F1 5.13 IFRS 15 Revenue from Contracts with Customers part 1

In this session we shall begin looking at IFRS 15 Revenue from Contracts with Customers. We shall look at its objective and how various terms relating to revenue are defined. We shall then look at the core principle of how revenue is recognized and measured. Finally, we shall look at the first three steps used to apply the core principle (the final two steps are covered in section 5.14).

Objective of IFRS 15 Revenue from Contracts with Customers

The objective of IFRS 15 is to establish how to provide useful information about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer.

At first glance it might appear that the recording and measurement of revenue should be straightforward and in most cases, it is. A newsagent sells a bar of chocolate and receives payment from the customer at the same time – this is a simple example of how sales revenue can be generated but many sales contracts are not so straightforward and include complexities that must somehow be reflected in the revenue generated from the contract. For example:

• Many online clothing retailers have incredibly high sales returns – between a third and a half of some businesses’ sales will subsequently be cancelled when customers return the goods to them. An accountant must therefore consider the value of goods sold before a year-end that might be returned after the year-end when calculating revenue for the year
• Some contracts with customers involve the sale of a variety of goods or services to be provided at different times and an accountant must consider how and when the overall sales price for the contract should be shared or allocated between different financial periods
• Other sales contracts can involve bonuses or penalties according to the company’s performance. Here an accountant would have to consider whether and when these bonuses or penalties should be taken into account when calculating sales revenue for a period

IFRS 15 attempts to provide a process that will deal with these and other complexities so that all companies using International Financial Reporting Standards will be consistent in the way they record and measure sales revenue.

Customers, Income and Revenue

IFRS 15 defines customers, income and revenue as follows:

Core principle of IFRS 15

“An entity recognises revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” IFRS 15

In order to recognise revenue, a company will follow five steps:

In the rest of this session we shall cover the first three steps and then look at the remaining two in the next session.

Step 1 Identifying the contract

Before revenue is recognised we must identify that a contract exists between the company and the customer.

A contract is a legally enforceable agreement which may be verbal, written or is some other form. It must include the following elements;

1. Offer and acceptance of the terms and conditions of the contract by the parties to the contract, i.e. the supplier and the customer. Note that offer and acceptance is often referred to as “agreement”.
2. Consideration; that is each party of the contract will provide something of value to the other (usually a customer offers a monetary payment to the supplier and the supplier offers goods or services). The terms of the contract should make clear exactly what goods or services are to be supplied and what and how payment is to be made
3. Intention to create legal relations; that is, both parties intend to be bound by the terms of the contract This is usually assumed to exist unless the parties are closely related in some way, e.g. an agreement between parent and child would not normally involve the intention to create legal relations.

A contract must also have commercial substance and it must be probable that the company will receive payment.

Illustration

Pen Ltd has made a verbal agreement to supply Paper Ltd with 100 boxes of standard paperclips for £25 on 30 days credit. We can say that a contract exists as:

The rights and responsibilities (i.e. the terms of the contract) are clear – Pen Ltd will supply goods in return for a payment by Paper Ltd. As such there is agreement, consideration and no reason to believe that either party does not intend creating legal relations.

In addition, the contract has commercial substance (the money and goods to be exchanged) and Pen Ltd believes it will receive payment otherwise it would not agree to supply the goods.

2 Identifying the performance obligations

The second step is for the company to identify the different elements of what is being promised to the customer (each of these different elements is classed as a performance obligation). In most cases, the performance obligations are very simple (e.g. the customer has ordered various goods that will be delivered at the same time) but some contracts are more complicated.

Illustration

A software developer enters into a contract with a customer to provide and then maintain a piece of software. The developer has determined that the contract contains four separate performance obligations:

1. To transfer a software license to permit the customer to use it
2. To install the software on the customer’s computers
3. To provide software updates for a year
4. To provide technical support for a year

The process of identifying the performance obligations will assist the software developer in determining as and when each performance obligation is satisfied and when the revenues associated with each of them can be recognized and valued.

3 Determining the transaction price

The transaction price is the consideration the company expects to be entitled to from the customer for the goods or services to be provided (excluding VAT).

In most cases the transaction price will be fixed; that is, it is known with certainty. For example, a company sells an item to a customer for £1,000 plus VAT. In this simple example, the transaction price is £1,000.

There can however, be situations where the transaction will not be known with certainty at the transaction date and some of the price will be dependent on something that has yet to happen. This uncertain element of the transaction price is referred to as a variable part of the transaction price.

The final transaction price to be charged might include a variable element if the contract includes discounts, rebates, concessions, incentives, bonuses or penalties that we could not say would be applied when the contract was agreed.

