Pre-Contract Establishment Date activities
or
Partially Satisfied Performance Obligations Before the Identification of a Contract
Entities sometimes begin activities on a specific anticipated contract with their customer before (1) the parties have agreed to all of the contract terms or (2) the contract meets the criteria in step 1 (see Step 1 Identify the contract) of IFRS 15. The IASB staff refer to the date on which the contract meets the step 1 criteria as the “contract establishment date” (CED) and refer to activities performed before the CED as “pre-CED activities.”
TRG Update — Pre-CED Activities
The FASB and IASB staffs noted that stakeholders have identified two issues with respect to pre-CED activities:
- How to recognize revenue from pre-CED activities.
- How to account for certain fulfillment costs incurred before the CED.
The TRG discussed these issues in March 2015.
TRG members generally agreed with the staffs’ conclusion that once the criteria in step 1 have been met, entities should recognize revenue for pre-CED activities on a cumulative catch-up basis (i.e., record revenue as of the CED for all satisfied or partially satisfied performance obligations) rather than prospectively because cumulative catch-up is more consistent with the new revenue standard’s core principle.
The two Q&A below demonstrates the application of the TRG’s general agreement.
Q&A Partial Satisfaction of a Performance Obligation Before Identification of the Contract — Revenue Recognition
Sometimes, pre-CED activities result in the transfer of a good or service to the customer on the date the contract meets the criteria in IFRS 15.9 (e.g., when the customer takes control of the partially completed asset) such that a performance obligation meeting the criteria in IFRS 15.35 for recognition of revenue over time is partially satisfied.
Question 1
In such circumstances, should revenue be recognized on the date the contract meets the criteria in IFRS 15.9?
Answer
Yes. On that date, the entity should recognize revenue on a cumulative catch-up basis that reflects the entity’s progress toward complete satisfaction of the performance obligation. In calculating the required cumulative catch-up adjustment, the entity should consider the requirements in IFRS 15.31 through IFRS 15.45 with respect to determining when a performance obligation is satisfied to determine the goods or services that the customer controls on the date the criteria in IFRS 15.9 are met.
Question 2
How should an entity account for fulfilment-type costs incurred in the period before identification of the contract?
Answer
It depends. If other Codification topics are applicable to those costs, the entity should apply the guidance in those other Codification topics. If it is determined that other Codification topics are not applicable, an entity should capitalize such costs as costs to fulfill an anticipated contract, subject to the criteria in IFRS 15.95. On the date the criteria in IFRS 15.9 are met, such costs would immediately be expensed if they are related to progress made to date or to services already transferred to the customer.
Costs that do not satisfy the criteria in other Codification topics or in IFRS 15.95 for recognition as an asset (e.g., general and administrative costs that are not explicitly chargeable to the customer under the contract) should be expensed as incurred in accordance with IFRS 15.98.
| Example 1 |
| In this example, assume that the criteria for recognizing revenue over time are met. In practice, whether those criteria are met will depend on a careful evaluation of the facts and circumstances. An entity is constructing a piece of specialized equipment to an individual customer’s specifications. Because of a delay in obtaining the customer’s approval for the contract, the entity commences work on constructing the equipment before the contract is signed. Consequently, the costs that meet the criteria in IFRS 15.95 that the entity incurs in performing this work are initially capitalized. Subsequently, the contract is approved, and the terms of the contract are such that the criteria for recognition of revenue over time are met. On the date the contract is signed and the criteria in IFRS 15.9 are met, a cumulative catch-up of revenue (and expensing of capitalized costs), reflecting progress made to date, should be recognized for the partially constructed equipment. |
| Example 2 |
| In this example, assume that the criteria for recognizing revenue over time are met. In practice, whether those criteria are met will depend on a careful evaluation of the facts and circumstances. An entity is constructing an apartment block, in a foreign jurisdiction, consisting of 10 apartments. In the period before commencing construction, the entity has signed contracts (meeting the criteria in IFRS 15.9) with customers for six of the apartments in the For the six apartments for which contracts have been signed with customers, the construction of each apartment represents the transfer of a performance obligation over time because the criteria in IFRS 15.35 are met. Accordingly, revenue is recognized as those six apartments are constructed, reflecting progress made to date, and the costs incurred in relation to those six apartments are expensed to the extent that they are related to progress made to date. For the four apartments for which contracts have not yet been signed with customers, costs that meet the criteria in IFRS 15.95 are initially capitalized. Subsequently, on the date a contract is signed with a customer for one of those four apartments and the criteria in IFRS 15.9 are met, a cumulative catch-up of revenue (and expensing of related capitalized costs) should be recognized for that apartment. |
apartment block but not for the remaining four. The entity uses standard There may be instances in which an entity has transferred goods or services to the customer but has not met the requirements of step 1 in IFRS 15.9 (i.e., one of the five required criteria is not met). For example, the entity may not have met the criterion stating that “[i]t 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.” In these instances, the entity must evaluate whether it is able to record a receivable to reflect its right to payment for performance completed before meeting the step 1 criteria.
IFRS 15.108 states that a “receivable is an entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due. . . . An entity shall account for a receivable in accordance with IFRS 9.” Refer to Step 1 Identify the contract for considerations related to how an entity should account for a receivable before the contract existence criteria are met.
Food for thought — Trial Periods |
| In a manner consistent with the discussion on free trial periods (see below), entities may need to consider the effect of trial periods on contracts with customers. An entity must evaluate whether a contract exists during a trial period and, if so, the appropriate timing of revenue recognition during the trial period. Factors to consider include whether the trial period is riskfree, whether the customer has an obligation to make further purchases beyond the trial period, and whether the goods or services transferred during the trial period are, in fact, performance obligations. This determination may require an entity to use judgment on the basis of the specific facts and Two types of trial periods that an entity may participate in to solicit customers are (1) “risk-free” trials (i.e., the customer is not committed to a contract until after some of the goods or services are delivered) and (2) the delivery of “free” goods or services upon execution of a contract (i.e., a contract under the new revenue standard exists when the free goods or services are delivered). As noted above, it is essential to evaluate whether a contract with a customer exists under the new revenue standard to determine whether the goods or services provided during the trial period are performance obligations to which revenue should be allocated and recognized when control transfers. In addition, consideration should be given to whether the entity’s performance obligation to transfer the goods or services during the trial period is satisfied at a point in time or over time (i.e., partly during the trial period and partly during the contractual period). Such factors are likely to affect the determination of whether and, if so, when revenue is recognized for the goods or services provided during the trial period. |
Food for thought — Free Trial Period |
| Certain arrangements provide a customer with free goods or services at the onset of the contract. Stakeholders have questioned whether all of the criteria in IFRS 15.9 are met during the free trial period. Specifically, they have asked whether the contract meets the commercial substance criterion (i.e., whether the risk, timing, or amount of an entity’s future cash flows is expected to change) and whether each party has approved the contract and is committed to perform. For example, suppose that an entity has a marketing program that offers a three-month “trial period” during which a customer can obtain free magazines. If the customer does not cancel at the end of three months, it will be charged the annual subscription fee of $12 per monthly magazine, or $144. Because the parties to the contract are not committed to perform their respective obligations, no contract exists during the free trial period unless and until the customer “accepts” the offer. Once the customer accepts the offer and is committed to pay $144, a valid contract exists and the rest of the revenue recognition model can be applied. Arrangements with trial periods have also raised questions about how an entity should recognize revenue once a contract exists. Specifically, questions have been raised about whether any of the transaction price should be allocated to the free goods or services (see above). |
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