IFRS 15- When to recognise revenue?

The incentive for doing business is to make profit. As you know, profit is the residual income after deducting all the costs. Substantial portion of business income is generated by selling goods or services. This major chunk of income is called revenue.?

Since revenue is earned from the core operations of business, investors use it to evaluate business performance. While a steady revenue trend suggests company is able to sustain its customers and market, a growing trend indicates demand for the product or service is rising. On the other hand, if revenue is plumbing, it shows product or service is losing market.

Since revenue is the lifeline of businesses, managers must understand the peculiarities of revenue recognition. While, revenue recognition can be a tricky and complex subject, IFRS 15 provides a splendid framework, famously known as the 5 steps model. Though it would have been logical to start with the fist step, i chose to discuss the most interesting stuff first. And, forgive me, it is the last step of 5 step model- the timing of revenue recognition.

When should we recognise revenue?

This is the perennial question managers are most concerned with.

• Should we recognise revenue at the time of?signing the contract?with customer??
• Or, Should it be recognized at the time of?billing to customer??
• Should it be recognized at the time of?shipping the goods??
• Should it be recognized at the time when?goods arrive at customer’s place??
• Should we recognise it when customer has?received the goods yet can reject?the goods within a certain period??
• Should it be recognized when the seller knows the?customer may not be able to pay?for the goods???
• When and how it should be recognized when seller provides a service?over a long period of time??

As you see, it’s pretty confusing. Let’s?take help from IFRS 15.

What does IFRS 15 says about the timing of revenue recognition?

?“An entity shall recognize revenue when the entity satisfies a performance obligation by transferring a promised goods or service to customer. Product or services are transferred, when the customer obtains the?control?of goods and services”?

Let’s breakdown the definition and understand the meaning of important terms. Performance obligation (PO) means a promise to transfer of goods and services (G&S) to customer.

Example: You and I have entered into a contract where I have promised you to deliver a car on 1st January 2021 for $20,000. Also, I promised you to construct a property that will take 3 years starting from 1st Jan 2021 for $300,000.

Though the contract is one, these are two separate PO.

Satisfaction of PO means transfer of goods and services to the customer. In this case, PO1 is satisfied when I transfer the car to you. PO2 will be satisfied as I construct the property for you.?

But a PO is only satisfied, if transfer of G&S, meets the definition of transfer as per IFRS 15

As per IFRS 15, Transfer of G&S means customer?obtaining control of G&S. Control can be obtained by the customer?at a particular point of time?or?over a period of time.

Continuing the example: You obtained the control of car on 1st Jan 2021. You will obtain the control of house over a period of time of 3 years. Hence, a PO can be satisfied at a particular point of time or over a period of time In this case, PO1 is satisfied on 1st Jan 2021 when I delivered the Car and you had the control. PO2 will be satisfied over a period of time as I will construct the house for you.?

How to identify whether a performance obligation will be satisfied ‘at a point of time’ or ‘over a period of time’??

IFRS 15 requires?at the beginning of contract, you should identify whether a PO will be satisfied at a point of time or over the period of time. It specifies?3 separate conditions?to identify a PO which is satisfied over a period of time.?

“Over a period of time”

Performance obligation satisfied over a period of time?If any one?of the below conditions met.?

1: Customer simultaneously receives and consumes benefits of performance as the entity performs. Example: Routine or recurring services such as cleaning services, internet access services etc.?

2: Performance creates or enhances an asset that customer controls as asset is created or enhanced. Example: Constructing a property over a period of time.

3: The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for the performance completed to date. Under this condition, a?PO should pass both of the below tests.?

No alternative use test: Seller doesn’t have any alternate use of the asset. This can be due to legal restrictions or practical restrictions (in case of uniquely customised product)?

Right to payment test: seller must have enforceable right to demand payment for the work completed to the date if the buyer terminates the contract.?

Example: I agreed to construct a residential property for you for $1 million over 3 years. You have paid $200,000 as a non-refundable deposit on 1 Jan 2021. As per the contract, you will pay the remaining amount only when it is fully completed and handed over to you. When should I recognize revenue?

