IFRS 15 - Revenue from contracts with customers...Episode 3

IFRS 15 Series Episode 3: Identifying Performance Obligations

In the introductory episode of this series, we established that IFRS 15 provides the basis for recognition of revenue, how and when revenue should be recognized and disclosures to be made in the financial statements. We discussed the first step of the five steps in revenue recognition in the previous episode.

In this episode, we will discuss the second step – Identifying performance obligations in an identified contract. The performance obligations simply refer to the promises made by an entity to a customer in its contracts with the customer. This promise might be explicitly stated in the contract or might be based on established customary business practices.

Remember that transaction prices are allocated to performance obligations in order to recognize revenue. This is one of the reasons why this step is so important.

A contract includes promises (goods or services) made by an entity to its customers. These promises become performance obligation that is expected of the entity to its customers.

A performance obligation is 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 and that have the same pattern of transfer to the customer.

A GOOD OR SERVICE THAT IS DISTINCT

There are two major considerations in assessing whether a good or service is distinct:

• Whether the customer can benefit from the good or service on its own or with other readily available resources, that is, the good or service is capable of being distinct. In simple terms, a promised good or service can be considered distinct where it is able to provide benefit to the customer on its own, for example, a book sold to a customer – this is distinct and is a performance obligation on its own. Or the customer can use the good or service with other readily available resources, for example, where a customer buys a remote control to use on her television set at home.

• Whether the good or service is separately identifiable from other promises in the contract, that is, the promise to transfer the good or service is distinct within the context of the contract. For example, where X has contracted Y (the seller) to supply a generator and in the same contract, it was stated that Y must carry out the servicing of this generator for the next two years. In this case, the sale of a generator is distinct from servicing the generator and can be seen as two different promises. The servicing of the generator can be separately identified from the sale of the generator. Hence, there are two performance obligations in this contract. Conversely, consider a scenario where a contractor is engaged to build a house, it is embedded in the contract that the contractor has to do the roofing, plumbing, wiring, among other duties. Although there are many obligations within the contract, each of these obligations are not separately identifiable because the main aim is for the contractor to deliver a completed house, hence, these obligations are not distinct within the context of the contract, thus, the combination of all the obligations within the contract will create only one performance obligation - a completed building.

As earlier mentioned, the reason for the above analysis is that transaction prices are allocated to performance obligations and this determines revenue recognized. In the generator example, transaction price will be allocated separately to the generator and separately to the servicing of the generator. However, transaction price will not be allocated separately to the obligations within the house construction contract, because it is only one performance obligation that exists – a completed building.

Let’s use figures to explain.

If the transaction price is 700,000 naira, the company can allocate 500,000 naira to the generator and 200,000 naira to the servicing of the generator for both years based on its transaction price allocation approach. However, if the transaction price for the building is 1,000,000 naira, the company cannot allocate transaction price to each of the obligations (roofing, plumbing, wiring, among others) within the contract. Hence, revenue cannot be recognized based on completion of each of the obligations within the contract since they are not distinct in the context of the contract. The company would rather use either an output or input method of allocating revenue to measure its progress on the construction of the building. You will learn more about this in subsequent episodes.

A SERIES OF DISTINCT GOODS OR SERVICES

There are scenarios where an entity provides an ongoing service to a customer. For example, a cleaning agency that renders cleaning services to a hotel. In this case, the cleaning service done daily is part of a series of distinct services (daily cleaning) that are substantially the same and have the same pattern of transfer to the customer. Where each cleaning service is satisfied over time, and has the same measure of progress, the series must be treated as one performance obligation even though it seems like multiple services rendered.

In conclusion, only when promised goods or services meet the requirements provided by IFRS 15 shall they be considered performance obligations. Any promised goods or services that do not meet this criterion shall either be combined with other goods or services in the contract to form a performance obligation or be totally ignored. An example of the later is when the identified promises do not transfer goods or services to the customer, for instance, administrative tasks of attending to customers.

Below are some probing questions to ask when in doubt:

•Do any of the identified promises not transfer goods or services (e.g., set-up activities or administrative tasks)?

•Is the promised good or service immaterial in the context of the contract?

•Do the goods or services serve as an input to the output for which the customer is contracting?

•Can other entities provide the other obligations?

In the next episode, we will discuss the third step in revenue recognition - Determining the transaction price. Kindly use the comment section to express your opinion on the write-up.

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Written by:

Adedamola Otun

For: IFRS IS EASY

IFRS 15 - Revenue from contracts with customers...Episode 2

IFRS 15 Series Episode 2: Identifying the contract

This episode is sequel to our previous blog post which introduced us to the 5 steps in revenue recognition as required by IFRS 15.

Before we delve in, it is important to note that lease contracts, insurance contracts, financial instruments and non-monetary exchanges between entities in the same line of business to facilitate sales to customers are out of scope of the standard. 

Here are some questions to jolt us as we proceed.

Have you ever considered how a company records money received as grant from a government? – as Revenue?

How about identifying who a customer is for a record label who just signed an upcoming artist? – The artist or the apple subscribers?

How are these accounted for by a Company?

IFRS 15 provides clarification to these and many more.

A Contract according to IFRS 15 is ‘an agreement between two or more parties that creates enforceable rights and obligations.’ Note that not all agreements have enforceable rights and obligations.

