Background and Effective Date
The International Accounting Standards Board (IASB) has published a new standard, IFRS 15 Revenue from Contracts with Customers (IFRS 15). IFRS 15 sets out requirements for recognizing revenue that apply to all contracts with customers and replaces the myriad of current revenue standards.
This new standard is effective for annual reporting periods beginning on or after January 1, 2018.
The core principle in IFRS 15 is that an entity should recognize revenue to depict the transfer of promised goods or services to the customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To recognize revenue, a company would apply the following five steps:
- Identify the contract(s) with the customer.
- Identify the performance obligations in the contract(s).
- Determine the transaction price.
- Allocate the transaction price.
- Recognize revenue when a performance obligation is satisfied.
Technology companies often enter into contracts to provide multiple goods and/or services as part of a single arrangement. An entity may enter into a contract to provide hardware and subsequent services, including consulting for customization, installation, ongoing customer support and upgrades. Current IFRS does not provide guidance that specifically addresses contracts with multiple elements. IFRS 15 provides more specific guidance and technology entities will need to consider whether the goods and/or services within a single contract are separable from one another. A thorough analysis of the nature of contracts entered into by the entity is critical on initial adoption, in order to establish IFRS 15 compliant accounting policies.
Once the separate performance obligations in a multiple-element arrangement are identified, additional accounting challenges will result from allocation of the transaction price between performance obligations and the recognition of the allocated transaction price.
Identifying Performance Obligations
An entity must evaluate the contractual terms and its customary business practices to identify the distinct goods or services within each contract. Distinct goods or services are considered to be separate performance obligations and are accounted for separately. A good or service is distinct if:
- The customer can benefit from the good or service either on its own or together with other readily available resources.
- The good or service is separately identifiable from other promises in the contract.
Questions to ask in determining whether goods or services are distinct include:
- Is the entity providing significant customization or integration services?
- Is the customer able to perform the contracted service for themself or through third parties?
- Can the customer benefit from a single element on its own or together with readily available resources?
Allocating the transaction price
The total transaction price must be allocated to each performance obligation on the basis of the relative stand-alone selling price of each distinct good or service. On occasion, the entity will be unable to identify stand-alone selling prices for certain performance obligations. When stand-alone selling prices are not readily identifiable, the entity shall estimate the stand-alone selling prices using a variety of methods including:
- The adjusted market assessment approach.
- The expected cost plus margin approach.
- The residual approach (under certain circumstances).
IFRS 15 allows any reasonable estimation method, so long as it is consistent with the notion of a stand-alone selling price and maximizes the use of observable inputs. Regardless of the estimation method used, the entity is required to apply estimation methods consistently. Current IFRS does not prescribe an allocation method for multiple-element arrangements and it does not restrict the use of the residual approach. The new guidance for the allocation of the transaction price to performance obligations could result in a change in practice for some entities. The initial choice of estimation methods will require significant judgment.
Recognizing revenue when a performance obligation is satisfied
Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. This can occur either at a point in time or over time. A performance obligation is satisfied over time if any of the following criteria are met:
- The customer receives and consumes the benefits of the entity's performance as the entity performs.
- The entity's performance creates or enhances an asset (work in process) 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 customer does not have control over the asset created, but the entity has an enforceable right to payment for performance completed to date.
IFRS 15 may require changes to the timing of revenue recognition for technology entities that enter into contracts with multiple elements. It will be necessary to determine whether there is a contractual right to payment. Recognition may also be impacted for revenue associated with the manufacture of highly customized equipment and for the sale of certain licenses.
In summary, the guidance surrounding IFRS 15 is expected to evolve ahead of the effective date. It will be important for entities to stay up to date with developments and to anticipate how the adoption of IFRS 15 will affect the entity. Impacts could extend to the availability of income for distribution, compliance with loan covenants and compensation and bonus plans calculations. Careful planning is critical. Contact your Collins Barrow advisor for assistance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.