Last month, our Accounting News article 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 separate performance obligations|
|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|
Step one requires the entity to identify the contract(s) with the customer. That sounds like an easy process, but there are three potential problems that can arise:
IFRS 15 defines a contract as ‘an agreement between two or more parties that creates enforceable rights and obligations’.
Contracts can be written, verbal, or implied by an entity’s customary business practices. Contracts can also have a fixed term or an open term and, where renewal is possible, may renew automatically or after renegotiation.
Under IFRS 15, a contract is only accounted for by an entity when all of the following requirements are met:
With respect to the last criterion, in evaluating whether collectability of an amount of consideration is probable, an entity must consider only the customer’s ability and intention to pay that amount of consideration when it is due.
If consideration is received from a customer prior to all of these criteria being met, it must be recognised as a liability. That consideration can only be recognised as revenue when one of the following occurs:
Seller Company, a property developer, sells a building for $1,000,000 to Buyer.
The building cost Seller Company $600,000 to construct.
The building is located in a retail precinct that Seller Company has been developing and selling over the last few years.
Buyer plans to use the building as a retail outlet for men’s clothing. In the retail precinct there are several established men’s clothing stores, many of which are struggling due to increases in online shopping by their target demographic. In addition, Buyer has limited experience in retail.
Buyer does not have the capacity to buy the building outright, nor does it have any other income sources, and it has been unable to secure a bank loan for the purchase of the building. Due to those factors, Seller Company will take a non-refundable deposit of $50,000 from Buyer, and enter into a long-term financing agreement with Buyer for the remaining 95% of the promised consideration.
The financing arrangement is provided on a non-recourse basis (which means that if Buyer defaults, Seller Company can repossess the building, but cannot seek further compensation from Buyer, even if the collateral does not cover the full value of the amount owed).
All payments made by Buyer are non-refundable.
On the sale date, Buyer pays the deposit and obtains control of the building.
Is there a contract?
In assessing whether a contract with a customer exists, Seller Company must assess, among other things, whether it is probable that it will be able to collect the consideration to which is entitled. In making this assessment, the factors that Seller Company will consider are:
These factors indicate that it is not probable that Seller Company will be able to collect the consideration to which it is entitled. Consequently, there is not a contract with a customer, and Seller Company must recognise the $50,000 deposit as a liability.
Seller Company then continues to account for the initial deposit, as well as any future payments received from Buyer, as a liability, until:
Under IFRS 15, an entity must combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met:
This requirement means that companies must have a robust process for tracking the contracts that they enter into with their customers, in order to:
This will require a level of contract management sophistication that has not previously been required by financial reporting standards.
When there is a modification to the scope and/or pricing of a contract with a customer, the modification may be accounted for either as a change in the original contract, or the issue of a new contract, depending on the underlying facts and circumstances.
In future editions of Accounting News we will provide some examples of the impacts of contract modification.
The first step in the IFRS 15 five step revenue recognition model is often considered to be the easiest. However, in some instances the requirements of this step will mean that revenue recognition lags behind the receipt of cash, while in other instances the requirements of this step will result in multiple contracts being entered into with one customer (or, in some cases, different customers that are related parties of each other) needing to be considered as one contract.
As always with IFRS 15, it is important for businesses to have an in-depth understanding of the nuances of their relationships with their customers. Until recently, it has been common for sales people and account managers to have an in-depth understanding of the company’s relationships with its customers, while the accounting team has had a more overarching, and less detailed understanding of those relationships. As companies move to adopt IFRS 15, it will be important for accounting teams to work with sales teams to gain a detailed understanding of the company’s relationships with its customers.