IFRS 15 – The 5-step model

In our 2-part post, we intend to summarize the main features of the new revenue standard, by which we would like to assist companies keeping their books in, and/or reporting according to, IFRS in the application of the new standard.

In May 2014, the IASB released the new standard regulating the accounting for contracts with customers. Leases, insurance contracts and financial instruments are excluded from the scope of the standard. The new standard is the outcome of a joint effort with the US regulatory body, the FASB.

The new standard provides a high quality, comprehensive framework for accounting for revenues and replaces IAS 11 and IAS 18 and the interpretations issued thereto (IFRIC 13, 15, 18 and SIC 31)

IFRS 15 is the result of a long project stretching for several years. The Discussion Paper in this topic was released for commenting in 2008, which was followed by the issue of the Exposure Draft in 2010 and the revised Exposure Draft in 2011.

The draft standards caused serious concerns with market participants and a number of critical feedbacks were shared with the IASB. For example, the major European telecom service providers expressed their concerns about the planned regulation in several rounds as it was obvious that the standard in the works (just as well as any new standards) was not quite tailored to companies with tens of millions of customers (or assets in case of other standards).

Companies listed in the EU’s markets have had to apply IFRS since 2005, before which date they prepared their financial statements according to the national accounting standards on their local markets. Nevertheless, the most significant EU listed companies were also listed on US markets where they also had to present their results and equity according to US GAAP, which – at least on a US GAAP basis – allowed comparability between these companies’ results and revenues. Consequently, when these companies listed on EU markets had to define IFRS accounting policies for the preparation of their 2005 (consolidated) financial statements, they adjusted their US GAAP policies applied for many years as little as possible in order to avoid the parallel application of 3 varying standards (national, IFRS, US GAAP). This, however, resulted in many companies applying revenue recognition practices stretching the limits of IFRS to the extremes, which the IASB now escorts back to the frames of IFRS.

What are the most significant changes compared to the preceding rules?

Accounting reflecting transfer of risks and rewards is replaced by accounting reflecting transfer of control
Due to the above major change in principle (control), the agent vs. principal issue will presumably result in net revenue recognition more often. Even though the agent may bear some significant risks, the control of the goods sold rarely passes through the agent. The restructuring of the agent’s business model however may help avoid this adverse change of accounting.
In case of multiple element arrangements, the basis for the allocation of revenue will be the standalone selling price replacing fair value applied generally in the past. In addition, allocation using the residual method will significantly be limited.
As for uncertain expected revenue, IAS 18 prohibited the recognition of revenue in some cases, while according to IFRS 15 uncertainty will only limit the amount of revenue that can be recognized and is not prohibited.
IFRS 15 explicitly regulates the revenue recognition issues in case of contract modifications, while IAS 18 and IAS 11 provided limited guidance for such cases.
Recognizing the incremental costs of obtaining a contract (e.g. agent commissions) as an asset is explicitly regulated in IFRS 15, while so far it was only IAS 38 that included limited framework for the recognition of such assets.
And as usual in case of new standards, IFRS 15 requires a lot more numeric and descriptive disclosures about the recognition of revenues in the notes to the financial statements

The 5-step model

As its main feature, IFRS 15 introduces a comprehensive 5-step model for the correct measurement and recognition of revenues which the entity has to apply as a template for each of its customer contracts. And it is exactly the individual approach that is painful for companies with millions of customers (such as the utility type service providers). These 5 steps are following:

Identify the contract
Identify the performance obligations
Determine the total transaction price
Allocate the transaction price to the performance obligations
Recognize revenue when/as the performance obligation is satisfied

To be honest, this 5-step model should not be surprising to accounting experts responsible for the determination of revenue recognition as regulations in place to date also required similar approach from responsible accountants. We’ve known quite long now from IFRS that it is the economic substance of the contract that has to be considered rather than its text worded with the active assistance of legal experts and the invoicing following the text of the contract. Consequently, this new guidance in fact only reminds us of our tasks also obvious from the principles of IFRS.

Let’s see the main features of the 5-step model.

