New IFRS on revenue recognition
On 28 May 2014, the International Accounting Standards Board (IASB) published International Financial Reporting Standard (IFRS) 15 Revenue from Contracts with Customers. The Standard was a joint project with the US Financial Accounting Standards Board (FASB) and provides guidance on when to report revenue (also known as turnover), at what amount, how to present it in the financial statements and what additional information to present in the financial statements on this issue.
“The effective date of IFRS 15 is 1 January 2017”
For some entities, IFRS 15 will result in revenue being reported earlier than is currently the case. For others, the Standard will have the opposite effect. For most entities, however, the effect of the Standard on when revenue will be reported will be insignificant.
IFRS 15 includes more guidance than the Standards it replaces, but at the same time some consider that IFRS 15 requires more judgement than current practice. There are probably two reasons for this:
In some industries many companies have chosen to fill gaps in current IFRS with US GAAP. US GAAP has provided specific criteria to deal with certain accounting issues that were previously not specifically addressed in IFRS. The guidance in IFRS 15 on these issues is more principles based than in US GAAP and could therefore require more judgement.
Entities have implemented the existing guidance on revenue in their operational models and systems in a manner that has automated many of the judgements needed.
This article presents an overview of the general principles in IFRS 15 focusing on some of the main areas of judgement to highlight some areas that may need special attention. Since only a fraction of the IFRS 15 guidance is considered in this article, application of IFRS 15 should not be based on the explanations included in this article.
In summary if revenue falls under the scope of IFRS 15, an entity will first have to identify the contract to be accounted for. When this is done, it will have to identify the distinct goods and services in the contract. The entity then needs to decide when to report revenue for each of the identified distinct goods and services and the amount of revenue to report. The total amount of revenue reported for each distinct goods or services is based on an allocation of the total contract price to the identified distinct goods and services.
The remainder of this article is structured around these steps.1
IFRS 15 only deals with revenue from contracts with customers. The standard defines a customer as a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. Contracts do not have to be written but can be oral or implied by an entity’s customary business practice.
Although in most cases it will be easy for the entity to determine whether there is a contract with a customer, there will also be cases where more judgement is required to determine whether a contract is with a customer or, for example, with a collaborator or partner. This is illustrated in the following example.
An entity sells its game console and video games over the internet. This notwithstanding, it enters into an agreement with a supermarket, whereby the supermarket:
Shall buy 1,000 consoles at a considerable discount. It will then be able to sell the console at a lower price than the consoles are sold at on the internet (the risk that the supermarket will not be able to sell all of the consoles is therefore minimal)
Shall not sell any games, Customers will therefore have to buy the entity’s games on the internet
Will provide special marketing events for one of the video games. It will receive 10% of the game’s sales in the period where the marketing events takes place.
Some would probably think that the supermarket is a customer for the gaming company, however, others may feel less confident about this. Indeed different assessments could be made and the IASB acknowledge that judgement will have to be applied to some circumstances. However, it decided that it would not be feasible to develop application guidance that would apply uniformly to various industries because the nature of the relationships would depend on specific terms and conditions in the contracts.
If revenue is within the scope of IFRS 15, an entity will have to assess whether the following criteria are met in relation to the contract with the customer:
The parties have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;
The entity can identify each party’s rights regarding the goods or services to be transferred;
The entity can identify the payment terms for the goods or services to be transferred;
The contract has commercial substance; and
It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Only if these criteria are met, can the entity apply the general requirements of IFRS 15. If the criteria are not met, IFRS 15 requires an entity to be very careful when reporting revenue, so that the entity does not report revenue it will not be entitled to or will not receive from the customer. In those cases revenue can only be reported when the entity has done all that it should according to the contract and has received all, or substantially all, of the customer consideration, which is non-refundable. In some cases an assessment by the entity about whether it is probable 2 that it will receive the money from the customer will be critical. Judgement will have to be applied in these circumstances.
Identify the contract
Often an agreement that will be considered as a contract for other purposes, will also be considered as the contract in IFRS 15. However, there may be exceptions. Two different contracts may be so interlinked that in IFRS 15 they would be considered as one contract. For example, an entity that is selling safes, could prepare two contracts for a sale:
One for the safe, which according to the contract is sold for €50; and
One for the key to the safe, which according to the contract is sold for €300.
For accounting purposes these two contracts should be considered to be one contract for a safe (including a key) sold for €350.
IFRS 15 includes specific requirements for when two or more contracts are so interlinked that they should be considered as one contract. The guidance matters in cases where the revenue from one contract would be reported in a different period than the revenue from another contract, unless the contracts for accounting purposes would be considered as one contract.
