IFRS 15 Industrial products revenue best and complete recognition

IFRS 15 Industrial products

This narrative is designed to explore the application of IFRS 15, broken down into the 5-steps of the IFRS 15 Revenue model, for companies in the industrial manufacturing, metals, chemicals, and forestry, paper and packaging sectors.

1. Identify the contract with the customer

A company may enter into multiple contracts with the same customer at the same time. The contracts could also be affected by subsequent modifications (such as change orders).IFRS 15 Industrial products

Contract combinations

Contracts entered into at or near the same time with the same customer need to be combined if one or more 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.
  • The goods or services promised in the separate contracts are a single performance obligation.

Contract modifications

A contract modification, including that resulting from a claim, exists when the parties to the contract approve a change that creates new enforceable rights and obligations or changes the enforceable rights and obligations of the parties. A modification only affects a contract once it is approved, which can be in writing, orally, or based on customary business practices.

A contract modification is treated as a separate contract only if (1) it results in the addition of a distinct performance obligation and (2) the price is reflective of the standalone selling price of that additional performance obligation.

If these two criteria are not met, the contract modification is accounted for as an adjustment to the original contract, either through a cumulative catch-up adjustment to revenue (if no additional distinct goods or services are added or remain to be delivered) or a prospective adjustment to revenue as future performance obligations are satisfied (if distinct goods or services remain to be delivered or are added by the modification).

A change to only the transaction price is treated like any other contract modification. As it does not result in a separate contract, the change in price is either accounted for prospectively or on a cumulative catch-up basis, depending on whether the remaining performance obligations are distinct.

Case – Widgets manufacturer

How it is: Manufacturer enters into an arrangement with a customer to sell 120 widgets for $12,000 ($100 per widget). The individual widgets are distinct and are transferred to the customer over a six-month period. The parties modify the contract in the fourth month to add an additional 30 widgets for $2,400 ($80 per widget). Sixty widgets have been delivered at the time of the modification. The price of the additional widgets does not represent the standalone selling price on the modification date.IFRS 15 Industrial products

How should Manufacturer account for this modification?

Consideration
The modification is accounted for as if the original arrangement is terminated at that point and a new contract is created for the delivery of 90 widgets because the additional widgets are distinct but the price does not reflect their standalone selling price.

The remaining consideration of $8,400 (60 units remaining from the original contract @ $100 = $6,000 plus 30 new units @ $80 = $2,400) would be allocated equally to all of the remaining widgets to be provided. Thus, Manufacturer recognizes $93.33 per unit ($8,400 / 90 units) prospectively.

This may result in creation of contract assets and liabilities as the amount of revenue per unit will differ from the amounts invoiced ($100 for the remaining 60 units and $80 for the additional 30 units). When Manufacturer recognizes more revenue than consideration received, it would record a contract asset. Conversely, if consideration exceeds revenue, a contract liability would be recognized.


2. Identify performance obligations

A company may enter into a contract with a customer that includes goods delivered to the customer and goods or services to be delivered directly to an end customer.

Performance obligations are the unit of account for revenue under the new standards. A performance obligation is either a good or service that is distinct, or a series of distinct goods or services that are substantially the same and meet certain criteria.

A good or service is distinct if both of the following criteria are met:

  • 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 (i.e., capable of being distinct).
  • The company’s promise to transfer the good or service is separately identifiable from other promises in the contract (i.e., distinct in the context of the contract).

Promises to provide goods or services to the customer’s customer can be performance obligations if they are identified in the contract.


3. Determine transaction price

The transaction price is the consideration to which the vendor expects to be entitled in exchange for satisfying its performance obligations in an arrangement. Determining the transaction price may require judgment if the consideration contains an element of variable or contingent consideration—such as volume rebates, volume discounts, awards/incentive payments, claims—or a significant financing component.

Variable consideration is included in the transaction price only to the extent that it is probable [US GAAP] or highly probable [IFRS] that a significant reversal in the cumulative amount of revenue recognized will not occur in future periods if the estimates of variable consideration change. Thus, even if the total transaction price is variable (i.e., there is no fixed consideration), companies need to consider whether there is some minimum amount that is not subject to reversal.

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In addition, companies may offer volume discounts when the price per good will decrease as sales volume increases. A volume discount may be (1) a form of variable consideration or (2) a customer option to purchase future products at a discount that could be considered a material right under the new standards.

Volume rebates

Volume rebates represent variable consideration and must be estimated and recognized as a reduction to revenue as performance obligations are satisfied. To ensure that revenue recognized would not be probable [US GAAP] or highly probable [IFRS] of a significant reversal, companies need to consider both qualitative and quantitative factors, including whether:

  • The amount of consideration is highly susceptible to factors outside the company’s influence.
  • The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
  • The company’s experience (or other evidence) with similar types of contracts is limited.
  • The contract has a large number and broad range of possible consideration amounts.IFRS 15 Industrial products

Volume discounts

A volume discount may be (1) a form of variable consideration or (2) a customer option to purchase future products at a discount that could be considered a material right.

