A contract must meet the following criteria in order to be accounted for under IFRS 15 (IFRS 15.9):
- the parties to the contract have approved the contract and are committed to perform their obligations;
- the entity can identify each party’s rights regarding the goods or services to be transferred;
- the entity can identify the payment terms for the goods or services to be transferred (not to be confused with unpriced contract modifications);
- the contract has commercial substance (i.e. the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract); and
- it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Reassessment of the above criteria is not required unless there is an indication of a significant change in facts and circumstances (e.g. significant deterioration of customer’s financial standing). Any reassessment is accounted for prospectively and relates only to remaining goods or services, therefore revenue already recognised is not reversed (IFRS 15.13, BC34). See also Example 4 accompanying IFRS 15.
A customer is defined as a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration (IFRS 15.6). Ordinary activities are not defined anywhere in IFRS.
In general, this definition aims to separate contracts with customers (in the scope of IFRS 15) from various collaborations or partnerships (outside the scope of IFRS 15). IFRS 15 does not include any application guidance on this distinction as IASB believed it would not be feasible to develop application guidance that would apply uniformly to various industries (IFRS 15.BC54). In most cases, there won’t be any difficulties in deciding whether a party to a contract is a customer or not. But for some contracts, entities need to carefully consider all relevant facts and circumstances. Paragraph IFRS 15.BC54 provides examples of arrangements in which an entity would need to make such an assessment:
- collaborative research and development efforts between biotechnology and pharmaceutical entities or similar arrangements in the aerospace and defence, technology and healthcare industries or in higher education;
- arrangements in the oil and gas industry in which partners in an offshore oil and gas field may make payments to each other to settle any differences between their proportionate entitlements to production volumes from the field during a reporting period; and
- arrangements in the not-for-profit industry in which an entity receives grants and sponsorship for research activity and the grantor or sponsor may specify how any output from the research activity will be used.
Approval of a contract and commitment to perform obligations
The way a contract is approved depends on local law and industry practices. A contract may be approved in writing, orally or by an entity’s customary business practices (e.g. by e-mail if allowed by local law). It is crucial that such an approval creates enforceable rights and obligations in a given jurisdiction (IFRS 15.10).
Paragraph IFRS 15.BC36 contains some interesting discussion on a contract where parties are not committed to perform all of their obligations but are ‘substantially committed to the contract’. Such a contract still falls within the scope of IFRS 15.
Paragraph IFRS 15.11 states that IFRS 15 should be applied to the duration of the contract (i.e. the contractual period) in which the parties to the contract have present enforceable rights and obligations. If there are early termination provisions without penalty (or with only nominal penalty) entities must carefully assess which rights and obligations are enforceable. It is possible that a long-term contract will be treated as a monthly contract if substantive early termination options exist.
A contract does not exist from IFRS 15 perspective if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (IFRS 15.12).
If only one party has a right to terminate a wholly unperformed contract, such a contract is within the scope of IFRS 15. The implication is that such a wholly unperformed contract will be in the scope of disclosure requirements of IFRS 15.
Commercial substance of a contract
The requirement relating to commercial substance of a contract (i.e. the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract) is aimed at preventing entities from artificially inflating their revenue by transferring goods or services back and forth to each other (IFRS 15.BC40).
Unfortunately, IFRS 15 does not cover barter transactions in great detail. When such a transaction is entered into, an entity has to assess it against the general criterion, i.e. whether the risk, timing or amount of the entity’s future cash flows is expected to change.
Probability of payment
For a contract to fall into the scope of IFRS 15 it must be probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. Paragraph IFRS 15.BC45 specifies that both the customer’s ability (i.e. financial capacity) and intent to pay should be taken into account in this assessment. Note that the reference is made to consideration for goods or services that will actually be transferred to the customer, i.e. this assessment does not relate to all goods or services promised in the contract. Therefore, if the customer would not pay and consequently the entity would not transfer any further goods or services, the likelihood of payment for those goods or services that would not be transferred is not taken into account when assessing collectability of consideration (IFRS 15.BC46).
Paragraph IFRS 15.BC46E states that it was not the intention that many contracts should fail the collectability of consideration condition as this condition only aims at assuring that revenue will be recognised from valid contracts that represent genuine transactions (IFRS 15.BC43).
See also Examples 1, 2 and 3 accompanying IFRS 15.
Combination of contracts
Paragraph IFRS 15.17 provides criteria which necessitate combination of two or more contracts into one for accounting purposes. Such a combination should be made if the contracts are entered into at or near the same time with the same customer (or related parties of the customer) and at least one of the following criteria are met:
- the contracts are negotiated as a package with a single commercial objective;
- the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or
- the goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.
