IFRS 15- Practicalities

Revenue recognition is an important topic for all companies, where often I am asked about my technical IFRS knowledge by FTSE listed clients’ in different industries. Having consulted across numerous industry sectors, I thought I would share some of the trigger points for revenue recognition and issues/ challenges I have faced in some of the industry sectors worked in.

The standard in brief

The principles are explained below.

A contract may be partially within the scope of IFRS 15 and partially within the scope of other IFRSs. In this situation a seller takes the approach summarised below:

In the statement of financial position, a seller is required separately to present contract assets, contract liabilities and receivables due from customers.

When a seller transfers control over goods or services to a customer before the customer pays consideration, the seller presents the contract as either a contract asset or a receivable. A contract asset is a seller’s right to consideration in exchange for goods or services that the seller has transferred to a customer, when that right is conditional on the seller’s future performance. A receivable is a seller’s unconditional right to consideration, and is accounted for in accordance with IFRS 9.

When a customer pays consideration in advance, or an amount of consideration is due contractually before a seller performs by transferring a good or service, the seller presents the amount received in advance as a contract liability.

Contract costs

A distinction needs to be made between incremental costs incurred in obtaining a contract and costs incurred to fulfil a contract.

Incremental costs of obtaining a contract

Incremental costs are those costs which would not have been incurred had contract not been obtained. This is restrictive, as any ongoing costs of operating the business will be expensed as incurred. IFRS 15 requires that these are recognised as an asset and then amortised to reflect the transfer of goods or services to the customer.

Note that incremental costs of acquiring a contract can be recognised immediately (more for non-listed businesses with no quarterly reporting requirements) if the transfer period for performance obligation is one year or less.

Costs to fulfil a contract

In contrast to incremental costs of obtaining a contract, not covered by another IFRS standard (IAS 2 Inventories, IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets) there are still restrictions and all of the following criteria need to be met:

1. The costs relate directly to a contract or to an anticipated contract that can specifically be identified;

2. The costs generate or enhance resources of the seller that will be used to satisfy performance obligations in future; and

3. The costs are expected to be recovered.

Changes in the transaction price after inception of contract

Changes in the transaction price subsequent to contract inception are allocated to the performance conditions on the same basis as at contract inception. This ensures that changes in estimates of variable consideration that are included in (or excluded from) the transaction price will be allocated to the performance obligation(s) to which the variable consideration relates.

A change in the transaction price is allocated entirely to one or more distinct goods or services only if the criteria for allocation of variable consideration to performance obligations are met.

Changes in stand-alone selling prices after contract inception are not reflected in the basis of determining the reallocation of the transaction price.

For a change in the transaction price that occurs as a result of a contract modification, the seller allocates the change in the transaction price in whichever of the following ways is applicable:

• The change in the transaction price is allocated to the performance obligations identified in the contract before the modification if, and to the extent that, the change in the transaction price is attributable to an amount of variable consideration promised before the modification and the modification is accounted for as termination of the original contract and the establishment of a new contract; or

• In all other cases, being those in which the modification is not accounted for as a separate contract, the change in the transaction price is allocated to the performance obligations in the modified contract (i.e. the performance obligations that were unsatisfied or partially unsatisfied immediately after the modification).

Sale with a right of return

A right to return enables a customer to receive:

• A full or partial refund of any consideration paid;

• A credit that can be applied against amounts owed or that will be owed to the seller;

• Another product in exchange; or

• Any combination of the above.

A right to return may be given for various reasons (e.g. dissatisfaction with the product). In practice, a right to return is usually attached to the sale of goods, but can also be attached to the transfer of some services that are provided by the seller subject to refunds.

When a seller transfers products with a right of return, revenue is recognised only to the extent that the seller expects to be entitled to it. To determine the amount of consideration to which it expects to be entitled, a seller should apply the guidance regarding constraining estimates of variable consideration and also considers the nature of the products expected to be returned.

A refund liability (not revenue) is recognised for any consideration received to which the seller does not expect to be entitled (that is, which relates to goods that it expects to be returned).