Volume discounts that are retroactive to prior purchases are similar to rebates and should be accounted for as variable consideration.

Discounts that apply only to future purchases after a certain threshold has been reached represent an option that the customer receives in connection with a current revenue transaction. Customer options are additional performance obligations in an arrangement if they provide the customer with a material right that it would not otherwise receive without entering into the arrangement.

Consideration payable to a customer

Cash payments to a customer, unless paid for a distinct good or service provided by the customer, are accounted for as reductions of the transaction price (reductions to revenue).

Case – Volume rebate

How it is: A chemical company has a one-year contract with a car manufacturer to deliver high performance plastics. The contract stipulates that the chemical company will give the car manufacturer a rebate when certain levels of future sales are reached, according to the following scheme:

Rebate

Sales volume

0%

0 – 10,000,000 lbs

5%

10,000,001 – 30,000,000 lbs

10%

30,000,001 lbs and above

The rebates are calculated based on gross sales in a calendar year and paid at the end of the first quarter of the following year. Based on its experience with similar contracts and forecasted sales to the car manufacturer for the year, management believes that the most likely rebate that it will have to pay is 5%.

How should the chemical company consider the volume rebate when recognizing revenue?

Consideration
Management defers 5% (the most likely rebate) of the per-unit price as goods are provided to the car manufacturer. Considering that experience and the forecasted usage by the car manufacturer for the year, management recognizes revenue based on the amount of estimated rebate to the extent that revenue is probable [US GAAP] or highly probable [IFRS] of not reversing.

Management monitors this estimate at each reporting date and adjusts it, as necessary, using a cumulative catch-up approach.

Case – Prospective volume discount

How it is: A chemical company has a three-year contract with a customer to deliver high performance plastics. The contract stipulates that the price per container will decrease as sales volume increases during the calendar year as follows:

Price per container

Sales volume

$100

0 – 1,000,000 containers

$90

1,000,001 – 3,000,000 containers

$85

3,000,001 containers and above

How should the chemical company consider the volume discount when recognizing revenue?

Consideration
The company should first determine whether the volume discount provides the customer with a material right that it would not otherwise receive without entering into the arrangement. The evaluation of whether an option provides a material right requires judgment; the company should consider whether the volume discount offered to its customers is incremental to the range of discounts typically given to the same class of customer.

Assuming the chemical company concludes that the volume discount is a material right, it would account for the option as a separate performance obligation. The company should allocate the transaction price to the goods (high performance plastics) and the material right (option for discounted future services) based on their relative stand-alone selling prices.

The estimate of the stand-alone selling price of the option should reflect the discount, adjusted for any discount that the customer could receive without the option (standard discount off of list price) and an expectation of the likelihood of exercise. However, the standards also provide a practical alternative if the material right is for the purchase of goods similar to the original goods.

The practical alternative would allow the company to allocate the transaction price to the optional goods by reference to the goods expected to be provided and the corresponding expected consideration (i.e., the discounted price), rather than estimating the stand-alone selling price of the material right.

Assuming the company elects to apply the practical alternative in this case, the allocation of transaction price would be:

Total consideration

$100 per container * 1,000,000 containers

$ 100,000,000

$90 per container * 1,500,000 containers

$ 135,000,000

Total expected consideration

$ 235,000,000

Total volume of goods expected to be provided

2,500,000 containers

Transaction price allocated per container

$ 94 per container ($235,000,000 / 2,500,000)

Transaction price of first container allocated to material right

$6 ($100 – $94)

Based on the allocation, the company would recognize revenue of $94 for the first container, with $6 (price paid by customer in excess of the transaction price allocated to a container) deferred as contract liability for the material right not yet satisfied. The contract liability accumulates until the discounted containers are delivered, at which time it will be recognized as revenue as the containers are delivered.

Management should update its estimate of the total sales volume at each reporting date.


4. Allocate transaction price

Under the new revenue guidance, the transaction price in an arrangement is allocated to each separate performance obligation based on the relative stand-alone selling prices (SSP) of the goods or services being provided to the customer. That allocation may need to be adjusted if variable consideration or discounts apply exclusively to only Standalone pricecertain performance obligations.

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The best evidence of SSP is the price a company charges for that good or service when the company sells it separately. If a particular good or service is not sold separately, the SSP needs to be estimated or derived by other means. SSP for each performance obligation is determined at contract inception and is not reassessed.

The transaction price is allocated to separate performance obligations in a contract based on relative stand-alone selling prices, as determined at contract inception.

