Revenue

1 Revenue from contracts with customers (IFRS 15)

 

Revenue is income arising in the course of an entity’s ordinary activities.

 

  • ‘Ordinary activities’ means normal trading or operating activities.

 

  • ‘Revenue’ presented in the statement of profit or loss should not include items such as proceeds from the sale of non-current assets or sales tax.

 

2 Revenue recognition

 

A five step process

 

IFRS 15 Revenue from Contracts with Customers (para IN7) says that an entity recognises revenue by applying the following five steps:

 

  • ‘Identify the contract

 

  • Identify the separate performance obligations within a contract

 

  • Determine the transaction price

 

  • Allocate the transaction price to the performance obligations in the contract

 

  • Recognise revenue when (or as) a performance obligation is satisfied.’

 

These five steps will be considered in more detail. However, the following illustration may help you to gain an understanding of the basic principles of the IFRS 15 revenue recognition model.

 

Illustration 1 – The five steps

 

On 1 December 20X1, Wade receives an order from a customer for a computer as well as 12 months’ of technical support. Wade delivers the computer (and transfers its legal title) to the customer on the same day.

 

The customer paid $420 upfront. If sold individually, the selling price of the computer is $300 and the selling price of the technical support is $120.

 

Required:

 

Apply the 5 stages of revenue recognition, per IFRS 15, to determine how much revenue Wade should recognise in the year ended 31 December 20X1.

 

 

 

Solution

 

Step 1 – Identify the contract

 

There is an agreement between Wade and its customer for the provision of goods and services.

 

Step 2 – Identify the separate performance obligations within a contract

 

There are two performance obligations (promises) within the contract:

 

  • The supply of a computer

 

  • The supply of technical support.

 

Step 3 – Determine the transaction price

 

The total transaction price is $420.

 

Step 4 – Allocate the transaction price to the performance obligations in the contract

 

Based on standalone selling prices, $300 should be allocated to the sale of the computer and $120 should be allocated to the technical support.

 

Step 5 – Recognise revenue when (or as) a performance obligation is satisfied

 

Control over the computer has been passed to the customer so the full revenue of $300 allocated to the supply of the computer should be recognised on 1 December 20X1.

 

The technical support is provided over time, so the revenue allocated to this should be recognised over time. In the year ended 31 December 20X1, revenue of $10 (1/12 × $120) should be recognised from the provision of technical support.

 

 

 

The five steps of revenue recognition will now be considered in more detail.

 

 

Step 1: Identify the contract

 

IFRS 15 says that a contract is an agreement between two parties that creates rights and obligations. A contract does not need to be written.

 

An entity can only account for revenue from a contract if it meets the following criteria:

 

  • the parties have approved the contract and each party’s rights can be identified

 

  • payment terms can be identified

 

  • the contract has commercial substance

 

  • it is probable that the entity will be paid.

 

The contract

 

Aluna has a year end of 31 December 20X1.

 

On 30 September 20X1, Aluna signed a contract with a customer to provide them with an asset on 31 December 20X1. Control over the asset passed to the customer on 31 December 20X1. The customer will pay $1m on 30 June 20X2.

 

By 31 December 20X1, as a result of changes in the economic climate, Aluna did not believe it was probable that it would collect the consideration that it was entitled to. Therefore, the contract cannot be accounted for and no revenue should be recognised.

 

Step 2: Identifying the separate performance obligations within a contract

 

Performance obligations are promises to transfer distinct goods or services to a customer.

 

Some contracts contain more than one performance obligation. For example:

 

  • An entity may enter into a contract with a customer to sell a car, which includes one year’s free servicing and maintenance.

 

  • An entity might enter into a contract with a customer to provide 5 lectures, as well as to provide a textbook on the first day of the course.

 

The distinct performance obligations within a contract must be identified. If goods or services are regularly sold separately then the supply of each is likely to form a distinct performance obligation if included within the same contract.

