A Review of the IASB’s revised Exposure Draft ED/2011/6
byTan Liong Tong
In November 2011, the IASB published a revised Exposure Draft ED/2011/6, Revenue from Contracts with Customers. The IASB received nearly 1,000 comment letters on the June 2010 exposure draft and, in response, have revised various aspects to refine and make further improvements to the original proposals. The revised ED also provides definitive guidance on the transfer of control over time, which when finalised as an IFRS, would require revenue to be recognised based on the percentage of completion method for long-term contracts with customers, such as agreements for the construction of real estate.
This article examines the salient features and changes made to the original ED. It also draws some implications on practice. It aims to assist preparers and users of financial statements better understand the requirements of the proposed standards and prepare for application when they become part of the IFRS-compliant Malaysian Financial Reporting Standards in the near future.
1. The Salient Features of the New Model for Revenue Accounting
The proposed model for revenue accounting is the same as in the original ED. It is based on the rationale that an entity should recognise revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the entity receives, or expects to receive, in exchange for goods or services. This serves as the core principle for revenue accounting.
Some minor amendments were made to the original ED but the five steps to revenue accounting remain the same, as follows:
(a) Identify the contract with a customer;
(b) Identify the separate performance obligations in the contract;
(c) Determine the transaction price;
(d) Allocate the transaction price to the separate performance obligations; and
(e) Recognise revenue when (or as) the entity satisfies a performance obligation.
In a straightforward sale of retail goods, applying these requirements to a single performance would not pose any practical problem. However, in some cases, the entity needs to consider the terms of the contract, and the related facts and circumstances, when using judgements in the application of the proposed standards.
(a) Identifying the Contract
The proposed model is a contract-based model, which means that revenue accounting applies only if there is a contract with a customer. The IASB considered but rejected the activity-based model, where revenue is recognised as an entity undertakes activities in producing goods or services, regardless of whether a contract with a customer exists. Note that for certain items, such as biological assets and agricultural produce that are not within the scope of this (draft) IFRS, income is recognised when an entity undertakes activities that enhance the value of the assets or produce the agricultural commodities.
Under the proposed model an entity needs to apply the (draft) IFRS to each contract with its customers. A contract is defined as “an agreement between two or more parties that creates enforceable rights and obligations”. Contracts can be written, oral or implied by the entity’s customary business practices and processes. An entity shall consider those practices and processes in determining whether a contract exists.
For revenue accounting, a contract exists only if: (a) the contract has commercial substance, (b) the parties to the contract have approved the contract and are committed to satisfying their respective obligations, (c) the entity can identify each party’s enforceable rights regarding the goods and services to be transferred, and (d) the entity can identify the terms and manner of payment for those goods and services. However, a contract does not exist for the purpose of applying the (draft) IFRS if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (parties).
In some cases, the entity needs to account for two or more contracts together (i.e. combine the contracts) when they are entered into at or near the same time with the same customer (or related parties). The original ED proposed the criterion of price interdependence for combining contracts. The revised ED requires an entity to account for separate contracts as a single contract if: (a) the contracts are negotiated as a package with a single commercial objective, (b) the amount of consideration to be paid in one contract depends on the price or performance of the other contract, or (c) the goods or services promised in the contracts (or some goods or services promised in the contracts) are a single performance obligation. The requirement that it must be with the same customer (or its related parties) means that an entity would not be able to combine contracts with different customers. For example, contracts with different land owners to build their respective bungalows must be accounted for separately even if those contracts have been negotiated as a package or can be performed concurrently or consecutively. However, the revised ED clarifies that, as a practical expedient, an entity may apply the (draft) IFRS to a portfolio of contracts (or performance obligations) with similar characteristics if the entity reasonably expects that the result of doing so would not differ materially from the result of applying the (draft) IFRS to the individual contracts (or performance obligations).