Identifying the contract with our customer

At this point, the standard in fact guides us to legal grounds as it requires that an agreement can only be considered a contract resulting in accounting consequences if it has been approved by the contracting parties and the parties’ rights and obligations can be identified. In addition, the contract has to have commercial substance and it has to be probable that the transaction price will be collectible. This – with the exception of the retail businesses – pretty much requires a written form. The standard, however, also provides guidance for the retail businesses whereby in absence of a written contract the entity can still recognize revenue if the company has no further obligation with respect to the good or service handed over and (virtually) the total transaction price has been collected and it is not refundable.

At this stage, the standard also reminds us that we may have to treat several agreements as one contract if those agreements were negotiated at the same time, or an amount payable defined in one contract depends on any element included in another contract, or if deliverables defined in several agreements have to be considered as one performance obligation. IFRS 15 in this respect also provides us with significantly clearer guidance than the previous standards.

Identifying the performance obligations

As a result of the previous step we proceed with one single contract or a combined contract, and now we have to determine how many separable performance obligations are included in the contract.

A commitment in the contract has to be considered a separate performance obligation if the customer can enjoy the benefits provided by the good or service delivered on its own or with the use of other goods or services available on the market, and the good or service delivered is not significantly dependent on other obligations determined in the contract. And this is where the standard explicitly requires the entity to analyze whether it has to slice its contract into elements, the future of which will be determined by the coming steps of the model. You surely guess that certain values will have to be allocated to these elements and the recognition periods be different for the elements, and this is the real meaning of listing the obligations.

At the same time, we also have to carefully assess the importance and significance of the integration of the deliverables. The customer contracting a vendor for a complex (construction or development) project in most cases could also issue a tender for each project phase and contract a vendor for each, but due to the administrative burden and the time it would require, the customer presumably highly appreciates the integration the vendor chosen for the delivery of the whole project also delivers.

Even though there may be easily separable performance obligations (phases) in the contract, in such cases the vendor often has to consider the whole contract as one performance obligation.

Another interesting aspect is whether a guarantee obligation attached to a good or service delivered should be considered as a separate performance obligation falling due sometime in the future, or whether it is just an “ordinary” liability to provide for.

Compared to the previous standards, IFRS 15 provides significantly more precise guidance how to identify the deliverable elements or components, thereby performances treated in the past as one deliverable may have to be separated, or the other way round.

Determining the transaction price

The transaction price we have to calculate with is the amount that the vendor is entitled to in return for the good or service delivered. When calculating it, we have to assume the orderly performance of the customer, i.e. we do not assume the early termination, renewal or modification of the contract.

The transaction price calculated for revenue recognition obviously does not include amounts collected on others’ behalf such as VAT or amounts flowing through our company as an agent.

The characteristics, timing and amount of the contractual price obviously influence the transaction price, for which we also have to consider whether there are any potential variable consideration or hidden (significant) financing component in the contract. We may also have similar calculating tasks if the transaction price is non-cash, or when we as a vendor also pay certain amounts to our customer for some real or assumed service, in which case we may have to treat our agreements as one contract.

In case of variable consideration IAS 18 in fact did not allow the recognition of revenue until the level of uncertainty decreased to a manageable level, while IFRS 15 allows the recognition of revenue even in case of significant uncertainty, however, the amount recognized as revenue can not exceed a level that ensures that it is highly unlikely that future changes would result in a significant reversal of revenue already recognized.

In case of payment terms significantly exceeding market terms we can assume a financing component in the contract, nevertheless, the new regulation only requires the separate treatment of this component in case the payment term exceeds 12 months. This is defined significantly better than in the old regulation where it was up to the entities (and their auditors) to decide when they considered a receivable or payable a financial instrument purely due to the longer than market payment terms.

In case of non-cash consideration it is the fair value of the consideration that needs to be applied, meaning no change to the regulation so far.

Assessment of the amounts payable to customers remains to be a subjective issue as amounts paid to a retailer customer for placing our products in well visible places, or sales commissions paid to retailer/wholesale customers need to be judged whether these should decrease our revenue or whether these are amounts paid for services resulting in accounting them as costs.

The second half of our post will talk about the allocation of the transaction price, recognition of the revenue and the accounting treatment of costs related to contracts. In the meantime, please do not hesitate to contact us if you have any questions about the topics discussed so far.