Identifying a Contract with a Customer (IFRS 15)

Last updated: 6 October 2023

To be accounted for under IFRS 15, a contract must meet the criteria set out in IFRS 15.9:

• Both parties have approved the contract and are committed to performing their respective obligations.
• The rights of each party concerning the goods or services to be delivered can be identified by the entity.
• The entity can identify the payment terms for the goods or services to be transferred. This shouldn’t be mistaken for unpriced contract modifications.
• The contract has commercial substance. This means that the contract is expected to change the risk, timing, or amount of future cash flows for the entity.
• It’s probable that the entity will receive the agreed consideration in return for the goods or services provided to the customer.

Let’s delve deeper.

Definition of a customer

A customer is a party that enters into a contract with an entity to obtain goods or services resulting from the entity’s ordinary activities, in return for a consideration (IFRS 15.6). The primary goal of this definition is to distinguish contracts with customers (falling under IFRS 15) from collaborations or partnerships (which do not). IFRS 15 doesn’t offer specific guidance on this distinction as the IASB felt that universal guidance wouldn’t be practical due to industry variations (IFRS 15.BC54). Usually, determining whether a party is a customer is straightforward. However, in specific scenarios, all relevant factors must be scrutinised. Paragraph IFRS 15.BC54 offers examples leading to such assessments:

• Biotech and pharmaceutical entities might collaborate on R&D, as might entities in aerospace, defence, tech, healthcare, or higher education.
• Partners in offshore oil and gas might pay one another to offset discrepancies in their entitled production from a field during a given period.
• Non-profit entities might receive grants for research, with the sponsor dictating the research outcome’s application.

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Contract approval and commitment to perform obligations

Contracts can be approved in different ways, depending on local laws and industry norms. It could be in writing, verbally, or via usual business practices (like emails, if permissible by local regulations). It’s vital that such an approval establishes rights and obligations that are enforceable within that jurisdiction (IFRS 15.10). IFRS 15.BC36 discusses contracts where parties are ‘substantially committed’, noting that such contracts still fall within the scope of IFRS 15.

Contract duration

IFRS 15 must be applied for the duration of the contract (i.e., the contractual period) where the parties possess current enforceable rights and obligations (IFRS 15.11). For contracts with non-penalising early termination clauses, it’s essential to identify which rights and obligations are enforceable. For instance, a long-term agreement might be treated as a monthly one if substantive early termination options are in place.

Cancellable contracts

From the IFRS 15 perspective, if both parties can unilaterally terminate a wholly unperformed contract without incurring a penalty to the other party, then no contract exists (IFRS 15.12). However, if only one party has this right, then the contract falls under IFRS 15 and is subject to its disclosure requirements.

Commercial substance of a contract

Under IFRS 15.9(d), a contract must possess commercial substance, implying that the entity’s future cash flows, in terms of risk, timing, or amount, are expected to change due to the contract. This requirement aims to prevent entities from artificially boosting their revenue by merely exchanging goods or services amongst themselves without genuine business intent (IFRS 15.BC40).

Barter transactions

Unfortunately, IFRS 15 does not provide specific guidelines for barter transactions. The previous SIC 31 Interpretation on this matter has been replaced by IFRS 15. As a result, entities must follow the general criteria outlined in IFRS 15 when accounting for these transactions. Key considerations include:

• Whether the transaction has commercial substance.
• If the counterparty meets the definition of a customer.
• Whether a contract specifies a distinct good or service that the customer will gain control over.
• If the reporting entity will gain control over a non-cash consideration in exchange for the goods or services provided.

Probability of payment

IFRS 15 mandates that for a contract to be within its scope, it must be probable that the entity will collect the promised consideration. This assessment should consider both the customer’s financial capability and their intent to pay. This evaluation is linked solely to the goods or services actually transferred to the customer, not all items in the contract. Hence, if a customer defaults and the entity doesn’t deliver further goods or services, the potential payment for undelivered items isn’t considered in this evaluation. The IASB clarified that they didn’t intend many contracts to fail the collectability condition. This criterion seeks to ensure that revenue is recognised from genuine, valid contracts (IFRS 15.BC45-46E). For application examples, refer to Examples 1, 2, and 3 accompanying IFRS 15.

Combining contracts

IFRS 15.17 states that if certain criteria are met, multiple contracts should be combined for accounting purposes. Such combinations should occur if the contracts are initiated close in time with the same customer (or their related parties) and if any of the following conditions are met:

• The contracts are negotiated together with a single commercial objective;
• The consideration in one contract is contingent upon the price or performance of the other; or
• Some of the goods or services promised the contracts are a single performance obligation.

IFRS 15 prioritises the underlying rights and obligations over the form of the contracts. Thus, the use of multiple contracts for related goods or services, or one for unrelated ones, shouldn’t affect their accounting treatment under IFRS 15.

Reassessment

Reassessment of the above criteria is required only in case of significant changes in circumstances, such as the customer’s financial standing deteriorating markedly. However, any resulting impact is applied prospectively to goods or services yet to be delivered, meaning previously recognised revenue isn’t reversed (IFRS 15.13, IFRS 15.BC34). For an illustration, refer to Example 4 accompanying IFRS 15.

Revenue recognition without a contract

When an entity receives payment under a contract not aligned with IFRS 15’s criteria, revenue is only recognised when the contract is either completed or terminated. Specifically, this means either:

• The entity has fulfilled all obligations, and most or all of the non-refundable consideration has been received; or
• The contract has been terminated and the received consideration is non-refundable.

If neither of the conditions is met, the received consideration is recognised as a liability, reflecting the entity’s future obligations to deliver goods or services, or return the payment. Example 1 of IFRS 15 illustrates the application of these requirements.

IFRS 15.BC46F-BC46H further discusses contract termination. The IASB concludes that even if an entity continues to seek payment from a customer, it can still consider the contract terminated. Furthermore, contracts often grant entities the right to end them upon customer default, but this doesn’t negate the entity’s rights to any owed amounts. Practically, this can apply when an entity stops servicing a customer and recognises the received consideration for satisfied performance obligations as revenue.

More about IFRS 15

See other pages relating to IFRS 15: