Advanced Financial Accounting

Revenue Recognition (I)

 Lecture Outline

 The ‘new’ IFRS 15 standard

 Five-step approach to revenue recognition
– Identifying contract with customer
– Identifying performance obligations
– Determine transaction price
– Allocate transaction price to performance obligations
– Recognise revenue when obligations are satisfied
 Construction contracts
 Applying principles to revenue recognition situations
 Lecture Objectives

 Describe the five-step approach to revenue recognition under IFRS 15

 Identify separate performance obligations in a contract
 Determine the transaction price and consider how variable consideration
and significant financing components need to be accounted for
 Allocate the transaction price to separate performance obligations using
appropriate methods
 Recognise revenue at the appropriate time
 The new IFRS 15

• IFRS 15 Revenue from Contracts with Customers was published in May

2014
• IFRS 15 is effective from 2018 and might be adopted early
• It replaces two other primary standards: IAS 18, Revenue and IAS 11,
Construction Contracts
• An almost equivalent standard was published at the same time in the US
by the FASB
 The new IFRS 15 (2)
• Income is the increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or decreases of liabilities
that result in increases in equity, other than those relating to contributions
from equity participants.
• Revenue is income arising in the course of an entity’s ordinary activities
• Revenue is the gross inflow, i.e. before the deduction of any expenses. We
must also presume that this gross inflow is to the enterprise although it is
not specifically stated in the definition.
• Revenue results from ordinary activities. This notion distinguishes
revenue from other gains. Gains are defined in the 1989 framework as
‘other items that meet the definition of income and may, or may not, arise
in the ordinary activities of an enterprise’.
• Revenue gives rise to an increase in equity.
 Complexities in accounting
for revenue
The accounting difficulties arise when:
• the full amount invoiced will not be received in full;
• gains arise from unusual or infrequent transactions;
• transactions are spread over several accounting periods;
• a single contract involves the supply of multiple goods and
services;
• payment is made in kind, volume discounts or possible
contract variations;
• an industry has to be treated as a separate case;
• impact on other standards such as leasing.
 Dealing with uncertainty
in recognising revenue
• The new standard is focused on ensuring minimising the
probability that revenue is recognised in one period needs to be
reversed / restated in the next period
• Therefore, when there is an element of variability, only amounts that
are highly probable are recorded
• There are a number of factors that may affect the level of certainty
of revenue received:
• Factors outside the entity’s influence, such as market volatility,
potential obsolescence
• The entity has limited experience with similar contracts to the extent
that it is difficult to predict receipt of payment
• The entity is likely to offer concessions or discounts, or changing
payment terms and conditions
 Five step approach to
revenue recognition

• IFRS 15 outlines five steps to be applied when recognising

revenue
• Identify the contract with the customer
• Identify the performance obligations
• Determine the transaction price
• Allocate the transaction price to performance obligations
• Recognise revenue when (or as) the entity satisfies a performance
obligation
• We will be examining each of these steps and looking at cases that
illustrate how they will be applied
 Step 1: Identify the contract
with the customer

• For a contract to be in place, there has to be an agreement

between two (or more) parties that creates enforceable rights
and obligations
• Needs not be in writing
• A contract does not exist in the case of each party having the
unilateral right to terminate a contract without compensating the
other party
• Apply all steps of IFRS 15 to each separate contract
• Can also combine more than one contract to be treated as one contract
under IFRS 15
 Step 1: Identify the contract
with the customer (2)
Example:
M sells 120 products to Customer X at €12,000 (€100 per
product), which are transferred to X over a six-month period.

In this case, the contract is very straightforward: M has an obligation to sell

products to X, and the contract specifies that the delivery of the item will be
made over six months. We recognise the sales for €12,000. (€100 x 120
units)
 Step 1: Identify the contract
with the customer (3)
Contracts can be modified. Modifications to the contract can be
defined as:
• A change in scope, price, or both of a contract
Note: If distinct goods or services are added at stand-alone
prices, this needs to be accounted for as a separate contract
Example:
M sells 120 products to Customer X at €12 000 (€100 per product), which are
transferred to X over a six-month period. After the entity has transferred 60 products,
the contract is modified to require the delivery of an additional 30 products (a total of
150 identical products). The price of the additional 30 products is €95 per product.
The pricing reflects the stand-alone price of the additional products.
 Step 1: Identify the contract
with the customer (4)
Consider the following instead:

M sells 120 products to Customer X at €12,000 (€100 per product),

which are transferred to X over a six-month period. After the entity has
transferred 60 products, the contract is modified to require the delivery of
an additional 30 products (a total of 150 identical products).

