Revenue (IFRS 15)

FR taught you the five steps of IFRS 15 Revenue from Contracts with Customers. SBR assumes them and examines the judgements inside them: whether a contract exists, what happens when it changes, how much variable consideration to include, whether the entity is a principal or an agent, when a licence is satisfied, and whether the costs of winning and fulfilling a contract are assets. Revenue is also where pressure on management shows first, so it is a favourite of the Section A question on reporting and ethical implications, and of Section B scenarios where a director wants a sale recognised sooner or grossed up. Keep the five steps as your structure, and you will always know which judgement you are making.

Step 1 at SBR depth: is there a contract?

IFRS 15 applies only once there is a contract that: has been approved by the parties, who are committed to it; identifies each party's rights and the payment terms; has commercial substance; and makes it probable that the entity will collect the consideration it is entitled to, given the customer's ability and intention to pay.

If these criteria are not met, no revenue is recognised. Any cash received is a liability until the criteria are met, or until the entity has no remaining obligations and the cash is non-refundable. Two contracts with the same customer, agreed at or near the same time, are combined if they were negotiated as a package, if the price of one depends on the other, or if their goods together form a single performance obligation. Note the difference between collectability and a price concession: if the entity expects to accept less than the invoice price from the start, the shortfall is variable consideration, not a credit risk.

Contract modifications

A modification is a change in the scope or price of a contract, or both, approved by the parties. If the scope is approved but the price is still being negotiated, the entity estimates the price change as variable consideration. There are three possible treatments, and the test is applied in this order.

A cumulative catch-up. A construction contract has a price of $10m and expected costs of $8m. When costs to date are $4m (50% complete), revenue to date is $5m. The parties then agree extra work, which is not distinct, adding $3m to the price and $2m to costs. The price is now $13m and total costs $10m, so progress is $4m ÷ $10m = 40%. Revenue to date becomes $13m × 40% = $5.2m, and $0.2m of extra revenue is recognised on the modification date.

Variable consideration and the constraint

Discounts, rebates, refunds, credits, incentives, performance bonuses and penalties all make consideration variable. The entity estimates it using whichever method better predicts the amount:

• the expected value, a probability-weighted amount, which suits a large number of similar contracts or a wide range of outcomes; or
• the most likely amount, which suits a contract with only two possible outcomes, such as a bonus that is either earned or not.

The estimate is then constrained: it is included in the transaction price only to the extent that it is highly probable that a significant reversal of the cumulative revenue recognised will not occur when the uncertainty is resolved. Reversal is more likely when the outcome depends on factors outside the entity's influence (markets, weather, a third party's judgement), when the uncertainty will last a long time, when the entity has little relevant experience, when it has a practice of granting price concessions, or when the range of outcomes is wide.

The estimate is updated at each reporting date. A change in the transaction price is allocated to the performance obligations on the same basis as at the start, and the part relating to obligations already satisfied is recognised as revenue, or a reduction in revenue, immediately. One exception: a sales-based or usage-based royalty on a licence of intellectual property is not estimated in advance; it is recognised when the customer's sale or usage occurs.

Principal or agent

When another party is involved in providing goods or services to the customer, first identify the specified good or service, which may be a right to a service that another party will perform, such as a ticket. The entity is a principal if it controls that good or service before it passes to the customer, and recognises revenue gross. It is an agent if its promise is to arrange for another party to provide it, and recognises only its fee or commission, usually when it has made the arrangement.

Three indicators help with the control assessment: the entity is primarily responsible for fulfilling the promise, it bears inventory risk before or after the transfer, and it has discretion in setting the price. The indicators support the judgement about control; they do not replace it. A travel company that buys hotel rooms in advance at its own risk and sets its own prices can be a principal even though it never runs a hotel, while an online platform that simply connects buyers with sellers is usually an agent. Because gross or net presentation changes revenue and margins, but not profit, it is an obvious target for anyone with a revenue-based bonus.

Licences of intellectual property

First decide whether the licence is distinct. A software licence that is useless without the vendor's continuous hosting or essential updates may form a single performance obligation with them. If the licence is distinct, its nature decides the timing.

Costs to obtain and to fulfil a contract

A practical expedient lets an entity expense a cost to obtain a contract if the amortisation period would be one year or less. Capitalised costs are amortised on a systematic basis that follows the transfer of the related goods or services, which may include specific anticipated renewals, and are impaired if their carrying amount exceeds the remaining consideration expected less the costs still to be recognised. For example, a $54,000 commission paid on signing a three-year service contract is an asset amortised at $18,000 a year, while the $6,000 of legal fees spent negotiating the contract is expensed, because it would have been incurred even if the deal had failed.

Other arrangements at SBR depth

FR covered bill-and-hold, consignment and rights of return; SBR applies the same control test in more complex settings, and adds these.

Worked example

Example 1: a modification of a services contract. On 1 January 20X5 Kaduna Data (fictional) agrees to provide data-centre services to a customer for three years at $480,000 a year, billed and paid at the end of each year. The services are a series of distinct, substantially similar services, satisfied over time. On 1 January 20X7, after two years, the parties extend the contract by two years to 31 December 20X9 at $360,000 a year. The stand-alone selling price of a year's service is still $480,000, and nothing about the customer or the circumstances justifies the lower price.

