Revenue recognition when or as

Revenue recognition when or as
the entity satisfies a performance obligation

The obligation to purchase and sell electricity under a PPA generally will be viewed as a single performance obligation that is satisfied over time (when). A power and utilities entity will be required to measure its progress towards complete satisfaction of its performance obligation to deliver electricity. The objective, when measuring progress, is to depict the seller’s performance in transferring control of the electricity to the customer.

Arrangements to sell other commodities, including natural gas and physical capacity, over a contractual term, could be viewed as a single performance obligation. More judgement might be required to determine if such arrangements meet the definition of a performance obligation satisfied over time.

Different pricing conventions

Some types of sales contract are not impacted by price or volume variability but they do have different fixed pricing conventions (for example, prices per unit might be stated, but they might change over the life of the contract). Under a particular arrangement, the price per unit might step up over time, to reflect expected costs to produce or an expectation of increased market pricing over time. Alternatively, the prices might be different to reflect seasonal or time of day pricing (such as peak versus off-peak).

A contract with stated, but changing, prices for a fixed quantity delivered does not contain variable consideration, because the transaction price for the contract is known at inception and does not change. It is important for the power and utility entity to understand what is giving rise to the pricing convention. For example, the escalations might be intended to reflect the expected market price of power in the future periods which a customer would expect to pay.

The total transaction price should be recognised as revenue over time by measuring progress towards complete satisfaction of the performance obligation. The seller applies a permissible form of the ‘output’ or ‘input’ method.

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Electricity revenue recognition example

Electricity revenue recognition example

Application of the five-step model

Facts: Bundle Seller Co (‘Seller’) and Bundle Buyer Co (‘Buyer’) executed an agreement for the purchase and sale of 1oMW of electricity per hour and the associated renewable energy credits (‘RECs’) (one REC for each MWh) at a fixed bundled price (‘the agreement’ or ‘the PPA’). The contract term begins on 1 January 20X1 and ends on 31 December 20X4, and the fixed bundled price during each of those respective years is $200, $205, $210 and $215.

The increase in the bundled price represents the increase in the forward price of electricity and RECs over the term of Electricity revenue recognition examplethe agreement as of the acquisition date. Control, including title to and risk of loss related to the electricity, will pass and transfer on delivery at a single point on the electricity grid. Control, including title to and risk of loss related to RECs, will pass and transfer when the associated electricity is delivered.

Seller and other market participants frequently execute contracts for the purchase and sale of electricity and RECs on a stand-alone basis.

Seller concluded that this arrangement does not contain a lease (that is, no property, plant or equipment is explicitly or implicitly identified). The electricity element of this arrangement qualifies for the ‘own use’ exception and thus is not accounted for as a derivative. The REC element has no net settlement characteristics. As such, each element of this agreement is within the scope of IFRS 15.

Electricity revenue recognition – IFRS 15 step-by-step

Step 1 – Identify the contract with a customer

This agreement, including each of its elements (that is, electricity and RECs), is within the scope of the standard, and collection of the contract consideration is considered probable.

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Contract modifications in power and utilities – Best IFRS 15 Revenue recognition

Contract modifications in power and utilities

One of the most judgemental aspects of implementing IFRS 15 for power and utilities entities is applying the contract modifications guidance to arrangements, such as ‘blend and extend’ arrangements.

Blend and extend arrangements

Blend and extend arrangements are common in the power and utilities industry. In a blend and extend arrangement, the buyer and seller negotiate amended pricing of an existing contractual arrangement, including extending the term of the existing arrangement. It is common for the buyer to benefit from a lower blended price (original price blended with the extension period price which is at a lower rate per unit) and for the seller to benefit from an extended term (original term plus the extension period term).

Management will need to evaluate these types of modifications in order to determine how and when they will be accounted for under the contract modification provisions in IFRS 15.

Blend and extend modifications will typically fall into one of the following scenarios:

  1. The modification creates a separate contract from the existing arrangement. This would be the case if the modification results in an increase in the amount of distinct goods (such as units of electricity to be delivered), and the additional consideration reflects the reporting entity’s stand-alone selling price of the additional promised goods.
  2. The modification represents a termination of the existing agreement and the creation of a new agreement, to be accounted for prospectively. This would be the case if the modification results in an increase in the amount of distinct goods (such as units of electricity to be delivered), but the additional consideration does not reflect the reporting entity’s stand-alone selling price of the additional promised goods (for example, the price per unit of the new distinct goods is different from the market due to the blended price).