Answer: Let’s do a thought experiment. Suppose, I have competed 50% of work and you have rejected the contract. I can keep the deposit of $200,000. But do I have enforceable right to demand compensation from you for the 50% of work completed? - NO. So, at the initiation of contract it should be decided that the PO will not be satisfied over a period of time. It will be satisfied at a point of time. Full revenue will be recognized at the time of handing over the completed property to you.?

Example: continuing the same example lets change the conditions in the contract. You will make progress payments as the work progress towards completion. You don’t have right to terminate the contact unless I fail to deliver. I don’t have any alternative use of the constructed property. If you default on your obligations and my work is completed, I am entitled for the full payment.

Answer: in this case, I have right to demand compensation from you for the work completed to the date. Hence at the initiation of the contract it is decided that the PO will be satisfied over a period of time. I will recognize revenue?on the basis of progress of work completed.?

NOTE: If the PO fails to satisfy at least one of three conditions mentioned above, it is considered to be satisfied at a point of time.?

How to determine the progress of work completed??

1. Input method: (inputs used till date / total inputs required to satisfy the PO) * 100?

2. Output method: Direct measurement of value of goods/services transferred to the date.?

Appropriate method to be used with respect to the nature of goods and services.?

Outputs: below are considered as outputs

Survey of performance completed to date

Appraisals of results achieved

Milestones reached?

Time Elapsed?

Units produced Units delivered??

Inputs: below are considered as inputs

Recourses consumed?

Labour hours expended?

Costs incurred?

Time Elapsed?

Machine hours used.?

Company should consistently use a single method to measure progress.?A change in method is treated as a change in accounting estimate and should be disclosed in the notes to financial statement. We have seen how to identify a PO satisfied over a period of time. Now, let’s see what are the requirements for a PO to be considered as satisfied at a point of time.?

“At a point of time”

Performance obligation satisfied at a point of time It is really simple. PO is satisfied when the?control?is obtained by the customer.?

Indicators?of transfer of control include but not limited to, the following?

Seller has the present right to payment for G&S

Customer has the legal title of asset

Seller has transferred physical possession of goods (control doesn’t always coincide with physical possession. Example: bill and hold agreements, consignment etc.)?

Customer has accepted the asset.?

Summary- Timing of revenue recognition?

Step 1: identify whether performance obligation will be satisfied at a point of time or over the period of time.?

Step 2: If satisfied over a period of time: book revenue on the basis of progress of work completed.?

Step 3: If satisfied at a point of time: Check when customer obtains control. Consider the indicators of transfer of control. Recognize revenue at time of customer obtaining control.

Journal entries

Lets say on 1st Oct, 2022, I entered into a contract to construct a house for you. The total contact price is $12,000. As of 31 December 2022, 10% of work has been completed. However, as per the contract the the payment will be done only when 50% and 100% of work is done. Billing happens twice a year on 31st March and 31st September. On 31st March, 50% work is done, however only 40% is billed.

Booking revenue on 31st Dec. 2022

Debit: Contract asset a/c 1,200

Credit: Revenue a/c 1,200

A?contract asset?is an entity’s right to payment for goods and services already transferred to a customer if that right to payment is?conditional?on something?other than?the passage of time. An entity will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment. In this case, though the entity is entitled to payment is the subject to the condition that 50% must have been completed. Hence 10% of contact price will be recorded as contract asset.

Booking revenue at 31st March 2023.

Debit: Accounts receivable 4,800

Debit: Unbilled receivable 1,200

Credit: Revenue 4,800

Credit: Contract asset 1,200

As opposed to contract asset, a receivable represents a right to payment that is?unconditional, except for the passage of time. Because a receivable is not a contract asset, receivables must be presented separately from contract assets on the balance sheet.

In this case, the entity’s right to payment at this point of time is not conditional upon satisfaction of other performance obligation. Hence 6,000 should have been be recognised as accounts receivable. However, since 10% is not billed to customer yet, 1,200 will be separated from AR and shown as unbilled receivable. Since unconditional right to payment is established now, previously recognised contract asset will be transferred to AR. As 10% of revenue is already recognised in 2022, 40% of revenue amounting 4,800 will be recognised on 31st March 2023.

Hope you found this article helpful.

Shubhasish Das

Note: You may use my journal entry reference tool available at playstore

link: https://play.google.com/store/apps/details?id=com.simpleje.accounting