The price of the additional 30 products was initially agreed to be €80 per
product, which is not the stand-alone price. But before modification, the
customer had identified minor defects in the 60 units already delivered.
Parties agree that for this reason a credit will be given for the amount of
€15 per product.
 Step 1: Identify the contract
with the customer (5)
Solution:
Initial price per unit is €100 per unit x 120 units = €12,000. After shipping the
first 60, 30 further units were ordered (total 150 units), which was priced at
€80 (not stand-alone). Of the initial 60 shipped, a defect was spotted, so credit
for €15/unit is agreed upon.
Because the remaining products to be delivered are distinct from those
already transferred, the entity accounts for the modification as a termination
of the original contract and the creation of a new contract.
So for each of the initial 60, there is a €15/unit discount (reduction of €900 in
revenue); and of the remaining units to be delivered (60 units + 30 units), the
price would be charged at (€100 x 60) + (€80 x 30)
 Step 2: Identify performance
obligations

• A performance obligation refers to the promise in the contract

to transfer:
• A distinct good or service
• A series of distinct goods or services that are substantially the same
and have the same pattern of transfer
• Each distinct performance obligation needs to be accounted for
separately
• E.g. a software developer enters into a contract with a customer to
transfer a software license, perform an installation service, provide
software updates and technical support for three years.
• There are FOUR performance obligations here:
• Deliver software, install software, provide software updates,
and provide tech support
 Step 2: Identify performance
obligations (2)

• In determining that the good or service is separately

identifiable, the criteria is as follows:
• The customer can benefit from the good or service
• The promise to transfer the good or service is separately identifiable
from other promises in the contract
• Goods or services are not considered to be separately identifiable if:
• It is bundled together with other goods or services
• It is significantly modified or customised
• There is high interdependence and interrelation between the
goods and services
 Step 2: Identify performance
obligations (3)

Example:
Vendor X enters into a contract to supply a license for an ‘off-the-shelf’
software package, install the software, and provide unspecified software
updates and technical support for two years. The license and the
technical support is sold separately, and the installation service can be
provided by any other vendor. Even without the technical support and
software updates, the software will remain functional.

How may performance obligations are there? 4

What if the software was customised? 1

 Step 2: Identify performance
obligations (4)

Special Offers and Material Rights

• Sellers often include options to acquire additional goods in the future for
free or at a discounted price to attract sales: e.g. via customer loyalty
schemes
• If the option to acquire the additional goods or services that can give rise
to material rights that the buyer would not have enjoyed had they not
entered into the contract, then the customer has effectively ‘prepaid’ for
the item
• In this situation, the material right is treated as a separate performance
obligation
• If the option however offers additional goods / services that reflected the
good’s stand-alone selling price, then there is no material right to the item,
and it is not considered a separate performance obligation
 Step 2: Identify performance
obligations (5)
Example:
• PCK Ltd produces a television series and enters into a contract to license
one season of 24 episodes to Notflex for $1m per episode. Notflex is
provided with an option to renew the contract for Season 2 at $0.8m per
episode. Is the option to renew the contract a material right?
Consider that Notflex would not have had that option had they not entered
into the contract.
Is the $0.8m a stand-alone price? i.e. would it be able to sell separately for
this price? Probably not, especially if the series takes off and becomes very
popular.
Therefore, the option to renew is a material right, and is accounted for as a
separate performance obligation.
 Step 3:Determine
transaction price
• The transaction price is the amount of consideration that the
supplier expects to be entitled to in exchange for the transfer of
goods or services, net of amounts collected on behalf of other
parties (e.g. sales taxes)
• This implies that if the seller anticipates that it will grant a discount
(perhaps based on previous business practice), the seller should
initially estimate revenue at the lower amount
• Two other factors should also be considered when
determining transaction price:
• Is the consideration variable?
• Is there a significant financing component?
 Step 3:Determine
transaction price (2)