 

Warranties

 

Most of the time, a warranty is assurance that a product will function as intended. If this is the case, then the warranty will be accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

 

If the customer has the option to purchase the warranty separately, then it should be treated as a distinct performance obligation. This means that a portion of the transaction price must be allocated to it.

 

 

 

Principal versus agent considerations

 

An entity must decide the nature of each performance obligation. IFRS 15 (para B34) says this might be:

 

  • ‘to provide the specified goods or service itself (i.e. it is the principal), or

 

  • to arrange for another party to provide the goods or service (i.e. it is an agent)’.

 

If an entity is an agent, then revenue is recognised based on the fee or commission it is entitled to.

 

Step 3: Determining the transaction price

 

IFRS 15 defines the transaction price as the amount of consideration the entity expects in exchange for satisfying a performance obligation. Sales tax is excluded.

 

When determining the transaction price, the following must be considered:

 

  • variable consideration

 

  • significant financing components

 

  • non-cash consideration

 

  • consideration payable to a customer.

 

Variable consideration

 

If a contract includes variable consideration then an entity must estimate the amount it will be entitled to.

 

IFRS 15 says that this estimate ‘can only be included in the transaction price if it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty is resolved’ (IFRS 15, para 56).

 

Test your understanding 1 – Bristow

 

On 1 December 20X1, Bristow provides a service to a customer for the next 12 months. The consideration is $12 million. Bristow is entitled to an extra $3 million if, after twelve months, the number of mistakes made falls below a certain threshold.

 

Required:

 

Discuss the accounting treatment of the above in Bristow’s financial statements for the year ended 31 December 20X1 if:

 

  • Bristow has experience of providing identical services in the past and it is highly probable that the number of mistakes made will fall below the acceptable threshold.

 

  • Bristow has no experience of providing this service and is unsure if the number of mistakes made will fall below the threshold.

 

Refunds

 

If a product is sold with a right to return it then the consideration is variable. The entity must estimate the variable consideration and decide whether or not to include it in the transaction price.

 

The refund liability should equal the consideration received (or receivable) that the entity does not expect to be entitled to.

 

 

 

Illustration: Refunds

 

Nardone enters into 50 contracts with customers. Each contract includes the sale of one product for $1,000. The cost to Nardone of each product is $400. Cash is received upfront and control of the product transfers on delivery. Customers can return the product within 30 days to receive a full refund. Nardone can sell the returned products at a profit.

 

Nardone has significant experience in estimating returns for this product.

 

It estimates that 48 products will not be returned.

 

Required:

 

How should the above transaction be accounted for?

 

 

 

Solution

 

The fact that the customer can return the product means that the consideration is variable.

 

Using an expected value method, the estimated variable consideration is $48,000 (48 products × $1,000). The variable consideration should be included in the transaction price because, based on Nardone’s experience, it is highly probable that a significant reversal in the cumulative amount of revenue recognised ($48,000) will not occur.

 

Therefore, revenue of $48,000 and a refund liability of $2,000 ($1,000 × 2 products expected to be returned) should be recognised.

 

Nardone will derecognise the inventory transferred to its customers. However, it should recognise an asset of $800 (2 products × $400), as well as a corresponding credit to cost of sales, for its right to recover products from customers on settling the refund liability.

 

Financing

 

In determining the transaction price, an entity must consider if the timing of payments provides the customer or the entity with a financing benefit.

 

If there is a financing component, then the consideration receivable needs to be discounted to present value using the rate at which the customer borrows money.

 

Indications of a financing component

 

IFRS 15 provides the following indications of a significant financing component:

 

  • the difference between the amount of promised consideration and the cash selling price of the promised goods or services

 

  • the length of time between the transfer of the promised goods or services to the customer and the payment date.

 

 

Test your understanding 2 – Rudd

 

Rudd enters into a contract with a customer to sell equipment on 31 December 20X1. Control of the equipment transfers to the customer on that date. The price stated in the contract is $1m and is due on 31 December 20X3.