In identifying a Contract according to IFRS 15, there are certain criteria any agreement must meet before being considered as a valid contract. Listed below are the 5 criteria required by IFRS 15 for an agreement to be considered a contract:

1. Agreement must have been approved by all parties involved
2. Rights of each party is identified
3. Payment terms are identified
4. The contract has commercial substance
5. Collectability of consideration is probable

Let’s examine each of these as brief and comprehensive as possible:

Criteria 1

Contracts are not mandated to be written, signed and sealed. They can be Written, Oral or Implied. A contract may be Written – where parties to the contract have to sign physical documents drafted with respect to the contract. It may be Oral – Like the mechanic contracted to service your car. This might not require any document, just word of mouth. Contracts may also be Implied – This may be based on previous or customary relationship with a customer(s). For example, if customers get a bottle of coke on every purchase made in your store, it means you have an implied contract with your customers. Approval is a function of mutual understanding between/among the parties to the contract. However, a contract does not exist if both parties to the contract can terminate a wholly unperformed contract without compensating the other party for such termination.

Criteria 2

Rights of each party must be identified. A contract cannot exist if goods or services are based on assumptions. Each party must know her right and obligation at the point of agreeing to the contract. For example, a book vendor has the right to receive payment for any book sold to a customer, so also does the customer have a right to the books bought.

Criteria 3

The parties should agree to the payment terms for the goods or services to be transferred. This includes credit period given to customers and payment method allowed to customers. This needs to be established so that a customer does not arbitrarily decide to pay for goods/services by means of other goods/services or delay payment unduly. 

Criteria 4

All agreements that do not have commercial substance is not considered to be a contract according to IFRS 15. Commercial substance means the risk, timing or amount of future cash flows to the parties to the contract is expected to change as a result of the contract. Whether it’s a Good-for-Cash transaction or a Good-for-Good transaction, contracts having commercial substance will affect future cash flows of all parties to the contract.

Criteria 5

Collectability of consideration is probable only if the customer has the ability and intention to pay the amount of consideration to which the entity will be entitled in exchange for the goods or services that will be transferred to the customer. Just as Economists define effective demand, collectability measures the capability and willingness of a customer to make payment for goods/services. However, collectability is not hinged on the total transaction price stated in the contract because the entity may offer the customer a price concession. This arises where consideration is variable. Detailed explanations and calculations will be made on this in subsequent episodes to this Standard.

Once the 5 criteria are satisfied, we have identified our contract, what next?

Find out in the next episode.

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Written by:

Tomiwa Eyinade

For: IFRS IS EASY

IFRS 15 - Revenue from contracts with customers

IFRS 15 Series Episode 1: An Introduction

Everyone makes transactions daily – from buying from a physical store to placing orders on online stores. Customers’ obligation is to give cash in exchange for the goods or services demanded. 

What does IFRS 15 say for your supplier and Vendor? Do they (suppliers) just collect payment and recognize same in their accounting books immediately?

IFRS 15 states the requirement for the recognition of revenue by entities, how and when the revenue should be recognized in the books and disclosure of relevant information related to revenue in the financial statements.

Prior to the issuance of IFRS 15, a number of standards and interpretations which guided the recognition of revenue existed – Standards – IAS 11, IAS 18 and Interpretations – IFRIC 13, IFRIC 15, IFRIC 18 and SIC 31 were all replaced by this single standard. One purpose for the collapse of all these into just one standard is to provide a one-stop standard for the recognition of revenue. This has made it easier for entities to recognize revenue as they just look into one standard for clarifications instead of different standards.

IFRS 15 provides the requirement for the recognition of revenue from CUSTOMERS. Yes, customers in capital letters because not everyone who is involved in transaction with an entity is a customer. Some are agents, representative, trustee or middlemen.

IFRS 15 defines a customer as ‘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'. For instance, for Mike to be Mercy’s customer, Mike must have contracted Mercy to provide a good or service that Mercy usually sells in exchange for a consideration from Mike which can be in cash or asset or provision of another service.

Disposal of non-financial assets that are not output of normal operation of an entity – such as disposal of motor vehicle, and property, plant and equipment are also within the scope of IFRS 15. In simpler terms, IFRS 15 covers all contracts with customers, and disposal or sale of non-currents assets owned by an entity. However, transactions involving Leases (IAS 17 – now IFRS 16), Insurance contracts (IFRS 17) and Financial instruments (IFRS 9) are not within the scope of IFRS 15.

In situations where transactions are partially within the scope of IFRS 15 and partially within the scope of other standards, entities are required to measure such transactions with respect to the other standard before applying the requirements of IFRS 15.

IFRS 15 provides 5 key step-by-step principles in the recognition of revenue for entities, the principles are as follows:

• Identify the contract(s) with the customer
• Identify the performance obligations in the contract
• Determine the transaction price
• Allocate the transaction price
• Recognize revenue when a performance obligation is satisfied

In subsequent IFRS 15 series, the 5 key IFRS 15 principles will be explained in-depth in an easy-to-understand way. Don’t forget to bookmark the website and also click on the email subscription button to stay up-to-date with us. 

Written by:

Tomiwa Eyinade

For: IFRS IS EASY