Understanding IFRS 15/IND AS 115: Revenue from Contracts with Customers

When we analyse performance of any business entity one of the most important indicator is  “Revenue”. This will indicate desirability of the product or services an entity is providing.  One should note that during the course of the business whatever income derived by the entity may not be revenue. It is subset of income and is derived from the ordinary activity of an entity.

Identifying what is revenue and specifying how and when to measure and report is very much critical. IFRS-15/IND AS 115: Revenue from Contract with Customer(“the Standard”) provides a comprehensive, industry-neutral model for recognizing revenue from contracts with customers.

Income is defined in IFRS 15 as” increase in economics benefits during the accounting period in the form of inflows or enhancement of assets or decrease of liabilities that result in an increase in equity, other than those relating to contributions from equity participants.” This definition includes both ‘revenue’ and ‘gains’.

IFRS 15 defines revenue as “income that arises in the course of the ordinary activities of an entity”

The standard provides the principles an entity must apply to measure and recognise revenue and the related cash flow. The core principles the standard provides is that an entity recognise revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for transferring goods or service to a customer. The principles in IFRS 15 are applied using the following 5 steps model:

1.       Identify the contract with a customer

2.       Identify the performance obligations in the contract.

3.       Determine the transaction price

4.       Allocate the transaction price to the performance obligations in the contract.

5.       Recognise revenue when (or as) the entity satisfies a performance obligation.

While applying the principles in the standard entities may have to apply judgment when considering the terms of the contract and all of the facts and circumstances,, including implied contract terms.

Let’s go little details through the process of revenue recognition.

Step 1: Identify the Contract(s) with a Customer

1. 1 Definition of a Contract

• Contract: An agreement between two or more parties that creates enforceable rights and obligations.
• Contracts can be written, oral, or implied by customary business practices.

1.2. Criteria for Identifying a Contract

A contract with a customer must meet the following criteria:

• Approval and Commitment: The parties to the contract have approved the contract and are committed to performing their respective obligations.
• Identification of Rights: Each party’s rights regarding the goods or services to be transferred can be identified.
• Payment Terms: The payment terms for the goods or services to be transferred can be identified.
• Commercial Substance: The contract has commercial substance, meaning the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract.
• Collectability: It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. The assessment of collectability is based on the customer’s ability and intention to pay the amount of consideration when it is due.

1.3. Combining Contracts

An entity should combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) if one or more of the following criteria are met:

• Negotiated as a Package: The contracts are negotiated as a package with a single commercial objective.
• Interdependence: The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
• Single Performance Obligation: The goods or services promised in the contracts (or some of the goods or services promised in each of the contracts) represent a single performance obligation.

1.4. Contract Modifications

• Definition: A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties to the contract.
• Types of Modifications: Separate Contract: If the modification results in the addition of distinct goods or services at their standalone selling prices, the modification is treated as a separate contract. Prospective Modification: If the remaining goods or services are distinct from those transferred on or before the date of the contract modification, the modification is accounted for prospectively as a termination of the existing contract and the creation of a new contract. Cumulative Catch-Up Adjustment: If the remaining goods or services are not distinct and form part of a single performance obligation that is partially satisfied, the entity should account for the modification by updating the transaction price and the measure of progress to reflect the remaining performance obligation. This results in a cumulative catch-up adjustment to revenue at the date of the modification.

1.5. Practical Considerations

• Assessing Contracts: Review all contracts with customers to ensure they meet the criteria for recognition under IFRS 15/IND AS 115
• Documentation: Maintain thorough documentation of the terms of the contract, the approval process, and the entity’s assessment of collectability.
• Combining Contracts and Modifications: Carefully evaluate the need to combine contracts or account for modifications, ensuring compliance with IFRS 15 criteria.

Step 2: Identify the Performance Obligations in the Contract

2.1. Definition of a Performance Obligation

• A performance obligation is a promise in a contract to transfer a good or service to the customer.
• Performance obligations can be explicitly stated in the contract or can be implied by the entity’s customary business practices.

2.2. Identifying Performance Obligations

• Explicit Promises: Goods or services that are explicitly stated in the contract.
• Implicit Promises: Promises that are implied by the entity's customary business practices, policies, or specific statements if those promises create a valid expectation of the customer that the entity will transfer a good or service.

2.3. Criteria for Distinct Performance Obligations

A good or service is distinct if both of the following criteria are met:

• Capable of Being Distinct: The customer can benefit from the good or service either on its own or together with other readily available resources.
• Distinct Within the Context of the Contract: The promise to transfer the good or service is separately identifiable from other promises in the contract.

