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.
This section is part of step 5 Recognise revenue as or when each performance obligation is satisfied. The performance obligation may be satisfied over time when the right to payment for performance completed to date is enforceable by the vendor in all circumstances, other than where the contract is terminated due to the vendor’s failure to carry out its obligations. In assessing that enforceability a vendor considers the terms of the contract as well as any laws or regulations that relate to the contract. The enforceable amount must at least compensate the vendor for performance completed to date (i.e. an amount that approximates the selling price of the goods or services transferred to date), even if the customer has a right of termination.
A vendor must always be entitled to compensation for recovery of costs that it has incurred plus either of the following amounts: Revenue recognition over time – Enforceable payment right
- A proportion of the expected profit margin under the contract, reasonably reflecting the extent of the vendor’s performance under the contract before termination by the customer or another third party; or Revenue recognition over time – Enforceable payment right
- A reasonable return on the vendor’s cost of capital for similar contracts (that is, the vendor’s typical operating margin in similar contracts or transactions) if the contract specific margin is higher than the return the vendor usually generates from similar contracts.
A vendor’s right to payment for performance completed to date does not need to be a present unconditional right to payment. In many cases, a vendor will have that right only at an agreed-upon milestone or upon complete satisfaction of the performance obligation, and not throughout the contract term. However, in the event of contract termination, the vendor must always be entitled to payment for performance completed to date. Revenue recognition over time – Enforceable payment right
A customer might terminate (or take steps to terminate) a contract without having the right to do so (this includes when a customer fails to perform its obligations as promised). In those circumstances, the contract (or other laws) might entitle the vendor to continue to carry out its obligations set out in the contract and require the customer to pay the consideration promised in exchange for those goods or services. This would result in the vendor having a right to payment for performance completed to date because the vendor has a right to continue to perform its obligations in accordance with the contract and to require the customer to perform its obligations which include paying the promised consideration. If the vendor is capable of forcing completion of its own and its customer’s contractual obligations (including payment in accordance with the original contractual terms), it is not necessary to satisfy other conditions for the right to payment for performance completed to date.
In assessing the existence and enforceability of a right to payment, a vendor considers whether:
- Legislation, legal precedent or administrative practice gives the vendor a right to payment for performance to date even though that right is not specified in the contract, Revenue recognition over time – Enforceable payment right
- A court (or other relevant legal precedent) has previously decided that similar rights to payment for performance to date in similar contracts have no binding legal effect, Revenue recognition over time – Enforceable payment right
- Its own customary business practices of choosing not to enforce a right to payment have caused that right to be unenforceable in that legal environment. If the vendor concludes that the right would still be enforceable, the vendor would have a right to payment for performance to date notwithstanding that the vendor has previously chosen, and may in the case being analysed choose, to waive that right. Revenue recognition over time – Enforceable payment right
Some real estate contracts may result in an asset that cannot (under the terms of the contract) be readily redirected to another customer (that is, the vendor‘s performance does not create an asset for which the vendor has an alternative use because it is unable to sell the unit specified in the contract to any other party). In those cases, the focus will be on whether the contract requires the customer to pay for performance to date in all circumstances other than vendor default; if that right exists then revenue will typically be recognised over time. However, other real estate contracts that do not create an asset with an alternative use to the vendor may not require the customer to pay for performance to date, with either a deposit being forfeited or penalties being payable which represent only the vendor’s loss of profit. For those contracts, a vendor will recognise the sale on completion (at a point in time).