#IFRS_Exam_Dec2019

Question 3 (a)

Explain the principles underpinning the TIMING of revenue recognition and the MEASUREMENT of that revenue which are outlined in IFRS 15. You should provide examples of revenue transactions to support your explanations of these key principles.

(12 marks)

First of all: this is very detailed answer for the sake of understanding very well the timing and measurement and if you would like to deliver the ideal answer you should summarize this detailed answer while keeping on the main points discussed.

First Part of the question: Timing of Revenue recognition

Regarding the timing of revenue recognition: Step number 5 in the revenue recognition model addresses the recognition of revenue once one performance obligation achieved.

Revenue is recognized when the customer obtains control of a good or service by transferring a promised good or service (that is, an asset) to a customer. Now, what do I mean by transferring the promised good or service?

A good or service is transferred when (or as) the customer obtains control of that asset. A customer obtains control of a good or service if it has the ability to direct the use of and obtain substantially all of the remaining benefits from that good or service. Ok? Not ok? What are these benefits of that good or service?

An asset’s benefits are the potential cash inflows (or reduced cash outflows) that can be obtained in various ways. Examples include using the asset to produce goods or provide services, selling or exchanging the asset, and using the asset to settle liabilities or reduce expenses. Some companies also have the ability to pledge the asset (such as land) as collateral for a loan or to hold it for future use so it is a sort of a benefit.

Now after explaining the concept of control and benefits, let’s come to another question: is this control transferred over time or at a point of time?

Performance obligations satisfied over time

Revenue is recognized over time if any of the following three criteria are met.

1.     The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs… (such as cleaning activity provided by a service company)

2.     The entity’s performance creates or enhances an asset (for example, work in progress that the customer controls as the asset is created or enhanced… )

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 performance completed to date

EXAMPLE 1

ABC Co. is a freight railway entity that enters into a contract with Shipper to transport goods from location A to location B for $1,000. Shipper has an unconditional obligation to pay for the service when the goods reach point B.

When should ABC Co. recognize revenue from this contract?

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Measures of progress over time

Now let’s come to another question; how companies should measure the progress of revenue over time?

Methods for measuring progress include:

1.     Output methods, that recognize revenue based on direct measurements of the value transferred to the customer

2.     Input methods, that recognize revenue based on the entity’s efforts to satisfy the performance obligation

Example 2 : Output Method:

ABC ConstructionCo lays railroad track and enters into a contract with Railroad to replace a stretch of track for a fixed fee of $100,000. All work in process is the property of Railroad.

ABC ConstructionCo has replaced 75 units of track of 100 total units of track to be replaced through year end. The effort required of ABC ConstructionCo is consistent across each of the 100 units of track to be replaced.

ABC ConstructionCo determines that the performance obligation is satisfied over time as Railroad controls the work in process asset being created. How should ABC ConstructionCo recognize revenue?

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Performance obligations satisfied at a point in time

A performance obligation is satisfied at a point in time if none of the criteria for satisfying a performance obligation over time are met. The guidance on control should be considered to determine when the performance obligation is satisfied by transferring control of the good or service. The revenue standard provides five indicators that a customer has obtained control of an asset:

1.     The entity has a present right to payment.

2.     The customer has legal title.

3.     The customer has physical possession.

4.     The customer has the significant risks and rewards of ownership.

5.     The customer has accepted the asset.

Not all of the indicators need to be met for management to conclude that control has transferred and revenue can be recognized.

EXAMPLE 3

Equipment Dealer enters into a contract to deliver construction equipment to Landscaping Inc. Equipment Dealer operates in a country where it is common to retain title to construction equipment and other heavy machinery as protection against nonpayment by a buyer. Equipment Dealer’s normal practice is to retain title to the equipment until the buyer pays for it in full. Retaining title enables Equipment Dealer to more easily recover the equipment if the buyer defaults on payment.

Equipment Dealer concludes that there is one performance obligation in the contract that is satisfied at a point in time when control transfers. Landscaping Inc has the ability to use the equipment and move it between various work locations once it is delivered. Normal payment and credit terms apply. When should Equipment Dealer recognize revenue for the sale of the equipment?

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Second Part of the question relates to Measurement of the transaction price of the contract

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). This is related to step 3 in the revenue recognition model.

Complexities can arise where a contract includes any of the following:

1.    Variable consideration

If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

Variable consideration is common and takes various forms, including (but not limited to) price concessions, volume discounts, rebates, refunds, credits, incentives, performance bonuses, and royalties.

The revenue standard provides two methods for estimating variable consideration.

A.    The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts.

B.    The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract).

2.    Existence of a significant financing component

In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties

3.    Noncash consideration

Any noncash consideration received from a customer needs to be included when determining the transaction price. Noncash consideration is measured at fair value.

EXAMPLE 4

ABC co.enters into a contract with DEF co.to build a machine. DEF co.pays ABC co.$1 million and contributes materials to be used in the development of the machine. The materials have a fair value of $500,000.

ABC co.would otherwise need to purchase the materials for the project and, once received, could elect to use the materials for other projects. DEF co.will deliver the materials to ABC co.approximately three months after development of the machine begins. ABC co.concludes that it obtains control of the materials upon delivery by TechnologyCo.

How should ABC co.determine the transaction price?

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I hope I clarified this part of the exam and please let me know if you have any questions.

Good Luck!

Hesham Mokhiemer