IFRS 15 - Revenue from Contracts with Customers

Overview:

Revenue from Contracts with Customers was introduced by the International Accounting Standards Board to provide one comprehensive revenue recognition model for all contracts with customers to improve comparability within industries.

Five Steps Approach:

• Identify the contract(s) with a customer.
• Identify the performance obligations in the contract.
• Determine the transaction price.
• Allocate the transaction price to each performance obligation.
• Recognize revenue when a performance obligation is satisfied.

Identifying the performance obligation:

What is performance obligation?, it’s a promise to the customer to transfer:

1. A distinct good or service; or
2. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Note: Sometimes the obligations can implicit, the contract obligation is not limited to the articles mentioned on the contract, also it includes those implied by an entity's customary business practices. Example: a maintenance service historically provided, but no mentioned in the contract.

What is distinct good or service? The following criteria should be met:

1. The customer can benefit from the good of service, either on its own or together with other resources that are readily available to the customer.
2. The entity’s promises to transfer the goods or services to the customer are separately identifiable.

Factors indicate that the goods and services transferred to the customer are not separately identifiable:

1. Bundle of goods and services: The entity is providing a bundle of goods and services as inputs to produce of deliver a combined output specified by the customer which includes more than one phase, element or unit. Example: Building a hospital for the client.
2. Significantly modified or customized: the goods or services contracted are customized by one or more of the other services or goods promised to the customer. Example: Customizable during installation software provided to a client.
3. Highly interdependent or interrelated: Each goods or services are affected by one or more of the other goods or services in the contract. in other words, the entity would not be able to transfer the goods and services separately. Example: License provided with updates when the first is not fully useful without the update.

Note: In all cases above, the entity may end up accounting thereof as a single performance obligation.

Examples of distinct goods and services:

1. Sale of a Laptop with Software Installation

• Laptop (distinct): The customer can use the laptop on its own.
• Software Installation Service (distinct): The customer can buy and install the software separately.

2. Construction Contract for a Building with Design Services

• Architectural Design Services (distinct): The customer can hire another contractor for construction after receiving the design. (this is a bundle if the designer includes multiple-services.)
• Construction Services (distinct): The actual building process is separate from the design phase.

3. Car Purchase with a Separate Maintenance Package

• Car (distinct): The customer can use the car without the maintenance package.
• Maintenance Service (distinct): The customer can purchase maintenance from another provider.

4. Sale of a Smartphone with a Monthly Data Plan

• Smartphone (distinct): The phone can be used independently or with any other network provider.
• Data Plan (distinct): The customer can subscribe to different network services separately.

Material Right:

Sometimes the vendor provides the client with an option to acquire additional goods or services which he won't receive without having signed the contract. These goods and services herby are paid in advance when entering the contract, and accounted as separate performance obligation. when are these items not identified as a single performance obligation?

Example: ABC company provided XYZ with a promotional discount of a contract of 60% discount if the latter entered the contract only. However, the company provided meanwhile 10% discount over all season sales on its services.

The situation here states that XYZ will get 60% on its contract including 10% already because of the general discount. Therefore, only 50% discount is solely considered as a separate performance obligation and 10% is ignored.

Treatment: The situation here states that XYZ will get 60% on its contract including 10% already because of the general discount. Therefore, only 50% discount is solely considered as a separate performance obligation and 10% is ignored.

Determine the transaction price:

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transfer goods or services to a customer, excluding amounts collected for third parties (e.g. Taxes).

It consists of: Amount Expected to be entitled, Impairment Loss, other consideration.

• Under IFRS 15: the revenue reflects the amount to which an entity expects to be entitled under a contract rather than the amount it expects exactly to collect. (e.g. The amount accounted may be lower if there is a discount).
• Impairment losses: If there is a loss expected by non-collecting the revenue which had been recognized, impairment losses should be recognized.

Variable Consideration: Consideration is variable if the amount to which the entity is entitled is contingent on the occurrence or none of a future event. and it's determined by using two approaches:

1- Expected value approach: works well when the entity has an experience and large number of similar contracts.

2 - Most likely approach: it's suitable when the entity has options of two scenarios or outcomes to meet the obligation or not.

Reversal Revenue:

The likely hood of the reversal revenue is affected by several factors:

1. Factors outside entity's influence: encompasses volatility of the market, the behavior of the third parties involved, the risk of the obsolescence of the promised goods or services.
2. Uncertainty: Uncertainty about the amount to be collected is not resolved soon.
3. Limited Experience or evidence: the entity's experience (or other evidence) with similar types of contract is limited.
4. Price concessions or change of payment terms.
5. Other possible consideration amounts.