Variable consideration or discounts may relate only to one or more, but not all, performance obligations in the contract. Variable consideration is allocated to specific performance obligations if both of the following criteria are met:

  • The terms of the variable consideration relate specifically to the company’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service)
  • The outcome is consistent with the allocation objective

A discount is allocated to a specific performance obligation if all of the following criteria are met:

  • The company regularly sells each distinct good or service on a stand-alone basis
  • The company regularly sells, on a standalone basis, a bundle of some of those distinct goods or services at a discount
  • The discount attributable to the bundle of distinct goods or services is substantially the same as the discount in the contract, and observable evidence supports the discount belonging to that performance obligation

5. Determine transfer of control and recognize revenue

Many companies have contracts that include long-term manufacturing processes and may include a service (installation or customization) along with the sale of products. The products and services may be delivered over a period ranging from several months to several years.

Transfer of control

Revenue is recognized upon the satisfaction of performance obligations, which occurs when control of the good or service transfers to the customer. Control can transfer at a point in time or over time.

Recognition over time

A performance obligation is satisfied over time if any one of the following criteria is met:

  • The customer receives and consumes the benefits of the company’s performance as the company performs (e.g., a service)
  • The company’s performance creates or enhances an asset that the customer controls (e.g., a major refurbishment of customer-owned equipment)
  • The company’s performance does not create an asset with alternative use to the company and the company has an enforceable right to payment (cost plus profit) for performance completed to date
Recognition point in time

A performance obligation is satisfied at a point in time if it does not meet one of these above mentioned criteria.

Determining the point in time when control transfers will require judgment. Indicators to consider in determining whether the customer has obtained control of a good include:

  • The company has a right to payment (not necessarily the same as the right to invoice)
  • The customer has legal title
  • The customer has physical possession
  • The customer has the significant risks and rewards of ownership
  • The customer has accepted the asset

Measuring progress for performance obligations satisfied over time

Methods for recognizing revenue when control transfers over time include:

Outputs used to measure progress may not be directly observable and the information to apply an output model may not be available without undue cost. In such cases, an input method may be necessary.

For contract manufacturers or companies that produce a large number of similar items, output methods such as “units produced” or “units delivered” may not faithfully depict a company’s performance if at the end of the reporting period the value of work-in-progress or finished goods that are controlled by the customer is material.

In addition, for contracts that provide both design and production services, output methods based on units delivered may not appropriately reflect performance because each item produced may not transfer an equal amount of value to the customer. In such cases, an input measure may be more appropriate.

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Case – Customized product sale & production

How it is: A vendor enters into a contract to produce a significantly-customized product for a customer. Management has determined that the contract is a single performance obligation. The contract has the following characteristics:

  • The customization is significant and the customer’s specifications may be changed at the customer’s request during the contract term.
  • Non-refundable, interim progress payments (cost plus margin) are required to finance the contract. The progress payments are scheduled to reflect the progress to date on the product, such that there is a right to payment for work performed to date.
  • The customer can cancel the contract at any time (with a termination penalty) and any work in process has no alternative use to the vendor.
  • Physical possession and title do not pass until completion of the contract.

How should the vendor recognize revenue?

Consideration
The terms of the contract, in particular the customer specifications (and ability to change the specifications), indicate that the work in process has no alternative use to the vendor, and the nonrefundable progress payments that include a profit element indicate that the vendor has the right to payment for work performed. Thus, control of the product is being transferred over the contract term. Revenue is therefore recognized over time as the products are produced. Management needs to select the most appropriate measurement model (either an input or output method) to measure the revenue arising from the transfer of control of the product over time.

Case – Several customized products sale & production

How it is: A vendor enters into a contract to construct several significantly-customized products for a customer. Management has determined that the contract is a single performance obligation. The contract has the following characteristics:

  • The majority of the payments are due after the products have been installed.
  • The customer can cancel the contract at any time (with a termination fee representing reimbursement for only the vendor’s costs) and any work in process remains the property of the vendor.
  • Due to the level of customization, the work in process cannot be sold to another customer.
  • Physical possession and title do not pass until completion of the contract.

How should the vendor recognize revenue?

Consideration
Although the products are significantly customized, the vendor is only entitled to payment for costs incurred in the event of termination, so the vendor should recognize revenue at a point in time, when control of the products transfers to the customer.

Case – Sale of ten products

How it is: A vendor enters into a contract to manufacture ten products for a customer. Management has determined that the contract is a single performance obligation satisfied over time. Each product takes a few weeks to be manufactured, and during production, the company has significant work in process.Harvested products

How should the vendor measure progress on the contract?

Consideration
The vendor should apply a method of measuring progress that depicts the company’s performance to date. The measure selected should not result in the recognition by the vendor of a material amount of inventory. Since the work in process is always significant, using a units-of-delivery or a units-of-production method would exclude from the measure of progress the work in process that belongs to the customer. Therefore, an input method, such as ratio of cost incurred to total estimated cost (cost-to-cost), is likely to better depict the vendor’s performance.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

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