IFRS 15 Revenue Recognition Lecture PDF

SESSION 3 Revenue Recognition Financial Reporting and International Accounting Professor Annita Florou  Overview IFRS 15: Introduction and Basic Concepts The Five-Step Model Disclosure Requirements 2  IFRS 15:...

SESSION 3 Revenue Recognition Financial Reporting and International Accounting Professor Annita Florou  Overview IFRS 15: Introduction and Basic Concepts The Five-Step Model Disclosure Requirements 2  IFRS 15: Revenue from Contracts with Customers Joint project of the FASB and IASB The overall aim was to develop a single, principles-based revenue standard for U.S. GAAP and IFRS that would apply to every industry But some industries will be affected more than others If industry-specific revenue recognition guidance is being used, that entity is likely to be significantly affected by the new standard (e.g. software, construction, real estate and, more generally, U.S. GAAP companies) 3  IFRS 15: Revenue from Contracts with Customers (cont. ) Issued in May 2014 Effective after 1st January 2018 − Early application is permitted Supersedes IAS 11 and IAS 18 Leases and insurance contracts are excluded; so are financial instruments and biological assets 4  Why the Need for a New Standard? Both U.S. GAAP and IFRS were deficient − U.S. GAAP had complex, highly detailed requirements for specific industries or transactions ⇒ different accounting for transactions that are economically similar − The problem with IFRS was just the opposite: not enough guidance ⇒ its two main revenue recognition standards (IAS 11 and IAS 18) were somewhat vague and difficult to apply Much of the problem stems from the inability of either regime to cope with changing business models − E.g. mobile phone contracts sold with a free phone, software sold with training and future upgrades 5 What does the New Standard accomplish? Provides a more robust framework for addressing revenue recognition issues Removes inconsistencies from existing requirements Improves comparability across companies, industries, capital markets Improves disclosure requirements Simplifies financial statement preparation by streamlining the volume of guidance In general, IFRS 15 aims to give analysts and investors confidence that revenue is being presented on a consistent basis 6  Basic Concepts Revenue is “income arising in the course of an entity's ordinary activities” Revenue generally arises from the sale of goods or the provision of services to customers Revenue excludes borrowings Revenue excludes amounts contributed by shareholders (e.g. equity issues) Revenue excludes gains (e.g. gains on disposal of non- current assets) 7  Basic Concepts (cont. ) The core principle of IFRS 15: A business should recognize revenue from contracts with customers when it transfers promised goods or services to the customer (and not when cash is paid) The amount of revenue recognized: The consideration promised (i.e. the transaction price) by the customer in exchange for the transferred goods or services 8  Overview IFRS 15: Introduction and Basic Concepts The Five-Step Model Disclosure Requirements 9  IFRS 15 (May 2014) A Framework for Revenue Recognition 10  IFRS 15 (May 2014) A Framework for Revenue Recognition (cont. ) 11  The Five-Step Model Step 1: Identify a contract with a customer Step 2: Identify the performance obligations in the contract Step 3: Determine the transaction price Step 4: Allocate the transaction price to the performance obligations in the contract Step 5: Recognise revenue when or as a performance obligation is satisfied 12  Step 1: Identifying the Contract A contract is “an agreement between two parties that creates enforceable rights and obligations” A contract with a customer should be accounted for only when: − The parties are committed to the contract − Each party's rights under the contract can be identified − Payment terms can be identified − The contract has commercial substance − It is probable that the entity will collect the consideration due for the goods or services transferred to the customer Payments that are received from a customer before these conditions are satisfied must be recognised as a liability 13 Step 2: Identifying Performance Obligations A performance obligation is “a promise in a contract with a customer to transfer to the customer good(s) or service(s)” A company should account separately for performance obligations if the goods/services are distinct A good or service is distinct if: − The customer could benefit from the good or service on its own; and − The promise to transfer the good or service is separately identifiable within the contract If a promised good or service is not distinct, it must be combined with other promised goods or services to form a distinct “bundle”. In this case, all of the goods or services promised in a contract might be treated as a single performance obligation (i.e. they are highly interrelated). 14  Step 2 (cont. ): Example 1 A company licenses customer relationship management software to a customer In addition, it promises to provide consulting services to customize the software for total consideration of €600.000 − The company is providing a significant service of integrating the goods and services (the license and the consulting services) into the combined item for which the customer has contracted − The software is significantly customized by the entity in accordance with the specifications negotiated with the customer The company would account for the license and consulting services together as one performance obligation. Revenue for that performance obligation would be recognized over time by selecting an appropriate measure of progress towards complete satisfaction of the performance obligation. 