Note: When the entity faces these constraints, it should be assessing if it's appropriate to include part of the variable consideration like a lower amount. Then determining the amount of variable consideration.

Significant Financing Component:

an entity should assess whether a contract contains a significant financing component by:

a) The difference between the amount of promised consideration and the cash selling price of the promised goods or services.

b) The combined effect of:

- The expected length of time between transfer of the promised goods or services and the payment.

- The prevailing interest rates in the relevant market.

The company should adjust the transaction price of the contract for a significant financing component unless the following conditions are met:

1. The time difference between the delivery of goods or services and the receipt of the payment is less than a year.
2. Specific factor exists to indicate that the contract does not have a significant component.

Factors that indicate that there is not significant financing component:

1. Discretion to decide: the client agrees to pay upfront and has the right to decide when these goods will be transferred.
2. Substantial Variable Consideration outside control of the client and the entity.
3. Difference for the reasons other than the provision of financing component: e.g. Customer decided to withhold a retention amount as a protection until the end of the work.

Where to imply a significant financing component?

• The deferred payment plan that includes interest, meaning the entity is effectively financing the purchase for the customer.
• A contract has a significant financing component if the timing of payments provides a material benefit in the form of an implicit loan.
• when the customer pays more in total when choosing the installment plan, the entity is receiving compensation for the time value of money.
• The financing component must be accounted for separately by recognizing interest income over time.

Accounting for Significant Financing Component:

When recognizing the financing component, entity should adjust the transaction price according to the discount rate implied. After contract inception, entity should not update the discount rate to re-adjust the transaction price for the changes in interest rates or other circumstances. An entity should present the effects of financing component separately from contracts with customers as interest expense or interest income in the income statement.

Note: in case of non-cash consideration receivable in exchange to the service provided, these considerations are measured by their fair-value, rather if not possible to access to their fair-value, they are measured by their stand-alone selling price of the goods and services provided to the client.

Allocation of transaction price:

A company should allocate the transaction price over its performance obligation on a relative stand-alone-selling price basis except for allocating discounts and variable consideration.

How to determine the stand-alone selling price?

1. Direct observable price.
2. Using an estimation method.
3. Adjusted market assessment approach.
4. Expected cost plus a margin approach.
5. Residual value approach (if the selling price is highly variable-the entity sells the same good to different customers for a range of amounts, or if the selling price is uncertain).

Allocation of variable consideration:

An entity should allocate variable consideration entirely to a performance obligation if both of the following criteria are met:

1- The term of a variable payment relate specifically to the entity's efforts to satisfy that performance obligation; and

2- Allocating the variable consideration entirely to that performance obligation would depict the consideration to which the entity expects to be entitled in satisfying that performance obligation when considering all of the performance obligations and payment terms in the contract.

Variable consideration refers to amounts in a contract that can change due to discounts, incentives, penalties, or bonuses. IFRS 15 requires an entity to allocate transaction prices to performance obligations based on their relative standalone selling prices, but in some cases, variable consideration can be allocated entirely to one performance obligation if certain criteria are met.

Criteria for Allocating Variable Consideration to a Single Performance Obligation:

An entity can allocate variable consideration entirely to a specific performance obligation if both of the following criteria are satisfied:

1. The variable payment relates specifically to that performance obligation.
2. The allocation reflects the amount the entity expects to be entitled to.

Why Is This Important?

• Ensures that revenue is recognized accurately and fairly in financial statements.
• Prevents misallocation of payments that could distort revenue recognition.
• Revenue should reflect what the entity expects to receive for fulfilling its obligations.

Include variable Consideration in the transaction price:

An amount of variable consideration should be included in the transaction price only to the extent that it is highly probable that there will not be a significant revenue reversal when the uncertainty associated with the variable consideration is resolved.

This means:

• The entity must assess all uncertainties affecting the variable consideration.
• The entity should only recognize revenue for variable amounts if it is very unlikely that those amounts will be reversed later.
• This prevents overstating revenue, ensuring that recognized revenue is reliable.

Subsequent change in transaction price:

The entity should update the transaction price at each reporting date, including an assessment of any constrained amount of a variable consideration.

Any changes in the transaction price should be allocated to the performance obligations in the contract on the same basis as at contract inception, and:

1- Amount allocated to a satisfied (POs) should be recognized as revenue in the period of the price change.

2- Amount allocated to an unsatisfied performance obligation should be recognized as revenue when the related POs related is satisfied.

3- An entity should re-allocate the transaction price to reflect changes in stand-alone prices after contract inception.

