IFRS 15 is called ‘Revenue from contracts with customers’. What is revenue?, What is a contract?, and what is a customer? Here are some of the explanations……
What is revenue? Revenue – Income – Contract – Customer?
Revenue has stepped reasoning with regards to the definition of revenue. Revenue is defined as ‘Income arising in the course of an entity’s ordinary activities’. It is something but not the end, income on its own is defined as ‘Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in an increase in equity, other than those relating to contributions from equity participants’.
Income has been defined in the Conceptual Framework for Financial Reporting 2018, Revenue in IAS 18 Revenue, the standard preceding IFRS 15. Income is defined in a much broader and universal sense.
The distinction between revenue and other types of income, such as gains, is important as many users of financial statements focus more on revenue than other types of income.
Income comprises revenue and gains and includes all benefits (enhancements of assets or settlements of liabilities) other than contributions from equity participants.
Revenue is a subset of income that arises from the sale of goods or rendering of services as part of an entity’s ongoing major or central activities, also described as its ordinary activities. Transactions that do not arise in the course of an entity’s ordinary activities do not result in revenue. For example, gains from the disposal of the entity’s fixed assets are not included in revenue. The distinction between revenue and other income is not always clear. Determining whether a transaction results in the recognition of revenue will depend on the specific circumstances. Here is a simple example….
The distinction between revenue and income:
A car dealership has cars available that can be used by potential customers for test drives (“demonstration cars”). The cars are used for more than one year and then sold as used cars. The dealership sells both new and used cars.
Is the sale of a demonstration car accounted for as revenue or as a gain?
Analysis Revenue – Income – Contract – Customer?
The car dealership is in the business of selling new and used cars. The sale of demonstration cars is, therefore, revenue since selling used cars is part of the dealership’s ordinary activities.
What is a contract? Revenue – Income – Contract – Customer?
Again, a contract is defined as ‘An agreement between two or more parties that creates enforceable rights and obligations’.
Many revenue transactions are straightforward, but some can be highly complex. For example, software arrangements, licenses of intellectual property, outsourcing contracts, barter transactions, contracts with multiple elements, and contracts with milestone payments can be challenging to understand. It might be difficult to determine what the entity has committed to deliver, how much and when revenue should be recognized.
Contracts often provide strong evidence of the economic substance, as parties to a transaction generally protect their interests through the contract. Amendments, side letters, and oral agreements, if any, can provide additional relevant information.
Other factors, such as local legal frameworks and business practices, should also be considered to fully understand the economics of the arrangement. An entity should consider the substance, not only the form, of a transaction to determine when revenue should be recognized.
The revenue standard provides principles that an entity applies to report useful information about the amount, timing, and uncertainty of revenue and cash flows arising from its contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to in exchange for those goods or services.
What is a customer? Revenue – Income – Contract – Customer?
It is getting boring but there is a definition: A customer is defined in IFRS 15 as: ‘A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration’.
In transactions involving multiple parties, it could be less clear which counterparties are customers of the entity. For some arrangements, multiple parties could all be considered customers of the entity. Depending on the specific facts and circumstances, the customer can be identified.
In certain transactions, a counterparty may not always be a ‘customer’ of the entity but a collaborator or partner that shares in the risks and benefits of developing a product to be marketed. This is common in the pharmaceutical, bio-technology, oil and gas, and health care industries. However, depending on the facts and circumstances, these arrangements may also contain a vendor-customer relationship component. Such contracts could still be within the scope of IFRS 15, at least partially, if the collaborator or partner meets the definition of a customer for some, or all, aspects of the arrangement. Entities will need to use judgement to determine whether transactions are between partners acting in their capacity as collaborators or reflect a vendor-customer relationship.