IFRS 15 Contracts with customers

IFRS 15 Contracts with customers defines a contract as an agreement between two or more parties that creates enforceable rights and obligations.

Based on IFRS 15.9, an entity should account for a contract with a customer that is within its scope only when all of the following criteria are met:

  1. The parties to the contract have approved the contract and are committed to perform their respective obligations.IFRS 15 Contracts with customers
  2. The entity can identify each party’s rights regarding the goods or services to be transferred.
  3. The entity can identify the payment terms for the goods or services to be transferred.
  4. The contract has commercial substance. IFRS 15 Contracts with customers
  5. It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer (collectability threshold).

As a practical expedient, IFRS 15 allows for application of the guidance to a portfolio of contracts (or performance obligations) with similar characteristics, if an entity reasonably expects that the effects on the financial statements of applying the guidance to the portfolio would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio.

1 Approval and Commitment to the Contract

Under the first criterion, both parties must approve the arrangement and be committed to perform. In other words, a contract creates enforceable rights and obligations between two parties. Enforceability of the rights and obligations in the contract is a matter of law. Contracts can be written, oral or implied by an entity’s customary business practices. These practices may vary across different legal jurisdictions, industries and entities. IFRS 15 Contracts with customers

A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party. A contract is wholly unperformed if both of the following criteria are met:

  • The entity has not yet transferred any promised goods or services to the customer. IFRS 15 Contracts with customers

  • The entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.

Key takeaway: Develop and document policies regarding approval requirements for different types of contracts. This may involve obtaining legal advice as to whether a contract is legally enforceable, particularly in the case of oral or implied contracts.

2 + 3 Identification of each Party’s Rights and Payment Terms

The second and third criteria are fairly straight forward – in that each party must be able to identify their rights regarding the goods or services to be transferred as well as the payment terms. IFRS 15 Contracts with customers

Entities need to be able to objectively identify both explicit and implicit rights in the contract.  For example, an entity’s past business practices of offering a general right of return would need to be considered as an implicit right in a contract, even when the contract is silent as to returns. IFRS 15 Contracts with customers

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Under the new guidance, identifying the payment terms does not require that the transaction price be fixed or stated in the contract with the customer. Rather, provided there is an enforceable right to payment, and the contract contains sufficient information to estimate the transaction price, the contract is likely to qualify for accounting under ASC 606, provided all the other criteria are met.

Key takeaway: Thoroughly review all contracts, and discern both explicit and implicit rights as well as payment terms. These rights and payment terms could vary among different customers, industries or even among different contracts with the same customers.

4 – Commercial Substance

The fourth criterion requires that the contract have commercial substance. In order to have commercial substance, the risk, timing or amount of an entity’s cash flows must be likely to change as a result of the contract. The commercial substance criterion was established to prevent entities from artificially inflating revenue, such as grossing up revenues through round-tripping transactions, whereby the parties exchange the same goods and services to show higher volume. IFRS 15 Contracts with customers

Key takeaway: The commercial substance determination is consistent with previous IFRS, and in some cases, requires significant judgement or legal interpretation. Entities have to ensure that their contracts pass the commercial substance test.

5 – Collectability Threshold

The fifth criterion requires that it be probable that the entity will collect substantially all of the consideration it is entitled to in exchange for the goods or services that will be transferred. The term probable is defined consistently with Current US GAAP, which is “likely to occur.”

This requires an assessment of both the customer’s ability and intent to pay substantially all of the consideration promised in exchange for the goods or services that will be transferred to the customer. In other words, an expectation of collecting all of the consideration promised in the contract is not required, only the consideration related to goods or services that will be transferred to the customer. As part of this assessment, an entity should consider its exposure to credit risk and its ability to mitigate that credit risk. Examples of contractual terms or customary business practices that might mitigate credit risk include the following: IFRS 15 Contracts with customers

  • Requiring up-front payment terms whereby the entity receives consideration before the transfer of the promised goods or services.

  • The ability to stop transferring the promised goods or services. (e.g. the ability to discontinue providing service in the third month of a 12 month contract in the event of customer nonpayment.)

Key takeaway: The collectability assessment requires judgement and consideration of all the facts and circumstances, including the entity’s customary business practices and its knowledge of the customer, in determining whether it is probable that an entity will collect substantially all of the consideration to which it expects to be entitled. Collectability is not considered in the transaction price, however, it is an important factor in determining whether a valid contract exists.