4- An entity should update the estimated transaction price at each reporting date, including an assessment of any constrained amount of variable consideration that may be included in the transaction price.

5- A change in the transaction price should be allocated entirely to one or more distinct goods or services based on same criteria as allocation variable consideration entirely to one or more distinct goods or services.

Recognize Revenue when (or as) the entity satisfies a performance obligation.

The context of revenue recognition will be:

• Satisfaction of performance obligations over time or at a point in time.
• Measuring progress towards completion of a performance obligation that is satisfied over time.

Seller’s performance creates or enhances asset controlled by customer

In determining whether a customer controls an asset as it is created or enhanced, an entity should apply the requirements for control in paragraphs 31 - 34 and 38 of IFRS 15, which includes considering whether the entity can:

• Use the asset to produce goods or provide services (including public services);
• Use the asset to enhance the value of other assets;
• Use the asset to settle liabilities or reduce expenses;
• Sell or exchange the asset;
• Pledge the asset to secure a loan; and
• Hold the asset.

The asset that is being created or enhanced (for example, a work-in-progress asset) could be either tangible or intangible.

Performance Obligation satisfied overtime:

An entity transfers control of a good or service over time and therefore satisfies a performance obligation and recognizes revenue over time if any of the three criteria are met:

• Customer simultaneously receives and consumes all benefits as seller performs.
• Seller's performance creates or enhances asset controlled by customer.
• Asset has no alternative use to seller and the seller has an enforceable right to payment. (means the goods or services cannot be transferred to another client, hereby, the PO is satisfied upon work completion, and this assessment is on the inception of the contract).

Performance Obligation satisfied at a point of time:

to determine the point of time, the entity should determine when the customer obtains control of a promised assets. that is determined by:

1- Present Right to payment.

2- Legal right, when the customer has a legal title for the asset, and the entity has a protective right.

3- the entity has a physical possession. (the goods have been transferred to the client).

4- the customer has a significant risk and rewards of ownership of the asset.

5- Customers has accepted the asset.

Note: Measuring progress towards completion of a performance obligation that is satisfied over time based on the outcome, performance obligation, transfer of control.

Output and Input methods:

Output method:

Direct measurements of the value of the goods and services transferred to date.

Input method:

Indirect measurement based on the inputs used to date relative to the total expected inputs to satisfy that performance obligation.

Note: Adjustment to the measure of progress may be required when:

a) The cost incurred does not contribute to the entity's progress in satisfying the performance obligation.

b) The cost incurred is not proportionate to the entity's progress in satisfying the performance obligation. In those circumstances, the best depiction of the entity's performance may be, for example, to recognize revenue at an amount equal to the cost of a good transferred if the following conditions are met at contract inception:

1. The good is not distinct.

2. The customer obtains control of the good significantly before receiving services related to the good.

3. The cost of the good is significant relative to the total expected costs to complete the performance obligation.

4. The entity procures the good from another entity and is not significantly involved in designing and manufacturing the good.

Contract Costs:

Contract costs can be capitalized or (incremental) not capitalized depending on the effect of them on the contract.

Incremental costs of obtaining a contract:

• An entity shall recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.
• The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, a sales commission).
• Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained.

When to capitalize the contract's costs?

Costs to fulfill a contract:

Entity should capitalize its incurred costs if All of the following criteria are met:

a) when the costs relate directly to a contract or anticipated contract that the entity can specifically identify (costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that hasn't been yet approved. They include the following:

1. Direct labor, e.g. salaries, wages engaged to provide the client the goods and services promised.
2. Direct materials (e.g. Supplies used to provide the customer the goods required.
3. Cost that relate directly to the contract (e.g. Insurance, depreciation of the tools engaged to provide the goods).
4. Costs that are chargeable to the customer under the contract (e.g. administration fees).
5. Any further costs incurred because of the contract.

b) The costs generate or enhance resources of the entity that will be used in satisfying performance obligation in the future.

c) The costs are expected to be recovered.

Costs to expense:

Any cost doesn't relate directly to the contract or relate to performance obligations previously had been satisfied. or undistinguishable costs whether they are related or not or partially to satisfied performance obligation.

Incremental costs of obtaining a contract:

1- should be recognized as an asset if the company expects to recover them.

2- As a practical expedient, the amortization period of these costs if capitalized should be one year or less.

3- Costs to obtain the contract that would have been incurred regardless of whether the contract existed should be recognized as expenses, unless the contract says the contrast.

References:

IFRS 15 link: https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2021/issued/part-a/ifrs-15-revenue-from-contracts-with-customers.pdf

Deloitte: https://www2.deloitte.com/us/en.html