 

Market rates of interest available to this particular customer are 10%.

 

Required:

 

Explain how this transaction should be accounted for in the financial statements of Rudd for the year ended 31 December 20X1.

 

 

Non-cash consideration

 

Any non-cash consideration is measured at fair value.

 

If the fair value of non-cash consideration cannot be estimated reliably then the transaction is measured using the stand-alone selling price of the good or services promised to the customer.

 

Test your understanding 3 – Dan and Stan

 

Dan sells a good to Stan. Control over the good is transferred on 1 January 20X1. The consideration received by Dan is 1,000 shares in Stan with a fair value of $4 each. By 31 December 20X1, the shares in Stan have a fair value of $5 each.

 

Required:

 

How much revenue should be recognised from this transaction in the financial statements of Dan for the year ended 31 December 20X1?

 

 

 

Consideration payable to a customer

 

If consideration is paid to a customer in exchange for a distinct good or service, then it should be accounted for as a purchase transaction.

 

Assuming that the consideration paid to a customer is not in exchange for a distinct good or service, an entity should account for it as a reduction of the transaction price.

 

Test your understanding 4 – Golden Gate

 

Golden Gate enters into a contract with a major chain of retail stores. The customer commits to buy at least $20m of products over the next 12 months. The terms of the contract require Golden Gate to make a payment of $1m to compensate the customer for changes that it will need to make to its retail stores to accommodate the products.

 

By the 31 December 20X1, Golden Gate has transferred products with a sales value of $4m to the customer.

 

Required

 

How much revenue should be recognised by Golden Gate in the year ended 31 December 20X1?

 

Step 4: Allocate the transaction price

 

The total transaction price should be allocated to each performance obligation in proportion to stand-alone selling prices.

 

The best evidence of a stand-alone selling price is the observable price when the good or service is sold separately.

 

If a stand-alone selling price is not directly observable then it must be estimated. Observable inputs should be maximised whenever possible.

 

If a customer is offered a discount for purchasing a bundle of goods and services, then the discount should be allocated across all performance obligations within the contract in proportion to their stand-alone selling prices (unless observable evidence suggests that this would be inaccurate).

 

Test your understanding 5 – Shred

 

Shred sells a machine and one year’s free technical support for $100,000. The sale of the machine and the provision of technical support have been identified as separate performance obligations. Shred usually sells the machine for $95,000 but it has not yet started selling technical support for this machine as a stand-alone product. Other support services offered by Shred attract a mark-up of 50%. It is expected that the technical support will cost Shred $20,000.

 

Required:

 

How much of the transaction price should be allocated to the machine and how much should be allocated to the technical support?

 

Step 5: Recognise revenue

 

Revenue is recognised when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer.

 

An entity must determine at contract inception whether it satisfies the performance obligation over time or satisfies the performance obligation at a point in time.

 

IFRS 15 (para 35) states that an entity satisfies a performance obligation over time if one of the following criteria is met:

 

  • ‘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 (for example, work in progress) that the customer controls as the asset is created or enhanced, or

 

  • 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’.

 

If a performance obligation is satisfied over time, then revenue is recognised over time based on progress towards the satisfaction of that performance obligation.

 

Test your understanding 6 – Evans

 

On 1 January 20X1, Evans enters into a contract with a customer to provide monthly payroll services. Evans charges $120,000 per year.

 

Required:

 

What is the accounting treatment of the above in the financial statements of Evans for the year ended 30 June 20X1?

 

Test your understanding 7 – Crawford

 

On 31 March 20X1, Crawford enters into a contract to construct a specialised factory for a customer. The customer paid an upfront deposit which is only refundable if Crawford fails to complete construction in line with the contract. The remainder of the price is payable when the customer takes possession of the factory. If the customer defaults on the contract before completion of the factory, Crawford only has the right to retain the deposit.

 

Required:

 

Should Crawford recognise revenue from the above transaction over time or at a point in time?