The extension adds distinct services, but its price is not their stand-alone selling price, so it is not a separate contract. The remaining services are distinct from those already provided, so the old contract is treated as terminated and a new one created. The new contract's consideration is the $480,000 not yet recognised for 20X7 plus 2 × $360,000 = $720,000 for the extension: $1,200,000 for three years, or $400,000 a year.

Example 2: a volume rebate. Onitsha Paints (fictional) sells paint to a retailer at $40 a tin. If the retailer buys more than 50,000 tins in the calendar year 20X6, the price of every tin bought in the year falls to $36. Onitsha reports quarterly.

At the end of the first quarter the retailer has bought 9,000 tins, and on past experience Onitsha does not expect the threshold to be reached: it is highly probable that revenue of 9,000 × $40 = $360,000 will not reverse. In the second quarter the retailer buys 16,000 tins and opens new stores, and Onitsha now expects the threshold to be exceeded. The estimate changes, and the cumulative revenue must reflect $36 a tin.

The quarter 2 journal is: debit receivables $640,000; credit revenue $540,000; credit refund liability $100,000. If the retailer buys 56,000 tins in total, revenue for 20X6 is 56,000 × $36 = $2,016,000 and the rebate due is 56,000 × $4 = $224,000.

What the directors need to hear. In Example 1, the sales director wanted to keep recognising $480,000 in 20X7, when the sales team's bonus is measured, and absorb the discount in 20X8 and 20X9. IFRS 15 does not allow it: the price concession buys the whole remaining service period, so it is spread across 20X7 to 20X9. In Example 2, keeping revenue at $40 a tin until the threshold is actually crossed in the fourth quarter would overstate the interim results, because the constraint asks whether the revenue is highly likely to stand, not whether the rebate has yet been triggered. In both cases the proposed treatment would favour a bonus or an interim target over a faithful picture, and an accountant asked to adopt it faces a self-interest or intimidation threat and should explain the correct treatment and escalate if necessary.

Common mistakes

• Treating every modification as a separate contract, without checking whether the price reflects stand-alone selling prices.
• Applying a cumulative catch-up to distinct services, or spreading a change prospectively when the remaining work is not distinct.
• Waiting for a rebate threshold or a bonus condition to be met before adjusting revenue, instead of re-estimating at each reporting date.
• Deciding principal or agent by who collects the cash or bears credit risk, instead of who controls the specified good or service.
• Recognising a licence of existing software over time, or capitalising bid costs and legal fees that would have been incurred anyway.

Exam technique

Name the step and the judgement in your first sentence: "this is a contract modification" or "the issue is whether the entity is a principal". Then apply the test in the standard's order, conclude, and quantify, setting out a year-by-year table where the timing changes. Tie your conclusion to the transfer of control, which is the principle markers look for, and finish with the effect on revenue, profit and the statement of financial position. Where a director is pushing a treatment, add the ethical point briefly once the accounting is clear.

Study with AI

I am studying ACCA Strategic Business Reporting (SBR), IFRS 15. Give me five short
scenarios, one at a time: a contract modification, a volume rebate that changes
estimate during the year, a principal versus agent decision, a licence of
intellectual property with a sales-based royalty, and a sales commission. For each,
wait for my answer, then give the correct treatment with figures in $, the IFRS 15
test that decides it, and the journal.

AI assistants often confuse the three types of contract modification and the two types of licence: check every answer against these notes before you rely on it.

Lecturer's note: Almost every SBR revenue judgement is the same question asked in a different setting: what has the customer received control of, and when? A modification is accounted for according to whether the remaining services are distinct; a licence according to whether the customer controls a fixed piece of property or access to a changing one; a principal is whoever controls the good before the customer does. Variable consideration adds one more question: how sure are you that this revenue will not have to be taken back? Ask those two questions and IFRS 15 becomes one idea, not a list of rules.

Key points

• A modification is a separate contract only if it adds distinct goods or services at their stand-alone selling price; otherwise it is a new contract (remaining items distinct) or a cumulative catch-up (remaining items not distinct).
• Variable consideration uses the expected value or the most likely amount, constrained so that a significant reversal is highly improbable, and is re-estimated at each reporting date.
• A principal controls the specified good or service before transfer and reports revenue gross; an agent reports its commission.
• A right to access intellectual property is satisfied over time; a right to use it at a point in time; sales-based royalties are recognised as the sales occur.
• Incremental costs of obtaining a contract, and qualifying fulfilment costs, are capitalised and amortised as the related goods or services transfer.

Quick check

1. A company grants a five-year licence to use its existing payroll software, which it will not update, for $500,000 paid on delivery plus a royalty of 2% of the customer's sales. In the first year the customer's sales are $3m. How much revenue does the company recognise in year 1?
2. A company pays a $30,000 commission on obtaining a two-year service contract that starts on 1 July 20X5. Its year end is 31 December. What expense and what asset are reported for 20X5?
3. A modification adds two years of distinct services at their stand-alone selling price. How is it accounted for?

Answers

1. The licence is a right to use the software as it exists, so $500,000 is recognised when it is delivered. The royalty is recognised as the sales occur: 2% × $3m = $60,000. Total year 1 revenue is $560,000.
2. The commission is an incremental cost of obtaining the contract, capitalised and amortised over 24 months: $30,000 × 6/24 = $7,500 expensed in 20X5, leaving an asset of $22,500.
3. As a separate contract: the original contract is unaffected, and the extension's revenue is recognised as its services are provided.