• Consideration is variable if the amount to which the

entity is entitled to is contingent on the occurrence of
a future event
• Examples include:
• Early settlement discounts, refunds on return of goods or
penalties if a completion deadline is not met
• Bonuses paid on attainment of particular targets
• Sales / usage based royalties
• Price concessions
 Step 3:Determine
transaction price (3)
• However, the estimated amount of variable consideration will only
be included in the transaction price to the extent that it is highly
probable that a significant reversal in the amount of cumulative
revenue recognised will not occur when the uncertainty associated
with the variable consideration is subsequently resolved.
• Example: a company enters into a contract with a customer to
build an asset for £1m. The terms of the contract includes a penalty
of £100,000 if the construction is not completed within three
months of the deadline.
• Must consider:
• Likelihood of revenue reversal
• Magnitude of possible reversal once uncertainty has been
resolved
 Step 3:Determine
transaction price (4)
Example (continued)
• If there is likelihood that the firm will not complete the contract in
time, then the variable consideration should be included in the
transaction price.
• If it has been decided that variable consideration should not be
included in the transaction price, then the following must be
considered:
• Assess if part of the variable consideration must be included
• If yes, then include the lower amount in the transaction price
 Step 3:Determine
transaction price (5)

Example:
Buybuy is a retailer company selling consumer electronics online.
Every customer has the right to return the product within 20 days if
they are not satisfied. They will receive a full refund when the product
is returned in its original state.
One of the products sold is a tablet. The cost of each product is €200;
the sales price is €500. Based on its experience, Buybuy expects that 5
per cent of the products sold will be returned. How should Buybuy
account for the sale of a tablet?
 Step 3:Determine
transaction price (6)

Solution
Buybuy recognizes revenue per tablet for an amount of €475 (95% x
€500). The journal entry will be:
Dr Cash 500
Cr Revenue (95% x 500) 475
Cr Refund liability (5% x 500) 25
And
Dr Costs of goods sold (95% x 200) 190
Dr Right on tablet (5% x 200) 10
Cr Tablet 200
 Step 3:Determine
transaction price (7)
• In the case of sales / usage based royalty payments, revenue should
only be recognised only when (or as) the later of the following
occurs:
• Subsequent sale or usage occurs
• Performance obligation to which some or all of the sales/usage
based royalty has been allocated is satisfied / partially satisfied
 Additional variable
consideration examples (8)

 End of year discount

Pink Pharma sells its products to pharmacies by charging the standard price,
and subsequently provides for a discount at the end of the year of 10%. For
2020, Pink Pharma invoiced customers £15,000,000 for goods supplied.

This should be recorded as follows:

DR Accounts Receivable 15,000,000
CR Sales Revenue 13,500,000
CR Sales Discount Liability 1,500,000
 Step 3:Determine
transaction price (9)

• If the contract has a significant financing component, then

adjustments need to be made
• The following must be considered:
• The difference between the amount of promised consideration and the
cash selling price
• The impact of the length between the sale and payment, considering
prevailing interest rates
• If the financing component is significant, adjustments need to be
made to the transaction price unless:
• Time between delivery of goods and payment is less than one year; or
• Specific factors exist to indicate that the contract does not have a
significant financing component
 Step 3:Determine
transaction price (10)
• Specific factors exist to indicate that the contract does not have a
significant financing component. These include:
• Customer has discretion to decide when goods / services are
transferred
• There is a substantial variable consideration component outside the
control of both the firm and the customer
• The difference between promised consideration and cash price arises
due to other reasons than provision of finance.
 Step 3:Determine
transaction price (11)
Example:
• Heavy Goods plc entered into a contract for the sale of 10 trucks, at
a cost of £181,500 each, which provided for deferred payment two
years later. If the terms were payment on delivery, the contract
price would be £150,000 for a similar vehicle. (This implies a 10%
per annum compounded interest rate). If the market interest rate is
also 10% p.a., how would this be recorded?
 Step 3:Determine
transaction price (12)

