IFRS 15 – The 5-step model – part two

Now we continue our analysis of IFRS 15 with the aim to provide an overview of the main features and requirements of the new revenue standard. Now let’s see the remaining steps of the 5-step model.

4. Allocating the transaction price to performance obligations

As a result of the steps completed so far we know how much revenue we have to recognize related to our contract, and we also know what performance obligations we have in return. Now it’s time to allocate the revenue to the performance obligations.

Before IFRS 15, certain entities applied the residual method by which the company had recognized the total transaction price as revenue with the exception of the fair value of the good or service not yet delivered. This is the point where IFRS 15 brings about a significant change in many service providers’ lives as the use of the residual method as an allocation technique will significantly be limited. Instead, the new standard requires the entities to allocate the transaction price to the performance obligations using the standalone selling prices of the performance obligations as a basis for the allocation. Consequently, IFRS 15 also provides better guidance as to the allocation of the discounts compared to IAS 18.

This will result in the earlier recognition of revenue for many companies unless they change their business model, especially in case of the equipment sales of the mobile service providers.

Like in many other countries, it is the common practice of the Hungarian mobile service providers to provide a subsidized or free handset for the customer if they sign up for a loyalty period of 1 or 2 years. Rooting from US GAAP and the national accounting laws, the service providers’ accounting practice was not to allocate more revenue to the equipment sale than the amount included in the invoice for the equipment. This resulted in significant losses at the beginning of the loyalty period and significant profits in the subsequent 1-2 years covered with the loyalty contracts owing to the subscription and airtime fees significantly exceeding the (close to zero) incremental costs. This customer acquisition cost (loss) had become a widely used key performance indicator (KPI) monitored by the management of the mobile service providers, their investors and analysts. The new regulation does not allow this residual method to be used for allocating revenues between the performance obligations. Instead, the standalone selling prices will have to be used as a basis for the allocation, which are observable for mobile equipment from the mobile companies’ own handset list prices or from other alternative sources.

This was the issue for which the major European mobile service providers joined forces to convince the IASB and the FASB that determining the performance obligations in each individual contract (multiple subscription plans * multiple equipment options) as well as the exclusion of the residual method will cause significant additional burden for these companies, and wanted to achieve that the final regulation would include more favorable terms for the mobile companies. The mobile companies’ lobbying efforts ended with fairly limited success, which resulted in major inevitable IT developments to be able to comply with IFRS 15, furthermore, the customer acquisition cost as a KPI has very limited future use.

The standard vaguely mentions the portfolio approach, which somewhat eases the lives of the entities with millions of customer contracts. Entities however can only apply this approach to their portfolio of contracts or performance obligations if the application of the portfolio approach does not provide a significantly different result when compared to the assessment of these contracts or obligations on an individual basis as required by IFRS 15.

In summary, it is a significant change that the basis for allocating revenue among the performance obligations is not the fair value of these elements any more (which could be defined quite subjectively), but it is the standalone selling prices of the individual elements. This would primarily mean the list prices of the entity. In absence of such we can also apply the list prices of competitors. If that is not available either, we can apply a cost plus margin formula. In absence of all the preceding sources, it is the very last option to apply the residual method.

5. Recognizing revenue as/when the performance obligation is completed

As a result of the steps so far we have the revenue allocated to each performance obligation, and our last task is to determine when we have to recognize the revenue. Logically, this is due when we have completed our performance obligation. This can be attached to a performance delivered at a point in time or over time, consequently, the revenue allocated to a performance obligation is recognized in one amount or continuously.

We have mentioned before that the new principle for recognizing revenue is the transfer of the control of a good or service, therefore, the revenue is generally recognized at the transfer of the good or service.

In case the customer continuously uses our service (e.g. utility services), the revenue will be recognized continuously (over time).

If the customer possesses the control continuously in case of a longer project (i.e. it has free access to the tangible or intangible asset during the course of its construction), we have to recognize the revenue over time. In this case the PoC technique known from IAS 11 remains the method to be applied to the measurement of revenue. We can use either our inputs or outputs as a measure for progress, but we have to choose the one that provides a more reliable picture of our performance.

It is a special case when we have control over the project in progress but the outcome of which could not reasonably be sold to any third parties. In this case, if we are legally entitled to the proportionate consideration due for the performance completed so far, our revenue recognition will also be continuous over time even though the control over the outcome of the project is only transferred following its completion.

Even though there’s no dramatic change compared to the previous standards in terms of the timing of the revenue recognition, there will be contracts for which IFRS 15 prescribes the revenue to be recognized in one amount at the time of completion, while there will also be contracts where the PoC method will have to be used for recognizing revenue instead of the point in time recognition applied so far.

Cost of obtaining a contract

The regulation of capitalizing costs incurred for obtaining a contract (e.g. agent fees) has been included in IFRS 15, while the possibility of capitalization in certain cases could be vaguely read from IAS 38. Such a capitalized cost has to be amortized over the term of the contract, but in case the contract term is less than 12 months, we can choose whether to capitalize such costs or to expense them as incurred. Like any other assets in the books, these capitalized costs may also be exposed to impairment depending on the profitability of the related contract.

Contract costs

Costs incurred related to a contract can be matched to the revenues originating from the same contract. Both revenues and costs have to be monitored during the whole term of the contract as it was required by IAS 11 as well. The difference between the planned revenues and the related planned costs will determine whether the contract will be profitable or not. If the contract is expected to generate losses, first we have to recognize impairment for assets, if any, directly related to the completion of the contract (e.g. inventory, PPE). If the costs expected to be incurred even after the impairment exceed the expected revenue from the particular contract, we have to recognize a provision for the total amount of expected losses yet to be incurred from the contract. This provision normally decreases over time gradually as the contract is being fulfilled since actual costs exceeding revenues are being recognized thereby realizing the actual losses gradually. When determining the contract costs we have to apply the same practices as those for own-produced inventory or capital work in progress, meaning we can only take into account incremental and other direct costs.

Contract modification

As the last topic of our introduction to IFRS 15, we would like to highlight the issue of contract modifications.

Even though it may be just a modification of a contract, we have consider a modification as a separate contract if we increase the contracted quantity of the goods or services deliverable with a proportionate increase in the consideration receivable. This modification in fact establishes a new commitment at market price leaving the original performance obligations and their accounting intact.

A contract modification does not constitute a separate contract if:

(1) the contract is amended to include additional distinct goods or services the pricing of which is not market based. In this case we have to re-perform the allocation of the total transaction price, therefore, we have to account for this modification as if it were a termination of the existing contract and the creation of a new (combined) contract. In this case, the revenue not yet recognized in relation to the original contract and the additional revenue created by the modification have to be combined and allocated to the quantities (performance obligations) not yet delivered, i.e. revenues recognized before the modification of the contract remain unchanged (prospective impact).

(2) the contract is modified in relation to a non-distinct uncompleted performance obligation. In this case the modification has to be considered as part of the uncompleted contract. In this case the total revenue of the original contract and the additional revenues created by the modification have to be combined and reallocated to the total of the old and new contractual obligations, which will have an impact on the revenues already recognized (retrospective impact).

 

Obviously, the analysis above can only be an introduction to IFRS 15, but we intended to grab the most important issues in the standard also highlighting the significant changes compared to the regulations IFRS 15 is replacing.

Should you have any questions about the application or implementation of IFRS 15, please contact us and we’ll do our best to help you out.