Identify the distinct goods and services in the contract
When the contract for accounting purposes has been isolated, the different distinct goods and services in the contract should be identified. A contract can include many different distinct goods and services (i.e. separate components). A contract for a holiday may, for example, include flights to and from the destination, a hotel stay and entrance fees to some attractions. How the different distinct goods and services in a contract are identified may affect when revenue is reported.
In some cases it can be difficult to identify all the distinct goods and services in a contract. For example, an entity is selling wind turbines and in addition to the turbines, the customer receives a warranty that the turbine will work for ten years and ten years of maintenance of the turbines. In this case are there one, two or three distinct goods or services?
IFRS 15 identifies a distinct good or service when both of the following criteria are met:
The customer can benefit from the good or service either 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.
It may seem a bit difficult to assess how many distinct goods and services the contract with the wind turbine includes based on these criteria. Fortunately, IFRS 15 includes some additional guidance and explains that a customer can benefit from a good or service on its own or together with other readily available resources if the good or service could be used, consumed or sold for an amount that is greater than scrap value. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. The fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.
For a contract to include at least two distinct goods and services, the second criteria also needs to be met. Although IFRS 15 does not explain what is meant by being ‘separately identifiable from other promises in the contract’, it seems to have had three different scenarios in mind illustrated below with three cases.
First consider the construction of a house. In this first scenario the delivery of each brick could strictly speaking meet the first criteria for being considered a distinct good. However, this was not the IASB’s intention. In addition, it might not produce useful information if revenue was recognised when a construction company delivered the bricks when the customer had asked for a house. The purpose of the second requirement is thus that if the customer contracts for a house (not only the bricks but also the integration of those bricks), the house is the distinct good in the contract.
Next consider a customer who orders computer software that needs to be significantly modified to be integrated with the customer’s IT environment. In the second scenario, if the entity is first installing the software on the customer’s server, this could be considered as a distinct good or service according to the first criterion. However, this was not the IASB’s intention. The programming activity and the integration are significantly related. If the entity would programme the software so that it would be easy to integrate, this could significantly reduce the time it would take to integrate the software. In addition, the software can be considered similar to the bricks in the house example above. When different actions (as the programming and the integration in this example) are so interrelated it was the IASB’s intention that they should not be accounted for as a distinct good or service.
Finally consider a customer who has ordered goods that are designed and manufactured specifically for him, such as fighter jets. In the third scenario since the manufacturing and the testing of the air fighters may result in redesign, the process of designing and manufacturing is quite iterative. The IASB therefore thought that in some cases the design and the manufacturing should not be considered as separate distinct goods and services.
These scenarios are reflected in the indicators provided in IFRS 15 on when a good or service is ‘separately identifiable from other promises in the contract’. The indicators are:
The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract into a bundle of goods or services that represent the combined output for which the customer has contracted. In other words, the entity is not using the good or service as an input to produce or deliver the combined output specified by the customer (the construction of the house);
The good or service does not significantly modify or customise another good or service promised in the contract (the computer software); and
The good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract. For example, the fact that a customer could decide not to purchase the good or service in the contract might indicate that the good or service is not highly dependent on, or highly interrelated with, those other promised goods or services (the fighter jets).
Determining the distinct goods and services in a contract will require some judgement (depending on the industry), and there is a chance that two different entities will assess identical circumstances differently. In many cases, however, this may not impact the reported revenue, as the revenue related to the distinct goods and services will be reported in the same period anyway. In the wind turbines example, it is likely that revenue from the warranty and the maintenance service will be recognised in the same periods with similar amounts regardless of whether the warranty and the maintenance is accounted for as one or two distinct goods and services.
IFRS 15 requires that all distinct goods and services in a contract give rise to revenue. This means that if an entity offers a ‘gift’, like a watch, to a customer that enters into a contract with the entity, for example, by subscribing for a magazine for a year, the entity should report revenue when it gives the watch to the customer. The more valuable the watch is, the higher would the amount of revenue be that should be reported when the watch is given to the customer. Currently, these types of ‘gifts’ are often regarded as marketing expenses by entities and would therefore not result in any revenue. Attaching revenue to such ‘gifts’ may therefore result in some revenue figures that should be read carefully. Often high revenue figures are linked with high performance. On the other hand, the fact that the entity has to provide a customer with a valuable ‘gift’ in order to be able to enter into a contract with those customers, could be indicative of below par performance.
Therefore it could seem counterintuitive that IFRS 15 results in high revenue figures when an entity provides its customers with valuable ‘gifts’ to a particular customer to secure a contract. The IASB, however, decided to require that all distinct goods and services should give rise to revenue, as it was concerned that if entities should decide on what distinct goods and services should result in revenue, the outcome could be very subjective. In addition, the decision could be difficult and could vary significantly depending on whether the entity would perform the assessment from the perspective of how it considers that it generates profit or from the perspective of the customer. The IASB thus decided that judgement should not be applied on this issue.
