Implicit promises in a contract
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. Implicit promises in a contract
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. Implicit promises in a contract
This section is part of step 2 identifying performance obligations. Goods or services that are to be transferred to a customer are normally specified in a contract. IFRS 15 specifies how and when an IFRS reporting entity will recognise revenue as well as requiring such entities to provide users of financial statements with more informative, relevant disclosures. The standard provides a single, principles based five-step model to be applied to all contracts with customers.
However, a contract may also include promises that are implied by a vendor’s customary business practices, published policies, or specific statements if those promises create a valid customer expectation that the vendor will transfer a good or service to it. Or to say it in a different way: ‘Goods or services are considered ‘promised’ when the customer has a valid expectation to receive them‘. So it is about customer perspective (see below). Implicit promises in a contract
This links to IFRS 15 extending the definition of a contract to include those which are written, oral, or implied by a vendor’s customary business practices (provided in all cases that the arrangements are enforceable). Implicit promises in a contract
Consequently, the performance obligations identified in a contract with a customer may not be limited to the goods or services that are explicitly promised in that contract. Implicit promises in a contract
Performance obligations do not include activities that a vendor must perform in order to fulfill a contract, unless the vendor transfers a good or service to the customer as those activities occur. For example, a service provider may need to perform various administrative tasks to set up a contract. Implicit promises in a contract
The performance of those tasks does not transfer a service to the customer as the tasks are performed and are therefore not performance obligations.
Implied promises are difficult items in IFRS 15 Revenue accounting. Here is some context from a more legal point of view to help in the assessment of these implicit promises in a contract. Implicit promises in a contract
Implied-in-law “good faith” terms
Many contracts include “satisfaction clauses”, in which a promiser (a person/entity/contract party who makes a promise to an other person/entity/contract party (the promisee)) can refuse to pay if he isn’t subjectively satisfied with the promisee’s performance. Strictly speaking, this is an illusory promise, since the promiser has no actual legal burden to pay if he chooses not to.
However, courts will generally imply in law that the promiser must act in good faith and reject the deal only if he is genuinely dissatisfied. As another example, if a contract promises a promisee a certain percentage of the proceeds of a promiser ‘s business activities, this is illusory, since the promiser doesn’t have to do anything: any percentage of zero is zero.
However, courts may find that the promiser made an implied promise to use reasonable efforts to try to make money, and cite him for breach of contract if he does absolutely nothing. The U.C.C. in contracts exclusive to both sides requires “best efforts” in such contracts. This may be read to be the same as a good faith effort, but is seen by some courts as a higher duty.
Judges will often infer terms into the contract that the parties did not explicitly cite. For instance, in the “satisfaction clause” case, judges might infer that the parties intended a “reasonableness test” – that the clause could be satisfied if a reasonable person would be satisfied by the promisee’s performance, regardless of whether the promiser himself asserts he is satisfied. (This interpretation is often used in cases in which a performance can be objectively evaluated, such as with the construction of a warehouse; the implied-in-law interpretation above is preferred where satisfaction is more subjective, as with the painting of a portrait.)
Penny Corporation has engaged Bond Corporation to create a special tool to machine engine valves. The machine is intended tolower variable costs and reduce defects by operating within tighter tolerances. The resulting valve is superior to any other manufacturer’s valve-train products. As Bond is building the machine, after the contract is signed, it decides to include a vacuum system to continuously remove steel shavings from the work surface.
The vacuum system was not part of the machine specifications originally contracted for and is intended to show Penny, which is Bond’s newest and largest client, that Bond is willing to go the “extra mile” to maintain their business. Adding design elements like this is not standard operating procedure and is very rarely done.
Bond Corporation determines that Penny believes it is only paying explicitly for the originally contracted machine and not for the vacuum system. Further, because this is not standard operating protocol, Bond determines Penny does not believe it is implicitly paying for the extra item. Analyzing from the customer perspective leads Bond to conclude that the vacuum system is not a promised good or service.
Implied Promises in a contract
CAD Auto Corporation has a contract with Blender Chemical Corporation to manufacture custom, automated production equipment. The equipment will enable Blender to produce the chemicals used in etching silicon wafers. The chemicals will subsequently be sold to microchip manufacturers. A critical part of CAD Auto’s business model is providing better customer service than all its competitors.
While not explicitly stated in the contract, CAD Auto customarily sends technicians once a month for one year after installation of new machinery to ensure that the machinery is functioning properly. Blender agreed to a contract with CAD Auto—and even paid a premium—because of this superior customer service.
Because Blender can reasonably expect that CAD Auto Corporation will send technicians once a month for a year, the technician visits qualify as a promised service. Furthermore, Blender paid a premium in anticipation of CAD Auto’s excellent quality and customer service. Consequently, the technician visits should be included in CAD Auto’s list of promised goods or services, and the company should consider whether these visits represent a distinct performance obligation.
Administrative tasks and setup activities are often necessary to facilitate a contract. While these activities are necessary to ultimately transfer goods and services to the customer, they do not qualify as promised goods or services because they do not directly transfer a good or service to the customer. Consequently, setup activities may be ignored in the context of identifying promised goods and services and recognizing revenue. Implicit promises in a contract
IFRS 15 provides further guidance for shipping and handling activities performed before or after the customer obtains control of a promised good. When these activities are performed before a customer takes control of the good, the activities are considered fulfillment activities and not a promised service to the customer. Implicit promises in a contract
However, when such activities are performed subsequent to a customer obtaining control of the good, the entity may elect to treat shipping and handling as either fulfillment activities or promised services as a matter of accounting policy to be applied consistently across all similar transactions. The costs related to these activities should be accrued if revenue is recognized for the services. Entities must disclose any accounting policy election regarding shipping and handling activities.
Performance obligations with multiple goods or services may include promises that should be accounted for as fulfillment costs rather than promised goods or services. For example, a Software-as-a-Service company may provide a license and implementation services to customers. If the company concludes that these two services should be combined into a single performance obligation and that the implementation does not transfer a service to the customer, the implementation service should be treated as a fulfillment cost. Implicit promises in a contract
Sometimes, an entity will provide incentives to “sweeten” a contract. These marketing incentives typically create a liability or an expense incidental to the contract. To be considered marketing incentives, the promised goods or services must be provided “independently of the contract they were designed to secure.”
In other words, if the customer pays for a something—even implicitly—it is not a marketing incentive, but part of the contract as a promised good or service. Examples of marketing incentives include customer loyalty points or “free” cell phones provided by a wireless carrier designed to entice a customer to sign a contract
Also read: Revenue hub
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