REVENUE REVISITED

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On 28 May 2014, the International Accounting Standards Board (IASB), as a result of the
joint project with the US Financial Accounting Standards Board (FASB), issued IFRS 15,
Revenue from Contracts with Customers. Application of the standard is mandatory for
annual reporting periods starting from 1 January 2017 onward (though there is currently a
proposal to defer this date to 1 January 2018) and earlier application is permitted.

In line with ACCA’s established rule, accounting standards issued by 1 September in a

given year are examinable from 1 September in the following year, so IFRS 15 will be
examinable in F7 from the September 2015 session.

This article considers the application of IFRS 15, Revenue from Contracts with Customers
using the five-step model. The new standard introduces some significant changes so you
should ensure that you have the latest editions of all study materials.

Historically, there has been a significant divergence in practice over the recognition of
revenue, mainly because International Financial Reporting Standards (IFRS) have
contained limited guidance in certain areas. The original standard, IAS 18, Revenue, was
issued in 1982 with a significant revision in 1993, however, IAS 18 was not fit for purpose
in today’s corporate world as the guidance available was difficult to apply to many
transactions. The result was that some companies applied US GAAP when it suited their
needs.

Users often found it difficult to understand the judgments and estimates made by an entity
in recognising revenue, partly because of the ‘boilerplate’ nature of the disclosures. As a
result of the varying recognition practices, the nature and extent of the impact of the new
standard will vary between entities and industries. For many transactions, such as those in
retail, the new standard will have little effect but there could be significant change to
current practice in accounting for long-term and multiple-element contracts.

IFRS 15 replaces the following standards and interpretations:

 IAS 11, Construction Contracts

 IAS 18, Revenue

 IFRIC 13, Customer Loyalty Programmes

 IFRIC 15, Agreements for the Construction of Real Estate

 IFRIC 18, Transfer of Assets from Customers

 SIC-31, Revenue – Barter Transactions Involving Advertising

Services

One effect of this for the ACCA exams is that construction contracts are no longer an
excluded topic in P2.

The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of
promised good or services to customers at an amount that reflects the consideration to
which the entity expects to be entitled in exchange for those goods and services. The
standard introduces a five-step model for the recognition of revenue.

The five-step model applies to revenue earned from a contract with a customer with
limited exceptions, regardless of the type of revenue transaction or the industry. 

Step one in the five-step model requires the identification of the contract with the
customer. Contracts may be in different forms (written, verbal or implied), but must be
enforceable, have commercial substance and be approved by the parties to the contract.
The model applies once the payment terms for the goods or services are identified and it is
probable that the entity will collect the consideration. Each party’s rights in relation to the
goods or services have to be capable of identification. If a contract with a customer does
not meet these criteria, the entity can continually reassess the contract to determine
whether it subsequently meets the criteria.

Two or more contracts that are entered into around the same time with the same customer
may be combined and accounted for as a single contract, if they meet the specified
criteria. The standard provides detailed requirements for contract modifications. A
modification may be accounted for as a separate contract or as a modification of the
original contract, depending upon the circumstances of the case.

Step two requires the identification of the separate performance obligations in the
contract. This is often referred to as ‘unbundling’, and is done at the beginning of a
contract. The key factor in identifying a separate performance obligation is the
distinctiveness of the good or service, or a bundle of goods or services. A good or service
is distinct if the customer can benefit from the good or service on its own or together with
other readily available resources and it is separately identifiable from other elements of
the contract.

IFRS 15 requires that a series of distinct goods or services that are substantially the same
with the same pattern of transfer, to be regarded as a single performance obligation. A
good or service which has been delivered may not be distinct if it cannot be used without
another good or service that has not yet been delivered. Similarly, goods or services that
are not distinct should be combined with other goods or services until the entity identifies
a bundle of goods or services that is distinct. IFRS 15 provides indicators rather than
criteria to determine when a good or service is distinct within the context of the contract.
This allows management to apply judgment to determine the separate performance
obligations that best reflect the economic substance of a transaction.