When to report revenue
IFRS 15 requires that revenue is reported separately for each distinct good or service in a contract. For some contracts revenue related to a distinct good or service should be reported at a particular point in time while for other distinct goods and services it should be reported over time. Whether revenue is reported at a point in time or over time is relevant for contracts that take a long time to complete. For example, if an entity has to construct a bridge, it will make a difference whether the related revenue is recognised in smaller portions over the years it will take for construction, or at the point in time when the bridge has been constructed.
“The basic principle of IFRS 15 is that revenue is reported when the control of a good is transferred to the customer.”
The customer controls a good when the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from the good. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, a good.
IFRS 15 does not provide specific criteria for when control of a good or a service has been transferred to a customer, but includes the following indicators an entity shall consider:
The entity has a present right to payment for the good;
The customer has legal title to the good;
The entity has transferred physical possession of the good;
The customer has the significant risks and rewards of ownership of the good;
The customer has accepted the good.
Although in many cases it will be straight forward to determine when control over a good has been transferred, in other cases it may be much more difficult to determine exactly when control is transferred to the customer. In some jurisdictions, for example, the transfer of a plot of land may take some time in view of the legal requirements that have to be fulfilled. The question here could be whether revenue should only be recognised when ALL paperwork has been completed even though the last part of the paperwork is a mere formality.
In some circumstances IFRS 15 would require that a good is considered transferred to a customer over time rather than at a specific point in time. For example, if an entity is building a house on the customer’s plot of land, control over the house could be considered to be transferred to the customer as the house if being constructed. This means that revenue should be reported as the construction takes place rather than, for example, when the house is completed.
If one of the following criteria is met, IFRS 15 requires revenue to be reported over time:
The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
The entity’s performance creates or enhances a good (for example a good being constructed) that the customer controls as it is being created or enhanced; or
The entity’s performance does not create a good with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
These criteria are not particularly easy to understand because the IASB tried to develop criteria that would work for many different circumstances. Basically, the criteria cover situations where an entity is:
Performing a service for the customer, for example, cleaning the customer’s office. Here the customer simultaneously receives and consumes the benefits provided by the entity, as it is not possible for the entity to ‘keep’ the cleaning provided by the entity to another day (the customer consumes the benefits from the cleaning as they are provided).
Modifying the customer’s property (for example by constructing a building on the customer’s plot of land). As the customer controls the plot of land, it would normally also control the building as it is created.
Constructing a special good and throughout the development has a right to payment for what it has developed so far if the customer would cancel the contract.
IFRS 15 provides further guidance on how to interpret these criteria. In practice, the last criterion may require more judgement then the other two criteria as an entity would have to assess whether a good has an alternative use and whether it has an enforceable right to payment for performance completed to date.
IFRS 15 provides important guidance on how to assess whether a good would have an alternative use. Firstly, a good may not have an alternative use if the entity is either restricted contractually from readily directing the good for another use during the creation or enhancement of the good or limited practically from readily directing the good in its completed state for another use. A contractual restriction should, however, not be considered if it is not substantive, for example, because the good is largely interchangeable with other goods that the entity could transfer to another customer without breaching the contract and without incurring significant costs that otherwise would not have been incurred in relation to that contract. A practical limitation on an entity’s ability to direct an asset for another use exists if an entity would incur significant economic losses to direct the asset for another use. The assessment of whether a good has an alternative use should be made at contract inception and not be updated later and the possibility of the contract with the customer being terminated should not be considered.
It seems likely that there will be cases where different parties will make different assessments on whether the criterion on ‘no alternative use’ is met in specific situations. For example, there may be different views on what significant economic losses are and whether a very limited number of potential customers would practically restrict an entity from redirecting something it is producing for one customer to another customer.
Enforceable right to payment for performance completed to date
According to IFRS 15, an entity shall consider the terms of the contract, as well as any laws that apply to the contract, when evaluating whether it has an enforceable right to payment for performance completed to date. The right to payment does not need to be for a fixed amount. However, at all times throughout the duration of the contract, the entity must be entitled to an amount that at least compensates it for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised.
An amount that would compensate an entity for performance completed to date would be an amount that approximates the selling price of the goods in their current state of finalisation (e.g. recovery of the costs incurred plus a reasonable profit margin) rather than only compensation for the entity’s potential loss of profit if the contract were to be terminated. Compensation for a reasonable profit margin need not equal the profit margin expected if the contract was fulfilled as promised.