15  Step 2 (cont. ): Example 2 A company enters into a contract to design and build a hospital Also, the company is responsible for the overall management of the project, including site clearance, procurement, installation of equipment and finishing etc. − The company is providing a significant service of integrating the above goods and services into the combined item (i.e. the hospital) − The goods or services are significantly modified and customised to fulfil the contract The company would account for the bundle of goods and services as a single performance obligation because these are highly interrelated. Revenue for that performance obligation would be recognized over time by selecting an appropriate measure of progress towards complete satisfaction of the performance obligation. 16 Step 3: Determining the Transaction Price Transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer” The transaction price may vary because of items such as discounts, refunds, incentives, penalties etc. In these circumstances, the amount of the variable consideration should be estimated using either: a) The “expected value” method or b) The “most likely amount” method The chosen method should be the one that best predicts the amount of the consideration 17 Step 4: Allocating the Transaction Price The transaction price is allocated between performance obligations according to the stand-alone selling price of each obligation If the transaction price is less than the sum of the stand-alone selling prices of each performance obligation, the customer is receiving a discount for purchasing several goods or services together Such a discount is allocated proportionately amongst performance obligations (depending on the specifics of the contract) 18  Step 4 (cont. ): Example A company enters into a contract with a customer to sell products A, B and C for €36 The entity regularly sells products A, B and C separately for €9, €11 and €20 respectively. The entity regularly sells products A and B together for €16 and regularly sells product C for €20. Allocate the transaction price of €36 to products A, B and C when these are sold together 19  Step 4 (cont. ): Example Because products A and B are transferred at the same time the company accounts for only two separate performance obligations: − One for products A and B combined − Another one for product C Because the company regularly sells products A and B together for €16 (i.e. at a €4 discount) and regularly sells product C for €20, the company has observable prices as evidence that the €4 discount in the contract should be allocated only to products A and B. Hence, the entity allocates the transaction price of €36 as follows: Allocated amounts: a) products A and B €16; b) product C €20 Total €36 20  Step 5: Satisfaction of Performance Obligations Revenue is recognised when (or as) a performance obligation is satisfied by transferring a good or service to the customer. The amount of revenue recognised is the amount which was allocated to that obligation. A good or service is transferred only when the customer obtains control of that good or service If a performance obligation is satisfied “at a point in time” revenue is recognised when the obligation is satisfied If a performance obligation is satisfied “over time”, revenue is recognised according to the progress made towards complete satisfaction of the obligation 21  Measuring Progress For performance obligations satisfied over time, progress may be measured using either: − Output methods: Progress is measured on the basis of direct measurement of the goods and services transferred to date (e.g. units delivered, time elapsed) − Input methods: Progress is measured on the basis of the entity's inputs to date (e.g. hours spent, costs incurred) relative to the total inputs required to satisfy the performance obligation The chosen method should faithfully depict the entity's progress 22  Contract Costs The costs incurred by an entity towards fulfilling a performance obligation are recognised as a “contract asset” until the obligation is satisfied, if: – The costs relate directly to the specific contract – The costs generate resources expected to be used – The costs are expected to be recovered These costs are then transferred to the Statement of Comprehensive Income as an expense and are matched against the revenue which is recognised when the obligation is satisfied 23  Contract Costs (cont. ): Example A company enters into a contract to outsource a customer’s information technology data centre for five years The company incurs selling commission costs of €10.000 to obtain the contract The customer promises to pay a fixed fee of €20.000 euros per month. The €10.000 incremental costs of obtaining the contract are recognised as an asset. The asset is amortised over the term of the contract (i.e. five years). 24  Overview IFRS15: Introduction and Basic Concepts The Five-Step Model Disclosure Requirements 25  Presentation If an entity has performed an obligation by transferring goods or services to a customer and the customer has not yet paid for these goods or services, the entity should present a “contract asset” or a receivable in the Statement of Financial Position, depending on the nature of the entity’s right to consideration. ― A contract asset is recognised when the entity’s right to consideration is conditional on something other than the passage of time, e.g. future performance of the entity. ― A receivable is recognised when the entity’s right to consideration is unconditional except for the passage of time. A “contract liability” should be presented in the Statement of Financial Position if payment is made before the entity transfers the goods or services to the customer. 26  Main Disclosure Requirements IFRS 15 requires that entities should disclose: − The amount of revenue for the period, analysed into appropriate categories − Any impairment losses recognised in the period in relation to contract assets or receivables arising from contracts with customers − The opening and closing balances of contract assets and contract liabilities, together with an explanation of significant changes during the period − The amount of revenue allocated to performance obligations that are unsatisfied at the end of the period − Significant judgements made by the entity in applying the requirements of IFRS 15 27