Calculation:
Non-financing price: £150,000 x 10 = £1,500,000
At 10% compounded annually:
Year 1: £1,500,000 x 1.1 = £1,650,000. Interest is £150,000
Year 2: £1,650,000 x 1.1 = £1,815,000. Interest is £165,000
Total price: £1,815,000
Total financing component: £315,000
 Step 3:Determine
transaction price (13)

Solution:

Year 1
Dr Accounts Receivable 1,815,000
Cr Sales Revenue 1,500,000
Cr Interest Revenue 150,000
Cr Deferred Interest 165,000

Year 2
Dr Deferred Interest 165,000
Cr Interest Revenue 165,000
Dr Bank 1,815,000
Cr Accounts Receivable 1,815,000
 Step 4: Allocate transaction
price to the performance of
obligations in the contract
• In principle, the transaction price to each performance obligation is
allocated on a relative stand-alone selling price basis
• Stand-alone selling price can be determined as follows:
• Use the directly observable price; otherwise
• Use an estimation method
• Examples of estimation methods:
• Adjusted market assessment approach
• Expected cost plus a margin approach
• Residual approach
 Step 4: Allocate transaction
price to the performance of
obligations in the contract
• Of the three methods discussed, the residual method should be used
as a means of last resort
• The actual ‘residual’ can vary according to circumstances.
• For example:
• Let’s say a company sells a combination of three products – A, B and
C – for a combined price of £33.
• If the market prices for A and B as stand-alone items are £10 and
£8 respectively but you have no market price for product C, then
the residual - £15 can be allocated to C
• However, if A and B are regularly sold as a bundle for £15, then
the price of C is allocated as £18
 Step 4: Allocate transaction
price to the performance of
obligations in the contract
An entity enters into a contract with a customer to sell products A, B and C in
exchange for €100. The entity will satisfy the performance obligations for each of
the products at different points in time. The stand-alone selling prices are €50
(A), €25 (B) and €75 (C), totalling €150. The customer receives a discount of €50
for purchasing the bundle of goods.

a) If the discount could not be allocated to a specific performance obligation, what

would the recognized revenue be?
b) If the discount is allocated to performance obligations B and C, what would the
recognized revenue be?
 Step 4: Allocate transaction
price to the performance of
obligations in the contract
Scenario A:

If the discount could not be allocated to a specific performance obligation, what

would the recognized revenue be?

Product A: 50/150 x 50 = discount is £17. Price is £50-17 = 33

Product B: 25/150 x 50 = discount is £8. Price is £25-8 = 17
Product C: 75/150 x 50 = discount is £25. Price is £75-25 = 50 100
CR Sales revenue A 33
Journal entries:
DR Trade Receivables 100
CR Sales revenue A 33
CR Sales revenue B 17
CR Sales revenue C 50
 Step 4: Allocate transaction
price to the performance of
obligations in the contract
Scenario B:
If the discount is allocated to performance obligations B and C, what would the
recognized revenue be?

Product A: 50 (no discount allocated)

Product B: 25/100 x 50 = discount is £12.5. Price is 25-12.50 = 12.50
Product C: 75/100 x 50 = discount is £37.50. Price is 75 - £37.50 = £37.50

Journal entries:
DR Trade Receivables 100
CR Sales revenue A 50
CR Sales revenue B 12.50
CR Sales revenue C 37.50
 Step 5: Recognise revenue
when entity satisfies
performance obligation
• We recognise revenue when (or as) it satisfies the performance
obligation by transferring control over a promised good or service
to a customer.
• There is an important distinction between:
• Performance obligations that are satisfied at a point in time
• In this case, we recognise revenue at the time the obligation is
satisfied
• Performance obligations that are satisfied over time
• In this case, we would need to recognise revenue over time,
selecting an appropriate method for measuring the entity’s
progress towards complete satisfaction of that obligation
• Particular criteria needs to be satisfied in order to recognise
revenue over time
 Step 5: Recognise revenue
when entity satisfies
performance obligation
A performance obligation is satisfied over time if one of the
following criteria is met:
(a) The customer simultaneously receives and consumes the
benefits provided by the entity’s performance as the entity
performs.
(b) The entity’s performance creates or enhances an asset (for
example work in progress) that the customer controls as the asset
is created or enhanced.
(c) 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 completed to date.
 Step 5: Recognise revenue
when entity satisfies
performance obligation (2)