IFRS 15 includes additional guidance on when an entity has an enforceable right to payment for performance completed to date. However, although the guidance is very comprehensive, assessments in this area may be different from person to person as it involves an assessment of legislation, administrative practice and/or legal precedent in various jurisdictions. Because terms outside the contract will also have to be taken into account it may be that exactly similar contracts should be accounted for differently, if they are entered into in different jurisdictions.
Reporting revenue over time
If revenue related to a good should be reported over time, the amount reported in each period should reflect the entity’s completion of the good. There are different methods for measuring this, and IFRS15 provides guidance on what method should be chosen in given circumstances. If an entity is not able to reasonably estimate the degree of completion it shall report revenue only to the extent of the costs incurred in completing the good until such time that the entity can reasonably measure the degree of completion.
The amount of revenue to report
In many cases it will be simple to determine what amount to report as revenue 3. If a hairdresser charges €20 (exclusive any taxes) for a haircut the amount of revenue to be reported for the haircut is €20. In some cases, it may, however, be more difficult to determine the amount of revenue to report. This happens when the price is variable. The price can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items. Back to the hairdresser, it may, for example, be that if a customer gets more than 10 haircuts within a year, the hairdresser offers a discount (a refund) so that the price of each haircut in the year is only €15. When the price is variable IFRS 15 requires that an entity shall estimate the amount of revenue to be reported by using either a probability weighted amount (an average amount) or the most likely amount. IFRS 15 requires that the estimation should be based on the method that best predicts what will ultimately be the amount to which the entity will be entitled.
In the example with the hairdresser, because the hairdresser has many customers, and some, but not all will receive a rebate, the total revenue amount will probably neither be the total number of haircuts multiplied by €20 nor the total number of haircuts multiplied by €15, but something in the middle. IFRS 15 would therefore require an entity to report an average amount as revenue for each haircut. For example, if based on experience, it is known that 60% of customers will have more than ten haircuts in one year, the revenue to be reported for each haircut will be ((0.60 * €15) + ((1 – 0.60) * €20)) €17.
However, if the hairdresser is not confident about how many customers will receive a rebate, only the maximum amount that will highly probable not result in a significant reversal can be reported. In other words, the hairdresser should be careful not to report too high a revenue figure. If, for example, the hairdresser can only say that it is highly probable that the number of customers that will be entitled to the rebate will not be much more than 80 percent, the hairdresser can only report a revenue of ((0.80 * €15) + ((1 – 0.80) * €20)) €16 per haircut. The approach in IFRS 15 is for an entity to be more careful not to recognise too much revenue than too little revenue. According to the IASB this is because users of financial statements are more sensitive to subsequent downward adjustments to revenue than to upward adjustments.
Allocation of the total contract price
The final matter for consideration in this article is the allocation of the total contract price to the identified distinct goods and services.
We know that revenue should be recognised separately for each distinct good or service in a contract. The total price of a contract will therefore have to be allocated to the various distinct goods and services in the contract. The basic principle is that the total price should be allocated to the various distinct goods and services based on the price that would be charged for each of these distinct goods and services if they had been sold separately. In many cases this price will not be directly observable and an entity would have to estimate it using one of the estimation methods in IFRS 15. An entity could base its price on competitors’ prices (if available) or on how much it costs to produce a good or deliver a service and then add a normal profit to this price. A third method is to estimate the price of one distinct good or service as the residual after subtracting the price of all the other distinct goods and services in a contract. Estimating the price for the distinct good or service will be challenging for some entities. In some industries, there is no standard price for a product.
For example, consider an entity producing computer software. It sells two software packages to a customer together with a course for the customer’s employees on how to use the software. The software has been produced and there are no additional costs of providing it to one more customers apart from the costs of providing the course. The entity determines the price for each contract not on standard prices but on how much it thinks the customer is willing to pay (i.e. how much the customer will benefit from the software). The entity cannot use the competitors’ prices to estimate the price of the software because its competitors adopt a similar pricing system and it cannot use the cost of production because it is close to zero. The entity cannot use the residual technique because this will only work if there is only one distinct good or service with an unknown price, whilst the entity has two distinct goods and services where the price is unknown. Combining the different methods also does not seem to lead to a clear answer on how the entity should estimate the prices for the two software packages. The entity may therefore have to base its estimates on other factors.
The article expresses the author’s own views and does not necessarily reflect those of EFRAG.
1 IFRS 15 also provides guidance on how to present revenue in the financial statements, what additional information to disclose about revenue, how to account for costs incurred in relation to a contract and amendments to other Standards. These issues will not be considered in this article.
2 The notion of probability is pinned to that which is more likely than not.
3 When revenue falls to be reported.