Examples IFRS 15 Contracts with customers

Assessing the existence of a contract: Sale of real estate

In an agreement to sell real estate, Seller X assesses the existence of a contract. In making this assessment, X considers factors such as:

  • the buyer’s available financial resources;
  • the buyer’s commitment to the contract, which may be determined based on
  • the importance of the property to the buyer’s operations;
  • X’s prior experience with similar contracts and buyers under similar
  • circumstances;
  • X’s intention to enforce its contractual rights;
  • the payment terms of the arrangement; and
  • whether X’s receivable is subject to future subordination.

If X concludes that it is not probable that it will collect the amount to which it expects to be entitled, then a contract to transfer control of the real estate does not exist. Instead, X applies the guidance on consideration received before concluding that a contract exists, and initially accounts for any cash collected as a deposit (liability).

Something else -   Assessing collectibility for a portfolio of contracts

Assessing the existence of a contract: No written sales agreement

Shoe Manufacturer S holds products available to ship to customers before the end of its current fiscal year. Shoe Shop T places an order for the product, and S delivers the product before the end of its current fiscal year.

S generally enters into written sales agreements with this class of customer that require the signatures of the authorised representatives of both parties. S prepares a written sales agreement and its authorised representative signs the agreement before the end of the year. T does not sign the agreement before the end of S’s fiscal year. However, T’s purchasing department has orally agreed to the purchase and stated that it is highly likely that the contract will be signed in the first week of S’s next fiscal year.

After consulting its legal counsel and obtaining a legal opinion, S determines that based on local laws and legal precedent in T’s jurisdiction, T is legally obliged to pay for the products shipped to it under the agreement, even though T has not yet signed the agreement.

Therefore, S concludes that a contract exists and applies the general requirements of the standard to sales made under the agreement up to the year end.

Collectability threshold: Assessment based on goods or services to be transferred

Company C contracts with Customer D to sell 1,000 units for a fixed price of 1 million. D has a poor payment history and often seeks price adjustments after receiving orders and so C assesses that it is probable that it will collect only 70% of the amounts due under the contract.

Based on its assessment of the facts and circumstances, C expects to provide an implicit price concession and accept 70% of the fixed price from D. When assessing whether collectability is probable, C assesses whether it expects to receive 700,000, which is the amount after the expected implicit price concession.

On subsequent reassessment, if C expects to collect more than 700,000, then it recognises the excess as revenue. If C subsequently assesses that it will collect less than 700,000, then C recognises the shortfall as a bad debt expense, which is measured using the guidance on impairment of receivables. However, if C determined that it had granted an additional price concession, then the shortfall would be a reduction in transaction price and revenue.

To Reassess or Not Reassess, That is the Question

If a contract meets all of the above criteria at contract inception, those criteria should not be reassessed unless there is an indication of a significant change in facts and circumstances. IFRS 15 Contracts with customers

Something else -   The five contract identification criteria

If a contract does not meet the above criteria, than the contract should continue to be assessed to determine whether the criteria are subsequently met. When a contract does not meet the criteria to be considered a contract under IFRS 15 and consideration is received from the customer, the entity should recognise the consideration received as revenue only when one or more of the following have occurred:

  • 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. IFRS 15 Contracts with customers
  • The contract has been terminated, and the consideration received from the customer is non-refundable.
  • The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is non-refundable.

Consideration received from the customer should be recognised as a liability until one of the events above occurs or until the contract meets the criteria to be considered a contract with a customer under IFRS 5. The liability recognised represents the entity’s obligation to transfer goods or services, or to refund the consideration received. IFRS 15 Contracts with customers

Assessment focuses on enforceability, not form of the contract

The assessment of whether a contract exists for the purpose of applying the standard focuses on the enforceability of rights and obligations based on the relevant laws, legal precedent and regulations, rather than the form of the contract (oral, implied or written). This may require significant judgement in some jurisdictions or for some arrangements, and may result in different assessments for similar contracts in different jurisdictions. In cases of significant uncertainty about enforceability, a written contract and legal interpretation by qualified counsel may be required to support a conclusion that the parties to the contract have approved and are committed to performing under the contract.

However, although the contract has to create enforceable rights and obligations, some of the promises in the contract to deliver a good or service to the customer may be considered performance obligations even though they are not legally enforceable.

IFRS 15 Contracts with customers

IFRS 15 Contracts with customers IFRS 15 Contracts with customers IFRS 15 Contracts with customers IFRS 15 Contracts with customers 

IFRS 15 Contracts with customers IFRS 15 Contracts with customers  IFRS 15 Contracts with customers  IFRS 15 Contracts with customers 

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