2.4. Assessing if Goods or Services are Distinct

• Customer Benefits: Determine if the customer can benefit from the good or service on its own or with other resources that are readily available.
• Separately Identifiable: Evaluate if the good or service is distinct within the context of the contract. Factors to consider include: The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract. The good or service does not significantly modify or customize another good or service promised in the contract. The good or service is not highly dependent on or highly interrelated with other goods or services promised in the contract.

2.5. Series of Distinct Goods or Services

• A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer is treated as a single performance obligation if both of the following criteria are met: Each distinct good or servi ce in the series that the entity promises to transfer represents a performance obligation that is satisfied over time. The same method would be used to measure the entity's progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

2.6. Practical Considerations

• Identifying Distinct Performance Obligations: Review all promises in the contract, including those that are explicit and implicit, to identify all distinct performance obligations.
• Documenting the Assessment: Maintain thorough documentation of the evaluation process used to determine whether goods or services are distinct.
• Complex Contracts: For complex contracts with multiple goods or services, carefully analyze each promise to determine if it is a distinct performance obligation.

Step 3: Determine the Transaction Price

3.1. Definition of Transaction Price

• The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.
• The transaction price excludes amounts collected on behalf of third parties (e.g., sales taxes).

3.2. Components of the Transaction Price

• Fixed Consideration: The base amount specified in the contract.
• Variable Consideration: Includes discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, and other similar items.
• Non-Cash Consideration: Consideration in a form other than cash, measured at fair value.
• Consideration Payable to the Customer: Includes items such as coupons, vouchers, and rebates.

3.3. Estimating Variable Consideration

• Expected Value Method: The sum of probability-weighted amounts in a range of possible consideration amounts. This method is suitable if the entity has a large number of contracts with similar characteristics.
• Most Likely Amount Method: The single most likely amount in a range of possible consideration amounts. This method is suitable if the contract has only two possible outcomes (e.g., a bonus that is either received or not).

3.4. Constraining Estimates of Variable Consideration

• An entity should include variable consideration in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
• Factors to consider when determining whether the constraint applies include: The entity’s experience with similar types of contracts. The length of time before the uncertainty is expected to be resolved. The extent to which the entity’s experience is predictive of the amount of consideration. The number and range of possible outcomes.

3.5. Significant Financing Component

• A contract contains a significant financing component if the timing of payments agreed to by the parties provides either the customer or the entity with a significant benefit of financing the transfer of goods or services.
• The transaction price should reflect the time value of money if the contract includes a significant financing component. Factors to consider include: The difference between the amount of promised consideration and the cash selling price of the promised goods or services. The combined effect of the expected length of time between the transfer of goods or services and the payment date. The prevailing interest rates in the relevant market.

3.6. Non-Cash Consideration

• If a customer promises consideration in a form other than cash, the entity should measure the non-cash consideration (or promise of non-cash consideration) at fair value.
• If the entity cannot reasonably estimate the fair value, it should refer to the standalone selling price of the goods or services promised in exchange for the non-cash consideration.

3.7. Consideration Payable to a Customer

• Any consideration payable to a customer should be accounted for as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service.

3.8. Practical Considerations

• Estimating Transaction Price: Carefully estimate the transaction price, including both fixed and variable considerations, and apply the constraint on variable consideration.
• Assessing Financing Components: Evaluate whether a significant financing component exists and, if so, adjust the transaction price to reflect the time value of money.
• Documenting Assumptions: Maintain thorough documentation of the assumptions and judgments made in determining the transaction price.

 Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

4.1. Overview

• After determining the transaction price (Step 3), the next step is to allocate that transaction price to each performance obligation identified in the contract (Step 2).
• The allocation is based on the relative standalone selling prices of each performance obligation.

4.2. Determining Standalone Selling Prices

• Standalone Selling Price: The price at which an entity would sell a promised good or service separately to a customer.
• Methods to Estimate Standalone Selling Price: Adjusted Market Assessment Approach: Estimate the price that customers in the market would be willing to pay for the goods or services. Expected Cost Plus a Margin Approach: Estimate the expected costs of satisfying a performance obligation and add an appropriate margin. Residual Approach: Use this approach if the standalone selling price is highly variable or uncertain. Subtract the sum of the observable standalone selling prices of other goods or services promised in the contract from the total transaction price.

4.3. Allocating the Transaction Price

• Allocate the transaction price to each performance obligation based on the relative standalone selling price of each performance obligation.
• If the standalone selling price is not directly observable, estimate it using one of the methods described above.