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Transaction price power and utilities under IFRS 15 – All best read

Determining the transaction price power and utilities

The determination of the transaction price in many power and utilities contracts will be fairly straightforward, particularly where the contract pricing and contract quantities are fixed; however, in practice, reporting entities often enter into contracts that contain index-based pricing, variable volume, or both.

For example, Seller might enter into a requirements contract to sell electricity to Buyer at predetermined prices, but volumes are not known at contract inception. Uncertainty exists with respect to the total consideration to be received by Seller over the term of the contract. Seller might be able to elect a practical expedient to recognise revenue based on the amount invoiced, if it directly corresponds with the value to the customer of Seller’s performance completed to date.

Contracts that contain forms of variable consideration, significant financing components, non-cash consideration and/or consideration payable to a customer are likely to be more complex and will require judgement.

Variable consideration power and utilities

Variable consideration should be estimated using the expected value method or the most likely amount method. This is not a ‘free choice’. An entity needs to consider which method it expects to better predict the amount of consideration to which it will be entitled and apply that method consistently for similar types of contract.

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IFRS 15 Power purchase agreement

IFRS 15 Power purchase agreement

It is common for customer contracts within the power and utilities industry to contain multiple performance obligations. It is essential that power and utilities entities evaluate their portfolio of customer contracts in order to identify explicit and implicit promises to transfer a distinct good or service to a customer.

A promise to transfer a series of distinct goods that are substantially the same and that have the same pattern of transfer to the customer is a performance obligation known as a ‘series’. Contracts for the sale of electricity, and many contracts for the sale of gas to residential and small commercial and industry clients, would represent such a promise.

Sometimes, two products (such as gas and electricity) are sold together. Where multiple products are sold simultaneously, generally:

  1. Gas and electricity are distinct, because (a) a customer can benefit from either gas or electricity on its own (that is, the customer can sell gas and electricity, on a stand-alone basis, into the marketplace, etc.), and (b) the promise to transfer gas or electricity is separately identifiable from other promises in the contract.
  2. The performance obligation to deliver gas and electricity, in many cases, is satisfied over time, since the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. This conclusion might not be applicable for gas or other commodity contracts, where the customer has storage facilities and does not consume the benefits of the commodity immediately as it is delivered.
  3. Each delivery of gas or electricity in the series, that the entity promises to transfer to the customer, meets the criteria to be a performance obligation satisfied over time, and the same method will be used to measure the entity’s progress towards complete satisfaction of the performance obligation to transfer each distinct delivery of gas or electricity in the series to the customer.

Judgement is required to identify performance obligations in power and utilities contracts. In some jurisdictions, distribution and energy might be distinct performance obligations; while, in others, energy and distribution might be a single integrated performance obligation. This will depend on a number of factors, including whether the customer can choose amongst retailers and the relationships between the providers of distribution, the retailer and the end customer.

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Contract costs from Contracts with Customers

Contract costs from Contracts with Customers

– IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here. Contract costs from Contracts with Customers

Contract costs are initially recognised as an asset and expensed on a systematic basis that is consistent with the transfer to the customer of the good or service to which those costs relate. Contract costs comprise both incremental costs of obtaining a contract and costs to fulfill a contract. Contract costs from Contracts with Customers

Incremental costs of obtaining a contract

Incremental costs incurred in obtaining a contract are those that would not have been incurred had that individual contract not been obtained. This is restrictive and includes only costs such as a sales commission that is paid only if the contract is obtained, unless the costs can be explicitly recharged to a customer. Contract costs from Contracts with CustomersContract costs from Contracts with Customers

As a practical expedient, incremental costs of obtaining a contract can be recognised as an immediate expense rather than capitalised if the period over which they would otherwise be expensed (or amortized) is one year or less. Contract costs from Contracts with Customers

All other ongoing costs of running the business, including costs that are incurred with the intention of obtaining a contract with a customer, are not incremental and will be expensed unless they fall within the scope of another accounting standard (such as IAS 16 Property, Plant and Equipment) and are required to be accounted for as an asset.

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Cloud based software in IFRS 15 Revenue

Cloud based software

Historically, companies acquiring IT and other infrastructure have only faced one decision – buy or lease? From a financial perspective, the choice was simple: lease, because it didn’t require up-front capital and potentially allowed assets to be kept off balance sheet under the old accounting rules. A buy decision meant an up-front investment of capital and a depreciating asset on the balance sheet.

However, with the evolution of technology, a new choice has emerged – cloud services, which can be obtained without Cloud based softwarebuying or leasing. Instead of expensive data centres and IT software licenses, users can choose to simply have a provider host all of their infrastructure and services. No upfront investment is required, just a simple monthly series of payments that can be scaled up, scaled back or cancelled as needed. But what does all of this mean for income statements – and your company’s balance sheet?

