Power of discretion in customer contract accounting according to IFRS 15 and its impact on the reliability of managerial ratios and entity classification

2.1 The five-step model

As mentioned above, IFRS 15 includes the following general five-step model for recognising nearly all kinds of revenue from customers:

(1) Identifying the contract(s) with a customer

(2) Identifying performance obligations in the contract

(3) Determining the transaction price

(4) Allocation the transaction price to the performance obligations in the contract

(5) Recognition of the revenues when (or as) the entity satisfies performance obligation

These five steps are further described in the following sections.

2.2 Identifying the contract(s) with a customer

This step contains two elements: first the assessment if a contract exists in general, and second the delineation of the contracts. According to IFRS 15.9 a contract covered by this standard exists only when all of the following criteria are met:

1. the parties have approved the contract (independent of the form of approvement),

2. the entity can identify each party’s rights regarding the goods or services to be transferred,

3. the entity can identify the payment terms for the goods or services to be transferred,

4. the contract has commercial substance (i.e. the contract has effects on the risk, the timing or the amount of the entity’s future cash flows) and

5. 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.7 Therefore the entity shall consider only the customer’s ability and intention to pay that amount when it is due.

In general, all of these criteria must be met if revenue is to be recognised. If the entity receives cash or cash equivalents before that point in time, the receipts have to be deferred. The deferred income is recognised as revenue if the entity fulfills its corresponding obligations in transferring goods or services and the consideration received from the customer is non-refundable, or the contract has been terminated and the consideration received from the customer is non-refundable.8 Furthermore, revenue from contracts with customers are recognised if the criteria of IFRS 15.9 are fulfilled after the date of contract inception.9

If the criteria of IFRS 15.9 were met at the date of contract inception, a reassessment of these criteria does not take place unless there is an indication of a significant change in facts and circumstances.10 For example, if the customer’s ability to pay the consideration significantly deteriorates and the criterion of IFRS 15.9 e) is thereby not met any more, no further revenues from this contract have to be recognised and the entity tests the existing receivable for any asset impairment in accordance with IFRS 9.11

In addition, at this stage of the model of recognising revenue, it has to be assessed if two or more contracts with the same customer shall be accounted for as a single contract or as separate contracts when they are entered into at the same, or nearly the same, time. For this assessment, the criteria listed in IFRS 15.17, which in substance reflect the commercial dependence of these contracts, are used.12 Contracts entered into at, or nearly at the same, time with the same customer shall be combined if at least one of the following criteria is met:

• the contracts are negotiated as a package with a single commercial objective,

• the amount of consideration to be paid in one contract depends on the price or performance of the other contract, or

• the goods and services promised in the different contracts are one single performance obligation in accordance with IFRS 15.22–15.30.13

For example, a building contractor enters into two contracts with the same customer at, or nearly at the same, time: The first contract is about the construction of an office building with a modern building automation system and includes a variable consideration in dependence of reaching energy consumption saving targets for a period of 5 years after completion of the office building. The second contract is a facility management contract about the control and optimisation of the energy consumption of this office building. The second contract is for the same period of time as the first contract. As the amount of the variable consideration for the office building depends on the quality of the services provided in the facility management contract over a 5-year period after completion of the office building, the criterion of IFRS 15.17 b) for combining these two contracts is fulfilled, and the contracts are accounted for together as a single contract.

2.3 Identifying performance obligations in the contract

At this stage, on contract inception an entity has to assess the goods or services14 promised in a contract with a customer and shall identify the performance obligations included in this contract. Independent performance obligations exist if a product (or a bundle of products) in this contract is distinct or if a series of distinct products that are substantially the same and have the same pattern of transfer to the customer (e.g. the cleaning services in a defined regular cycle included in a one-year cleaning contract) is promised in the contract.15 The products promised to the customer are distinct when they meet the following two criteria, namely that the products must be capable of being distinct and that the products are also distinct, in the specific context of the contract.16 The first criterion is met if the customer can benefit from a product on its own or together with other resources that are readily available to the customer. An indication of this is that the entity regularly sells a product on its own or with other readily available resources.17 Complex business transactions in particular involve difficulties in regard to determining if the criterion of distinction in the context of the contract is fulfilled. IFRS 15.29 provides a list of (exemplary) factors which satisfy the criterion of distinction in the context of the contract:

