4 Revenue recognition 6/08, 12/08, 6/11, 12/11, 6/13, 12/13,

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1 framework that does not explore such topics in more detail may have gaps that will make its applicability less useful The Financial Reporting Council (FRC) In a July 2015 meeting, the FRC s Accounting Council considered the ED and produced a draft response. While the proposals were broadly welcome, the FRC had tentative criticisms, of which the following are the most relevant to your exam. (d) (e) Prudence. The ED does not reflect the notion of asymmetric prudence the recognition of losses and liabilities at a lower level of likelihood (and hence often earlier) than gains and assets. This notion is mentioned in the Basis for Conclusions, but ought to be part of the Conceptual Framework itself. Neutrality. Prudence is a way of achieving neutrality, defined as without bias. However, the FRC believe that unbiased would be a clearer word. Reliability. The description of faithful representation given in the Exposure Draft does not include the idea, which was in the discussion of reliability in a previous version of the Conceptual Framework, that the information can be depended upon by users. The idea of reliability needs to be reinstated. Statement of profit or loss. Terms such as profit, return and performance need to be defined, and the significance of recycling adjustments needs to be explained. Elements. The Exposure Draft does not propose to define elements for the statement of cash flows. Exam focus point The examining team have flagged this topic as important. Keep an eye on future developments by reading Student Accountant and 4 Revenue recognition 6/08, 12/08, 6/11, 12/11, 6/13, 12/13, 6/14, 12/15 FAST FORWARD Revenue recognition is straightforward in most business transactions, but some situations are more complicated. 4.1 Introduction Accruals accounting is based on the matching of costs with the revenue they generate. It is crucially important under this convention that we can establish the point at which revenue may be recognised so that the correct treatment can be applied to the related costs. For example, the costs of producing an item of finished goods should be carried as an asset in the statement of financial position until such time as it is sold; they should then be written off as a charge to the trading account. Which of these two treatments should be applied cannot be decided until it is clear at what moment the sale of the item takes place. The decision has a direct impact on profit since under the prudence concept it would be unacceptable to recognise the profit on sale until a sale had taken place in accordance with the criteria of revenue recognition. Revenue is generally recognised as earned at the point of sale, because at that point four criteria will generally have been met. The product or service has been provided to the buyer. The buyer has recognised his liability to pay for the goods or services provided. The converse of this is that the seller has recognised that ownership of goods has passed from himself to the buyer. Part A Regulatory and ethical framework 1: Financial reporting framework 17

2 The buyer has indicated his willingness to hand over cash or other assets in settlement of his liability. The monetary value of the goods or services has been established. At earlier points in the business cycle there will not, in general, be firm evidence that the above criteria will be met. Until work on a product is complete, there is a risk that some flaw in the manufacturing process will necessitate its writing off; even when the product is complete there is no guarantee that it will find a buyer. At later points in the business cycle, for example when cash is received for the sale, the recognition of revenue may occur in a period later than that in which the related costs were charged. Revenue recognition would then depend on fortuitous circumstances, such as the cash flow of a company's customers, and might fluctuate misleadingly from one period to another. However, there are times when revenue is recognised at other times than at the completion of a sale. For example, in the recognition of profit on long-term construction contracts (performance obligations satisfied over time, see below). Contract revenue and contract costs associated with the construction contract are recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the year end. Owing to the length of time taken to complete such contracts, to defer taking profit into account until completion may result in the statement of profit or loss and other comprehensive income reflecting, not so much a fair view of the activity of the company during the year, but rather the results relating to contracts which have been completed by the year end. Revenue in this case is recognised when production on, say, a section of the total contract is complete, even though no sale can be made until the whole is complete. 4.2 IFRS 15 Revenue from contracts with customers FAST FORWARD IFRS 15 Revenue from contracts with customers is concerned with the recognition of revenues arising from fairly common transactions. The sale of goods The rendering of services The use by others of entity assets yielding interest, royalties and dividends Generally revenue is recognised when the entity has transferred promised goods or services to the customer. The standard sets out five steps for the recognition process. Income, as defined by the IASB Conceptual Framework (see above), includes both revenues and gains. Revenue is income arising in the ordinary course of an entity's activities and it may be called different names, such as sales, fees, interest, dividends or royalties. IFRS 15 Revenue from contracts with customers was issued in May It is the result of a joint IASB and FASB project on revenue recognition. It seeks to strike a balance between the IASB rules in IAS 18, which were felt to be too general, leading to a lot of diversity in practice, and the FASB regulations, which were too numerous. IFRS 15 replaces both IAS 18 Revenue and IAS 11 Construction contracts. It is effective for reporting periods beginning on or after 1 January Its core principle is that revenue is recognised to depict the transfer of goods or services to a customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Under IFRS 15 the transfer of goods and services is based upon the transfer of control, rather than the transfer of risks and rewards as in IAS 18. Control of an asset is described in the standard as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. For straightforward retail transactions IFRS 15 will have little, if any, effect on the amount and timing of revenue recognition. For contracts such as long-term service contracts and multi-element arrangements it could result in changes either to the amount or to the timing of revenue recognised. 18 1: Financial reporting framework Part A Regulatory and ethical framework