Cloud accounting – a different business model

Historically, any company purchasing its IT infrastructure would capitalise the costs and amortise them over time. Under the new leases standard, a company using a lease or hire purchase arrangement to access IT infrastructure would end up with a similar capitalised asset and amortisation charge over time. However, the cloud alternative represents a fundamentally different business model, one where, unlike the legacy purchase model, a user of cloud services does not ever own the underlying assets.

While this isn’t yet another article about the leases standard, it’s useful to step through some of the sensitivities in financial metrics under the leasing standard. While cloud services are likely to result in a differing accounting treatment, the all too familiar concerns in lease accounting are still relevant.

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Contingent

Contingent

Contingent is a word used regularly in IFRS Standards and it is used in a rather normal way, most of the times a s contingent being dependent on. Here are the IFRS Standards in which contingent is used and in which context.

IFRS 3 Business combinations

Buyer’s accounting for royalties and milestones payable to a seller in a business combination

Acquisitions and divestitures have been headline news in the pharmaceutical and life sciences industry lately. With expiring patents on blockbuster products and downward pricing pressure, many companies have increased their M&A activity and turned to acquisitions to expand research pipelines in order to fuel innovation. In addition, companies have also looked to sell businesses or assets as part of R&D portfolio decisions to streamline operations and focus their efforts on faster growing areas of the business.

A common theme in acquisitions is that part of the purchase consideration may be in the form of future payments, such as royalties (i.e., the buyer has an obligation to make future royalty payments to the seller) or milestones. Payments related to these contingent obligations are often triggered by regulatory approval of in-process research and development (IPR&D) projects, or based on future performance measures, such as a percentage of sales.

Because many acquisitions or licenses of intellectual property, particularly those still in development, include milestone or royalty payments to the seller/licensor, the accounting and valuation of those contingent payments is often complex.

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When to Recognize Revenue in IFRS 15

When to Recognize Revenue

In accordance with the core principle of the IFRS 15 revenue standard, revenue is recognized when the entity transfers promised goods or services to the customer.

Specifically, the boards intended to depict performance through the recognition of revenue. That is, when the entity performs by delivering goods or services, it should recognize revenue because doing so demonstrates to a financial statement user that the performance has taken place.

However, current revenue practices preclude the entity from recognizing revenue when (1) revenue is contingent on future events (e.g., it is not fixed or determinable) or (2) vendor-specific objective evidence of fair value is unavailable for undelivered software elements. In both of these examples, revenue recognition is disconnected from the entity’s performance (i.e., the entity is precluded from recognizing revenue even though it has performed).

In developing the revenue standard, the boards believed that it is important to demonstrate to financial statement users when the entity performs; accordingly, that depiction is the recognition of revenue. Uncertainties about whether and, if so, how much revenue should be recognized would be dealt with separately in the measurement of revenue.

How Much Revenue to Recognize

Under the core principle, revenue is recognized in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the promised goods or services.

The measurement concept within the core principle was fiercely debated and changed over time. In the end, the wording “expects to be entitled,” which was introduced in the boards’ 2011 revised exposure draft (ED) and represented a change from their 2010 ED, was deliberate and intended to reflect a measure of revenue that did not include variability attributable to customer credit risk.

At the time the boards were developing the revenue standard, they were also debating financial instruments and the impairment model for those financial instruments. As a result, there were many debates about whether the measurement of revenue should reflect the risk that the customer cannot or will not pay the amounts as they become due. The final decisions of the boards distinguished customer credit risk from other sources of variability in a revenue contract.

Accordingly, the phrase “expects to be entitled” was intentional — specifically, the phrase “be entitled” is intentionally different from the word “collect” or the word “receive” since each of those words would imply that the amount estimated encompasses all risks, including the risk that the customer cannot or will not pay.

Therefore, unlike a fair value measurement model, the allocated transaction price approach under the revenue standard generally does not reflect any adjustments for amounts that the entity might not be able to collect from the customer (i.e., customer credit risk). However, the transaction price is inclusive of all other uncertainties. The boards outlined this allocated transaction price approach in IFRS 15.BC181.

In addition, the amount to which an entity expects to be entitled is not always the price stated in the contract or the invoiced amount, either of which may be expected on the basis of a common interpretation of the word “entitled.” For purposes of IFRS 15, the term “entitled” is aligned with the determination of the “accounting” contract (as opposed to the “legal” contract). Therefore, “entitlement” is influenced by the entity’s past practices, which affect the enforceable rights and obligations in the accounting contract. As a result, under IFRS 15, the amount to which an entity expects to be entitled is inclusive of any price concessions that the entity explicitly or implicitly provides.

