F1 5.14 IFRS 15 Revenue from Contracts with Customers part 2

In this session we shall continue our look at IFRS 15 and examine the final two steps that are considered when determining the revenue to be recorded from a contract with a customer.

Steps to recognise revenue

In the previous session we examined the first three steps required to recognise revenue. In this session we shall look at the final two steps; how we allocate the transaction price to the contract’s performance obligations and how we determine whether the performance obligations have been satisfied.

Step 4 Allocating the transaction price to performance obligations

Once we have determined the transaction price of the contract we can then allocate (or share) that price between the different performance obligations. This is done according to the amount the company expects to be entitled to for those goods or services.

In most cases this will be straightforward; the company will be able to refer to the price lists it has for its products or services and allocate the overall contract price accordingly but there can be circumstances where this can be more difficult. For example where:

• The company does not have separate prices for the different performance obligations that are included in a contract. Where this occurs the company will have to identify a reasonable method to split the price
  • For example, let’s say that an accountant has agreed with a customer that he will charge £2,000 for preparing the customer’s financial statements, its VAT returns for a year and the directors’ personal tax returns but the accountant did not consider how the overall fee would be split between these different performance obligations or parts of the contract
  • The accountant might decide that the fairest way to split the overall price between the different obligations is to base it on the time each obligation is likely to take. Let’s say that the financial statements are expected to take 15 hours, the VAT returns 20 hours and the directors’ tax returns 5 hours. The total amount of £2,000 to be charged would then be split as follows:
    • 15/40ths, or £750 would be in respect of the financial statements;
    • 20/40ths, or £1,000 would be in respect of the VAT returns; and
    • 5/40ths, or £250 would be in respect of the directors’ tax returns
• The company provides a discount that covers different performance obligations that will be satisfied at different times
  • For example, a company has agreed to supply a variety of different goods to a customer with a discount being offered on the total price. These different goods will be supplied to the customer at different times over the next several months. The company must consider how this discount should be applied; that is, should it be applied equally to all the goods supplied, or is it to be applied to some of the goods and not to others in which case the timing of the discounts and their effect on revenue will be different.

Illustration 1

A company enters into a contract to supply and maintain a piece of equipment for a customer for one year for £3,500. The performance obligations identified in the contract are to supply the equipment and to maintain it for one year. As the different obligations will occur at different times it is important to split the overall price between the two obligations. If the company has always bundled these two obligations together when calculating its prices, how will it calculate the stand-alone prices?

Answer – the company could estimate how much it would charge for the machine as a stand-alone product and how much it would charge for the maintenance.

Allocating a discount

If the sum of the stand-alone selling prices of goods and/or services in a contract exceeds the overall price to be charged then the customer is receiving a discount for purchasing a bundle of goods or services.

For example, let’s say a company sells twenty computers and twenty printers to a customer for a total of £15,000. Had the company sold the computers and printers separately the customer would have been charged £12,000 for the computers and £4,000 for the printers, a total of £16,000. By bundling these items together the company has given the customer a discount of £1,000.

These types of discounts should be allocated proportionately to the different performance obligations in the contract (unless it can be demonstrated that the discount is in respect of a particular performance obligation).

For the above example, a discount of £1,000 was offered on a pre-discount price of £16,000, a discount of 6.25% (i.e. 1,000/16,000 x 100). This discount would be applied to each performance obligation so that the prices of the computers and printers would be recorded as follows:

• 20 computers: £11,250 (i.e. £12,000 less 6.25% of £12,000)
• 20 printers: £3,750 (i.e. £4,000 less 6.25% of £4,000)

Illustration 2

A business agrees to supply 110 units of Product A and 30 units of Product B to a customer. Product A is sold for £10 per unit so these products should be sold for £1,100 in total. Product B is sold for £30 per unit so these products should be sold for £900 in total.

The business agrees to sell all the products for £1,600 (a discount of 20% from the standard price of the products; £1,100 plus £900). The discount will be applied proportionately to both products, i.e. a 20% discount will be applied to both.

The units of Product A are supplied to the customer before the year-end, those of Product B are supplied after the year-end. When calculating the revenue to be recognised in the financial statements the company will record its revenue from this contract as follows:

• £880 of revenue will be recorded in the current year’s financial statements in respect of Product A (i.e. £1,100 less 20% of £1,100)
• £720 of revenue will be recorded in the next’ year’s financial statements in respect of Product B (i.e. £900 less 20% of £900)

Step 5 Satisfaction of performance obligations

Companies will recognise the transaction prices allocated to the different performance obligations in step 4 as those different performance obligations are satisfied.

A company satisfies a performance obligation when it transfers the goods or services associated with the performance obligation to a customer. This is occurs when the customer obtains control of the goods or services.

But what do we mean by obtaining, or alternatively, transferring control?

Control transferred over time

Some goods or services are supplied to customer over a period of time rather than at a single point in time. Where this is the case, control can be transferred over time as follows:

1. Where the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
   1. For example, a company provides security at a customer’s nightclub. The service is received and consumed simultaneously
2. Where the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced
   1. For example, a company is repainting a customer’s offices. The customer will still control the offices throughout the repainting process.
3. Where the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date
   1. For example, a solicitor charges its customers by the hour and has been working on a client’s case. It has a right to receive payment for the work carried out so far but that work will have no alternative use to the solicitor as it is only relevant to that particular client.

Methods for measuring progress towards complete satisfaction of a performance obligation

In many cases, performance obligations are satisfied at a single point in time, for example, when items that have been ordered from a company are delivered to and accepted by the customer. In other cases, however, the performance obligations are satisfied over a period of time and where this occurs we must consider the best way to spread the transaction price over this period.

Companies can use a variety of methods to measure their progress towards the complete satisfaction of a performance obligation. These can be split into two broad categories, Output Methods and Input Methods. The method used by a company should be appropriate for a particular performance obligation. For example, if a contract specifies that a particular number of products will be supplied over the next year, it would make sense to measure progress using the number of units supplied.

Output methods focus on the goods or services actually supplied to the customer relative to the total goods or services to be provided under the contract. This will then enable the company to determine how much revenue to recognize.

Examples:

• A company providing goods over a period might measure its progress using units produced or units delivered
• A company might measure the percentage of goods to be provided that have been provided. So if a company has completed three-quarters of the work under the contract, it may be reasonable to recognise three quarters of the total revenue from the contract
• A company might use milestones reached in order to measure its revenue. So a company building a shopping centre may recognise some revenue when the site has been prepared, some when the structure has been erected and so on
• A company providing maintenance cover for a customer’s factory might measure its progress using the time that has elapsed over the period of the contract

Input methods look at the entity’s efforts or inputs such as the labour or machine hours that have been expended so far, or alternatively the costs that have been incurred relative to the total inputs expected to be used in satisfying the performance obligations.

Example:

A company has agreed to provide workers for a customer’s production line for four months. The company might measure the number of hours of labour supplied each period as a portion of the total hours to be supplied and then recognize the same portion of the total revenue as revenue for the period so far.

If the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on the a straight line basis.

For example, let’s say an accountancy firm has agreed to provide monthly payroll services for a client over the next year for £1,200 in total. As a similar amount of time will spent each month on the payroll the firm decides to recognize revenue from the contract at a rate of £100 per month.

Control transferred at a point in time

Where goods or services are provided at a particular point in time control is transferred when:

1. The entity has a present right to payment for the asset
2. The customer has legal title to the asset
3. Physical possession of the asset has passed to the customer
4. The risks and rewards of ownership have passed to the customer
5. The customer has accepted the asset

For example, a company would recognise revenue from the sale of goods when the goods have been delivered and accepted by the customer.