Topic 8 - REVENUE IFRS 15

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1 Topic 8 - REVENUE IFRS 15 IFRS 15 sets out rules for the recognition of revenue based on transfer of control to the customer from the entity supplying the goods or services Some Key Definitions.. - Stand Alone Selling Price: The price at which an entity would sell a promised good or service separately to a customer There is a 5 step model for recognising revenue from contracts with customers Use the COPAR memory aid: 1) Contract Identification: Can be written, verbal or implied. A contract must exist in Substance 2) Separate Performance Obligations Identified: Where a good or service is sold separately or if it could be sold separately because it has a distinct function/profit margin, then this constitutes a separate performance obligation. Those promises are called performance obligations. Performance Obligations can be satisfied over time (using output and input methods) or at a point in time i.e the point in time at which the customer obtains control of the promised asset. 3) 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 1

2 company s probability-weighted estimate of variable consideration, customers credit risk and time value of money (if material) 4) Allocation of transaction price to performance obligation: 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 have to estimate its stand alone selling price. Example: Allocating the Transaction Price to the Performance Obligations A mobile phone company gives customers a free handset when they sign a two year contract for provision of network services. The handset has a stand alone price of $100 and the contract is for $20 per month. Under IFRS 15, revenue must be allocated to the handset because delivery of the handset constitutes a performance obligation. This will be calculated as follows $ % Handset % Contract 2 Years % Total Value % As the total receipts are $480 ($20*12 months * 2 years), this is the amount which must be allocated to the separate performance obligations. Revenue will be recognised as follows $ Year 1 Handset (480 * 17%) 82 Contract (480-82)/ Year 2 $ Contract as above 199 2

3 5) Recognise Revenue: 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. The amount of revenue recognised is the amount allocated to that performance obligation in Step 4. 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. Common Types of Transactions 1) 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 2) Principal versus agent: A reporting entity 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. It is a principal if it controls the promised good or service before it is transferred to the customer. 3) Repurchase Agreements Generally, there are 3 forms of repurchase agreements - An entity has an obligation to repurchase the asset (a forward contract) - An entity has the right to repurchase the asset ( a call option Seller can buy back from Buyer). 3

4 - An entity must repurchase the asset if requested to do so by the customer ( a put option Buyer can sell back to Original Seller) 4) Consignment Arrangements Typically arises between a manufacturer and a dealer 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/distributor) does not have an unconditional obligation to pay for the product. Required Accounting: - Where it is concluded that control of the inventory has been transferred to the dealer Inventory should be recognised by the dealer, together with liability to the manufacturer. Any deposit paid by the dealer should be deducted from the liability and the balance classified as a trade payable o Where it is concluded that control of the inventory has not been transferred to the dealer Inventory should not be included in the dealer statement of financial position until the transfer of control has taken place. Any deposit should be included under other receivables 5) Bill and Hold Arrangements Where goods are sold but remain in the possession of the seller for a specified period, perhaps because the customer lacks storage facilities. The reporting entity will need to determine at what point they (i.e. the customer) obtains control of the product once control of the product has been achieved, then revenue should be recognised (assuming all other criteria are also met) 4

5 For a customer to have obtained control of a product in a bill and hold arrangement, the following criteria must all be met: o The reason for the bill and hold must be substantive (for example, requested by the customer) o The product must be separately identified as belonging to the customer o The product must be ready for physical transfer to the customer o The selling entity cannot have the ability to use the product or to transfer it to another customer. 5

6 Examples of Specific Transactions 1. Consignment Inventories 2. Sale and Repurchase Agreements Right of Return Over Inventories Sale with an option to Repurchase Price at which the Sale is set Has the entity given up all the rights and rewards of ownership? Whether or not the dealer has the right to use the inventories Call Option Secured Loan Only one party can recognise the Inventory Put Option A lease transaction KEY QUESTION: WHICH PARTY BEARS THE RISKS AND REWARDS OF OWNERSHIP? 6

7 6) Performance Obligations satisfied over time Where performance obligations are satisfied over time, an entity must determine what amounts to include as revenue and costs in each accounting period A company is building a large tower block that will house offices, under a contract with an investment company. It will take 3 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. How does it decide, in each of the 3 years, what to include as income and expenditure for the contract in profit or loss?? Step 1 Estimate the Total Profit or Loss Contract Revenue (Selling price) x Less: Costs Incurred To Date x Less: Expected Costs to Complete x Estimated Profit or Loss on the Contract x Contract Costs Include the following: CONTRACT COSTS Costs relating directly to the contract such as 1. Site Labour Costs 2. Costs of materials used in construction 3. Depreciation of Plant and Equipment used on the Contract 4. Costs of moving plant, equipment and materials to and from the contract site 5. Costs of hiring plant and equipment 6. Costs of design & technical assistance directly related to contract 7. Estimated costs of rectification work and guarantee work 8. Claims from third parties Costs attributable to general contract activity which can be allocated to the contract, such as insurance, cost of design and technical assistance 7