An asset is also be recognised for the seller’s right to recover the goods from customers on settling the refund liability. The asset is measured by reference to the former carrying amount of the good less any expected costs to recover those products (including potential decreases in the value of the good). The asset is presented separately from the refund liability (offsetting is not permitted). If the value is less than the amount recorded in inventory, the carrying amount of inventory is reduced with a corresponding adjustment to cost of goods sold.

A seller’s obligation to accept a returned product during the return period is not accounted for as a performance obligation in addition to the obligation to provide a refund.

In subsequent periods the seller updates:

• Its assessment(s) of amounts to which it expects to be entitled in exchange for the transferred products;

• The measurement of the refund liability at the end of each reporting period for changes in expectations about the amount of refunds; and

• The measurement of the asset (i.e. so that it corresponds with changes in the measurement of the refund liability and any impairment recognised).

Warranties

IFRS 15 distinguishes two types of warranties:

Warranties that provide a customer with the assurance that the product will function as intended because it complies with agreed-upon specifications. These warranties are accounted for in accordance with the guidance on product warranties included within IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

Warranties that provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. These ‘additional service’ warranties are accounted for as a performance obligation and allocated a portion of the transaction price in accordance with the principles of IFRS 15.

In assessing whether a contract contains a service in addition to the assurance that the product complies with agreed-upon specifications, a seller considers factors such as:

• Whether the warranty is required by law

• The length of the warranty coverage period

• The nature of the tasks that the seller promises to perform.

If a customer does not have an option of whether to purchase a warranty separately, it is accounted for in accordance with IAS 37 unless part or all of that warranty provides the customer with a service in addition to an assurance that the good or services complies with agreed-upon specifications.

Principal vs. agent selling

When a third party is involved in providing goods or services to a customer, the seller is required to determine whether the nature of its promise is a performance obligation is to:

• Provide the specified goods or services itself (principal) or

• Arrange for a third party to provide those goods or services (agent).

A seller acting as principal controls a good or service before the seller transfers the good or service to the customer. A seller that qualifies as a principal may satisfy a performance obligation by itself or engage another party (for example, a subcontractor) to satisfy some or all of a performance obligation on its behalf. When a seller, in its role as a principal, satisfies a performance obligation, it recognises revenue at the gross amount. However, the seller is not necessarily acting as a principal if the seller obtains legal title of a product only shortly before legal title is transferred to a customer.

The obligation of an agent is to arrange for the provision of goods or services by another third party. When a seller represents an agent and satisfies a performance obligation, it recognises revenue as the amount of any fee or commission to which it expects to be entitled, i.e., on a net basis. A seller’s fee or commission might be the net amount of consideration that the seller retains after paying the third party the consideration received in exchange for the goods or services to be provided by that party.

The following points indicate that the seller qualifies as an agent:

• Another third party is responsible for fulfilling the contract

• The seller does not have inventory risk

• The seller does not have discretion in establishing prices for the other third party’s goods or services

• The seller’s consideration is in the form of a commission

• The seller is not exposed to credit risk for the amount receivable from the customer.

Customer options for additional goods or services

Customer options to acquire additional goods or services (either free of charge or at a discount) come in many forms, including sales incentives, customer award credits (or points), contract renewal options, or other discounts on future goods or services. Such customer options give rise to a performance obligation in the contract when the option provides a material right to the customer that it would not receive without entering into the contract. In those cases, the seller is required to defer the portion of payment received from its customer that relates to those future goods or services and recognises that portion as revenue only when those future goods or services are transferred to the customer (or when the option expires).

The allocation is based on the relative stand-alone selling prices of the goods or services and, if the prices of the future potential goods or services are not observable, they are estimated. This estimate takes into account any discount that the customer would receive without exercising the option together with the likelihood that the option will be exercised.

Renewal options for goods and services

A renewal option gives a customer the right to acquire additional goods or services of the same type as those supplied under an existing contract. If a renewal option provides a customer with what IFRS 15 terms a ‘material right’, the effect can be to defer the recognition of revenue to future periods.