• no significant service of integrating the product with other products promised in the contract into a bundle of products that represent the combined output for which the customer has contracted,

• the product does not significantly modify or customise another product promised in the contract,

• no high degree of dependence or interrelationship between the products promised in the contract (i.e. the renunciation of purchasing a product in the contract has no influence on the purchase of another product included in this contract.18)

If a promised product is not distinct, an entity shall combine that product until it is identified as a bundle of products that fulfills the distinction criteria.19 Regarding warranties in connection with the sale of products, a distinction has to be made between a warranty required by law, a normal customary business practice in this business line, or a warranty providing additional guarantees. A separate performance obligation is recognised only in the last mentioned case. An indication of this situation is that the warranty can be purchased separately. In contrast, warranties provided by law or are part of a normal customary business practice have to be accounted for as provisions in accordance with IAS 37.20

2.4 Determining the transaction price

The transaction price is defined as the amount of consideration to which an entity expects to be entitled in exchange for transferring promised products to a customer.21 The transaction price includes variable considerations and also estimated amounts. Depending on the contractual arrangements and the experiences of similar contracts, the amount of variable consideration shall be estimated either by the expected value or by the most likely amount.22 If the contractual provision of a construction contract includes a bonus payment for the punctual completion of a construction contract, the entity has to assess if it is probable to keep the deadline in the contract. In this case the most likely amount may be an appropriate estimation of the variable consideration, i.e. the amount of the bonus has to be included completely in the transaction price.23 In contrast, the expected value (i.e. the sum of the probability-weighted amounts) is a better appraisal for the amount of variable consideration if premiums are agreed in terms of the number of days of premature completion of a construction contract. In this case the entity weighs the alternative premiums (that correspond to the different number of days of premature completion) against the estimated probability of being entitled to receiving the different premiums and adds these to the expected value.

Furthermore, in determining the transaction price it has to be assessed if there is a significant financing component included in the contract which has to be eliminated from the transaction price. The transaction price represents the cash selling price for transferring the products promised when the transfer takes place.24 The existence of an explicit contractual arrangement is irrelevant for the elimination of a significant financing component.25 Despite this, IFRS 15.62–63 contain some exceptions to the elimination of a financing component. Most important is the practical expedient mentioned in IFRS 15.63. According to this, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised product to a customer and when the customer pays for that product will be one year or less.

2.5 Allocating the transaction price to the performance obligations in the contract

After determining the transaction price, the entity shall allocate the transaction price to each performance obligation identified in the contract on a relative stand-alone selling price basis.26 The best evidence of a stand-alone selling price is the observable price of a product when the entity sells that product separately in similar circumstances and to similar customers.27 If the entity does not offer products included in the multi-component contract separately, the entity shall estimate the stand-alone selling price and consider all information reasonably available to it.28 Without specifying any order of preference, IFRS 15.79 lists the following methods as suitable for assessing the stand-alone selling price:

• adjusted market assessment approach: estimation of the stand-alone selling price by referring to prices from the entity’s competitors for similar products and adjusting those prices as necessary to reflect the entity’s costs and margins.

• expected cost plus a margin approach or

• residual approach: estimation of the stand-alone selling price by reference to the total transaction price less the sum of the observable stand-alone prices of other products promised in the contract. This retrograde determination of the transaction price of a product with a stand-alone selling price not directly observable is only allowed if the entity either sells the product for a broad range of amounts or the entity has not yet established a price for the product and the product has not previously been sold on a stand-alone basis (e.g. a new product).