The revised ED provides further guidance on the accounting for contract modifications. A contract modification exists only when the parties to a contract have approved a change in the scope or price of a contract (or both). A contract modification is accounted for as a separate contract if it results in addition to the existing contract of both: (a) promised goods or services that are distinct, and (b) an entity’s right to receive an amount of consideration that reflects the entity’s stand-alone selling prices of the promised good(s) or service(s) and any appropriate adjustments to that price to reflect the circumstances of the particular contract. In other words, a modification is accounted for as a separate contract if it only results in the addition of a distinct good or service at a price commensurate with the additional good or service. In all other cases of contract modifications, an entity would need to re-evaluate the performance obligations in the existing contracts and re-allocate the transaction price to each performance obligation.
The guidance on segmenting a contract into separate contracts in the original ED has been removed. The segmentation guidance in the original ED is redundant when an entity applies the separate performance obligations approach of the (draft) IFRS i.e. if a contract has separate performance obligations, each has to be accounted for separately, which is the same as the segmentation requirement of the original ED.
(b) Identifying the Separate Performance Obligations
An essential feature of the ED is the concept of performance obligation embodied in a contract with a customer to provide goods and services in exchange for consideration. A performance obligation is defined as “an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer”. Under the new model, an entity should evaluate the terms of the contract and its customary business practices to identify all promised goods or services and determine whether to account for each promised good or service as a separate performance obligation.
The goods and services include not only those routinely sold or provided by the entity but also those that an entity arranges with another party to transfer those goods and services (for example, acting as an agent of another party), standing ready to provide goods and services, constructing or developing an asset on behalf of a customer, granting licences, rights to use and options, and performing a contractually agreed task.
An entity needs to identify all its performance obligations in a contract. If an entity promises to transfer more than one good or service, the entity shall account for each promised good or service as a separate performance obligation only if it is distinct. If a good or service is not distinct, an entity shall combine that good or service with other promised goods and services until the entity identifies a “bundle” of goods or services that is distinct. In some cases, such bundling may result in an entity accounting for all the goods and services promised in the contract as a single performance obligation.
The revised ED clarifies that a good or service is distinct if either: (a) the entity regularly sells the good or service separately, or (b) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. Readily available resources are goods or services that are sold separately (by the entity or by another entity) or resources that the customer has already obtained (from the entity or from other transactions or events). The requirement that the good or service must have a distinct function and a distinct profit margin in the original ED has been removed.
For example, in a public-to-private power plant service concession arrangement with a government, an operator would need to identify and to account separately, its performance obligations: (a) to construct the plant, (b) to operate the plant to supply the energy; and (c) to upgrade the plant before it is handed over to the government.
A good or service in a bundle of promised goods or services is not distinct and, therefore, the entity would account for the bundle as a single performance obligation if (a) the goods or services in the bundle are highly interrelated and transferring them to the customer requires that the entity also provides a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted; and (b) the bundle of goods or services is significantly modified or customised to fulfil the contract. Also, as a matter of practical expedient, an entity may account for two or more distinct goods or services promised in a contract as a single performance obligation if those goods or services have the same pattern of transfer to the customer. For example, if an entity promises to transfer two or more distinct services to a customer over the same period of time, the entity could account for those promises as one performance obligation if applying one method of measuring progress would faithfully depict the pattern of transfer of those services to the customer.
The revised ED also provides further guidance on warranties arising from contracts with customers. It identifies two types of product warranties. One type provides coverage for latent defects in the product (assurance that the related product complies with agreed-upon specifications) and this does not give rise to a separate performance obligation. For this type of warranty, an entity would only need to recognise a provision i.e. cost accrual, for any unsatisfied performance obligations in respect of defective products transferred to the customer. The other type of warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications. This type of warranty gives rise to a separate performance obligation if a customer has the option to purchase the warranty separately, for example, when the warranty is priced or negotiated separately. The original ED did not specify the criterion of customer’s option to purchase. For either type, there is a deferral of revenue recognition as an entity would need to reduce the revenue amount by the expected warranty cost of latent defects or allocate the consideration i.e. the transaction price to the product and to the warranty service.
(c) Determining the Transaction Price
Transaction price for a contract is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, sales taxes). When determining the transaction price, an entity would consider the effects of: (a) variable consideration; (b) the time value of money; (c) non-cash consideration; and (d) consideration payable to the customer, if any.
