IFRS 15 Revenue from Contracts with Customers applies to annual periods beginning on or after 1 January 2018. It replaced IAS 18, IAS 11 and several related interpretations with a single, principles-based model. The core principle: recognise revenue to depict the transfer of promised goods or services to a customer, in an amount that reflects the consideration the entity expects to be entitled to in exchange.
The standard gets there through five steps. Each is simple to state; the judgement sits in applying them to real contracts.
Step 1: Identify the contract with a customer
A contract exists for IFRS 15 purposes when it is approved by the parties and they are committed to perform, each party's rights and the payment terms can be identified, the contract has commercial substance, and it is probable that the entity will collect the consideration it is entitled to. If these criteria are not met, consideration received is generally recognised as a liability rather than revenue until they are, or until specific events occur.
Contracts entered into at or near the same time with the same customer (or related parties) must be combined if they were negotiated as a package, if the price in one depends on the other, or if the goods or services are a single performance obligation. Contract modifications are accounted for as a separate contract, or as part of the existing one, depending on whether they add distinct goods or services at a standalone selling price.
Step 2: Identify the performance obligations
A performance obligation is a promise to transfer a good or service (or a bundle, or a series of substantially identical ones) that is distinct. A promise is distinct when the customer can benefit from it on its own or with readily available resources, and it is separately identifiable from other promises in the contract. A software licence bundled with significant customisation that the customer cannot use without it, for example, may not be distinct.
Common traps: warranties (an assurance-type warranty is accounted for under IAS 37, a service-type warranty is a separate performance obligation), and customer options that give a material right, such as a discount on future purchases that the customer would not otherwise receive.
Step 3: Determine the transaction price
The transaction price is the amount the entity expects to be entitled to, excluding amounts collected for third parties such as sales taxes. It can include:
- Variable consideration (rebates, discounts, penalties, performance bonuses), estimated using either the expected value or the most likely amount, whichever better predicts the outcome. It is included only to the extent it is highly probable that a significant reversal of cumulative revenue will not occur. This is the "constraint".
- A significant financing component, which is separated out so revenue reflects the cash selling price. There is a practical expedient when the gap between payment and performance is expected to be a year or less.
- Non-cash consideration, measured at fair value.
- Consideration payable to the customer, usually treated as a reduction of the transaction price unless it is a payment for a distinct good or service.
Step 4: Allocate the transaction price
The price is allocated to each performance obligation in proportion to their relative standalone selling prices. Where a standalone price is not directly observable, it is estimated using an adjusted market assessment, an expected cost plus margin, or (only in limited circumstances) a residual approach. Discounts and variable consideration are allocated across all obligations, unless there is clear evidence that they relate to only one or some of them.
Step 5: Recognise revenue when (or as) each obligation is satisfied
Revenue is recognised when control of the good or service transfers to the customer. That happens either over time or at a point in time.
Revenue is recognised over time if any one of three criteria is met:
- The customer simultaneously receives and consumes the benefits as the entity performs (for example, a recurring service).
- The entity's performance creates or enhances an asset that the customer controls as it is created.
- The entity's performance does not create an asset with alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
If none apply, revenue is recognised at the point in time control transfers. Indicators include a present right to payment, legal title, physical possession, transfer of significant risks and rewards, and customer acceptance. For over-time obligations, progress is measured using an output method or an input method, applied consistently.
Principal or agent?
An entity is a principal, and reports revenue gross, if it controls the specified good or service before it is transferred to the customer. It is an agent, and reports only its fee or commission net, if it arranges for another party to provide it. The assessment is about control, not about who bears credit risk or who sets the final price alone. Marketplaces, travel and advertising intermediaries and resellers are the usual areas of debate.
Contract balances and costs
Where revenue is recognised before the entity has an unconditional right to payment, the difference is a contract asset. Where the customer pays before the entity performs, it is a contract liability. A receivable is recognised only when the right to consideration is unconditional apart from the passage of time. Incremental costs of obtaining a contract (such as sales commissions) are capitalised if the entity expects to recover them, with a practical expedient to expense them when the amortisation period would be one year or less.
Where this typically goes wrong
- Treating a bundle as one obligation (or many) without testing whether each promise is actually distinct
- Recognising variable consideration without applying the constraint, then reversing revenue later
- Allocating a bundle discount to one item by default instead of proportionately
- Recognising revenue over time without checking that one of the three criteria is genuinely met
- Reporting gross revenue as principal when the entity does not control the good or service before transfer
- Missing a significant financing component in long-dated or prepayment arrangements
The five steps are straightforward. The difficulty is applying them consistently across a large population of contracts with bespoke terms, and keeping a record of the judgement behind each conclusion for the auditor.