 

 

 

Methods of measuring progress towards satisfaction of a performance obligation include:

 

  • output methods (such as surveys of performance, or time elapsed)

 

  • input methods (such as costs incurred as a proportion of total expected costs).

 

If progress cannot be reliably measured then revenue can only be recognised up to the recoverable costs incurred.

 

Test your understanding 8 – Baker

 

On 1 January 20X1, Baker enters into a contract with a customer to construct a specialised building for consideration of $2m plus a bonus of $0.4m if the building is completed within 18 months. Estimated costs to construct the building are $1.5m. If the contract is terminated by the customer, Baker can demand payment for the costs incurred to date plus a mark-up of 30%. On 1 January 20X1, as a result of factors outside of its control, such as the weather and regulatory approval, Baker is not sure whether the bonus will be achieved.

 

At 31 December 20X1, Baker is still unsure whether the bonus target will be met. Baker decides to measure progress towards completion based on costs incurred. Costs incurred on the contract to date are $1.0m.

 

Required:

 

How should Baker account for this transaction in the year ended 31 December 20X1?

 

If a performance obligation is not satisfied over time then it is satisfied at a point in time. The entity must determine the point in time at which a customer obtains control of a promised asset.

 

An entity controls an asset if it can direct its use and obtain most of its remaining benefits. Control also includes the ability to prevent other entities from obtaining benefits from an asset.

 

IFRS 15 (para 38) provides the following indicators of the transfer of control:

 

  • ‘The entity has a present right to payment for the asset

 

  • The customer has legal title to the asset

 

  • The entity has transferred physical possession of the asset

 

  • The customer has the significant risks and rewards of ownership of the asset

 

  • The customer has accepted the asset’.

 

Test your understanding 9 – Clarence

 

On 31 December 20X1, Clarence delivered the January edition of a magazine (with a total sales value of $100,000) to a supermarket chain. Legal title remains with Clarence until the supermarket sells a magazine to the end consumer. The supermarket will start selling the magazines to its customers on 1 January 20X2. Any magazines that remain unsold by the supermarket on 31 January 20X2 are returned to Clarence.

 

The supermarket will be invoiced by Clarence in February 20X2 based on the difference between the number of issues they received and the number of issues that they return.

 

Required:

 

Should Clarence recognise revenue from the above transaction in the year ended 31 December 20X1?

 

 

 

3 Contract costs

 

IFRS 15 says that the following costs must be capitalised:

 

  • The costs of obtaining a contract. This must exclude costs that would have been incurred regardless of whether the contract was obtained or not (such as some legal fees, or the costs of travelling to a tender).

 

  • The costs of fulfilling a contract if they do not fall within the scope of another standard (such as IAS 2 Inventories) and the entity expects them to be recovered.

 

The capitalised costs of obtaining and fulfilling a contract will be amortised to the statement of profit or loss as revenue is recognised.

 

4 Presentation on the statement of financial position

 

When an entity has recognised revenue before it has received consideration, then it should recognise either:

 

  • a receivable if the right to the consideration is unconditional, or

 

  • a contract asset.

 

An entity has an unconditional right to receive consideration if only the passage of time is required before payment is due.

 

A contract liability should be recognised if the entity has received consideration (or has an unconditional right to receive consideration) before the related revenue has been recognised.

 

5 Other issues

 

 

Revenue disclosures

 

IFRS 15 requires an entity to disclose:

 

  • revenue recognised from contracts with customers

 

  • contract balances and assets recognised from costs incurred obtaining or fulfilling contracts

 

  • significant judgements used, and any changes in judgements.

 

 

IFRS 15 and judgement

 

Management judgement is required throughout all five steps of revenue recognition. For example:

 

  • Contracts with customers do not need to be in writing but may arise through customary business practice. An entity must therefore ascertain whether it has a constructive obligation to deliver a good or service to a customer.

 

  • A contract can only be accounted for if it is probable that the entity will collect the consideration that it is entitled to. Whether benefits are probable is, ultimately, a judgement.