3 4.3 Scope IFRS 15 applies to all contracts with customers except: Leases within the scope of IAS 17 Insurance contracts within the scope of IAS 4 Financial instruments and other contractual rights and obligations within the scope of IFRS 9, IFRS 10, IFRS 11, IAS 27 or IAS 28. Non-monetary exchanges between entities in the same line of business 4.4 Definitions The following definitions are given in the standard. Key term Income Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in an increase in equity, other than those relating to contributions from equity participants. Revenue - Income arising in the course of an entity s ordinary activities. Contract An agreement between two or more parties that creates enforceable rights and obligations. Contract asset An entity s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example the entity s future performance). Receivable An entity s right to consideration that is unconditional ie only the passage of time is required before payment is due. Contract liability An entity s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer. Customer A party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities in exchange for consideration. Performance obligation A promise in a contract with a customer to transfer to the customer either: A good or service (or a bundle of goods or services) that is distinct; or A series of distinct goods or services that are substantially the same ad that have the same pattern of transfer to the customer. Stand-alone selling price The price at which an entity would sell a promised good or service separately to a customer. Transaction price 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. (IFRS 15) Revenue does not include sales taxes, value added taxes or goods and service taxes which are only collected for third parties, because these do not represent an economic benefit flowing to the entity. 4.5 Recognition and measurement of revenue Under IFRS 15 revenue is recognised and measured using a five step model. Step 1 Identify the contract with the customer. A contract with a customer is within the scope of IFRS 15 only when: The parties have approved the contract and are committed to carrying it out. Each party s rights regarding the goods and services to be transferred can be identified. The payment terms for the goods and services can be identified (d) The contract has commercial substance (e) It is probable that the entity will collect the consideration to which it will be entitled. Part A Regulatory and ethical framework 1: Financial reporting framework 19

4 Step 2 The contract can be written, verbal or implied. Identify the separate performance obligations. The key point is distinct goods or services. A contract includes promises to provide goods or services to a customer. Those promises are called performance obligations. A company would account for a performance obligation separately only if the promised good or service is distinct. A good or service is distinct if it is sold separately or if it could be sold separately because it has a distinct function and a distinct profit margin. Factors for consideration as to whether an entity s promise to transfer the good or service to the customer is separately identifiable include, but are not limited to: The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract. The good or service does not significantly modify or customize another good or service promised in the contract. Step 3 Step 4 The good or service is not highly dependent on or highly interrelated with other goods or services promised in the contract. Determine the transaction price. The transaction price is the amount of consideration a company expects to be entitled to from the customer in exchange for transferring goods or services. The transaction price would reflect the company s probability-weighted estimate of variable consideration (including reasonable estimates of contingent amounts) in addition to the effects of the customer s credit risk and the time value of money (if material). Variable contingent amounts are only included where it is highly probable that there will not be a reversal of revenue when any uncertainty associated with the variable consideration is resolved. Examples of where a variable consideration can arise include: discounts, rebates, refunds, price concessions, credits and penalties. Allocate the transaction price to the performance obligations. Where a contract contains more than one distinct performance obligation a company allocates the transaction price to all separate performance obligations in proportion to the stand-alone selling price of the good or service underlying each performance obligation. If the good or service is not sold separately, the company would estimate its stand-alone selling price. So, if any entity sells a bundle of goods and/or services which it also supplies unbundled, the separate performance obligations in the contract should be priced in the same proportion as the unbundled prices. This would apply to mobile phone contracts where the handset is supplied free. The entity must look at the stand-alone price of such a handset and some of the consideration for the contract should be allocated to the handset. Step 5 Recognise revenue when (or as) a performance obligation is satisfied. The entity satisfies a performance obligation by transferring control of a promised good or service to the customer. A performance obligation can be satisfied at a point in time, such as when goods are delivered to the customer, or over time. An obligation satisfied over time will meet one of the following criteria: The customer simultaneously receives and consumes the benefits as the performance takes place. 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. The amount of revenue recognised is the amount allocated to that performance obligation in Step : Financial reporting framework Part A Regulatory and ethical framework

