In the first of two articles on IFRS 15, Graham Holt looks at issues surrounding the definition and nature of a contract under IFRS 15
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There has been significant divergence in practice over recognition of revenue, mainly because International Financial Reporting Standards (IFRS) have contained limited guidance in certain areas. The original standard, IAS 18, Revenue, was issued in 1982 with a significant revision in 1993. IAS 18 was not fit for purpose in today’s corporate world as the guidance available was difficult to apply to many transactions, with the result that some companies applied US GAAP when it suited their needs.
Users often found it difficult to understand the judgments and estimates made by an entity in recognising revenue, partly because of the ‘boilerplate’ nature of the disclosures. As a result of the varying recognition practices, the nature and extent of the impact of the new standard will vary between entities and industries. For many transactions, such as those in retail, the new standard will have little effect but there could be significant change to current practice in accounting for long-term and multiple-element contracts.
On 28 May 2014, the International Accounting Standards Board (IASB), as a result of the joint project with the US Financial Accounting Standards Board (FASB), issued IFRS 15, Revenue from Contracts with Customers.
Application of the standard is mandatory for annual reporting periods starting from 1 January 2017 onward and earlier application is permitted.
IFRS 15 replaces the following standards and interpretations:
- IAS 11, Construction Contracts
- IAS 18, Revenue
- IFRIC 13, Customer Loyalty Programmes
- IFRIC 15, Agreements for the Construction of Real Estate
- IFRIC 18, Transfer of Assets from Customers
- SIC-31, Revenue – Barter Transactions Involving Advertising Services.
This article looks at some of the issues surrounding the definition and nature of a contract under IFRS 15. It also looks at the criteria that must be met before an entity can apply the revenue recognition model to that contract.
The definition of what constitutes a contract for the purpose of applying the standard is critical. The definition of contract is based on the definition of a contract in the US and is similar to that in IAS 32, Financial Instruments: Presentation. A contract exists when an agreement between two or more parties creates enforceable rights and obligations between those parties.
The agreement does not need to be in writing to be a contract, but the decision as to whether a contractual right or obligation is enforceable is considered within the context of the relevant legal framework of a jurisdiction.
Thus, whether a contract is enforceable will vary across jurisdictions. The performance obligation could include promises that result in a valid expectation that the entity will transfer goods or services to the customer even though those promises are not legally enforceable.
The criteria that must be met before an entity can apply the revenue recognition model to that contract have been derived from previous revenue recognition and other standards. If some or all of these criteria are not met, then it is unlikely that the contract establishes enforceable rights and obligations. The criteria are assessed at the beginning of the contract and are not reassessed unless there has been a significant change in circumstances, which make the remaining contractual rights and obligations unenforceable.
The first criteria set out in IFRS 15 is that the parties should have approved the contract and are committed to perform their respective obligations. In the case of oral or implied contracts, this may be difficult, but all relevant facts and circumstances should be considered in assessing the parties’ commitment. The parties need not always be committed to fulfilling all of the obligations under a contract.
IFRS 15 gives the example where a customer is required to purchase a minimum quantity of goods, but past experience shows that the customer does not always do this and the other party does not enforce their contract rights. There needs to be evidence, however, that the parties are substantially committed to the contract. If IFRS 15 had required all of the obligations to be fulfilled, there would have been circumstances, as set out above, where revenue would not have been recognised, even though the parties were substantially committed to the contract.
It is essential that each party’s rights and the payment terms can be identified regarding the goods or services to be transferred. This latter requirement is the key to determining the transaction price. The construction industry was concerned as to whether it was possible to identify the payment terms for orders where the scope of work had been determined but the price of the work may not be decided for a period of time. These transactions are referred to as unpriced change orders or claims. IFRS 15 includes the need to determine whether the unpriced change order or contract claim should be accounted for on a prospective basis or a cumulative catch-up basis. If the scope of the work has been approved and the entity expects that the price will be approved, then revenue may be recognised.
The contract must have commercial substance before revenue can be recognised as without this requirement, entities might artificially inflate their revenue and it would be questionable whether the transaction has economic consequences.
Further, it should be probable that the entity will collect the consideration due under the contract. An assessment of a customer’s credit risk is an important element in deciding whether a contract has validity, but customer credit risk does not affect the measurement or presentation of revenue. The consideration may be different to the contract price because of discounts and bonus offerings.
The entity should assess the ability of the customer to pay and the customer’s intention to pay the consideration. In cases where the contract does not meet the criteria for recognition as a contract in IFRS 15, the consideration received should only be recognised as revenue when the contract is either complete or cancelled, or until the contract meets all of the criteria for recognition.
IFRS 15 does not apply to wholly unperformed contracts where all parties have the enforceable right to end the contract without penalty. These contracts do not affect an entity’s financial position until either party performs under the contract. The standard defines the term ‘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’.
This is to distinguish contracts that should be accounted for under IFRS 15 from under other IFRSs.
Some respondents asked for a clarification of the meaning of ordinary activities, but none was given. Instead reference was made to the description of revenue in the IASB’s Conceptual Framework and the FASB Concepts Statement No 6. An entity needs to consider all relevant facts and circumstances, such as the purpose of the activities undertaken by the other party, to determine whether that party is a customer.
At first sight this definition may seem relatively straightforward to apply; however, there are circumstances where an appropriate assessment is needed.
For example, in cases where there is collaborative research and development between biotechnology and pharmaceutical entities, or grants received for research activity where the grantor specifies how the output from the research activity will be used. Additionally, it is possible that a joint arrangement accounted for under IFRS 11 could fall within the scope of IFRS 15 if the partner meets the definition of a customer.
In the case of the transfer of non-financial assets that are not an output of an entity’s ordinary activities, it is now required that an entity applies IFRS 15 in order to determine when to derecognise the asset and to determine the gain or loss on derecognition. This is because these transactions are more like transfers of assets to customers, rather than other asset disposals.
IAS 18 did not provide specific guidance for variable consideration in these circumstances, but IFRS 15 does.
IFRS 15 excludes transactions involving non-monetary exchanges between entities in the same industry to facilitate sales to customers or to potential customers. It is common in the oil industry to swap inventory with another oil supplier to reduce transport costs and facilitate the sale of oil to the end customer. The party exchanging inventory with the entity meets the definition of a customer, because of the contractual obligation which results in the party obtaining output of the entity’s ordinary activities. In this situation, the recognition of revenue would not be appropriate as there would be an overstatement of revenue and costs.
Leases, insurance contracts, and financial instruments and other contractual rights or obligations within the scope of IFRS 9, Financial Instruments, IFRS 10, Consolidated Financial Statements, IFRS 11, Joint Arrangements, IAS 27, Separate Financial Statements, and IAS 28, Investments in Associates and Joint Ventures, are also scoped out in the standard. Some contracts with customers will fall partially under IFRS 15 and partially under other standards.
An example of this would be a lease arrangement with a service contract. If other IFRSs specify how to account for the contract, then the entity should first apply those IFRSs. The specific subject standard would take precedence in accounting for a part of a contract and any residual consideration should be accounted for under IFRS 15. Essentially, the transaction price will be reduced by the amounts that have been measured by the other standard.
The second article will deal with the five-step model of IFRS 15.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School