If the bundle of products included in a multi-product contract is sold at a lower price than the sum of the stand-alone prices of those promised products, the discount shall in general be allocated proportionately to all performance obligations.29 If the entity has observable evidence that the entire discount relates only to one or more, but not all, performance obligations, the entity shall allocate this discount only to these performance obligations. This also applies for variable considerations of the transaction price.30

2.6 Recognising revenue by satisfying the performance obligations

Depending on the manner of satisfying the performance obligation, IFRS 15 distinguishes between performance obligations satisfied at a point in time and performance obligations satisfied over time. At first, the criteria that apply to performance obligations satisfied over time have to be assessed because otherwise the performance obligations are those that are satisfied at a point in time.31 Performance obligations and revenues are recognised over time if one of the following criteria mentioned in IFRS 15.35 is met:

• the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (e.g. routine or recurring services, such as cleaning service32),

• the entity’s performance creates or enhances an asset which is already under control of the customer (e.g. construction of a building on the customer’s land33), or

• 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 (e.g. consulting service). With regard to the alternative use of an asset to the entity, both contractual restrictions and practical limitations have to be taken in account.34 The right to receive payment for performance completed to date includes not only recovery of the cost but also either a proportion of the expected profit margin in the contract or a reasonable return on the entity’s cost of capital for similar contracts.35

If one of the criteria of IFRS 15.35 is met and the entity furthermore can reasonably measure its progress in satisfying the performance obligation,36 according to IFRS 15.39, the entity shall recognise revenue over time according to the progress of satisfying the performance obligation towards complete satisfaction of that performance obligation. Appropriate methods to measure the progress include output (e.g. determination of the progress by external experts) and input (based) methods (e.g. recognising revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation, like a cost-based input method).37 An entity shall apply a single method of measuring progress consistently to similar performance obligations and in similar circumstances.38 When applying a method for measuring progress, an entity shall exclude from the measure of progress any products for which the entity does not transfer control to the customer. This is the case if the entity procures goods from a third party and is not significantly involved in designing and manufacturing the goods (“uninstalled materials”39).40 At least,at the end of a reporting period, the entity shall update its measure of progress to reflect any changes in the outcome of the performance obligations and account for the change in estimations in accordance with IAS 8.32–8.40 (i.e. immediate recognition in profit or loss).41

If a reliable estimation of the outcome of a performance obligation is not possible (e.g. missing information for using a suitable method of measuring the progress of satisfying the performance obligation, or in the early stages of a contract), the recognition of revenues has to be limited to the extent of the costs incurred which the entity expects to recover.42 If, at a later point in time, the entity can reliably measure the progress of the performance obligation, it has to start to recognise and measure the revenue over time according to the progress of satisfying the performance obligation towards complete satisfaction.

If a performance obligation is satisfied at a point in time (i.e. no criterion of IFRS 15.35 is fulfilled) the entity recognises the revenues at the date when the control of the products promised in the contract is transferred to the customer.43 In order to determine the point in time, the entity considers especially (not limited to the following factors) the indicators listed in IFRS 15.38 a)–e):

• date of obtaining the present right to receive payment for the asset or service transferred to the customer,

• date of transferring the legal title of the asset to the customer,

• date of transferring the physical possession of the asset to the customer,

• date of transferring the significant risks and rewards linked to the ownership of the asset to the customer, or

• date of the customer’s acceptance of the asset.

3.1 Overview

At all stages of the 5-step model of recognising revenue, according to IFRS 15 there are discretionary powers, of which the most significant ones are listed in the following schedule:

3.2 Estimate of the variable consideration of the transaction price

As variable considerations are a component of the transaction price, the most important discretionary powers at the third stage of the model of recognising revenue are linked to the estimate of the variable considerations. These discretionary powers exist in the application of both the expected value and the most likely amount. Variable considerations and therewith linked discretionary potentials are especially notable in the following cases:

• variable considerations if the contract parties agree on premium or penalty payments for premature or delayed satisfaction of the performance obligations;44

• estimating the implicit price concessions, the entity will accept because the transaction price includes only the expected consideration less an implicit price concession;45

• adjustment of the revenues by the amount of the expected returned goods for which the entity grants the customer the right of return. Especially in the case of new products and missing historical experience, the entity has quite a huge discretionary potential. In rare cases, if the entity cannot make any reliable estimation of the returns or significant returns are highly probable, the entity defers the recognition of the revenues until the date when the uncertainty associated with this kind of variable consideration is subsequently resolved.46