The promised amount of consideration may vary because of discounts, rebates, refunds, credits, incentives, performance bonuses, penalties, contingencies, price concessions or other similar items. For example, an IT company grants a software licence to a customer for a fixed price plus 10% of the customer’s sales from the use of the software for a specified period. In this case, the consideration receivable is variable because it includes a sales-type royalty.
When the consideration receivable is variable or uncertain, the revised ED proposes that the transaction price should be estimated using a method that the entity expects to better predict the amount of the consideration to which it will be entitled. Depending on the circumstances, the method would either be the expected value that reflects the entity’s probability-weighted estimate of variable consideration (including reasonable estimates of contingent amounts, in addition to the effect of the time value of money), or the most likely amount i.e. the single most likely amount in a range of possible consideration amounts. The original ED required only the probability-weighted estimate of expected value. The expected value method is considered appropriate if there are many possible outcomes and the entity has a large number of contracts with similar characteristics. The most likely amount may be an appropriate estimate of the transaction price if the contract has only two possible outcomes (for example, in a construction contract with an incentive payment for early completion, the possible outcome is either the entity will achieve the early completion or it will not).
The revised ED introduces a constraint on the cumulative amount of revenue recognised if the consideration is variable. The cumulative amount recognised to date should not exceed the amount to which the entity is reasonably assured to be entitled. An entity is reasonably assured to be entitled to the amount of consideration allocated to satisfied performance obligations only if it satisfies both criteria of: (a) the entity has experience with similar types of performance obligations (or has other evidence such as access to the experience of other entities); and (b) the entity’s experience (or other evidence) is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations.
Indicators that an entity’s experience (or other evidence) is not predictive of the amount of consideration to which the entity will be entitled include: (a) the amount of the consideration is highly susceptible to factors outside the entity’s influence, such as volatility in a market, (b) the uncertainty about the amount of consideration is not expected to be resolved for a long period of time, (c) the entity’s experience (or other evidence) with similar types of performance obligations is limited, and (d) the contract has a large number and broad range of possible consideration amounts.
If the entity is not reasonably assured to be entitled to the amount of the transaction price allocated to satisfied performance obligations, the cumulative amount of revenue recognised as of a reporting date is limited to the amount of the transaction price to which the entity is reasonably assured to be entitled. For example, an entity sells an asset to a customer for a fixed price of RM10 million plus a sales-based royalty, calculated at 10% of the customer’s subsequent sales of the goods produced by the asset in excess of RM2 million. If the entity has experience of similar types of arrangements and the experience is predictive of the consideration receivable, it estimates the transaction price by taking into account both the fixed price and the expected additional revenue arising from the sales-based royalty. If the entity does not have experience or its experience is not predictive of the consideration receivable, it limits the measurement of the transaction price to the amount reasonably assured i.e. the fixed price of RM10 million.
Time Value of Money
Unlike the proposal in the original ED, the revised ED requires an entity to adjust the transaction price for the time value of money only if the contract includes a financing component that is significant to the contract. A financing component is significant if: (a) the consideration would be substantially different if the customer had paid cash at the time of transfer, (b) there is a significant timing difference between transfer of goods or services and payment; or (c) the contract contains an implicit or explicit interest rate. If the financing component is not significant, the effect of the time value of money is ignored. This exception would typically apply to transfers of promised goods or services where substantially all the promised considerations are received within one year or less. The original ED required the rate to reflect only the time value of money, which might be interpreted as the risk-free rate. The revised ED clarifies that the discount rate should reflect the rate an entity would charge its customer in a separate financing arrangement, and this would include the credit characteristics of the party receiving the financing. This rate can be calculated by the IRR (internal rate of return) that equates the nominal amounts of the consideration receivable to the cash selling price of the promised good or service.
If a customer promises consideration in a form other than cash, an entity would measure the non-cash consideration (or promise of non-cash consideration) at fair value. If an entity cannot reasonably estimate the fair value of the non-cash consideration, it would measure the consideration indirectly by reference to the stand-alone selling prices of the goods or services promised to the customer in exchange for the consideration.