 

  • The entity must identify distinct performance obligations in a contract. However, past performance may give rise to expectations in a customer that goods or services not specified in the contract will be transferred. The identification of distinct performance obligations thus relies on management judgement about both contract terms, and the impact of the entity’s past behaviour on customer expectations.

 

  • Variable consideration should be included in the transaction price if it is highly probable that a significant reversal in the amount of cumulative revenue recognised to date will not occur. This may involve making judgements about whether performance related targets will be met.

 

  • The transaction price must be allocated to distinct performance obligations, based on observable, standalone selling prices. However, estimation techniques must be used if observable prices are not available.

 

  • If a performance obligation is satisfied over time, revenue is recognised based on progress towards the completion of the performance obligation. There are various ways to measure completion, using either input or output methods, and the entity must determine which one most faithfully represents the transaction.

 

  • If a performance obligation is satisfied at a point in time, the entity must use judgement to ascertain the date at which control of the asset passes to the customer.

 

These judgements increase the risk that the management of an entity could manipulate its profits. Adherence to the ACCA ethical code is, therefore, vital.

Test your understanding 1 – Bristow

 

The $12 million consideration is fixed. The $3 million consideration that is dependent on the number of mistakes made is variable.

 

Bristow must estimate the variable consideration. It could use an expected value or a most likely amount. Since there are only two outcomes, $0 or $3 million, then a most likely amount would better predict the entitled consideration.

 

  • Bristow expects to hit the target. Using a most likely amount, the variable consideration would be valued at $3 million.

 

Bristow must then decide whether to include the estimate of variable consideration in the transaction price.

 

Based on past experience, it seems highly probable that a significant reversal in revenue recognised would not occur. This means that the transaction price is $15 million ($12m + $3m).

 

As a service, it is likely that the performance obligation would be satisfied over time. The revenue recognised in the year ended 31 December 20X1 would therefore be $1.25 million ($15m × 1/12).

 

  • Depending on the estimated likelihood of hitting the target, the variable consideration would either be estimated to be $0 or $3 million.

 

Whatever the amount, the estimated variable consideration cannot be included in the transaction price because it is not highly probable that a significant reversal in revenue would not occur. This is because Bristow has no experience of providing this service. Therefore, the transaction price is $12 million.

 

As a service, it is likely that the performance obligation would be satisfied over time. The revenue recognised in the year ended 31 December 20X1 would be $1 million ($12m × 1/12).

 

Test your understanding 2 – Rudd

 

Due to the length of time between the transfer of control of the asset and the payment date, this contract includes a significant financing component.

 

The consideration must be adjusted for the impact of the financing transaction. A discount rate should be used that reflects the characteristics of the customer i.e. 10%.

 

Revenue should be recognised when the performance obligation is satisfied.

 

As such revenue, and a corresponding receivable, should be recognised at $826,446 ($1m × 1/1.102) on 31 December 20X1.

 

The receivable is subsequently accounted for in accordance with IFRS 9 Financial Instruments.

 

 

 

Test your understanding 3 – Dan and Stan

 

The contract contains a single performance obligation.

 

Consideration for the transaction is non-cash. Non-cash consideration is measured at fair value.

 

Revenue should be recognised at $4,000 (1,000 shares × $4) on 1 January 20X1.

 

Any subsequent change in the fair value of the shares received is not recognised within revenue but instead accounted for in accordance with IFRS 9 Financial Instruments.

 

 

 

Test your understanding 4 – Golden Gate

 

The payment made to the customer is not in exchange for a distinct good or service. Therefore, the $1m paid to the customer must be treated as a reduction in the transaction price.

 

The total transaction price is essentially being reduced by 5% ($1m/ $20m). Therefore, Golden Gate reduces the price allocated to each good by 5% as it is transferred.

 

By 31 December 20X1, Golden Gate should have recognised revenue of $3.8m ($4m × 95%).