When to Recognize Revenue
The 5 step revenue recognition model

That is, if the entity will accept an amount of consideration that is less than the contractually stated or invoiced price, that amount is a price concession and is treated as variable consideration. See Step 3 Determine the transaction price for further discussion of the determination of the transaction price and sales- or usage-based royalties for discussion of an exception to the general rule on estimating variable consideration for sales- or usage-based royalties.

One exception to this “entitlement” notion within measurement is when a significant financing component is identified in a contract because, for example, a customer pays in arrears. In that case, customer credit risk will be reflected in the amount of revenue recognized. This is because an entity will take customer credit risk into account in determining the appropriate discount rate (see Determining the discount rate).

In addition, as noted in IFRS 15.BC260 and BC261, the FASB and IASB decided that revenue should be measured at the amount to which an entity expects to be entitled in response to comments from users of financial statements that “they would prefer revenue to be measured at the ‘gross’ amount so that revenue growth and receivables management (or bad debts) could be analyzed separately.”

Changes Attributable to the Core Principle

The creation of the core principle and its embedded key concepts could lead individuals to think that applying the standard will significantly change the amount of revenue they recognize. However, the amount of change will vary depending on the entity’s business and how the entity previously accounted for transactions. While IFRS 15.BC478 states that IFRS 15 “appears to be a significant change from previous revenue recognition guidance,” it adds that “previous practices were broadly consistent with this approach, and many entities determined the amount of revenue on the basis of the amounts the customer promised to pay.”

Thinking It Through — No Simple Answer

Typically, the first reaction of those new to the implementation efforts on revenue is some version of the question “How does the standard change how I recognize revenue?

Unfortunately, this is not a simple question with a quick checklist to assess the change. Rather, entities will each haveWhen to Recognize Revenue to critically read and comprehend the standard because they know their business best and can apply the steps to arrive at the correct answer.

While there may be wholesale changes in some situations, there may be other situations in which the framework leads to the same outcome as current practice. However, even when the outcome (i.e., the amount of revenue recognized) does not change, the processes and controls related to the financial reporting cycle are likely to change.

In addition, all entities are required to provide significantly more disclosures under the revenue standard and will therefore need to capture and report new information (see Disclosure requirements for IFRS 15 for further discussion).

Changing Lanes — From Risks and Rewards to a Control Model

The old standard IAS 18 Revenue included the concept that revenue should be recognized when the transfer of risks and rewards has occurred. Under IFRS 15, an entity would recognize revenue when it determines that its customer has obtained control of an asset by demonstrating that the customer can obtain substantially all of the benefits from the asset.

That is, the underlying concept has shifted from a “risks and rewards” model to a control model. While the underlying revenue recognition criteria between the standards appear similar, there are subtle differences that could drive changes for entities ranging from insignificant to major.

Entities have to go through the details of all five steps of the revenue standard to appropriately recognize revenue because simply attempting to think about the control concept in isolation could lead them to the wrong answer.

Read also: IFRS 15 Revenue from Contracts with Customers – Best overview

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When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue

When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue When to Recognize Revenue

IFRS 15 Sale of Non financial assets

IFRS 15 Sale of Non financial assets

INTRO IFRS 15 Sale of Non financial assets – Certain aspects of IFRS 15 apply to the sale or transfer of non financial assets (such as intangible assets and property, plant, and equipment) that are not an output of the entity’s ordinary activities. [IAS 16, IAS 38, IAS 40]

When an entity sells or transfers a non financial asset that is not an output of its ordinary activities, it derecognises the asset when control transfers to the recipient, using the guidance on transfer of control in IFRS 15 (see Transfer of control from Step 5 IFRS 15 in the link).

The resulting gain or loss is the difference between the transaction price measured under IFRS 15 (using the guidance IFRS 15 Sale of Non financial assetsin Step 3 of the model) and the asset’s carrying amount. In determining the transaction price (and any subsequent changes to the transaction price), an entity considers the guidance on measuring variable consideration – including the constraint, the existence of a significant financing component, non cash consideration, and consideration payable to a customer (see consideration payable to a customer from Step 5 IFRS 15 in the link).

The resulting gain or loss is not presented as revenue. Likewise, any subsequent adjustments to the gain or loss – e.g. as a result of changes in the measurement of variable consideration – are not presented as revenue.

Judgment required to identify ordinary activities

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