5 An entity must be able to reasonably measure the outcome of a performance obligation before the related revenue can be recognised. In some circumstances, such as in the early stages of a contract, it may not be possible to reasonably measure the outcome of a performance obligation, but the entity expects to recover the costs incurred. In these circumstances, revenue is recognised only to the extent of costs incurred Example: identifying the separate performance obligation Office Solutions, a limited company, has developed a communications software package called CommSoft. Office Solutions has entered into a contract with Logisticity to supply the following: (d) Licence to use CommSoft Installation service. This may require an upgrade to the computer operating system, but the software package does not need to be customized Technical support for three years Three years of updates for CommSoft Office Solutions is not the only company able to install CommSoft, and the technical support can also be provided by other companies. The software can function without the updates and technical support. Required Explain whether the goods or services provided to Logisticity are distinct in accordance with IFRS 15 Revenue from contracts with customers. Solution CommSoft was delivered before the other goods or services and remains functional without the updates and the technical support. It may be concluded that Logisticity can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available. The promises to transfer each good and service to the customer are separately identifiable In particular, the installation service does not significantly modify the software itself and, as such, the software and the installation service are separate outputs promised by Office Solutions rather than inputs used to produce a combined output. In conclusion, the goods and services are distinct and amount to four performance obligations in the contract under IFRS Example: determining the transaction price Taplop supplies laptop computers to large businesses. On 1 July 20X5, Taplop entered into a contract with TrillCo, under which TrillCo was to purchase laptops at $500 per unit. The contract states that if TrillCo purchases more than 500 laptops in a year, the price per units is reduced retrospectively to $450 per unit. Taplop s year end is 30 June. Required As at 30 September 20X5, TrillCo had bought 70 laptops from Taplop. Taplop therefore estimated that TrillCo s purchases would not exceed 500 in the year to 30 June 20X6, and would therefore not be entitled to the volume discount. During the quarter ended 31 December 20X5, TrillCo expanded rapidly as a result of a substantial acquisition, and purchased an additional 250 laptops from Taplop. Taplop then estimated that TrillCo s purchases would exceed the threshold for the volume discount in the year to 30 June 20X6. Calculate the revenue Taplop would recognise in: The quarter ended 30 September 20X5 The quarter ended 31 December 20X5 Your answer should apply the principles of IFRS 15 Revenue from contracts with customers. Part A Regulatory and ethical framework 1: Financial reporting framework 21

6 Solution Applying the requirements of IFRS 15 to TrillCo s purchasing pattern at 30 September 20X5, Taplop should conclude that it was highly probable that a significant reversal in the cumulative amount of revenue recognised ($500 per laptop) would not occur when the uncertainty was resolved, that is when the total amount of purchases was known. Consequently, Taplop should recognise revenue of 70 x $500 = $35,000 for the first quarter ended 30 September 20X5. In the quarter ended 31 December 20X5, TrillCo s purchasing pattern changed such that it would be legitimate for Taplop to conclude that TrillCo s purchases would exceed the threshold for the volume discount in the year to 30 June 20X6, and therefore that it was appropriate to reduce the price to $450 per laptop. Taplop should therefore recognise revenue of $109,000 for the quarter ended 31 December 20X5. The amount is calculated as from $112,500 (250 laptops x $450) less the change in transaction price of $3,500 (70 laptops x $50 price reduction) for the reduction of the price of the laptops sold in the quarter ended 30 September 20X Contract costs The incremental costs of obtaining a contract (such as sales commission) are recognised as an asset if the entity expects to recover those costs. Costs that would have been incurred regardless of whether the contract was obtained are recognised as an expense as incurred. Costs incurred in fulfilling a contract, unless within the scope of another standard (such as IAS 2 Inventories, IAS 16 Property, plant and equipment or IAS 38 Intangible assets) are recognised as an asset if they meet the following criteria: The costs relate directly to an identifiable contract (costs such as labour, materials, management costs) The costs generate or enhance resources of the entity that will be used in satisfying (or continuing to satisfy) performance obligations in the future; and The costs are expected to be recovered Costs recognised as assets are amortised on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates. 4.7 Performance obligations satisfied over time A performance obligation satisfied over time meets the criteria in Step 5 above and, if it entered into more than one accounting period, would previously have been described as a long-term contract. In this type of contract an entity has an enforceable right to payment for performance completed to date. The standard describes this as an amount that approximates the selling price of the goods or services transferred to date (for example recovery of the costs incurred by the entity in satisfying the performance plus a reasonable profit margin). Methods of measuring the amount of performance completed to date encompass output methods and input methods. Output methods recognise revenue on the basis of the value to the customer of the goods or services transferred. They include surveys of performance completed, appraisal of units produced or delivered etc. Input methods recognise revenue on the basis of the entity s inputs, such as labour hours, resources consumed, and costs incurred. If using a cost-based method, the costs incurred must contribute to the entity s progress in satisfying the performance obligation. 22 1: Financial reporting framework Part A Regulatory and ethical framework

