This blog summarizes the important ideas related to IFRS 15, “Revenue from Contracts with Customers,” with a particular focus on identifying performance obligations, the concept of distinct goods and services, the nature of licenses, and repurchase agreements.
1. Core Principle and the 5-Step Model:
IFRS 15 establishes a comprehensive framework for recognizing revenue from contracts with customers. The core principle is that an entity should recognize revenue when (or as) it transfers control of promised goods or services to a customer, at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This is achieved through a five-step model:
- Step 1: Identify the contract with a customer. A contract exists when certain criteria are met, including the agreement being legally enforceable and the entity being able to identify the rights and obligations, payment terms, and it being probable that the entity will collect the consideration.
- Step 2: Identify the performance obligations in the contract. This involves identifying the promises to transfer goods or services to the customer. These promises are performance obligations if the goods or services are distinct.
- Step 3: Determine the transaction price. This is the amount of consideration the entity expects to be entitled to in exchange for transferring promised goods or services to a customer.
- Step 4: Allocate the transaction price to the performance obligations in the contract. This allocation is generally based on the relative stand-alone selling prices of the distinct goods or services promised.
- Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation. Revenue is recognized when the entity transfers control of the promised good or service to the customer. This can be either over time or at a point in time.
2. Identifying Performance Obligations and the Concept of “Distinct”:
A key aspect of IFRS 15 is identifying the performance obligations within a contract. A promised good or service is a performance obligation if it is distinct. The standard outlines two criteria for a good or service to be distinct:
(a) Capable of being distinct: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. A customer can benefit from a good or service if it can be used, consumed, or sold (other than for scrap value), or if it can generate economic benefits. Readily available resources are those that the customer possesses or is able to obtain from the entity or another third party.
(b) Distinct within the context of the contract: The promise to transfer a good or service is separate from the other promised goods or services in the contract. The objective is to determine whether the promise is to transfer each good or service individually or as a combined item. Indicators that a promise is not distinct include significant integration, modification, or interdependence between goods or services.
3. Licensing of Intellectual Property (IP):
Licensing of IP (e.g., software, music, franchises, patents, trademarks) is a common performance obligation. The accounting for revenue from licenses depends on whether the license is distinct and the nature of the entity’s promise:
- Distinct Licenses: If a license is distinct from other promised goods or services, it is accounted for as a separate performance obligation.
- Nature of the Promise: For a distinct license, the entity must determine whether the nature of its promise is to provide the customer with:
- A right to access the entity’s IP as it exists throughout the license period (revenue recognized over time).
- A right to use the entity’s IP as it exists at the point in time at which the license is granted (revenue recognized at a point in time).
- Non-Distinct Licenses: If a license is not distinct, it is combined with other promised goods or services into a single performance obligation.
- Sales-based Royalties: For licenses of intellectual property, revenue from sales-based or usage-based royalties is recognized when the subsequent sale or usage occurs.
4. Repurchase Agreements:
When an entity sells an asset and promises or has the option to repurchase it, this is a repurchase agreement. The accounting depends on whether the customer obtains control of the asset.
- Forward or Call Option: If the repurchase price is equal to or more than the original selling price, it is often considered a financing arrangement, and no revenue is recognized.
- Put Option: If the repurchase price significantly exceeds expected market value, control is not considered transferred, and the transaction is accounted for as a lease. If there is no significant economic incentive for the customer to exercise the put option, the transaction is accounted for as a sale with a right of return.
- No Transfer of Control: If the terms indicate that the customer does not obtain control, no sale is recognized.
5. Control:
Revenue is recognized when control of the promised good or service is transferred to the customer. Control is defined as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Indicators of control transfer include the customer having a present obligation to pay, obtaining physical possession, holding legal title, assuming the risks and rewards of ownership, and accepting the asset.
6. Allocation of Transaction Price:
The transaction price is allocated to each performance obligation based on its relative stand-alone selling price at contract inception. Discounts or variable consideration are allocated similarly unless they clearly relate to only one or more, but not all, performance obligations.
7. Other Important Considerations:
- Probability of Collection: A contract exists only if it is probable that the entity will collect the consideration to which it will be entitled.
- Consideration Payable to a Customer: Payments made by an entity to its customers may represent a reduction in the transaction price unless the payment is in exchange for a distinct good or service.
- Bill-and-Hold Arrangements: Revenue recognition for bill-and-hold arrangements occurs only when the customer obtains control, which requires a valid business reason for the arrangement and the goods being separately identified and ready for transfer.
- Principal vs. Agent: An entity must determine whether it is acting as a principal (controls the goods or services before transfer) or an agent (arranges for another party to provide them). Revenue for an agent is recognized in the amount of the fee or commission.
- Customer Options for Additional Goods or Services (Material Rights): If a contract grants a customer an option for additional goods or services that they would not receive otherwise, this option is accounted for as a separate performance obligation.
- Customers’ Unexercised Rights (Breakage): For prepayments and similar arrangements, revenue from unexercised rights (breakage) can be recognized in proportion to the pattern of rights exercised by the customer.
This briefing document provides a high-level overview of key aspects of IFRS 15. Applying these principles requires careful consideration of the specific facts and circumstances of each contract.