The EU has now endorsed IFRS 15 Revenue from contracts with customers that will be applicable for all companies applying IFRS for years commencing on or after 1 January 2018. The standard introduces a five step approach to recognising revenue that could see radical changes in the timing of revenue recognition for many companies.
The five steps that companies will have to work through before recognising revenue are:
Step 1 – Identify the contract with a customer
A contract creates enforceable rights and obligations between two or more parties and can be written, oral or in accordance with normal business practices. For a contract to be recognised under IFRS 15 it must be possible to identify each party's rights regarding goods or services to be transferred, have identifiable payment terms, where it is probable that the consideration due will be collected, and have commercial substance.
Step 2 – Identify performance obligations
Performance obligations are promises in a contract to transfer goods or services to a customer. They must be distinct and separately identifiable.
For many companies this will be the first area of complexity within IFRS 15, as it will require contracts to be assessed so as to identify performance obligations. For companies with long term contracts this might involve the identification of multiple performance obligations that could vary from contract to contract. Companies will need to consider their systems and processes for undertaking this analysis.
Step 3 – Determine the transaction price
The transaction price is the amount of consideration an entity expects to be entitled to before credit risk is taken into account. When determining the transaction price the impact of discounts, rebates, contingencies, incentives and, for contracts over one year, the time value of money should be considered.
On the face of it determining the transaction price is simple yet possibly significant estimates will be required when assessing the impact of rebates and incentives, for example. This could have an impact on the period in which revenue is recognised.
Step 4 – Allocate the transaction price to the performance obligations
This should be done on the basis of relative stand alone selling prices with discounts allocated proportionately across all performance obligations, unless evidence exists to the contrary. Where stand alone selling prices do not exist for some, or all, of the performance obligations judgement will again be needed. The standard mentions a number of possible methods for doing this (such as cost plus or a market assessment) but companies will have to decide what is most appropriate.
Step 5 – Recognise revenue when the performance obligations are satisfied
Revenue should be recognised when performance obligations are satisfied upon the transfer of the promised goods or services to the customer. Control is deemed to pass when the customer can direct the use and obtain the benefits of the asset. The point at which control passes will vary from contract to contract and will have to be identified. The emphasis in the standard on control passing (as opposed to transferring the risks and rewards of ownership) is likely to result in revenue being recognised later.
At present many companies with long term contracts will recognise revenue over time. IFRS 15 allows this only if one of the following conditions are met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
- Performance creates or enhances an asset that the customer controls as it is created or enhanced; or
- The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
Companies currently recognising revenue over time should review their engagement terms to determine whether this accounting treatment can continue. The consequence of not being able to meet one of the above criteria is likely to be a delay in recognising any revenue until the end of the contract.
IFRS 15 is not a minor adjustment to revenue recognition rules but rather a complete rethink and many companies will recognise revenue differently as a result. As with any major change, early planning for a smooth transition is vital and will allow Boards to assess the impact and communicate with investors accordingly.
This article was written by Matthew Stallabrass, Partner at Crowe Clark Whitehill LLP and Chairman of the QCA Financial Reporting Expert Group. For more information, please contact Matthew Stallabrass.