7 4.8 Performance obligations satisfied at a point in time A performance obligation not satisfied over time will be satisfied at a point in time. This will be the point in time at which the customer obtains control of the promised asset and the entity satisfies a performance obligation. Some indicators of the transfer of control are: (d) (e) 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 significant risks and rewards of ownership have been transferred to the customer. The customer has accepted the asset. 4.9 Sale with a right of return Where goods are sold with a right of return, an entity should not recognise revenue for goods that it expects to be returned. It can calculate the level of returns using the expected value method (the probability-weighted sum of amounts) or simply estimate the most likely amount. This will be shown as a refund liability and a deduction from revenue. The entity also recognises an asset (adjusted against cost of sales) for its right to recover products from customers on settlement of the refund liability Warranties If a customer has the option to purchase a warranty separately from the product to which it relates, it constitutes a distinct service and is accounted for as a separate performance obligation. This would apply to a warranty which provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. If the customer does not have the option to purchase the warranty separately, for instance if the warranty is required by law, that does not give rise to a performance obligation and the warranty is accounted for in accordance with IAS Principal versus agent An entity must establish in any transaction whether it is acting as principal or agent. It is a principal if it controls the promised good or service before it is transferred to the customer. When the performance obligation is satisfied, the entity recognises revenue in the gross amount of the consideration for those goods or services. It is acting as an agent if its performance obligation is to arrange for the provision of goods or services by another party. Satisfaction of this performance obligation will give rise to the recognition of revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the other party to provide its goods or services. Indicators that an entity is an agent rather than a principal include the following: (d) (e) Another party is primarily responsible for fulfilling the contract. The entity does not have inventory risk before or after the goods have been ordered by a customer, during shipping or on return. The entity does not have discretion in establishing prices for the other party s goods or services and, therefore, the benefit that the entity can receive from those goods or services is limited. The entity s consideration is in the form of a commission. The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the other party s goods or services. Part A Regulatory and ethical framework 1: Financial reporting framework 23

8 Example: principal versus agent This example is taken from the standard. An entity operates a website that enables customers to purchase goods from a range of suppliers. The suppliers deliver directly to the customers, who have paid in advance, and the entity receives a commission of 10% of the sales price. The entity s website also processes payments from the customer to the supplier at prices set by the supplier. The entity has no further obligation to the customer after arranging for the products to be supplied. Is the entity a principal or an agent? Solution The following points are relevant: Goods are supplied directly from the supplier to the customer, so the entity does not obtain control of the goods. The supplier is primarily responsible for fulfilling the contract. The entity s consideration is in the form of commission. The entity does not establish prices and bears no credit risk. The entity would therefore conclude that it is acting as an agent and that the only revenue to be recognised is the amounts received as commission Options for additional goods or services If an option in the contract grants the customer the right to acquire additional goods or services at a discount which can only be obtained by entering into the contract, that option gives rise to a performance obligation. Revenue is recognised when the additional future goods or services are transferred, or when the option expires. Revenue will be based on the stand-alone selling price of the goods or services, taking account of the discount. If the option granted to the customer does not offer a discount, it is treated as a marketing offer and no contract exists until the customer exercises the option to purchase Customers unexercised rights When a customer pays in advance for goods or services the prepayment gives rise to a contract liability, which is derecognised when the performance obligation is satisfied. If, having made a non-refundable prepayment, the customer does not exercise their right to receive the good or service, the unexercised right is often referred to as breakage. A breakage amount can be recognised as revenue if the pattern of rights exercised by the customer gives rise to the expectation that the entity will be entitled to a breakage amount. If this does not apply, it can be recognised as revenue when the likelihood of the customer exercising its rights becomes remote Non-refundable upfront fees A non-refundable upfront fee is often charged at the beginning of a contract, such as joining fees in health club membership contracts. In many cases upfront fees do not relate to the transfer of any promised good or service but are simply advance payments for future goods or services. In this case revenue is recognised when the future goods or services are provided. 24 1: Financial reporting framework Part A Regulatory and ethical framework