4.4. Allocating Discounts

• Step Allocation: Allocate the discount proportionately to all performance obligations in the contract.
• Specific Allocation: Allocate the discount entirely to one or more specific performance obligations if the criteria for allocation are met: The entity regularly sells each distinct good or service (or each bundle of goods or services) on a standalone basis. The entity regularly sells a bundle of some of those goods or services at a discount to the standalone selling prices of the goods or services in each bundle. The discount attributable to each bundle of goods or services is substantially the same as the discount in the contract and is based on similar circumstances.

4.5. Allocating Variable Consideration

• Allocate variable consideration to specific performance obligations or distinct goods or services if: The terms of the variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service. Allocating the variable amount entirely to the performance obligation or the distinct good or service is consistent with the allocation objective.

4.6. Changes in Transaction Price

• Reallocation: If the transaction price changes after contract inception, reallocate the revised transaction price to the performance obligations in the contract based on the same criteria and methods used at contract inception.

4.7. Practical Considerations

• Accurate Estimations: Ensure that the standalone selling prices are accurately estimated using reliable methods.
• Documentation: Keep thorough documentation of the allocation process, including the rationale for chosen methods and any estimations made.
• Monitor Changes: Continuously monitor for changes in the transaction price and reallocate as necessary.

Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

5.1. Overview

• Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer.
• A good or service is considered transferred when (or as) the customer obtains control of that good or service.

5.2. Methods of Recognizing Revenue

• Over Time: Recognize revenue over time if one of the following criteria is met: The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. 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.
• Point in Time: If a performance obligation is not satisfied over time, recognize revenue at the point in time when the customer obtains control of the good or service.

5.3. Indicators of Transfer of Control

• Right to Payment: The entity has a present right to payment for the asset.
• Legal Title: The customer has legal title to the asset.
• Physical Possession: The customer has physical possession of the asset.
• Risks and Rewards: The customer has assumed the significant risks and rewards of ownership of the asset.
• Customer Acceptance: The customer has accepted the asset.

5.4. Measuring Progress Toward Complete Satisfaction (for Over Time Recognition)

• Output Methods: Recognize revenue based on direct measurements of the value transferred to the customer (e.g., surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed).
• Input Methods: Recognize revenue based on the entity’s efforts or inputs toward satisfying a performance obligation (e.g., resources consumed, labor hours expended, costs incurred, time elapsed, machine hours used) relative to the total expected inputs to satisfy the performance obligation.

5.5. Considerations for Measuring Progress

• The method chosen should faithfully depict the entity’s performance in transferring control of goods or services.
• The entity should apply a single method of measuring progress for each performance obligation consistently over time.
• If circumstances change over time, the entity should update its measure of progress to reflect any changes.

5.6. Practical Considerations

• Consistent Application: Apply the chosen method of measuring progress consistently for similar performance obligations.
• Documentation: Maintain detailed documentation of the method chosen for recognizing revenue and the rationale behind it.
• Review and Adjust: Regularly review the method of recognizing revenue and make adjustments as necessary to reflect changes in circumstances.

 Warranty Costs Under IFRS 15

A warranty is a contractual promise made by a seller or manufacturer to a buyer that a product will meet certain performance and quality standards over a specified period. Warranties provide assurance to the buyer that any defects or issues with the product that arise during the warranty period will be addressed by the seller or manufacturer, typically through repair, replacement, or refund.

1. Types of Warranties

• Assurance-Type Warranty: Provides a guarantee that the product will function as intended and comply with agreed-upon specifications. It covers defects existing at the time of sale.
• Service-Type Warranty: Provides additional services beyond guaranteeing that the product will function as intended, often including maintenance or repair services over a specified period.

2. Evaluating Warranties

• Assurance-Type Warranty: This type of warranty does not represent a separate performance obligation. It is accounted for under IAS 37 "Provisions, Contingent Liabilities and Contingent Assets." The cost of providing this warranty should be accrued as a liability when the related revenue is recognized.
• Service-Type Warranty: This type of warranty represents a separate performance obligation. It is accounted for under IFRS 15. Revenue related to this warranty should be deferred and recognized over the period in which the warranty services are provided.

3. Identifying the Type of Warranty

• Consider the nature of the promises made in the warranty: Assurance-Type: If the warranty simply assures that the product complies with agreed-upon specifications and corrects defects that existed at the time of sale. Service-Type: If the warranty provides additional services beyond assurance, such as maintenance, repairs, or periodic inspections.