8 should be allocated on the normal level of construction activity Borrowing costs may be attributed in this way Any other costs that can be charged to the customer under the contract If rectification costs relate to a specific time period, then they are allocated only to that time period and are not spread evenly over the life of the construction contract. Contract Costs Some costs cannot be attributed to contract activity and so should be excluded from construction contract costs. Examples 1. General Admin Costs (unless reimbursement is specified in the contract) 2. Selling Costs R&D (unless reimbusrement is specified in the contract) 3. Depreciation of idle plant and equipment not used on any particular contract Step 2: Estimate the % Completion of the Construction Contract 2 Methods 1. Sales Basis: Value of Work Certified to Date = % Total Contract Revenue 2. Cost Basis: Costs Incurred to Date = % Total Expected Contract Costs Step 3: Using the % Completion as calculated in Step 2 (subject to the outcome of the activity being estimated reliably i.e. Probable inflow of economic benefits), apply to total contract revenue/profit to arrive at attributable contract revenue/ attributable contract profit Cost of Sales is a plug figure! 8

9 What if a Contract satisfied over time will make an overall loss??? If a loss is expected, this means that a proportion of the entity s costs will not be recovered, the full loss must be recognised immediately, Recognised Revenue will be Contract Price * % Completion Cost of Sale will be a plug Additional Cost being expected loss recognised in order to show full loss on contract Recognised Loss Expected loss on Contract Less: Losses recognised in Previous Periods Loss Recognised in Current Period OR Expected Loss on Contract Profits Recognised in Previous Periods Loss Recognised in Current Period x x-y X X + Y Y y Step 4: Construction Contracts in the SOFP Terminology The contractor invoices the customer for work done so far (work certified). These are progress billings, which the customer pays. The customer may hold back an agreed percentage of progress billings (retentions) until the contract work is completed. In some contracts, the customer may make payments in advance. Payments received from the customer in advance are a liability in the statement of financial position 1. When a contract is finished Costs Incurred + Profit (or loss) = Total Amount Invoiced (Contract Revenue) 2. When a contract is unfinished Contract Costs Incurred to date Total Profits Recognised to Date OR Total losses recognised to date A+B (or c) A B (C) Progress Billings Invoiced (i.e. Amounts Invoiced) to Date Contract Asset (i.e. Unbilled Revenue ) X (D) By calculating contract costs incurred to date plus Contract profit recognised to date and then subtracting payments on Account Invoiced, the Balance Represents 9

10 Unbilled Revenue (i.e. Amts due from Customers)..this would be shown under Current Assets. Where X is a net amount due to the customer, this amount should be included as a contract liability, presented separately under current liabilities. Billed Revenue that is unpaid is shown separately under Trade Receivables Note! Do not forget to capitalise and recognise accumulated depreciation on assets acquired which are directly related to the contract!!!! - Also include accumulated depreciation as part of Costs Incurred To Date Contracts in the SOFP Positive Balance - Asset Shown in the SOFP as Gross Amount due from the customer May also be referred to as the contract inventory or contract work in progress Negative Balance Liability Shown in the statement of financial position as Gross Amount due to the customer Outcome of the Contract cannot be reliably measured When the contracts outcome cannot be reliably estimated, the following treatment should be followed Only recognise revenue to the extent of contract costs incurred which are expected to be recoverable Recognise contract costs as an expense in the period in which they are incurred How to know when the Outcome of a Contract can be reliably measured? I've come across a question where 15% was too early but there isn't a benchmark. In the case of an exam question it will be very obvious if it's too early, i.e. very low %. In practice a lot of companies have a cut off applied to all contracts where no profit is recognised until a contract is at least a certain % complete. Otherwise : -To be able to estimate the outcome of a contract reliably, the entity must be able to make a reliable estimate of total contract revenue, the stage of completion, and the costs to complete the contract. If all of those can't be estimated reliably it doesn't matter what the % completion is. 10

11 Tutorial Question Performance Obligation Satisfied Over Time A company entered into a contract on 1 January 20X5 to build a factory. The total contract revenue was $2.8 million. At 31 December 20X5, the contract was certified as 35% complete. Costs incurred during the year were $740,000 and costs to complete are estimated at $1.4 million. $700, 000 has been billed to the customer, but not yet paid. What amount will be recognised as a contract asset or liability in respect of this contract in the statement of financial position as at 31 December 20X5? Servicing Fees Included in the Price - After Sales Servicing & Support Costs IFRS 15 requires that where sales revenue includes an amount for after sales servicing & support costs, then a proportion of the revenue should be deferred. The amount deferred should cover the cost and a reasonable profit (as given in question) on the services. Application of the matching concept (accruals basis) Past Exam Questions : Q3 April 15 (4) Q3 April 13 (3) Q5 Apr