Example:
The listed entity Hollystone hires the audit firm DEKP, not being the
auditor of the financial statements, to write a memo to assist
management to account in accordance with IFRS for a major
acquisition during the year. DEKP charges on the basis of hours taken.
DEKP receives payment even if Hollystone terminates the contract
early or management does not agree with the memo, unless the audit
firm has performed culpably badly.
Analyze whether DEKP satisfies the performance over time, on the basis of
hours taken, or at a point in time, upon delivery of the memo. Use the three
criteria described in the last slide.
 Step 5: Recognise revenue
when entity satisfies
performance obligation
Mrs. Jones is a long-term member of the tennis club, Passing Shot. She
pays an amount of €1000 a year, paid in advance. The membership
allows unlimited access to the tennis courts throughout the year. During
the autumn and winter seasons, there are indoor facilities. Mrs. Jones
will normally only use the tennis courts during spring and summer and
has never used the indoor facilities.
How should Passing Shot recognize its revenue related to Mrs. Jones: evenly
spread over time, or allocated to the spring and summer season when Mrs.
Jones uses the tennis facilities?
 Step 5: Recognise revenue
when entity satisfies
performance obligation (3)
Appropriate measures of progress when a performance obligation is
satisfied over time include:

output methods: direct measurement of the value to the customer of the

goods or services transferred to date

input methods: measurement on the basis of the entity’s efforts or inputs

to the satisfaction of a performance obligation, such as costs incurred.
 Step 5: Recognise revenue
when entity satisfies
performance obligation (4)
Example:
An entity enters into 100 separate contracts with customers to provide one
year of maintenance services for €1000 per contract. The terms of the
contract specify that at the end of the year, each customer has the option to
renew the maintenance contract for a second year by paying an additional
€1000. The entity charges a significantly higher price (€3000) for customers
that do not sign up for the maintenance service in the first year. The entity
expects that 90 per cent of customers will renew. Estimated costs for
maintenance are €600 for each contract in year 1 and €750 in year 2. Revenue
is recognized on the basis of costs incurred.
How much revenue is recognized per contract in year 1 and how much in year 2?
SOLUTION:

Revenue
Year 1: €1,000
Year 2: €1,000 x 90% = €900
Total: €1,900

Costs incurred:
Year 1: €600
Year 2: €750 x 90% = €675
Total: €1,275

Revenue apportioned on the basis of costs incurred:

Year 1: 600 / 1275 x 1,900 = €894
Year 2: 675 / 1275 x 1,900 = €1,006
 Illustrative example of
all five steps

Shurebuy sells sets of recording equipment on credit at a price of

£4,000 each. It also provides a special offer worth £4,800 per set
that includes the recording equipment and two years’ worth of
maintenance. The maintenance cost if supplied by other
companies separately would be £1,000 for the two years.
Apply the five steps of revenue recognition as per IFRS 15 if a
customer were to purchase the special offer.
STEP 1: Identify contract

Yes

STEP 2: Identify performance obligations

1) Supply of recording equipment

2) Maintenance

Step 3: Identify transaction price

£4,800
Step 4: Allocate transaction price to performance obligations

Equipment 4,000
Maintenance Year 1: 500
Maintenance Year 2: 500
Total: £5,000

We then allocate the discount of £200 offered

Year 1
4,000 / 5,000 x 200 = 160. And 4,000 – 160 = 3,840
500 / 5,000 x 200 = 20. And 500 – 20 = 480

Year 2
500 / 5,000 x 200 = 20. And 500 – 20 = 480

Total 4,800
Step 5: Recognising revenue when performance obligations
are satisfied

In Year 1:

DR Receivables 4,800
CR Sales revenue (equipment) 3,840
CR Sales revenue (maintenance) 480
CR Deferred revenue 480

In Year 2:
DR Deferred revenue 480
CR Sales revenue (maintenance) 480

DR Cash 4,800
CR Receivables 4,800