Through this “Understanding Accounting Standards” series, we hope to simplify and clarify on certain questions or comments which our clients have in regards to the adoption of accounting standards in the preparation of their Company’s financial statements. To kick-off this series of articles, we will discuss further about the new and upcoming standard – IFRS 15 Revenue from Contracts with Customers.
IFRS 15 was published by the International Accounting Standards Board in May 2014. The new standards were introduced to ensure more accurate and comprehensive accounting treatment and disclosures relating to revenue recognition. The development of this new revenue standard took over a decade to complete, due to its comprehensiveness which led to multiple rounds of review by the IASB. Due to the weaknesses and loopholes in the current revenue standards, i.e. IAS 18 Revenue and IAS 11 Construction Contracts, IFRS 15 will be adopted with the aim to supersede these two existing standards in the near future. IFRS 15 is equivalent to MFRS 15 (for Malaysia incorporated companies) and SFRS 115 (for Singapore incorporated companies).
Also, kindly note that the deadline for the adoption of MFRS 15/SFRS 115 is closing in on local companies, as the standards are compulsory to be implemented for all Malaysia and Singapore incorporated companies from the financial year beginning 1 January 2018.
So, what are the changes brought in through IFRS 15? If you have the time to go through the publications issued by IASB and the other large accounting firms, you will notice that there are long and comprehensive commentaries regarding the adoption of IFRS 15 and examples of adoption. In this article, we just want to give you an overview of this new standard. The core principle of revenue recognition in IFRS 15 is based on the following five steps:
Step 1: Identify the contract
Firstly, when determining whether revenue recognition falls under the scope of IFRS 15, you have to determine whether a “contract” exists. Under IFRS 15, a valid contract is required to have all of the following attributes:
- Contract has been approved
- Rights and payment terms can identified
- The contract has commercial substance, i.e. expected to be a change in cashflow arising from the transaction
- It is probable that consideration will be received, i.e. expected that the customer has the intention and ability to pay
Also, if any of the parties to a contract has a right to terminate the contract without any compensation, no contract exists. If the above attributes have been fulfilled, the contract with the customer will fall within the scope of IFRS 15.
In addition to the above, are also other more detailed situations which requires further assessment, i.e. combination of multiple contracts and contract modifications. Due to its complexity, it will not be discussed in this article.
Step 2: Identify the Performance Obligations
Once the contract has been determined, we need to identify the various performance obligations under the contract. Performance obligations are defined as the contractual promise by the seller to transfer to a customer, distinct goods or services, either individually, in a bundle or over a certain period of time.
In the context of IFRS 15, distinct is defined as:
- Something which the customer can benefit from
- The transfer of a good or service is separable from other promises within the contract
From the above definition, a single contract can contain multiple performance obligations. For example, a phone contract bundle with a certain telco company. Let’s say in Bundle A, for a fee of RM200 a month, paid for a period of two years (total contract sum of RM4,800), a customer will receive a mobile phone with a warranty of 12 months, 2GB of mobile data per month, 200 minutes of talktime per month and 200 SMSs per month.
From this Bundle A, we can see that there are a total of five performance obligations which the telco company has to fulfil – i) transfer to new mobile phone to customer, ii) warranty service over 12 months, iii) monthly 2GB wifi, iv) monthly 200 minutes of talktime and v) monthly 200 SMSs. Hence, from the perspective of the telco company, there are five performance obligations to fulfil if we are to account for this Bundle A under IFRS 15.
Step 3: Determine the Transaction Price
The transaction price of the contract is the amount of consideration which a Company expects to receive in exchange of transferring the promised goods and services. In the example above, the transaction price of the contract is straightforward, i.e. a consideration of RM200 a month for a period of two years. The total sum of the contract is RM4,800.
There are other more complex situations which requires further assessment when determining the transaction price of a contract, namely where there is a financing component, variable considerations, considerations payable to the customer and non-cash considerations. Due to its complexity, it will not be discussed in this article.
Step 4: Allocate transaction price to performance obligations
The transaction price (discussed in Step 3) has to then be allocated to the separate performance obligations (discussed in Step 2) based on the stand-alone selling price of each performance obligation. If the stand-alone selling price of the performance obligations are not observable, the prices will have to be based on an estimate, i.e. through adjusted market assessment approach, expected cost plus a margin approach or residual approach.
Hence, for Bundle A as discussed above, the telco company needs to allocate the RM200 per month to these performance obligations. For certain performance obligations, like the transfer of phone to customer, the transaction price can be easily ascertained, i.e. market price of a similar model on the market. However, for the warranty and telco services provided, more detailed assessment will have to be made to allocate the residual transaction price to these separate performance obligations. In our opinion, the price of telco services provided can be computed based on costs of infrastructure and operations with a certain markup, whereas the price of warranty can be determined by obtaining a report on the warranty status of that particular phone model and determining how much warranty expenses is expected to be paid out.
Step 5: Recognise revenue as and when each performance obligation is satisfied
Revenue from these performance obligations are to be recognised either:
- Over time (if any of the three criteria are met – i) customer simultaneously receives and consumes all of the benfits, ii) the entity’s work creates or enhances an asset controlled by the customer or iii) 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 competed to date)
- At a point in time (revenue recognised when the entity transfers control of the asset to the customer)
Again, with reference to our telco company example above, the revenue from the transfer of the mobile phone to customer would be recognised at a point in time, i.e. when phone is transferred to customer. On the other hand, the revenue derived from services and warranty provided will have to be recognised over the contract period, i.e. 2 years.
We hope the above article has given you a better understanding of the new IFRS 15 which is due for adoption soon. If you have any queries or comments on the write-up on IFRS 15 above, please feel free to contact us.
Published by : WX Kao - Finance and Accounting Consultant of Rockwell Global Solution
Disclaimer: The example above is for illustrative purposes only, and might not be applicable for all business contracts. For further understanding of IFRS 15, please read up on available publications and consult your financial accountant/consultant. The material and information contained on this website is for general information purposes only. Rockwell makes no representations or warranties of any kind, express or implied about the completeness, accuracy, reliability, suitability or availability with respect to the website or the information, products, services or related graphics contained on the website for any purpose. Any reliance you place on such material is therefore strictly at your own risk. Rockwell will not be liable for any false, inaccurate, inappropriate or incomplete information presented on the website.You should always refer to latest update or revision of relevant law and regulations, or contact your accountant more details. If you need professional advise, ROCKWELL is always here to assist you. Please contact us.