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.
In step 1 Identify the contract there are some specifically identified circumstances to capture the day-to-day complexities of selling products and services to customers into useful financial reporting:
- Combination of contracts,
- Contract modifications – account for modification as termination, continuation or a mix of both,
- Contract enforceability and termination clauses
Combination of contracts
Two or more contracts that are entered into at (or near) the same time, and with the same customer or related parties of the customer, are accounted for as if they were a single contract for accounting purposes, if one of the following criteria are met:
- The contracts are negotiated as a package with a single commercial objective;
- The amount of consideration in one contract depends on the price or performance of the other contract(s); or
- The goods or services that are promised in the contracts (or some of the goods or services) represent a single performance obligation.
The requirement to consider contracts which are entered into with two or more separate parties that are related to each other has been included because there may be interdependencies between or among those contracts. The term ‘related parties’ has the same meaning as the definition in IAS 24 Related Party Disclosures, which encompasses a wide range of entities and individuals, and careful analysis may be required to ensure that all of these are considered.
Accounting for contract modifications
When a contract modification is not accounted for as a separate contract (i.e. neither of two criteria are met, see Contract modifications), the vendor identifies the total goods or services that have not yet been transferred. This will be comprised of the remaining goods or services from the original contract, and any new goods or services arising from the contract modification. The approach which is then followed as follows:
- Termination: If the remaining goods and services (not transferred yet) under the existing contract are distinct the existing contract can be terminated, and a new contract is agreed,
- Continuation: If there is only a single performance obligation the modification can be treated as part of the existing contract to be renewed,
- Mixed approach: the approach will be a mixture of termination and continuation. This is the most likely and practical solution.
The accounting for these possible approaches is as follows:
Accounting for the contract modification
Contract enforceability and termination clauses What can happen to a contract with a customer?
Under IFRS 15, a contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties).
A contract is ‘wholly unperformed’ if: What can happen to a contract with a customer?
- The entity has not yet transferred any promised goods or services to the customer; and
- The entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.
An entity only applies IFRS 15 to the term of the contract in which the parties to the contract have enforceable rights and obligations.
In order to get familiar with accounting for these contracts that are more or less not existing (yet) for accounting purposes here are some (simplified) examples considered by the Transition Resource Group, a convergence project between IASB and FASB in the creation of IFRS 15:
An entity enters into a service contract with a customer under which the entity continues to provide services until the contract is terminated. Each party can terminate the contract without compensating the other party for the termination (that is, there is no termination penalty).
The duration of the contract does not extend beyond the services already provided. What can happen to a contract with a customer?
An entity enters into a contract with a customer to supply services for two years. Each party can terminate the contract at any time after fifteen months from the start of the contract without compensating the other party for the termination.
The duration of the contract is fifteen months. What can happen to a contract with a customer?
An entity enters into a contract with a customer to provide services for two years. Either party can terminate the contract by compensating the other party.
The duration of the contract is the specified contractual period of two years. What can happen to a contract with a customer?
An entity enters into a contract to provide services for 24 months. Either party can terminate the contract by compensating the other party. The entity has a past practice of allowing customers to terminate the contract at the end of 12 months without enforcing collection of the termination penalty.
In this case, whether the contractual period is 24 months or 12 months depends on whether the past practice is considered by law (which may vary by jurisdiction) to restrict the parties’ enforceable rights and obligations. The entity’s past practice of allowing customers to terminate the contract at the end of month 12 without enforcing collection of the termination penalty affects the contract term only if that practice changes the parties’ legally enforceable rights and obligations. If that past practice does not change the parties’ legally enforceable rights and obligations, then the contract term is the stated period of 24 months.