9 If the fee relates to a good or service the entity should evaluate whether or not it amounts to a separate performance obligation. This depends on whether it results in the transfer of an asset to the customer. The fee may relate to costs incurred in setting up a contract, but these setup activities may not result in the transfer of services to the customer Licensing A licence establishes a customer s rights to the intellectual property of an entity. Intellectual property can include software, music, franchises, patents, trademarks and copyrights. The promise to grant a licence may be accompanied by the promise to transfer other goods or services to the customer. If the promise to grant the licence is not distinct from the promised goods or services, this is treated as a single performance obligation. If the promise to grant the licence is distinct, it will constitute a separate performance obligation. The entity must establish whether the performance obligation is satisfied at a point in time or over time. In this respect the entity should consider whether the nature of the entity s promise in granting the licence to a customer is to provide the customer with either: A right to access the entity s intellectual property as it exists throughout the licence period; or A right to use the entity s intellectual property as it exists at the point in time at which the licence is granted. A right to access exists where the entity can make changes to the intellectual property throughout the licence period, the customer is exposed to the effects of these changes and the changes do not constitute the transfer of a good or service to the customer. In this case the promise to grant a licence is treated as a performance obligation satisfied over time and the entity recognises revenue over time by measuring the progress towards complete satisfaction of that performance obligation. Where this does not apply, the nature of the entity s promise is the right to use its intellectual property as it exists at the point in time at which the licence is granted. This means that the customer can direct the use of, and obtain substantially all of the remaining benefits from, the licence at the point at which it is transferred. The point at which revenue can be recognised may be later than the date on which the licence is granted if the customer does not have immediate access to the intellectual property, for instance if it has to wait to be granted an access code. When royalties, based on sales or on usage, are promised by the customer in exchange for a licence of intellectual property, revenue can be recognised at the later of the following occurrences: The sale or usage occurs; and The performance obligation to which the royalty has been allocated has been satisfied Repurchase agreements Under a repurchase agreement an entity sells an asset and promises, or has the option, to repurchase it. Repurchase agreements generally come in three forms: An entity has an obligation to repurchase the asset (a forward contract) An entity has the right to repurchase the asset (a call option) An entity must repurchase the asset if requested to do so by the customer (a put option). In the case of a forward or a call option the customer does not obtain control of the asset, even if it has physical possession. The entity will account for the contract as: A lease in accordance with IAS 17, if the repurchase price is below the original selling price; or A financing arrangement if the repurchase price is equal to or greater than the original selling price. In this case the entity will recognise both the asset and a corresponding liability. If the entity is obliged to repurchase at the request of the customer (a put option), it must consider whether or not the customer is likely to exercise that option. Part A Regulatory and ethical framework 1: Financial reporting framework 25

10 If the repurchase price is lower than the original selling price and it is considered that the customer does not therefore have significant economic incentive to exercise the option, the contract should be accounted for as an outright sale, with a right of return. If the repurchase price is greater than or equal to the original selling price and is above the expected market value of the option, the contract is treated as a financing arrangement Example: contract with a call option This example is taken from the standard. An entity enters into a contract with a customer for the sale of a tangible asset on 1 January 20X7 for $1 million. The contract includes a call option that gives the entity the right to repurchase the asset for $1.1 million on or before 31 December 20X7. This means that the customer does not obtain control of the asset, because the repurchase option means that it is limited in its ability to use and obtain benefit from the asset. Solution As control has not been transferred, the entity accounts for the transaction as a financing arrangement, because the exercise price is above the original selling price. The entity continues to recognise the asset and recognises the cash received as a financial liability. The difference of $0.1 million is recognised as interest expense. If on 31 December 20X7 the option lapses unexercised, the customer now obtains control of the asset. The entity will derecognise the asset and recognise revenue of $1.1 million (the $1 million already received plus the $0.1 million charged to interest) Example: contract with a put option The same contract as above includes instead a put option that obliges the entity to repurchase the asset at the customer s request for $900,000 on or before 31 December 20X7, at which time the market value is expected to be $750,000. Solution In this case the customer has a significant economic incentive to exercise the put option because the repurchase price exceeds the market value at the repurchase date. This means that control does not pass to the customer. Since the customer will be exercising the put option, this limits its ability to use or obtain benefit from the asset. In this situation the entity accounts for the transaction as a lease in accordance with IAS 17. The asset has been leased to the customer for the period up to the repurchase and the difference of $100,000 will be accounted for as payments received under an operating lease Consignment arrangements When a product is delivered to a customer under a consignment arrangement, the customer (dealer) does not obtain control of the product at that point in time, so no revenue is recognised upon delivery. Indicators of a consignment arrangement include: The product is controlled by the entity until a specified event occurs, such as the product is sold on, or a specified period expires. The entity can require the return of the product, or transfer it to another party. The customer (dealer) does not have an unconditional obligation to pay for the product 4.18 Bill-and-hold arrangements Under a bill-and-hold arrangement goods are sold but remain in the possession of the seller for a specified period, perhaps because the customer lacks storage facilities. 26 1: Financial reporting framework Part A Regulatory and ethical framework

