transferring an asset to another customer and that restriction is substantive, the entity does not have an alternative use for that asset because it is legally obliged to direct the asset to the customer. Consequently, this indicates that the customer controls the asset as it is created…”

The boards observed “that contractual restrictions are often relevant in real estate contracts, but might also be relevant in other types of contracts.” This leads to a recent Grant Thornton publication on applying the concept in that industry. Considered against the backdrop above, the lines it draws should be fairly clear. For example:

  • (an appropriate degree of restriction) could be accomplished by the inclusion of contractual terms naming the specific unit being sold (eg, Apartment 730) or describing its attributes in sufficient detail that substitutability is effectively restricted (e.g, the southwest facing corner unit on the 17th floor). A contractual restriction may not be substantive if, for example, it represents a protective right that does not effectively restrict the vendor from physically substituting a largely interchangeable asset (eg a contractual term intended to protect the customer against the vendor’s insolvency).
  • …while individual apartments in some complexes may be fairly standardized, contractual provisions are often present that act to restrict the vendor from redirecting a specific unit to another customer and in that case the ‘no alternative use’ criterion would once again be met.

Still, some may wonder whether such cases may sometimes veer in the direction of privileging form over substance. That is, if it’s plain that a particular customer will acquire and move into one of the largely identical units 730, 731 or 732, does it matter that the contract doesn’t specify which one, especially (say) where the other two units have also already been sold, for similar consideration? Perhaps the answer is in part that even in that kind of situation, it’s not likely all the transactions will conclude at once, and so the interchangeability might still allow too much room for manipulating revenue across different periods.

I must admit that I’m a little intrigued by how often such a situation arises in practice. I mean, on the few occasions I’ve gone shopping for real estate, I’ve always wanted to know exactly what I was buying…

The opinions expressed are solely those of the author

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