What are promises in a contract, from an accounting/financial reporting point of view and from a legal point of view.
IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here.
Promises in a contract from an accounting/financial reporting point of view
Promises in a contract can be explicit, or implicit if the promises create a valid expectation that the entity will provide a good or service based on the entity’s customary business practices, published policies, or specific statements. It is therefore important to understand an entity’s policies and practices, representations made during contract negotiations, marketing materials, and business strategies when identifying the promises in an arrangement.
Promised goods or services include, but are not limited to: [IFRS 15 26]
- Transferring produced goods or reselling purchased goods, Promises in a contract
- Arranging for another party to transfer goods or services,
- Standing ready to provide goods or services in the future, Promises in a contract
- Building, designing, manufacturing, or creating an asset on behalf of a customer,
- Granting a right to use or access to intangible assets, such as intellectual property,
- Granting an option to purchase additional goods or services that provides a material right to the customer,
- Performing contractually agreed-upon tasks. Promises in a contract
Administrative tasks to set up a contract are not performance obligations as they do not transfer goods or services to the customer. [IFRS 15 25]
Determining when promises are performance obligations
After identifying the promised goods and services in a contract, an entity determines which of those promises will be treated as performance obligations. At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either (IFRS 15 22):
- a good or service (or a bundle of goods or services) that is distinct; or
- a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer
Therefore promises to transfer goods or services are performance obligations if the goods or services are:
- distinct (including as part of a bundle); or Promises in a contract
- part of a series of distinct goods and services that are substantially the same and have the same pattern of transfer
If a promised good or service is not distinct, an entity should combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, this would result in accounting for all the goods or services promised in a contract as a single performance obligation (IFRS 15 30).
Promises in a contract from a legal point of view.
The word promise is also a quite well accepted concept in law.
A buyer in a departmental store who picks out a bottle of hair oil and pays cash for it at the register makes a purchase and the store makes a sale of the hair oil but it would be difficult to find a contract between the store and the customer. Most likely, neither party made nay promises so there was no point at which either was bound to some future performance.
Law of contract determines the enforceability of the promises of the parties and is the body of law applicable to the formation, interpretation, and performance of the contracts, as well as for the remedies in the event of the failure of a party to perform the promises made.
The basic ingredient in this regard is the agreement of the parties. For example, was a promise in fact made, was it sufficiently definite to define the rights and obligations of the parties? Since casual promises do not generally serve as a basis for recognizing rights, there is the additional question whether the promisor had the necessary intent. In the language of the law, the question is whether the promisor manifested the intention to the legally bound. The essentials in this regard include free consent, competency of parties, lawful object and consideration, agreement must be valid and not void.
See also: The IFRS Foundation