11 An entity will need to determine at what point the customer obtains control of the product. For some contracts, control will not be transferred until the goods are delivered to the customer. For others, a customer may obtain control even though the goods remain in the entity s physical possession. In this case the entity would be providing custodial services to the customer over the customer s asset. For a customer to have obtained control of a product in a bill and hold arrangement, the following criteria must all be met: (d) The reason for the bill-and-hold must be substantive (for example, requested by the customer). The product must be separately identified as belonging to the customer. The product must be ready for physical transfer to the customer. The entity cannot have the ability to use the product or to transfer it to another customer Example: bill and hold arrangement This example is taken from the standard. An entity enters into a contract with a customer on 1 January 20X8 for sale of a machine and spare parts. It takes two years to manufacture these and on 31 December 20X9 the customer pays for both the machine and the spare parts but only takes physical possession of the machine. The customer inspects and accepts the spare parts but requests that they continue to be stored at the entity s warehouse. Solution There are now three performance obligations transfer of the machine, transfer of the spare parts and the custodial services. The transaction price is allocated to the three performance obligations and revenue is recognised when (or as) control passes to the customer. The machine and the spare parts are both performance obligations satisfied at a point in time, and for both of them that point in time is 31 December 20X9. In the case of the spare parts, the customer has paid for them, the customer has legal title to them and the customer as control of them as they can remove them from storage at any time. The custodial services are a performance obligation satisfied over time, so revenue will be recognised over the period during which the spare parts are stored Example: applying the IFRS five-step model On 1 January 20X4, Angelo enters into a twelve-month pay monthly contract for a mobile phone. The contract is with TeleSouth, and terms of the plan are: Angelo receives a free handset on 1 January 20X4 Angelo pays a monthly fee of $200, which includes unlimited free minutes. Angelo is billed on the last day of the month Customers may purchase the same handset from TeleSouth for $500 without the payment plan. They may also enter into the payment plan without the handset, in which case the plan costs them $175 per month. The company s year-end is 31 July 20X4. Required Show how TeleSouth should recognise revenue from this plan in accordance with IFRS 15 Revenue from contracts with customers. Your answer should give journal entries: Solution On 1 January 20X4 On 31 January 20X4 IFRS 15 requires application of its five-step process: (i) Identify the contract with a customer. A contract can be written, oral or implied by customary business practices. Part A Regulatory and ethical framework 1: Financial reporting framework 27

