Identifying performance obligations is critical to revenue recognition under IFRS 15

In our April 2018 edition of Accounting News we discussed the five step model for revenue recognition introduced by IFRS 15 Revenue from Contracts with Customers (IFRS 15):

Step 1 Identify the contract(s) with the 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
Step 5 Recognise revenue when a performance obligation is satisfied

In the May and June 2018 editions we examined the first step of this five step process in greater depth.  In this article, we look at the complexities of the second step in the IFRS 15 revenue recognition model.

Step two requires the entity to identify the performance obligations in the contract with a customer. This is a critical step in the revenue recognition process because revenue is recognised when (or in some instances as) a performance obligation is satisfied. Failing to correctly identify performance obligations may therefore result in the timing of revenue recognition not complying with the requirements of IFRS 15, and revenue being recognised in the incorrect reporting period.

What is a performance obligation?

A contract with a customer includes promises to transfer goods or services to the customer. If those goods or services are distinct, the promises are performance obligations and must be accounted for separately.

Examples of goods or services that may be promised in a contract with a customer include:

  • The sale of goods produced by an entity (for example, a manufacturer selling its inventory)
  • The resale of goods purchased by an entity (for example, a retailer selling its inventory)
  • Performing a contractually agreed-upon task for a customer
  • Providing a service of standing ready to provide goods or services to a customer (such as software updates that are provided on a when-and-if-available basis)
  • Providing a service of arranging for another party to transfer goods or services to a customer (i.e. acting as an agent of another party)
  • Constructing, manufacturing or developing an asset on behalf of a customer
  • Granting licences.

What are ‘distinct’ goods and services?

A good or service that is promised to a customer is ‘distinct’ if both of the following criteria are met:

  • The customer can benefit from the good or service either on its own, or together with other resources that are readily available to the customer, and
  • The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. 

When is the entity’s promise to transfer goods and services ‘separately identifiable’?

In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable, the objective is to determine whether the nature of the promise in the contract is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs.  This assessment is done from the perspective of the customer.

If a promised good or service is not distinct, the entity must combine that good or service with other promised goods or services until it identifies a bundle of goods and/or services that is distinct.  Promises are not separately identifiable (i.e. they must be bundled) if any of the following circumstances exist:

  • The seller performs a significant amount of work to integrate the good or service with other goods or services promised in the contract
  • Goods or services provided are highly interdependent or interrelated, or
  • One or more of the goods or services provided by the seller significantly modifies or customises, or is significantly modified or customised by, other goods or services promised in the contract.

The following decision tree summarises the process discussed above and will assist in determining whether goods and services promised in a contract are ‘distinct’:

Distinct decision tree

Example

Entity XYZ has contractually agreed to build a fence at the home of a customer. From an operational perspective, there are likely three stages to the contract:

  • Purchase the timber, nails, concrete and other required building supplies
  • Deliver the required building supplies to the customer’s home, and
  • Build the fence.

However, from the perspective of the customer, a completed fence has been promised.  In addition:

  • Entity XYZ performs a significant amount of work to integrate the goods (building materials) and services (building of the fence) provided under the contract
  • The goods (building materials) and services (building of the fence) are highly interrelated, and
  • The service (building of the fence) provided by Entity XYZ significantly modifies the goods (building materials) promised in the contract.  

Given the above there is only one performance obligation in the contract and that is the provision of a completed fence.

In future editions of Accounting News, we will examine some real life situations in which the identification of performance obligations can be difficult. 

Concluding thoughts

The concept of performance obligations is new, but it is central to ensuring that the timing of revenue recognition is correct.  For that reason, it is important that finance teams become familiar with the concept and correctly identify the performance obligations within their company’s contracts with its customers.  This will require the finance team to have a much greater understanding of the particular terms and conditions of contracts with customers than has been required in the past.