Step three requires the entity to determine the transaction price, which is the amount of
consideration that an entity expects to be entitled to in exchange for the promised goods
or services. This amount excludes amounts collected on behalf of a third party – for
example, government taxes. An entity must determine the amount of consideration to
which it expects to be entitled in order to recognise revenue.

Additionally, an entity should estimate the transaction price, taking into account non-cash
consideration, consideration payable to the customer and the time value of money if a
significant financing component is present. The latter is not required if the time period
between the transfer of goods or services and payment is less than one year. In some
cases, it will be clear that a significant financing component exists due to the terms of the
arrangement.

In other cases, it could be difficult to determine whether a significant financing component

exists. This is likely to be the case where there are long-term arrangements with multiple
performance obligations such that goods or services are delivered and cash payments
received throughout the arrangement. For example, if an advance payment is required for
business purposes to obtain a longer-term contract, then the entity may conclude that a
significant financing obligation does not exist.

If an entity anticipates that it may ultimately accept an amount lower than that initially
promised in the contract due to, for example, past experience of discounts given, then
revenue would be estimated at the lower amount with the collectability of that lower
amount being assessed. Subsequently, if revenue already recognised is not collectable,
impairment losses should be taken to profit or loss.

Step four requires the allocation of the transaction price to the separate performance
obligations. The allocation is based on the relative standalone selling prices of the goods
or services promised and is made at the inception of the contract. It is not adjusted to
reflect subsequent changes in the standalone selling prices of those goods or services.

The best evidence of standalone selling price is the observable price of a good or service
when the entity sells that good or service separately. If that is not available, an estimate is
made by using an approach that maximises the use of observable inputs – for example,
expected cost plus an appropriate margin or the assessment of market prices for similar
goods or services adjusted for entity-specific costs and margins or in limited
circumstances a residual approach. The residual approach is different from the residual
method that is used currently by some entities, such as software companies.

When a contract contains more than one distinct performance obligation, an entity should
allocate the transaction price to each distinct performance obligation on the basis of the
standalone selling price.

This will be a major practical issue as it may require a separate calculation and allocation
exercise to be performed for each contract. For example, a mobile telephone contract
typically bundles together the handset and network connection and IFRS 15 will require
their separation.

Step five requires revenue to be recognised as each performance obligation is satisfied.

This differs from IAS 18 where, for example, revenue in respect of goods is recognised
when the significant risks and rewards of ownership of the goods are transferred to the
customer. An entity satisfies a performance obligation by transferring control of a
promised good or service to the customer, which could occur over time or at a point in
time. The definition of control includes the ability to prevent others from directing the use
of and obtaining the benefits from the asset. A performance obligation is satisfied at a
point in time unless it meets one of the following criteria, in which case, it is deemed to be
satisfied 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 an asset that the customer controls as the asset is
created or enhanced.
 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.

Revenue is recognised in line with the pattern of transfer. Whether an entity recognises
revenue over the period during which it manufactures a product or on delivery to the
customer will depend on the specific terms of the contract.

If an entity does not satisfy its performance obligation over time, it satisfies it at a point in
time and revenue will be recognised when control is passed at that point in time. Factors
that may indicate the passing of control include the present right to payment for the asset
or the customer has legal title to the asset or the entity has transferred physical
possession of the asset.
As a consequence of the above, the timing of revenue recognition may change for some
point-in-time transactions when the new standard is adopted.

In addition to the five-step model, IFRS 15 sets out how to account for the incremental
costs of obtaining a contract and the costs directly related to fulfilling a contract and
provides guidance to assist entities in applying the model to licences, warranties, rights of
return, principal-versus-agent considerations, options for additional goods or services and
breakage.

IFRS 15 is a significant change from IAS 18 and even though it provides more detailed
application guidance, judgment will be required in applying it because the use of estimates
is more prevalent.

For exam purposes, you should focus on understanding the principles of the five-step
model so that you can apply them to practical questions.

Written by a member of the P2 examining team

Last updated: 10 Sep 2017