IFRS 15 includes criteria to distinguish renewal options from other options to acquire additional goods or services:

1. The additional goods or services are similar to the original goods or services in the contract (i.e. a seller continues to provide what it was already providing). Consequently, it is more intuitive to view the goods or services underlying such options as part of the initial contract.

2. The additional goods or services are provided in accordance with the terms of the original contract. Consequently, the seller’s position is restricted because it cannot change those terms and conditions and, in particular, it cannot change the pricing of the additional goods or services beyond the parameters specified in the original contract.

IFRS 15 also includes a practical alternative to estimate the stand-alone selling price of the option, by allowing entities to include the optional goods or services that it expects to provide (and corresponding expected customer consideration) in the initial measurement of the transaction price. This practical alternative acknowledges that for some entities it may be simpler to account for renewal options within a single contract, rather than as a contract with a series of options.

A renewal option is different from customer loyalty programmes and many discount vouchers. This is because, for those programmes and vouchers, the underlying goods or services in the contract with the customer will often have a different nature.

Customers’ unexercised rights to break a contract

Customers’ unexercised rights refer to instances where there is breakage in a contract, such as where a customer does not exercise all its contractual rights from the contract to receive goods or services in the future. Common examples for customers’ unexercised rights include the purchase of gift cards and non-refundable tickets.

When a seller expects to be entitled to a breakage amount in a contract liability, the seller recognises the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer. This effectively increases the transaction price allocated to the individual goods or services to be transferred to include revenue from the seller’s estimate of unexercised rights, and means that breakage is not recognised as revenue until the seller has fulfilled its obligations. This reflects that an airline that sells non-refundable tickets would be presumed to increase its selling price per ticket if no breakage was expected.

When the seller does not expect to be entitled to a breakage amount, the expected breakage amount is recognised as revenue when the likelihood of the customer exercising its remaining rights becomes remote.

Non-refundable upfront fees

A seller may charge a customer a non-refundable upfront fee at (or near) contract inception, which may be related to an activity that the seller is required to undertake at (or near) contract inception in order to fulfil the contract (for example, joining fees in health club membership contracts). The seller is required to determine whether the fee relates to the transfer of a promised good or service, in order to identify the performance obligations within the contracts.

When the non-refundable upfront fee is not related to a performance obligation but to setup activities or other administrative tasks, the non-refundable upfront fee is accounted for as an advance payment for future goods or services and is therefore only recognised as revenue when those future goods or services are provided.

In practice, non-refundable upfront fees typically relate primarily to setup activities, and not to a performance obligation.

Licencing

A licence establishes a customer’s rights over the intellectual property of a seller, such as:

• Software and technology

• Media and entertainment (e.g. music, film)

• Franchises

• Patents, trademarks, and copyrights

A contract to transfer (provide) a licence to a customer may include performance obligations in addition to the promised licence. Those obligations may be specified in the contract or implied by the seller’s customary business practices, published policies or specific statements. The accounting treatment depends on whether or not the licence is ‘distinct’ from other goods or services promised.

When the licence is not distinct from other goods or services to be provided in accordance with the contract, the licence and other goods or services are accounted for together as a single performance obligation. This would be the case, for example, when the licence forms a component of a tangible good and is integral to the good’s functionality (for example, software which requires ongoing maintenance and upgrade services in order for it to continue to operate), or it is a licence that the customer can benefit from only in conjunction with a related service (for example, a software hosting agreement on an internet site).

When the licence is distinct from other promised goods or services in the contract, the licence is a separate performance obligation. Revenue is then recognised either at a point in time, or over time, depending on whether the nature of the seller’s promise in transferring the licence to the customer is to provide that customer with either:

• Access to the seller’s intellectual property as it exists at any given time throughout the licence period (i.e. the seller continues to be involved with its intellectual property); or

• A right to use the seller’s intellectual property as it exists at a point in time the licence is granted.