 

Test your understanding 5 – Shred

 

The selling price of the machine is $95,000 based on observable evidence.

 

There is no observable selling price for the technical support. Therefore, the stand-alone selling price needs to be estimated.

 

A residual approach would attribute $5,000 ($100,000 – $95,000) to the technical support. However, this does not approximate the stand-alone selling price of similar services (which normally make a profit).

 

A better approach for estimating the selling price of the support would be an expected cost plus a margin (or mark-up) approach. Based on this, the selling price of the service would be $30,000 ($20,000 × 150%).

 

The total of standalone selling prices of the machine and support is $125,000 ($95,000 + $30,000). However, total consideration receivable is only $100,000. This means that the customer is receiving a discount for purchasing a bundle of goods and services of 20% ($25,000/$125,000).

 

IFRS 15 assumes that discounts relate to all performance obligations within a contract, unless evidence exists to the contrary.

 

The transaction price allocated to the machine is $76,000 ($95,000 × 80%).

 

The transaction price allocated to the technical support is $24,000 ($30,000 × 80%).

 

The revenue will be recognised when (or as) the performance obligations are satisfied.

 

 

 

Test your understanding 6 – Evans

 

The payroll services are a single performance obligation.

 

This performance obligation is satisfied over time because the customer simultaneously receives and consumes the benefits of the payroll processing. This is evidenced by the fact that the payroll services would not need to be re-performed if the customer changed its payroll service provider.

 

Evans must therefore recognise revenue from the service over time. In the year ended 30 June 20X1, they would recognise revenue of $60,000 (6/12 × $120,000).

 

Test your understanding 7 – Crawford

 

In assessing whether revenue is recorded over time, it is important to note that the factory under construction is specialised. Therefore, the asset being created has no alternative use to the entity.

 

However, Crawford only has an enforceable right to the deposit received and therefore does not have a right to payment for work completed to date.

 

Consequently, Crawford must account for the sale of the unit as a performance obligation satisfied at a point in time, rather than over time. Revenue will most likely be recognised when the customer takes possession of the factory (although a detailed assessment should be made of the date when the customer assumes control).

 

 

 

Test your understanding 8 – Baker

 

Constructing the building is a single performance obligation.

 

The bonus is variable consideration. Whatever its estimated value, it must be excluded from the transaction price because it is not highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur.

 

The construction of the building should be accounted for as an obligation settled over time. This is because the building has no alternative uses for Baker, and because payment can be enforced for the work completed to date.

 

Baker should recognise revenue based on progress towards satisfaction of the construction of the building. Using costs incurred, the performance obligation is 2/3 ($1.0m/$1.5m) complete. Accordingly, the revenue and costs recognised at the end of the year are as follows:

 

$m
Revenue ($2m × 2/3) 1.3
Costs ($1.5m × 2/3) (1.0)
––––
Gross profit 0.3
––––

 

Test your understanding 9 – Clarence

 

The performance obligation is not satisfied over time because the supermarket does not simultaneously receive and benefit from the asset. Clarence therefore satisfies the performance obligation at a point in time and will recognise revenue when it transfers control over the assets to the supermarket.

 

The fact that the supermarket has physical possession of the magazines at 31 December 20X1 is an indicator that control has passed. Also, Clarence will invoice the supermarket for any issues that are stolen and so the supermarket does bear some of the risks of ownership.

 

However, as at 31 December 20X1, legal title of the magazines has not passed to the supermarket. Moreover, Clarence has no right to receive payment until the supermarket sells the magazines to the end consumer. Finally, Clarence will be sent any unsold issues and so bears significant risks of ownership (such as the risk of obsolescence).

 

All things considered, it would seem that control of the magazines has not passed from Clarence to the supermarket chain. Therefore, Clarence should not recognise revenue from this contract in its financial statements for the year ended 31 December 20X1.

 

(Visited 1,019 times, 1 visits today)
Share this:

Written by 

Leave a Reply

Your email address will not be published. Required fields are marked *