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Revenue revisited – part 1

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This two-part article considers the application of IFRS 15,

On 28 May 2014, the International Accounting Standards Board (the Board), 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.

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.

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Historically, there has been a significant divergence in practice over the recognition of revenue, mainly because IFRS standards
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

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.

Using the five-step model

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.

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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.

The transaction price might include variable or contingent consideration. Variable consideration should be estimated as either the
expected value or the most likely amount. The expected value approach represents the sum of probability-weighted amounts for
various possible outcomes. The most likely amount represents the most likely amount in a range of possible amounts.

Management should use the approach that it expects will best predict the amount of consideration and it should be applied
consistently throughout the contract. An entity can only include variable consideration in the transaction price to the extent that it

is highly probable that a subsequent change in the estimated variable consideration will not result in a significant revenue
reversal. If it is not appropriate to include all of the variable consideration in the transaction price, the entity should assess

whether it should include part of the variable consideration. However, this latter amount still has to pass the ‘revenue reversal’

test.

Variable consideration is wider than simply contingent consideration as it includes any amount that is variable under a contract,

such as performance bonuses or penalties.

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.

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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.

Where the transaction price includes a variable amount and discounts, it is necessary to establish whether these amounts relate

to all or only some of the performance obligations in the contract. Discounts and variable consideration will typically be allocated

proportionately to all of the performance obligations in the contract. However, if certain conditions are met, they can be allocated
to one or more separate performance obligations.

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.

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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 examining team

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• Read part 2

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