So a transaction price might be fixed, variable or include elements of both. [NB. Please note that when we refer to fixed and variable elements we are not using the same definitions of fixed and variable that are used in Management Accounting]

The impact of a variable element in a transaction price is that the company might have to include an estimate of the revenue earned under a contract when it prepares its financial statements. As further information is received, adjustments to sales revenue will then be made to ensure that overall, the correct amount of revenue is recorded.

Illustration

A company agrees to install a new conveyor belt in a customer’s production plant over a weekend. The company will charge £15,000 plus VAT but has agreed that if the conveyor belt is not installed correctly by 8am on Monday morning, the company will incur a penalty of £500 per hour until it is installed. In this contract the £15,000 is a fixed transaction price and the £500 plus VAT per hour penalty is variable.

Estimating variable consideration

IFRS 15 provides two methods that may be used when estimating the amount of any variable consideration. Accountants should use whichever method they believe will better predict the consideration to which it will be entitled.

Process for calculating the expected value of variable consideration

1. List the possible outcomes
2. Assign probabilities to all of the possible outcomes (e.g. one outcome might have a 20% chance of occurring, alternatively this might be expressed as a fraction; 1/5)
3. Multiply each possible outcome by its assigned probability
4. Add up all the figures calculated in step 3 – this is the expected value

Expected values are particularly useful where there are numerous contracts in existence that include variable consideration of a similar nature.

Process for identifying the most likely amount of variable consideration

1. List the possible outcomes
2. Assign probabilities to all of the possible outcomes (e.g. one outcome might have a 20% chance of occurring, alternatively this might be expressed as a fraction; 1/5)
3. Identify the possible outcome associated with the highest probability – this is the most likely amount

The most likely amount is useful when there is only a small number of contracts that include variable consideration.

Illustration 1

A company agrees to sell a product to a customer at a price of £40 per unit. It the customer then buys more than 5,000 units in a calendar year the contract specifies that the price per unit will be reduced retrospectively to £35 per unit (as a consequence the amount of this potential discount will not be known until the earlier of the end of the calendar year or the point at which more than 5,000 units are sold).

Three months into the calendar year, the company has shipped 1,500 units to the customer.

How much revenue should it record for the 1,500 units shipped so far under this contract?

The price per unit under this contract can be split between a fixed and a variable element. The fixed element is £40 per unit as this will be charged irrespective of whether a separate discount is applied. The variable element is the possible reduction of £5 per unit which would apply if the customer purchases more than 5,000 units in the coming year.

In order to estimate the variable price we will first list the possible outcomes:

1. The customer will have bought more than 5,000 units by the end of the calendar year and the discount of £5 per unit will be applied
2. The customer will not have bought more than 5,000 units by the end of the calendar and there will be no discount applied

Next, we will assign probabilities to the possible outcomes (these are our estimates of how likely each outcome is). Let’s say that the probability of selling more than 5,000 units is 75% and the probability of not doing so is 25%.

The company would decide which of the two methods would provide the better prediction of the eventual price. For our example however, we will illustrate how the transaction price is calculated using both methods.

Method 1 Expected Value

The fixed element of the transaction price: 1,500 units at £40 per unit is £60,000

The variable element of the transaction price is the expected value of the potential penalties calculated for each possible outcome multiplied by the probability that the outcome will occur. These are summarised in the table below.

The sales revenue for the 1,500 units which will be recognised will be the fixed element of £60,000 less the expected value of the discount £5,625. The sales revenue recorded for the 1,500 units will therefore be £54,375.

Method 2 Most likely amount

The fixed element of the transaction price: 1,500 units at £40 per unit is £60,000

The variable element is the most likely discount. The company believes that the most likely outcome is that a discount will be applied, so a £5 per unit discount for 1,500 units amounts to a total discount of £7,500.

The sales revenue for the 1,500 units which will be recognised will be the fixed element of £60,000 less the most likely value of the discount of £7,500. The sales revenue to be recorded would be £52,500

Which method is likely to provide the best estimate?

If this is the only contract the company has that involves this type of discount the company will probably choose the amount that is most likely to happen; so it would record revenue of £52,500.

If there are several similar contracts offering this type of discount, the company will probably choose to use the expected value when calculating the revenue to record from each of these contracts (as it would be reasonable to presume that 75% of them will qualify for the discount and 25% won’t). So, for this contract the company would record revenue of £54,375.

As more units are sold throughout the year, the company will keep reviewing the possible outcomes and the associated probabilities and will update its calculations and amend the sales revenues recorded, so that eventually the correct amount of revenue will be recorded from this contract.