Revenue Recognition: IFRS 15 vs. ASC 606

Revenue recognition is a critical aspect of financial reporting that directly impacts a company’s financial performance. IFRS 15 (International Financial Reporting Standards) and ASC 606 (Accounting Standards Codification under U.S. GAAP) both share a five-step model for revenue recognition. However, despite this common foundation, there are key differences in how these standards are applied.

Let’s delve into these differences using real-world examples and illustrations.

The Five-Step Model for Revenue Recognition

Both IFRS 15 and ASC 606 are based on the same five-step model:

1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations
5. Recognize revenue when (or as) the entity satisfies a performance obligation

While the approach is similar, differences emerge when applied in practice. The following examples and illustrations highlight key distinctions.

1. Contract Modifications

Scenario: A SaaS Company Contract

A SaaS (Software-as-a-Service) company enters into a contract with a client to provide cloud storage services for two years, with an option to add additional storage at a later date. Halfway through the contract, the client opts to add more storage space for an additional fee.

• IFRS 15: The company first assesses whether the additional storage represents a separate performance obligation or a modification of the existing contract. If the storage is distinct and the pricing reflects its standalone selling price, the modification is treated as a new contract. If it is not distinct or sold at a discounted price, the modification is treated as an adjustment to the existing contract.
• ASC 606: The same scenario under ASC 606 might be treated similarly if the added storage is distinct. However, U.S. GAAP provides more prescriptive guidelines, requiring the company to assess whether the modification significantly changes the contract’s scope or price. If not, the contract would be updated rather than treated as a new one.

Illustration: Imagine the original contract as a single line with two performance obligations (cloud storage and customer support). Under IFRS 15, the line could split into two distinct contracts if the new storage is deemed separate, while ASC 606 might keep it as a single extended contract with adjustments.

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2. Performance Obligations

Scenario: A Manufacturing Contract

A manufacturing company signs a contract to deliver customized machinery along with installation and after-sales maintenance services. The contract price is Rs.2 million for the machinery and an additional Rs.500,000 for the services.

• IFRS 15: The company evaluates whether the machinery and services represent distinct performance obligations. If the installation is essential for the machinery to function, IFRS 15 would likely require the entire contract to be treated as a single performance obligation, and revenue would be recognized over time as the machinery is installed and tested.
• ASC 606: U.S. GAAP may require more disaggregation of performance obligations. If the machinery and installation services are deemed distinct, the company must allocate a portion of the transaction price to each performance obligation based on their standalone selling prices.

Illustration: Under IFRS 15, the entire contract might be represented as a single pie, with revenue recognized as slices as the installation progresses. Under ASC 606, the contract would be divided into two smaller pies (machinery and services), and revenue from each would be recognized separately as they are delivered.

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3. Transaction Price Allocation and Variable Consideration

Scenario: A Telecommunications Contract

A telecommunications company signs a three-year service agreement with a customer that includes monthly service fees and performance bonuses if the customer uses a certain amount of data each month.

• IFRS 15: The company calculates the transaction price, including variable consideration (the bonuses). If the outcome is highly uncertain, the company only includes the variable consideration to the extent that it is highly probable that a significant reversal in revenue will not occur.
• ASC 606: Similar to IFRS 15, but ASC 606 allows for two methods to estimate variable consideration: the expected value method (based on probability-weighted outcomes) or the most likely amount method. The company can choose the method that best predicts the expected outcome.

Illustration: Think of the variable consideration as different sized boxes. Under IFRS 15, the company will include only the boxes (bonuses) that are highly probable. Under ASC 606, the company might use either the average size of the boxes (expected value) or the size of the box most likely to occur (most likely amount).

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4. Costs to Obtain a Contract

Scenario: A Consulting Firm

A consulting firm incurs sales commission costs when obtaining a multi-year consulting contract with a large client.

• IFRS 15: Only the incremental costs of obtaining a contract can be capitalized if the company expects to recover these costs. The commission costs would likely be capitalized and amortized over the contract’s term.
• ASC 606: U.S. GAAP is slightly broader in its approach. It allows for the capitalization of both incremental costs and some costs to fulfil a contract (such as pre-contract engineering work) if certain conditions are met.

Illustration: Imagine the sales commission costs as a bucket of paint. Under IFRS 15, the company can paint only the walls of the building it expects to recover costs from. Under ASC 606, the company has a bigger bucket and can paint more areas (other indirect costs) as long as they meet the criteria.

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5. Revenue Recognition Timing: Over Time vs. Point in Time

Scenario: A Construction Project

A construction company enters into a contract to build a commercial building for Rs.10 million. The project will take two years to complete.

• IFRS 15: The company assesses whether the customer receives control over the asset as it is being constructed (over time) or only at the end (point in time). If the customer controls the asset as it's built, revenue is recognized over time based on milestones or percentage completion.
• ASC 606: Similarly, ASC 606 provides guidance on recognizing revenue over time if the customer is receiving benefits as the construction progresses. If not, revenue is recognized when the building is completed and handed over to the customer (point in time).

Illustration: Under IFRS 15, imagine a meter slowly filling up with colour as the building is constructed, with revenue recognized gradually. Under ASC 606, if recognized at a point in time, the meter stays empty until the moment the building is handed over, when it fills all at once.

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To conclude ……..?

Both IFRS 15 and ASC 606 aim to bring consistency to revenue recognition across industries, but the nuances in application can lead to different results. Companies operating globally, or in industries where revenue recognition is complex, need to pay close attention to the distinctions between these two frameworks.

Understanding these differences helps CFOs and Finance Controllers, make informed decisions about financial reporting, ensuring compliance and transparency.

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