In general, IFRS 15 focuses on rights and obligations. The fact that, due to legal or similar reasons, the parties use several contracts for the sale of related goods/services, or a single contract for unrelated goods/services, should not impact the accounting treatment under IFRS 15.
What is a contract modification?
A contract modification is a change in the scope or price (or both) of a contract that creates new or changes existing enforceable rights or obligations of the parties to the contract. Contract modification must be approved by all the parties to the contract. Discussion on ways of approving the original contract applies to approval of the modification as well. When a modification has not been approved by all parties, the existing contract is still in force for accounting purposes (IFRS 15.18).
Contract modification that is an additional separate contract
A contract modification should be treated as a separate contract for accounting purposes when both of these criteria are met (IFRS 15.20):
- the scope of the contract increases because of the addition of promised goods or services that are distinct; and
- the price of the contract increases by an amount of consideration that reflects the entity’s stand-alone selling prices of the additional promised goods or services.
When the above criteria are met, there is no substantial difference between entering into a new contract and modifying an existing one. For such modifications, performance obligations under an existing contract are unaffected by the contract modification.
The stand-alone selling prices mentioned in the second criterion above should be adjusted to take into account facts and circumstances specific to that contract, e.g. discounts reflecting the fact that an entity didn’t have to pay commission for acquisition of a new customer or volume rebates.
See also Example 5 (Case A) accompanying IFRS 15.
Contract modification that is not an additional separate contract
When a contract modification is not treated as an additional separate contract based on the above-mentioned criteria, entities need to assess whether the promised goods or services that are still to be transferred are distinct from the goods or services transferred on or before the date of the contract modification (IFRS 15.21).
If the remaining goods or services are distinct, the contract modification is accounted for prospectively, i.e. the revenue recognised for previously satisfied performance obligations is not adjusted (IFRS 15.21a). Instead, the remaining transaction price is allocated to remaining performance obligations. These include transaction price of the performance obligation remaining under a contract before modification and added by the modification. See also Examples 6 and 7 accompanying IFRS 15.
If the remaining goods or services are not distinct, entities treat the additional goods or services as a part of a single performance obligation that is partially satisfied at the date of the contract modification with a one-off cumulative catch-up adjustment to revenue (IFRS 15.21b). See also Examples 8 and 9 accompanying IFRS 15.
A combination of these two approaches is also allowed if it best reflects the substance of the contract modification (IFRS 15.21c). Typically, this approach will be applied when a contract modification is unrelated to already satisfied performance obligations, but is related to remaining performance obligations. See also Example 5 (Case B) accompanying IFRS 15.
Some contract modifications may in substance include price modifications relating to already satisfied performance obligations (e.g. an entity gives a discount for additional goods because those already delivered were faulty). In such a case, requirements relating to changes in transaction price should be applied which may result in a one-off catch-up adjustment to revenue.
Changes in transaction price and unpriced change orders
If the parties to a contract have approved a change in the scope of the contract but have not yet determined the corresponding change in price (so-called unpriced change orders), the contract should be considered to be modified. The change in price should be estimated using criteria relating to variable consideration (IFRS 15.19).
See also changes in transaction price which do not result from a contract modification.
Revenue without a contract
When entity receives consideration from a customer with a contract that does not meet the IFRS 15 criteria, revenue is recognised only when the contract is either:
- complete or
Specifically, revenue is recognised when one of the following conditions is met (IFRS 15.15):
- the entity has no remaining obligations to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is non-refundable; or
- the contract has been terminated and the consideration received from the customer is non-refundable.
If the above conditions for revenue recognition are not met, consideration received is recognised as a liability representing the entity’s obligation to either transfer goods or services in the future or refund the consideration received. See also Example 1 accompanying IFRS 15.
Paragraphs IFRS 15.BC46F-BC46H include some deliberations by IASB on contract termination. The conclusion is that the fact that an entity continues pursuing collection of consideration due from the customer does not preclude the entity to consider the contract to be terminated. Moreover, IASB notes that it is often the case that a contract often gives the entity right to terminate the contract in the event of non-payment by the customer and such a termination does not affect the entity’s rights to recover any amounts owed by the customer. In practice, this may be applied to situations when entity stops providing goods or services to the customer and recognises consideration received for satisfied performance obligations as revenue.
More about IFRS 15
See other pages relating to IFRS 15:
Identify a Contract
Performance Obligations and Timing of Revenue Recognition
Principal vs Agent, or Reporting Revenue Gross vs Net
Revenue from Licensing of Intellectual Property
Revenue from Customers’ Unexercised Rights (Breakage)
Customer Loyalty Programmes and Other Options for Additional Goods or Services
Contract Assets and Contract Liabilities