Consideration Payable to a Customer
If an entity pays, or expects to pay, consideration to a customer (or to other parties that purchase the entity’s goods and services from the customer) in the form of cash, credit or other items that the customer can apply against amounts owed to the entity, the entity would account for the consideration payable to the customer as a reduction of the transaction price unless the payment is in exchange for a distinct good or service. For example, a property developer sells an apartment to a customer at an agreed price. In the contract, the developer is obliged to lease back the property with a minimum guaranteed rental for a specified period. In this case, the consideration receivable in the contract is variable because contingent amounts are payable to the customer if rental income in the specified period is below the minimum guaranteed level. In this case, the developer needs to account for any contingent consideration payable to the customer as a reduction of the agreed price to determine the transaction price in the contract.
The collectibility or credit risk element that was included as a determinant of transaction price in the original ED has been removed. Thus, credit risk of a customer is excluded in the measurement of the consideration receivable. Instead, an entity recognises an allowance for any expected impairment loss in contracts with customers and the corresponding amount in profit or loss would be presented as a separate line adjacent to revenue (i.e. a contra revenue presentation). This change in the proposed requirement on collectibility is consistent with the “expected loss” model proposed for impairment of financial assets in the current IASB’s IAS 39 replacement project.
(d) Allocating the transaction price to separate performance obligations
When a contract contains more than one performance obligation, an entity needs to allocate the transaction price to all separate performance obligations. The proposed allocation method is based on the relative selling prices i.e. in proportion to the stand-alone selling prices of the goods and services underlying each performance obligation. If the good or service is not sold separately, the entity would need to estimate its stand-alone selling price. The techniques or methods to estimate this selling price may include: (a) adjusted market assessment approach, (b) expected cost plus a margin approach, and (c) residual approach. The original ED was silent on the techniques or methods of allocation.
(e) Recognising Revenue when a Performance Obligation is Satisfied
An entity would recognise revenue when (or as) it satisfies a performance obligation identified in the contract by transferring a promised good or service (an asset) to a customer. An asset is transferred when (or as) the customer obtains control of the asset. The amount recognised is the amount of the transaction price allocated to that performance obligation. The revised ED adds the term “or as” to provide for circumstances where control is transferred to a customer over time.
Control of an asset refers to one’s ability to direct the use of, and receive the benefits from, the asset (as clarified in the Conceptual Framework). Control is thus the most critical criterion for determining the timing of revenue recognition and it should be assessed from the perspective of the customer. A customer obtains control of an asset (even if only momentarily, such as in many services) when the customer has the ability to direct the use of, and receive the benefits from, the good or service. Control includes the ability to prevent other entities from directing the use of, and receiving the benefits from, a good or service. Ability to use refers to the present right to use the asset for its remaining economic life or to consume the asset. Ability to receive the benefits from an asset refers to the present right to obtain substantially all of the potential cash flows from that asset. The customer can obtain cash flows from an asset directly or indirectly in many ways, such as by using the asset to produce goods or services, using the asset to enhance the value of other assets, using the asset to settle liabilities or reduce expenses, selling or exchanging the asset, pledging the asset to secure a loan, or simply holding the asset.
For example, in a contract to sell and build an apartment or a housing unit, the customer obtains control of the asset as it is being developed. This is because the customer obtains substantially all of the potential cash flows from that specified apartment or housing unit, including pledging the asset in its current uncompleted stage to secure a loan.
The revised ED takes a new approach to test the satisfaction of a performance obligation. An entity applies this test at contract inception to determine whether it satisfies the performance obligation over time by transferring control of a promised good or service over time (this concept of transfer over time replaces the concept of transfer continuously used in the original ED and IFRIC 15). If the entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.
An entity transfers control of a good or service over time and, hence, satisfies a performance obligation and recognises revenue over time if at least one of the following two criteria is met:
(a)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; or
(b)The entity’s performance does not create an asset with an alternative use to the entity and at least one of the following criteria is met:
(i) the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs.