3.3 Allocation of transaction price to the performance obligations of a multi-product contract in the case of new products

The general rule to allocate a discount proportionately to all performance obligations included in a contract is qualified by various exceptions47 which grant the entities under IFRS 15 quite a remarkable discretionary potential in the allocation of the transaction price to the single performance obligations. Furthermore, the discretionary potential is even increased if the stand-alone selling prices of new products can be estimated by using the residual approach. Moreover, the delineation of new products can be interpreted in different ways. For example, as construction contracts are always customer-specific, the performance obligations under these contracts are normally unique and therefore stand-alone selling prices are not directly observable. This implies that the entity has a broad range for estimating the stand-alone selling price. However, also the adjusted market assessment approach, which could be assumed to be more objective than the alternative methods, also includes some power of discretions as the prices of competitors for similar products are adjusted by the cost or margin situation of the entity according to this method.48 Despite this, under IFRS 15.126 c) the entity has to disclose in the notes details regarding the allocation of the transaction prices, including estimating the stand-alone selling prices or allocating discounts and variable considerations to the performance obligations.

3.4 Recognising revenue from satisfying performance obligations at a point in time or over time

As already mentioned in section 2.5, the decision to recognise revenue from satisfying performance obligations at a point in time or over time is based on the criteria listed in IFRS 15.35. Especially the criterion mentioned in IFRS 15.35 c) includes quite a notable discretionary potential. According to IFRS 15.35 c), one requirement for recognising revenue over time is that the entity’s performance does not create an asset with an alternative use to the entity. In this context not only technical or practical limitations but also contractual restrictions could exclude an alternative use.49 This condition could be easily fulfilled by a contractual exclusion of an alternative use of the promised asset. Provided that the entity also has an enforceable right to payment for performance completed to date, the entity shall recognise revenue over time from such a contract from satisfying performance obligations even without the acceptance of the work in progress by the customer. If the entity has an enforceable right to payment for performance completed to date and the alternative use is not excluded by contract, the entity has to review if practical limitations of an alternative use of the asset exist. Practical limitations could result from technical or economical reasons. Especially economical reasons that could exclude an alternative use of the asset hold a noteable discretionary potential.50 IFRS 15.123 a) acknowledges the discretionary potential related to the criteria of deciding whether to recognise revenue at a point in time or over time because in the notes the entity has to explain the judgements used in determining the timing of satisfaction of performance obligations.

3.5 Output and input methods for measuring the progress of performance obligations satisfied over time

Just as the replaced IAS 11, under IFRS 15, output and input methods are allowed to measure the progress if performance obligations are satisfied over time. Furthermore, even IFRS 15.124 b) prescribes presenting an explanation to why the methods used provide a faithful depiction of the transfer of products, from which no serious limitations of the various methods51 that generally are suitable for measuring the progress will result.52 In addition, the discretionary potential of IAS 11 regarding the reliable measurement of the progress of satisfying performance obligations remains unchanged;53 this also includes the assumption that an entity may not be able to measure the outcome of a performance obligation reliably in the early stages of the contract.54 This means that the entity has considerable opportunities to control the recognition of revenues and also the profits. If the entity claims in earlier stages of a contract that it cannot reliably measure its progress towards complete satisfaction of the performance obligation, the amount of recognised revenues is limited to the incurred costs. Conversely, in the reporting period, in which the entity assesses that a reliable measurement of the progress of satisfying the performance obligation is possible, the entity does not only recognise the revenues attributable to this reporting period but also the cumulative differences of revenues attributable to the previous reporting periods according to the applied output or input method used in order to measure the progress and the recorded cumulative revenues until the beginning of this reporting period (i.e. catch-up effect on revenues). Moreover, in the case of a lack of reliable information that would be required to apply an appropriate method of measuring progress, IFRS 15.44 sent. 2 does not allow the recognition of revenue depending on the progress of satisfying performance obligations. The otherwise normally existing obligation to use the best available information under IFRS,55 eventually by using estimations, is missing. Therefore an entity can defer the recognition of revenues and also of profits by claiming not to have sufficiently reliable information.