4. Accounting for Assurance-Type Warranties

• Recognition: Recognize a liability for the expected costs of fulfilling the warranty obligation.
• Measurement: Estimate the costs based on historical data and other relevant information. The provision should reflect the best estimate of the expenditure required to settle the present obligation at the reporting date.

Journal entry:

·       When the product is sold:

o   Warranty Expenses                                         Dr

To Provision for warranty Expenses         Cr

·       When the warranty claims are made

o   Provision for warranty Expenses               Dr

To Cash/Inventory or Service cost           Cr

5. Accounting for Service-Type Warranties

·        Recognition: Identify the service-type warranty as a separate performance obligation.

·        Allocation of Transaction Price: Allocate a portion of the transaction price to the service-type warranty based on its standalone selling price.

·        Revenue Recognition: Recognize revenue related to the service-type warranty over the period the warranty services are provided.

Journal entry:

·       When the product is sold:

o   Cash/Accounts Receivable                        Dr

To Revenue(for product/service)       Cr

To Deferred Revenue(for warranty)   Cr

·       As the warranty services are provided

o   Deferred Revenue                  Dr

To Revenue                     Cr

 6. Practical Considerations

·        Combination Warranties: Some warranties may have both assurance and service components. Allocate the transaction price between the components based on their relative standalone selling prices.

·        Estimates and Judgments: Use historical data and other relevant information to make reliable estimates of warranty costs and to determine the appropriate standalone selling prices.

·        Disclosure Requirements: Disclose information about warranties, including the nature and terms of the warranties, significant judgments made, and changes in estimates.

 Disclosure Requirements Under IFRS 15

1. General Disclosure Objective

• To provide sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

2. Disaggregation of Revenue

• Entities must disaggregate revenue into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors.
• Categories could include: Type of goods or services (e.g., product lines or specific services). Geographical regions. Market or customer type (e.g., retail, wholesale, government). Contract duration (e.g., short-term, long-term). Timing of revenue recognition (e.g., goods transferred at a point in time, services transferred over time). Sales channels (e.g., direct, indirect).

3. Contract Balances

• Receivables, Contract Assets, and Contract Liabilities: Disclose the opening and closing balances of receivables, contract assets, and contract liabilities. Explain the significant changes in these balances during the reporting period.

4. Performance Obligations

• Nature of Performance Obligations: Describe when the entity typically satisfies its performance obligations (e.g., upon shipment, upon delivery, as services are rendered). Describe significant payment terms (e.g., when payment is due, whether the contract has significant financing components). Describe the nature of goods or services the entity has promised to transfer.
• Transaction Price Allocated to Remaining Performance Obligations: Disclose the aggregate amount of the transaction price allocated to performance obligations that are unsatisfied (or partially unsatisfied) at the end of the reporting period. Provide an explanation of when the entity expects to recognize this amount as revenue. This can be disclosed in quantitative terms using time bands that are most appropriate for the duration of the remaining performance obligations or by using qualitative information.

5. Significant Judgments and Changes in Judgments

• Judgments Made in Applying IFRS 15/INDAS 115: Disclose the judgments, and changes in judgments, made in applying IFRS 15 that significantly affect the determination of the amount and timing of revenue from contracts with customers. These include judgments in determining the timing of satisfaction of performance obligations and the transaction price and the amounts allocated to performance obligations.
• Determining the Timing of Satisfaction of Performance Obligations: Explain the judgments made in determining when performance obligations are satisfied (i.e., over time or at a point in time) and the methods used to recognize revenue for performance obligations satisfied over time.
• Determining the Transaction Price and Amounts Allocated to Performance Obligations: Explain the judgments made in estimating variable consideration and allocating the transaction price, including the estimation methods and inputs used.

6. Assets Recognized from the Costs to Obtain or Fulfil a Contract

• Capitalized Costs: Disclose the closing balances of assets recognized from the costs incurred to obtain or fulfil a contract with a customer.
• Amortization and Impairment: Disclose the amount of amortization recognized in the reporting period. Disclose the amount of any impairment losses recognized in the reporting period.

7. Practical Expedients

• If the entity has elected to use any of the practical expedients available in IFRS 15, disclose: The expedients used. To the extent reasonably possible, a qualitative assessment of the estimated effect of applying the expedient.             

By adhering to the guidelines and principles of IFRS 15, entities can achieve greater consistency and comparability in financial reporting, fostering trust and confidence among investors, analysts, and regulators. This thorough understanding and application of IFRS 15 not only ensures compliance but also promotes a clearer and more reliable presentation of an entity's financial performance and prospects.