(ii) another entity would not need to substantially re-perform the work the entity has completed to date if that other entity were to fulfil the remaining obligation to the customer. In evaluating this criterion, the entity shall presume that another entity fulfilling the remainder of the contract would not have benefit of any asset (for example, work in progress) presently controlled by the entity. In addition, an entity shall disregard potential limitations (contractual or practical) that would prevent it from transferring a remaining performance obligation to another entity.
(iii) the entity has a right to payment for performance completed to date and it expects to fulfil the contract as promised. The amount entitled must at least compensate the entity for performance completed to date.
When evaluating whether an asset has an alternative use, an entity considers at contract date, the effects of contractual and practical limitations on the entity’s ability to readily direct the promised asset to another customer. A promised asset would not have an alternative use to an entity if the entity is unable, either contractually or practically, to readily direct the asset to another customer. For example, in a housing development project, a developer that has sold an uncompleted housing unit (the asset in its current stage, which may be an empty land or an uncompleted high rise apartment unit) to a customer would not have an alternative use for the promised unit because the contract has substantive terms that preclude the developer from directing or re-selling the promised unit to another customer.
Example 7 of the Illustrative Examples to the revised ED is of particular significance to property developers in Malaysia, and it is reproduced here to illustrate how a developer should assess the transfer of control over time.
With these revised proposals, it is now clear that for long-term contracts with customers, such as contracts for the construction of real estate, the performance obligation is satisfied over time. Hence, revenue would be recognised over time by using the percentage of completion method. Appropriate methods to measure the stage of completion include the output methods and the input methods (similar to those applied in current practice). To recognise revenue over time, an entity must be able to reasonably measure its progress towards complete satisfaction of the performance obligation and this requires reliable information about the outcome of a performance obligation. In some circumstances (for example, in the early stages of a contract), an entity may not be able to reasonably measure the outcome of a performance obligation, but the entity expects to recover the costs incurred in satisfying the performance obligation. In those circumstances, the entity recognises revenue only to the extent of the costs incurred until such time that it can reasonably measure the outcome of the performance obligation.
Note that for a contract that transfers control of an asset over time, an entity needs only assess the above criteria. By default, if the above criteria are not met, a performance obligation is satisfied at a point in time. An entity considers the control criterion and the specified indicators of the transfer of control, which include, but not limited to, the following:
(a) The entity has a present right to payment for the asset.
(b) The customer has legal title to the asset.
(c) The entity has transferred physical possession of the asset to the customer.
(d) The customer has the significant risks and rewards of ownership of the asset.
(e) The customer has accepted the asset.
The indicator of customer-specific design or function of the good or service in the original ED has been removed. Note that not one of the preceding indicators determines by itself whether the customer has obtained control of the good or service. Moreover, some of the indicators may not be relevant to a particular contract (for example, physical possession and legal title would not be relevant to services). Thus, a reporting entity would need to apply judgements to determine when control has passed, by considering those five indicators and other facts and circumstances.
2. Licensing and Rights to Use Arrangements
In the original ED, the accounting for granting of licences or other intellectual property was determined primarily by the criterion of “exclusivity”. The IASB now acknowledges that exclusivity is not the appropriate basis in accounting for licences. In granting a licence, an entity gives a promised right to the customer. That right gives rise to a performance obligation that is satisfied at a point in time when the customer obtains control of the right. The control of rights to use an intellectual property, such as a software licence, is met only if the customer can use and benefit from the licenced software, that point in time being when the customer has obtained the access code to the software.
3. Other Guidance
The ED also proposes guidance on accounting for costs of contracts with customers. An entity would recognise as an asset the incremental costs of obtaining a contract if the entity expects to recover those costs. Other costs, such as selling and marketing costs, would be recognised as expenses when incurred. To account for the costs of fulfilling a contract with a customer, an entity would apply the requirements of other standards (for example, IAS 2, Inventories, IAS 16, Property, Plant and Equipment, and IAS 38, Intangible Assets) if applicable. If the costs incurred in fulfilling a contract are not eligible for capitalisation in accordance with other IFRSs, an asset is recognised only if those costs: (a) relate directly to a contract, (b) generate or enhance resources of the entity that will be used in satisfying performance obligations in the future, and (c) are expected to be recovered.