As already mentioned in section 2.5, in measuring the progress of satisfying the performance obligation, the uninstalled materials by which the customer obtains control directly from a third party (not from the entity) have to eliminated. Conversely, if the entity is responsible not only for the procurement, but also for the installation and integration of the goods delivered by a third party then these goods are not classified as uninstalled materials. As the entity transfers the control over these integrated goods to the customer, the entity recognises the revenues and also profits of these goods. Especially in the case of minor adjustments to integrate the goods delivered from third parties, the entity has considerable discretionary power to measure the progress, including the goods delivered by the third party but integrated by the entity, or excluding these goods as uninstalled materials.

Compare the similar example in IFRS 15. IE 95–100.

Example:56

During the financial year 01, the entity is contracted to do the renovation of the interior of a building, including the installation of a building automation system. The transaction price is 60 Mio. CU. The contract includes the delivery of the elevators, which are purchased from a third party at a price of 15 Mio. CU. The entity calculates the total expected costs (including the costs for the elevators) at an amount of 45 Mio. CU. Some minor adjustments performed by the entity are necessary to integrate the delivered elevators in the building automation system provided by the entity. At the end of the financial year 01, 30 Mio. CU including the costs of the elevators have been incurred. Normally the progress in satisfying the performance obligation increases with the costs incurred. The entity has two alternative choices depending on the classification of the elevators delivered from a third party:

a) Classification of the delivered elevators as uninstalled materials

In this case the transaction price (excluding the elevators) is 45 Mio. CU. At the end of the financial year 01, the costs incurred by the entity amounted to 15 Mio. CU (excluding the elevators). As the total costs of the contract (excluding the elevators) amount to 30 Mio. CU, the entity has satisfied 50% of its performance obligation. Therefore, for the financial year 01, the entity recognises revenues of 22,5 Mio. CU and realises a profit of 7,5 Mio. CU. (The costs of the elevators can be disclosed as an item in transit).

b) Assessment of the integration work of the elevators as part of the performance obligation of the entity (no “uninstalled materials”)

In this case the transaction price is 60 Mio. CU. At the end of the financial year 01, the costs incurred by the entity amount to 30 Mio. CU. As the total costs of the contract amount to 45 Mio. CU, the entity has satisfied 66,67 % of its performance obligation. Therefore, for the financial year 01, the entity recognises revenues of 40 Mio. CU and realises a profit of 10 Mio. CU.

According to IFRS 15.124 a), an entity shall disclose for its performance obligations satisfied over time the methods used to recognise revenue and how those methods are applied. Especially if the classification of uninstalled materials might be doubtful (as in the example above), the entity should disclose this fact and the criteria used for distinguishing uninstalled materials because both information are relevant for explaining the application of the methods used for recognising revenue.

3.6 Determining the point in time for recognising revenue

Notwithstanding the supposed unambiguity of the point in time at which the recognition of revenues shall take place, this point in time is sometimes not as clearly defined as it seems. This is a direct consequence of the several indicators57 that should be used in order to determine the point in time for recognising revenue of performance obligations that are satisfied at a point in time. For example, according to the indicators mentioned in IFRS 15.38 the point in time for recognising revenue from the sale of a building could be

• point in time at which the acceptance of the building takes place (IFRS 15.38 e),

• point in time at which the benefits, encumbrances and risks associated with the building pass to the customer (IFRS 15.38 d),

• point in time at which the legal ownership passes over to the customer (regularly with the entry in the land register; see IFRS 15.38 b), or

• point in time at which the entity is entitled to receive the payment for the building (IFRS 15.38 a).

If the above-mentioned and alternative points in time are in different financial years, the entity has the possibility to recognise the revenue from the sale of the building in a previous year or to defer the revenue recognition to a following year. IFRS 15.125 acknowledges the discretionary potential of choosing one single point in time for recognising revenue explicitly. According to this rule, the entity shall disclose for performance obligations satisfied at a point in time and significant judgements made in evaluating when a customer obtains control of promised goods or services.