12 (ii) (iii) (iv) (v) Identify the separate performance obligations in the contract. If a promised good or service is not distinct, it can be combined with others. Determine the transaction price. This is the amount to which the entity expects to be 'entitled'. For variable consideration, the probability weighted expected amount is used. The effect of any credit losses shown as a separate line item (just below revenue). Allocate the transaction price to the separate performance obligations in the contract. For multiple deliverables, the transaction price is allocated to each separate performance obligation in proportion to the stand-alone selling price at contract inception of each performance obligation. Recognise revenue when (or as) the entity satisfies a performance obligation, that is when the entity transfers a promised good or service to a customer. The good or service is only considered as transferred when the customer obtains control of it. Application of the five-step process to TeleSouth (i) (ii) Identify the contract with a customer. This is clear. TeleSouth has a twelve-month contract with Angelo. Identify the separate performance obligations in the contract. In this case there are two distinct performance obligations: (1) The obligation to deliver a handset (2) The obligation to provide network services for twelve months (The obligation to deliver a handset would not be a distinct performance obligation if the handset could not be sold separately, but it is in this case because the handsets are sold separately.) (iii) (iv) (v) Determine the transaction price. This is straightforward: it is $2,400, that is 12 months the monthly fee of $200. Allocate the transaction price to the separate performance obligations in the contract. The transaction price is allocated to each separate performance obligation in proportion to the standalone selling price at contract inception of each performance obligation, that is the stand-alone price of the handset ($500 and the stand-alone price of the network services ($ = $2,100.00): Performance obligation Stand-alone selling price % of total Revenue (=relative selling price = $2,400 %) $ $ Handset % Network services 2, % 1, Total 2, % 2, Recognise revenue when (or as) the entity satisfies a performance obligation, that is when the entity transfers a promised good or service to a customer. This applies to each of the performance obligations: (1) When TeleSouth gives a handset to Angelo, it needs to recognize the revenue of $ (2) When TeleSouth provides network services to Angelo, it needs to recognize the total revenue of $1, It s practical to do it once per month as the billing happens. Journal entries On 1 January 20X4 The entries in the books of TeleSouth will be: DEBIT Receivable (unbilled revenue ) $ CREDIT Revenue $ Being recognition of revenue from the sale of the handset 28 1: Financial reporting framework Part A Regulatory and ethical framework

13 On 31 January 20X4 The monthly payment from Angelo is split between amounts owing for network services and amounts owing for the handset. DEBIT Receivable (Angelo) $200 CREDIT Revenue (1,939.20/12) $ CREDIT Receivable (unbilled revenue )(460.80/12) $38.40 Being recognition of revenue from monthly provision of network services and repayment of handset 4.20 Presentation Contracts with customers will be presented in an entity s statement of financial position as a contract liability, a contract asset or a receivable, depending on the relationship between the entity s performance and the customer s payment. A contract liability is recognised and presented in the statement of financial position where a customer has paid an amount of consideration prior to the entity performing by transferring control of the related good or service to the customer. When the entity has performed but the customer has not yet paid the related consideration, this will give rise to either a contract asset or a receivable. A contract asset is recognised when the entity s right to consideration is conditional on something other than the passage of time, for instance future performance. A receivable is recognised when the entity s right to consideration is unconditional except for the passage of time. In practice, this aligns with the previous IAS 11 treatment. Where revenue has been invoiced a receivable is recognised. Where revenue has been earned but not invoiced, it is recognised as a contract asset Disclosure The following amounts should be disclosed unless they have been presented separately in the financial statements in accordance with other standards: (d) (e) Revenue recognised from contracts with customers, disclosed separately from other sources of revenue. Any impairment losses recognised (in accordance with IFRS 9) on any receivables or contract assets arising from an entity s contracts with customers, disclosed separately from other impairment losses. The opening and closing balances of receivables, contract assets and contract liabilities from contracts with customers. Revenue recognised in the reporting period that was included in the contract liability balance at the beginning of the period; and Revenue recognised in the reporting period from performance obligations satisfied in previous periods (such as changes in transaction price). Other information that should be provided; An explanation of significant changes in the contract asset and liability balances during the reporting period Information regarding the entity s performance obligations, including when they are typically satisfied (upon delivery, upon shipment, as services are rendered etc.), significant payment terms (such as when payment is typically due) and details of any agency transactions, obligations for returns or refunds and warranties granted. The aggregate amount of the transaction price allocated to the performance obligations that are not fully satisfied at the end of the reporting period and an explanation of when the entity expects to recognise these amounts as revenue. Part A Regulatory and ethical framework 1: Financial reporting framework 29