Also, an entity would recognise a liability and a corresponding expense if a performance obligation is onerous. A performance obligation is onerous if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. The lowest cost is the lower of: (a) the amount of costs that relate directly to satisfying the performance, and (b) the amount the entity would pay to exit the performance obligation. The onerous test must be applied to each separate performance obligation and at the level of the remaining performance obligation in a contract.
The ED further proposes enhanced disclosure requirements to help users better understand the amount, timing and uncertainty of revenue and cash flows from contracts with customers. An entity would need to disclose qualitative and quantitative information about: (a) its contracts with customers, including a maturity analysis for the contracts extending beyond one year, and (b) the significant judgements, and changes in judgements, made in applying the proposed standards to those contracts.
4. The Improvements and the Implications on Practice
In straightforward contracts for sales of goods or rendering of services, the proposed requirements would have little, if any, effect on current practice. For construction contracts, the (draft) IFRS would not change the general requirement that contract revenue should be recognised based on stage of completion. A significant improvement in the revised ED is the definitive guidance on transfer of control over time, which when the specified criteria are met, requires the application of the percentage of completion method for long-term contracts with customers to manufacture or construct an asset.
The IASB also noted that the proposed standards may differ from current practice in the following ways:
(a) Recognition of revenue only when control of goods or services has passed to the customer – contracts for the development of an asset (for example, construction, manufacturing and customised software) would result in transfer over time if the customer controls the asset as it is developed or the entity has no alternative use of the asset. This requirement may differ from current practice of recognising revenue only on completion of a contract.
(b) Identification of separate performance obligations – an entity would be required to divide a contract into separate performance obligations for goods or services that are distinct. As a result of this requirement, an entity might separate a contract into units of account that differ from those identified in current practice.
(c) Licensing and rights to use – an entity would be required to evaluate a licence to use the entity’s intellectual property and recognise revenue when control of the right to use the licence is transferred at a point in time. The requirement for assessing whether the licence is granted on an exclusive or non-exclusive basis in the original ED has been removed. The pattern of revenue recognition based on transfer of control at a point in time may differ from current practice of recognising revenue over the term of the licence
(d) Effect of credit risk – the effect of a customer’s credit risk (i.e. collectibility) would not affect how much revenue an entity recognises but an allowance for expected impairment loss must be recognised separately and presented as a contra revenue.
(e) Use of estimates – in determining the transaction price (for example, estimating variable consideration) and allocating the transaction price on the basis of stand-alone selling prices, an entity would be required to use estimates more extensively than in applying existing IFRSs.
(f) Disclosure – the proposed standards would require an entity to disclose more information about its contract with customers than is currently required, including more disaggregated information about recognised revenue and more information about its performance obligations remaining at the end of the reporting period.
The proposals in the revised ED would correct the weaknesses and deficiencies that are apparent in the current IFRSs on revenue. The proposed five-step approach to revenue accounting would result in systematic and consistent revenue recognition, and thus enhance the comparability characteristic of financial statements.
The revised ED now provides definitive guidance and clarification on the transfer of control over time and the criteria for recognising revenue over time. These revisions would resolve the controversies and diverse interpretations of IFRIC 15. It also means that for property developers that operate the “sell and build” model, revenue from contracts with customers should be recognised based on the percentage of completion method.
1. ED/2010/6, Revenue from Contracts with Customers, June 2010, IASB.
2. ED/2011/6, Revenue from Contracts with Customers, November 2011, IASB
3. FRS 201, Property Development Activities, January 2004, MASB
4. IAS 11, Construction Contracts, March 1979, IASC.
5. IAS 18, Revenue, December 1982, IASC.
6. IFRIC 12, Service Concession Arrangements, November 2006, IFRIC.
7. IFRIC 15, Agreements for the Construction of Real Estate, July 2008, IFRIC.
8. Summary of Revenue Recognition Model, April 2011, IASB.
Tan Liong Tong is the Project Manager of the MASB Working Group (WG 63) on Consolidation. The views expressed in this article are those of the author and not the official views of the MASB.