IFRS 15 and Revenue Recognition for Long-Term Contracts

Posted In | Finance | Accounting Software | Revenue Recognition

International Financial Reporting Standard (IFRS) 15 was established to introduce a uniform and comprehensive model of revenue recognition for contracts with customers. IFRS 15 was designed to replace numerous international standards, such as IAS 11 and IAS 18, as well as various interpretations related to revenue recognition. It applies to nearly all contracts with customers, including long-term contracts, except for leases, financial instruments, and insurance contracts.

 

1. The Five-Step Model of IFRS 15

To recognize revenue under IFRS 15, organizations must follow a five-step model:
 

  1. Identify the Contract with the Customer: The agreement must be enforceable, with agreed-upon rights and payment terms.
     

  2. Identify the Performance Obligations in the Contract: These are promises to deliver distinct goods or services to the customer.
     

  3. Determine the Transaction Price: This is the amount the entity expects to receive in exchange for the goods or services provided.
     

  4. Allocate the Transaction Price to the Performance Obligations: If a contract contains multiple performance obligations, the transaction price is allocated to each performance obligation based on its standalone selling price.
     

  5. Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation: Revenue is recognized when the customer gains control of the goods or services.
     

2. Revenue Recognition for Long-Term Contracts

Long-term contracts, such as construction or manufacturing contracts, can be complex due to their duration and the potential for changes during the contract term. IFRS 15 provides specific guidelines for these contracts. For a long-term contract, an entity often satisfies a performance obligation over time. This could be because the customer receives and consumes the benefits as the entity performs, because the entity's performance creates or enhances an asset that the customer controls, or because 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. When a performance obligation is satisfied over time, an entity must select a method to measure progress towards complete satisfaction of that obligation. This measure should faithfully depict the entity’s performance in transferring control of goods or services to the customer. Possible methods include output methods, such as units produced or delivered, and input methods, like costs incurred or passage of time.

 

3. Changes in the Contract and Variable Consideration

Long-term contracts often undergo changes. If the parties to the contract agree to a modification, and this introduces new or changes existing enforceable rights and obligations, the entity treats the modification as a separate contract or part of the existing contract, depending on specific criteria. Moreover, the transaction price may not always be fixed. It might include variable consideration - amounts that depend on the outcome of future events, such as performance bonuses or penalties, price concessions, volume discounts, or refunds. IFRS 15 provides guidance on how to estimate and constrain (to limit the risk of significant revenue reversal) variable consideration.

 

IFRS 15 presents a comprehensive revenue recognition framework that offers explicit guidance for long-term contracts. By providing a single, principles-based five-step model, it aims to improve comparability within industries, across industries, and across capital markets. Companies engaged in long-term contracts should review their contracts, business models, and revenue recognition policies to ensure they are in compliance with the new standard.