14 (d) (e) Judgements, and changes in judgements, made in applying the standard that significantly affect the determination of the amount and timing of revenue from contracts with customers. Assets recognised from the costs to obtain or fulfil a contract with a customer. This would include pre-contract costs and set-up costs. The method of amortisation should also be disclosed Contracts where performance obligations are satisfied over time These contracts are generally construction contracts, and it is possible that you will see this term used as the old standard, IFRS 11 used it. A company is building a large tower block that will house offices, under a contract with an investment company. It will take three years to build the block and over that time it will obviously have to pay for building materials, wages of workers on the building, architects' fees and so on. It will receive periodic payments from the investment company at various predetermined stages of the construction. How does it decide, in each of the three years, what to include as income and expenditure for the contract in profit or loss? Example: contract where performance obligations are satisfied over time Suppose that a contract is started on 1 January 20X5, with an estimated completion date of 31 December 20X6. The final contract price is $1,500,000. In the first year, to 31 December 20X5: Costs incurred amounted to $600,000. Half the work on the contract was completed. Certificates of work completed have been issued, to the value of $750,000. (d) It is estimated with reasonable certainty that further costs to completion in 20X6 will be $600,000. What is the contract profit in 20X5, and what entries would be made for the contract at 31 December 20X5? Solution This is a contract in which the performance obligation is satisfied over time. The entity is carrying out the work for the benefit of the customer rather than creating an asset for its own use and it has an enforceable right to payment for work completed to date. We can see this from the fact that certificates of work completed have been issued. IFRS 15 states that the amount of payment that the entity is entitled to corresponds to the amount of performance completed to date, which approximates to the costs incurred in satisfying the performance obligation plus a reasonable profit margin. In this case the contract is certified as 50% complete. At 31 December 20X5 the entity will recognise revenue of $750,000 and cost of sales of $600,000, leaving profit of $150,000. The contract asset will be the costs to date plus the profit - $750,000. We are not told that any of this amount has yet been invoiced, so no amount is deducted for receivables. Summary of accounting treatment Statement of profit or loss Revenue and costs (i) (ii) Sales revenue and associated costs should be recorded in profit or loss as the contract activity progresses. Include an appropriate proportion of total contract value as sales revenue in profit or loss. 30 1: Financial reporting framework Part A Regulatory and ethical framework

15 (iii) (iv) The costs incurred in completing that amount of the performance obligation are matched with this sales revenue, resulting in the reporting of results which can be attributed to the proportion of work completed. Sales revenue is the value of work carried out to date. Profit recognised in the contract (i) (ii) It must reflect the proportion of work carried out. It should take into account any known inequalities in profitability in the various stages of a contract. Statement of financial position Contract asset (presented separately under current assets) Costs to date Plus recognised profits Less any recognised losses Less receivables (amounts invoiced) Contract asset (amount due from the customer) Receivables Unpaid invoices $ X (X) X (X) X (X) X X Contract liability. Where gives a net amount due to the customer this amount should be included as a contract liability, presented separately under current liabilities. Example P Co has the following construction contract (performance obligations satisfied over time) in progress: $m Total contract price 750 Costs incurred to date 225 Estimated costs to completion 340 Progress payments invoiced and received 290 Now we will calculate the amounts to be recognised for the contract in the statement of profit or loss and statement of financial position assuming the amount of performance obligation satisfied is calculated using the proportion of costs incurred method. 1 Estimated profit $m Total contract price 750 Less costs incurred to date (225) Less estimated costs to completion (340) Estimated profit Percentage complete Costs to date / total estimated costs: 225 / ( ) = 40% Part A Regulatory and ethical framework 1: Financial reporting framework 31

16 3 Statement of profit or loss $m Revenue (40% x $750) 300 Cost of sales (40% x ( )) (226) Profit (40% x 185) 74 4 Statement of financial position $m Costs incurred to date 225 Recognised profits 74 Less receivable (290) Contract asset 9 How would we account for this if it was a loss-making contract? We will reduce P Co s contract price to $550m. 1 Estimated loss $m Total contract price 550 Less costs incurred to date (225) Less estimated costs to completion (340) Estimated loss (15) 2 Percentage complete Costs to date / total estimated costs: 225 / ( ) = 40% 3 Statement of profit or loss $m Revenue (40% x $550) 220 Cost of sales (balancing figure) (235) Loss (15) 4 Statement of financial position $m Costs incurred to date 225 Recognised loss (15) Less receivable (290) Contract liability (80) 4.23 Likely impact on companies Revenue is generally an entity s most important financial performance indicator, and one extensively scrutinised by analysts and investors. IFRS 15 is likely to impact on the timing, measurement, recognition and disclosure of revenue. These impacts will require adjustments in policies, procedures, internal controls and systems Timing of revenue By far the most significant change in IFRS 15 is to the pattern of revenue reporting. Even if the total revenue reported does not change, the timing will change in many cases. The example of TeleSouth, our fictitious company in Section 4.19 above, illustrates this point. Under IAS 18 Revenue, the old standard, TeleSouth would not recognise any revenue from the sale of handset, on the grounds that TeleSouth has given it to Angelo free. TeleSouth would view the free handset as a cost of acquiring a new customer, and the cost would be recognised in profit or loss immediately. 32 1: Financial reporting framework Part A Regulatory and ethical framework