A seller continues to be involved with its intellectual property by undertaking activities that do not transfer goods or services to the customer, but instead change its intellectual property to which the customer has rights. This applies if all of the following criteria are met:

(i) The contract requires, or the customer reasonably expects that the seller will undertake, activities that significantly affect the intellectual property to which the customer has rights (that is, the intellectual property to which the customer has rights is dynamic).

Factors that may indicate that a customer could reasonably expect that a seller will undertake activities that will significantly affect the intellectual property include: The seller’s customary business practices; Published policies; Specific statements; The existence of a shared economic interest (e.g. a sales-based royalty) between the seller and the customer related to the intellectual property licenced to the customer.

(ii) The rights granted by the licence directly expose the customer to any positive or negative effects of the seller’s activities that affect the intellectual property as and when the seller undertakes those activities.

(iii) The seller’s activities do not transfer a good or a service to the customer as those activities occur (that is, the activities are not accounted for as performance obligations).

When all of the above criteria are met, a seller accounts for the licence as a performance obligation satisfied over time because the customer will simultaneously receive and benefit from the seller’s performance as the performance occurs. An appropriate method is required to measure the seller’s progress toward complete satisfaction of its performance obligation to provide access to the intellectual property.

Sales-based or usage-based royalties/ licence of intellectual property

When the consideration takes the form of a sales-based or usage-based royalty for a licence of intellectual property the seller recognises revenue only when (or as) the later of the following events occurs:

• The subsequent sale or usage occurs; and

• The performance obligation to which some or all of the sales- or usage-based royalty has been allocated has been satisfied (or partially satisfied).

The interaction of this restriction and the requirement to consider stand-alone selling prices when allocating consideration to multiple performance obligations in a contract, can lead to patterns of revenue recognition which differ from amounts stated in contracts.

This arises, for example, in cases where two or more licences over intellectual property that are to be transferred to a customer at different times are included in a single overall contract, and the prices specified in the contract do not reflect the stand-alone selling prices of the licences. The approach required by IFRS 15 is designed to ensure that the timing and profile of revenue recognition is not affected by what might be considered to be artificial price allocations in contracts.

See section on Changes in the transaction price after inception of contract on ‘Allocation of variable consideration’.

Repurchase of goods agreements

A repurchase agreement arises when a seller sells an asset to a customer and is either required, or has an option, to repurchase the asset. The asset itself could be the same one as was originally sold to the customer, one which is substantially the same, or another (larger) asset of which the one which was originally sold is a component.

When a seller has an obligation or right to repurchase the asset, the customer is limited in its ability to direct the use of and obtain substantially all of the remaining benefits from the asset. Therefore the customer does not obtain control of the asset. This means that the seller does not recognise revenue from a sale and instead, depending on the contractual terms, the transaction is accounted for either as a lease or as a financing arrangement.

In determining whether a contract with a repurchase agreement gives rise to a lease or a financing arrangement, the seller compares the repurchase price of the asset with it original selling price, taking into account the effects of the time value of money. When the repurchase price is lower than the original selling price of the asset the agreement is accounted for as lease in accordance with IFRS 16. If the repurchase price is greater than or equal to the original selling price of the asset than the contract gives rise to a financing arrangement; the seller recognises a financial liability for any consideration received from the customer and continues to recognise the asset.

When a seller has an obligation to repurchase the asset at the customer’s request (the customer has a put option) the accounting will depend on the relationship between the repurchase price of the asset and the original selling price of the asset.

When the repurchase price of the asset is lower than the original selling price of the asset, the seller considers whether the customer has a significant economic incentive to exercise its right. If this is the case, the customer does not obtain control of the asset, and the agreement is accounted for as a lease (unless the contract is part of a sale and leaseback transaction, in which case the contract is accounted for as a financing arrangement). If the repurchase price is expected significantly to exceed the market value of the asset at the date of exercise, it is assumed that the customer has a significant economic incentive to exercise the put option (meaning that the customer has not obtained control of the asset).

If the customer does not have a significant economic incentive to exercise its option, the customer obtains control of the asset and seller records a sale of the product with a right of return.

The repurchase price of the asset might be equal to or greater than the original selling price and be more than the expected market value of the asset at the date of exercise of the customer’s put option. In those cases, the customer does not obtain control of the asset and the contract is instead accounted for as giving rise to a financing arrangement.

Consignment goods arrangements

A seller may deliver a product to another party, such as a dealer or retailer, for sale to end customers. In these circumstances, the seller is required to assess whether the other party has obtained control of the product. If the other party has not obtained control, the product may be held in a consignment arrangement. A seller does not recognise revenue on delivery of a product to another party which is held on consignment.

The following indicates the existence of a consignment arrangement:

• The product is controlled by the seller until a specified event occurs (e.g. sale of the product to a customer of the dealer or retailer, or until a specified period expires);

• The seller is able to require the return of the product or transfer the product to a third party (e.g. transfer to another dealer or retailer); and

• The dealer or retailer does not have an unconditional obligation to pay for the product. However, there might be a requirement for a deposit to be paid.

Bill-and-hold of goods arrangements

Bill-and-hold arrangements involve the seller invoicing a customer for a product but, instead of delivering it to the customer, the seller retains physical possession with the product being shipped or delivered to the customer at a later date. A customer might request this type of arrangement if, for example, it does not have sufficient space of its own to accommodate the product. The effect is that in addition to selling the product, the seller provides a custodial service.

In determining the point at which it is appropriate to recognise revenue from a sale of the product, the seller applies the same control criteria as for any other sale (or performance obligation) to be recognised at a point in time. In addition, all of the following criteria are required to be met:

• The reason for the bill and hold arrangement must be substantive (for example, the arrangement might be requested by the customer because of a lack of physical space to store the goods);

• The product must be identified separately as belonging to the customer (that is, it cannot be used by the supplier to satisfy other orders);

• The product must currently be ready for physical transfer to the customer; and

• The seller cannot have the ability to use the product, or to direct it to another customer.

When a seller recognises revenue for the sale of an asset on a bill-and-hold basis, it is also required to consider whether there are any remaining performance obligations (e.g. for custodial services) to which a portion of the transaction price needs to be allocated.

Customer acceptance

If a customer accepts an asset, this may indicate that control over the asset has passed to the customer. However, contractual arrangements typically include clauses which enable the customer to require the seller to take action if the asset does not meet its contractually agreed upon specifications, and might allow the customer to cancel the contract.

If a seller can demonstrate that an asset that has been transferred to a customer meets the contractually agreed upon specifications, then customer acceptance is considered to be a formality that is not taken into account when determining whether control over the asset has passed to the customer. This might apply if the sale is subject to an asset meeting certain size and weight specifications; the seller would be able to confirm whether these had been met. However, if revenue is recognised in advance of receiving customer acceptance, the seller is required to consider whether there are any other performance obligations that have not yet been fulfilled.

If the seller is not able to determine that the asset that has been transferred to the customer meets the contractually agreed upon specifications, then control over the asset does not transfer to the customer until the seller has received the customer’s acceptance. In addition, if products or services are delivered to a customer for trial purposes, and the customer has no commitment to pay any consideration until the trial period has ended, control of the asset does not pass to the customer until the earlier of the point at which the customer accepts the asset or the trial period ends.

Dee Singh Kothari is a senior partner in Kothari Partners Ideas expressed and/ or methodologies in this article are solely of the authors. The author nor Kothari Partner’s accept any liability for the incorrect application of these ideas either used by companies, employees or other individuals alike.

At Kothari Partners, we have worked with various UK and overseas listed and PE/ VC backed clients across various industries to consider how their business and finance services can bring them both cost reductions and performance improvement. Our approach is to help our clients understand their current situation, identify the value and decide on the scope, vision and set of strategies for what they could achieve for their business. We help plan their implementation and support them and deliver the solution/ change needed, so it is properly and permanently embedded in their organisation. We aim to help past and future clients by delivering high-quality work to their organisation, generate real efficiencies and free up time to support better business decisions. For a confidential discussion please free to contact us, via our corporate website: https://www.KothariPartners.com