Historically significant diversity existed in revenue recognition practices under IFRS as previous revenue standards contained limited guidance on many important topics, such as accounting for arrangements with multiple elements. Furthermore, the limited guidance that was provided was often difficult to apply to complex transactions, particularly because limited application guidance in previous revenue standards. Consequently, some companies supplemented the limited guidance in IFRS by selectively applying US GAAP.
Overview of IFRS 15— new framework for recognising revenue
International Financial Reporting Standard 15 Revenue from Contracts with Customers (IFRS 15) establishes principles for reporting useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from an entity’s contracts with customers. It is effective for annual periods beginning on or after 1 January 2018 and earlier application is permitted.
IFRS 15 supersedes:
- IAS 11 Construction Contracts;
- IAS 18 Revenue;
- IFRIC 13 Customer Loyalty Programmes;
- IFRIC 15 Agreements for the Construction of Real Estate;
- IFRIC 18 Transfers of Assets from Customers; and
- SIC-31 Revenue—Barter Transactions Involving Advertising Services.
The new five step model
To recognise revenue, a company would apply the following five steps:
Step 1: Identify the contract(s) with the customer
The first step in IFRS 15 is to identify the “contract,” which IFRS 15 defines as “an agreement between two or more parties that creates enforceable rights and obligations.” A contract can be
written, oral, or implied by an entity’s customary business practices.
In addition, the IFRS 15 model applies only when or if: (a) the contract has commercial substance, (b) the parties have approved the contract, (c) the entity can identify (a)each party’s rights, (b) the payment terms for the goods and services to be transferred and (d) it is probable the entity will collect the consideration.
If a customer contract does not meet these criteria, revenue is recognised only when either: (a) the entity’s performance is complete and substantially all of the consideration in the arrangement has been collected and is non-refundable or (b) the contract has been terminated and the consideration received is non-refundable.
Step 2: Identify the performance obligations in the contract
Having identified a contract, the entity next identifies promises to transfer goods or services to a customer within that contract. If those goods or services are distinct, the promises are performance obligations and are accounted for separately. A good or service is distinct if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer and the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.
IFRS 15 Illustrative Example 11: Distinct good or services
An entity, a software developer, enters into a contract with a customer to transfer a software licence, perform an installation service and provide unspecified software updates and technical support (online and telephone) for a two-year period. The entity also sells the licence, installation service and technical support separately. The installation service is routinely performed by other entities and does not significantly modify the software.
Under IFRS 15 the entity observes that the software is delivered before the other goods and services and remains functional without the updates and the technical support. Thus, the entity concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available. Furthermore, the entity also determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises as the installation service does not significantly modify or customise the software itself and are considered separate outputs promised by the entity.
On the basis of this assessment, the entity identifies four performance obligations in the contract namely (a) the software licence; (b) an installation service; (c) software updates; and (d) technical support.
Step 3: Determine the transaction price
Under IFRS 15, the “transaction price” is defined as the amount of consideration an entity expects to be entitled to in exchange for the goods or services promised under a contract, excluding any amounts collected on behalf of third parties (for example, sales taxes). The transaction price can be a fixed amount of customer consideration, but it may sometimes include variable consideration or consideration in a form other than cash. The transaction price is also adjusted for the effects of the time value of money (if the contract includes a significant financing component) and for any consideration payable to the customer.
If the consideration is variable, an entity estimates the amount of consideration to which it will be entitled in exchange for the promised goods or services. The estimated amount of variable consideration will be included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
IFRS 15 illustrative Example 21—Estimating variable consideration
An entity enters into a contract with a customer to build a customised asset. The promise to transfer the asset is a performance obligation that is satisfied over time. The promised consideration is CU2.5 million, but that amount will be reduced or increased depending on the timing of completion of the asset. Specifically, for each day after 31 March 20X7 that the asset is incomplete, the promised consideration is reduced by CU10,000. For each day before 31 March 20X7 that the asset is complete, the promised consideration increases by CU10,000.
In determining the transaction price, the entity decides to use the expected value method to estimate the variable consideration associated with the daily penalty or incentive (ie CU2.5 million, plus or minus CU10,000 per day)
Step 4: Allocate the transaction price
Under IFRS 15, an entity allocates a contract’s transaction price to each separate performance obligation within that contract on a relative stand-alone selling price basis at contract inception. IFRS 15 defines a stand-alone selling price as “the price at which an entity would sell a promised good or service separately to a customer.” IFRS 15 suggests, but does not require, the following three methods as suitable for estimating the stand-alone selling price:
- Adjusted market assessment approach: Involves evaluating the market in which the entity sells goods or services and estimating the price that customers in that market would pay for those goods or services.
- Expected cost plus margin approach: An entity would forecast its expected costs to provide goods or services and add an appropriate margin to the estimated selling price.
- Residual approach: Involves subtracting the sum of observable stand-alone selling prices for other goods and services promised under the contract from the total transaction price to arrive at an estimated selling price for a performance obligation.
Step 5: Recognise revenue when a performance obligation is satisfied
Under IFRS 15, an entity recognises revenue when or as it transfers control over promised goods or services to a customer. A customer obtains control of an asset (good or service) when it can direct the use of and obtain substantially all the remaining benefits from it. Control can be transferred over time or at a point in time. Therefore, for performance obligations where control is transferred over time, an entity recognises revenue over time using appropriate method and for performance obligations where control is transferred at point in time, recognise revenue at the point of transfer.
The implementation of IFRS 15 will impact business in varying degrees and the impact will not be limited to finance function alone!!!
With effective date of 1 January 2018 impacted business should start analysing the impact of implementing IFRS 15 and its consequent effect on wider business process such as changes to IT systems to gather additional data, changes to internal control systems, training employees, communication with external stakeholders such as banks, creditors, stock market etc.