A European example of deficiencies in identifying performance obligations for purposes of recognizing and measuring revenue under IFRS 15
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA); this is from their 24th edition:
- The issuer is an industrial company active in the automotive sector. The issuer produces and sells automotive parts to original equipment manufacturers (OEMs). In the production process of those parts, the issuer uses moulds (molds, for our North American readers) that are designed by the issuer and constructed by a third-party supplier. Once the OEM selects the issuer as supplier for the parts, both parties sign a nomination letter. This document contains information such as the estimated program life, the estimated annual volume of parts, start of production date, the specification of the moulds to be used, the number of moulds to be used, the price of the moulds and the price for the parts, etc. The nomination letter stipulates that the moulds become the property of the OEM but includes no commitment for the customer (the OEM) for the quantity of parts. Commitments on quantities of parts are only established when the OEM issues purchase orders.
- Within a short period after signing the nomination letter the issuer initiates the design and production of the moulds. On average after 2 years, the moulds are finished and accepted, prototype parts are approved and the first purchase orders for parts are initiated by the OEM.
- In Step 1 of IFRS 15 regarding the revenue recognition process (identification of the contract with a customer) the issuer considered that the nomination letter qualified as a sales contract for both the moulds and the parts. When identifying each party’s rights regarding the goods or services to be transferred in accordance with paragraphs 9(b) and 10 of IFRS 15, the issuer acknowledged that the quantity of parts that will be purchased under the contract was not determined. The contract only indicated an estimated minimum quantity of parts that the issuer must be able to deliver but did not include a volume commitment by the OEM.
- According to the issuer, history has proven that in all cases parts will be delivered. The issuer argues that they can make a reliable estimate of a minimum number of parts (a floor) and that there is a high probability (based on historical experience) that the actual number of parts will not be lower than this amount. Consequently, the issuer determined that enforceable rights and obligations are created for both parties, for the moulds as well as for the parts, and thus there is a contract for both sets of items. The consequence of the issuer’s view is that there is a single contract for the sale of both moulds and parts. When analyzing identification of the performance obligations in the contract, the moulds are considered by the issuer to be not distinct and, together with the parts, to form one performance obligation. The revenue related to the moulds is thus recognized over time along with the revenue related to the parts.
The enforcer (as ESMA likes to term it) disagreed, taking the view that the two performance obligations should not be combined but accounted for separately. Here’s the rationale:
- For the sale of moulds, the signed nomination letter qualifies as a contract as the rights and obligations for both parties can be identified in accordance with paragraph 9(b) of IFRS 15.
- For the sale of parts, the nomination letter includes an estimation of volume but no committed volume for the OEM. As IFRS 15 does not permit a minimum expected quantity to qualify as a commitment for the customer, the enforcer believed that there are no rights for the issuer to produce a certain amount of parts. Only in combination with the purchase orders (which are started to be issued on average two years after signing the nomination letter) there would be committed rights and obligations for both parties. Consequently, for the parts, the nomination letter qualifies purely as a framework agreement and not as a contract. Therefore, there are separate contracts for the sale of moulds and the sale of parts.
- The enforcer further analyzed whether both contracts should be combined in accordance with paragraph 17 of IFRS 15. However, as this requires the contracts to be entered into ‘at or near the same time’, and as there are on average two years between the signing of the nomination letter and the issuance of the first purchase orders (with purchase orders continuing to be issued over a period of seven years on average), the enforcer deemed paragraph 17 of IFRS 15 not to be applicable.
- The enforcer also considered whether the obligation to produce the moulds could be considered as activities that the issuer must undertake to fulfil a contract (the production of the parts), that do not transfer a good or service to customer in accordance with paragraph 25 of IFRS 15 and thus do not generate revenue on their own. The enforcer however determined that this was not the case in this fact pattern as the OEM obtains control of the moulds as it can prevent other entities from directing the use and obtaining the benefits from them as described in paragraphs 31 and 33 of IFRS 15.
When citing these ESMA cases, I always try to make some editorial comment, perhaps to bring out further complexities or to identity aspects where more information might have been useful. In this case though, it speaks quite impeccably for itself. So as it ain’t broke, I won’t fix it!
The opinions expressed are solely those of the author