A company’s revenue is the financial measure of the goods and services that it has provided to its customers during a financial reporting period. The IFRS recognition of revenue stipulates how and when revenue should be recognized. It is an accounting principle that determines how to account for revenue just like the U.S. GAAP and specifies the conditions in which revenue is recognized.
Revenue recognition as per IFRS uses accrual accounting, which requires that revenues are recognized when realized and earned; and not when cash is received. In this article, we will discuss the IFRS recognition of revenue as well as IFRS 15 revenue from contracts with customers which is the revenue recognition standard that provides an invariable framework for revenue recognition from contracts with customers.
IFRS recognition of revenue explained
Revenue is considered recognized when it is included in the income statement of a company. In May 2014, IFRS 15 Revenue from Contracts with Customers was issued by the Board, together with the introduction of Topic 606 into the Financial Accounting Standards Board’s Accounting Standards Codification. IFRS 15 provides a comprehensive framework for recognizing revenue from contracts with customers and replaces IAS 11, IAS 18, IFRIC 13, IFRIC 15, IFRIC 18, and SIC‑31.
This accounting standard specifies how and when a company or organization under IFRS will recognize revenue and requires such companies to provide users of financial statements with more informative, relevant disclosures. Hence, the IFRS 15 provides a single, principles-based five-step model to be applied to all contracts with customers.
It establishes the principles that a company applies when reporting information about the amount, nature, timing, and uncertainty of revenue and cash flows from a contract with a customer. A company applying IFRS 15, recognizes revenue to depict the transfer of promised products or services to the customer in an amount that reflects the consideration to which it expects to be entitled, in exchange for those products or services.
In order to understand revenue recognition as per IFRS, here are some key terms one needs to know:
- Contract: This is an agreement between two parties (or more) that generates enforceable rights and obligations.
- Customer: The party that has a contract with the company to obtain goods or services that are an output of the company’s core activities in exchange for consideration.
- Performance obligation: This is a promise in a contract with a customer to transfer to the customer goods or services
- Revenue: This is the income arising in the course of a company’s core activities.
- Transaction price: This is the amount of consideration to which a company expects to be entitled in exchange for transferring promised goods or services to a customer; this excludes the amounts collected on behalf of third parties.
IFRS 15 5-step model for recognition of revenue
- Identify the contract(s) with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when a performance obligation is satisfied by transferring a promised good or service to a customer
Under IFRS 15, listed above is the 5-step model for recognition of revenue. For IFRS recognition of revenue, companies are required to apply these steps. After identifying the contract(s) with a customer, the next thing is to identify the performance obligations in the contract. Then, determine the transaction price. In a contract, if the consideration promised includes a variable amount, the company must estimate the amount of consideration to which it expects to be entitled in exchange for delivering the promised products or services to a customer.
The next step is to allocate the transaction price to each performance obligation on the basis of the relative stand-alone selling prices of each distinct good or service promised in the contract. After that, the company can only recognize revenue when the performance obligation has been satisfied by transferring the promised good or service to the customer. It is when the customer obtains control of that good or service that the performance obligation has been satisfied.
The satisfaction of a performance obligation may be done at a point in time (usually for promises to transfer goods to a customer) or over time (usually for promises to transfer services to a customer). For a performance obligation satisfied over time, a company would have to select an appropriate measure of progress to determine how much revenue should be recognized as the performance obligation is satisfied.
IFRS recognition of revenue
When it comes to IFRS recognition of revenue, a company under this accounting standard recognizes revenue when (or as) it satisfies a performance obligation which is when control has been passed to the customer, either over time or at a point in time (IFRS 15:32).
The ability to direct the use of an asset (the goods or services that the company sells) and to obtain substantially all of the remaining benefits from an asset is what is referred to as having control of an asset. This also involves the ability to prevent others from directing the use of the asset and obtaining benefits from it. The benefits related to the asset are the potential cash flows that may be obtained directly or indirectly. A company recognizes revenue over time if any of the following criteria are met (IFRS 15:35):
- The customer simultaneously receives and consumes all of the benefits provided by the company as the company performs
- The company’s performance creates or enhances a good or service that the customer controls as the good or service is created
- The company’s performance does not create a good or service with an alternative use to the company and the company has an enforceable right to payment for performance completed to date.
Furthermore, if a company does not satisfy its performance obligation over time, it definitely satisfies it at a point in time. Hence, revenue will be recognized when control is passed at a certain point in time. The following are the factors that may indicate the point in time at which control passes (IFRS 15:38):
- The company has a present right to payment for the goods or service
- The customer has legal title to the goods or service
- The entity has transferred physical possession of the goods or services
- The customer has significant risks and rewards related to the ownership of the goods or services, and
- The goods or service has been accepted by the customer
Hence, in conclusion, IFRS recognition of revenue requires that revenues are recognized when goods or services are transferred to the customer; and not necessarily when cash is received.
An example to illustrate IFRS recognition of revenue
ABC Company entered into a contract with Mr. Peter to provide a custom-made kitchen cabinet. The contract price is $3,000 which includes installation and delivery. Hence, the standalone market prices include:
- Delivery- $200
- Installation- $200
- Similar custom-made kitchen cabinet- $2,800
According to step 2 of the IFRS 15 revenue from contracts with customers, we have to identify the performance obligation in the contract. Hence, from this particular contract, there are two performance obligations:
- The delivery of the cabinet
- The cabinet and installation
Next is to determine the transaction price of the contract which is $3,000. Step 4 of the IFRS 15 5-step model for recognition of revenue requires that we allocate the transaction price to separate performance obligations. That is:
|Performance obligation||Standalone price||Percentage||Allocation of the transaction price of $3000|
|Delivery of kitchen cabinet||$200||($200 / $3,200) x 100= 6.25%||$3,000 x 6.25%= $187.5|
|Kitchen cabinet and installation||$2,800 + $200 = $3,000||($3,000 / $3,200) x 100= 93.75%||$3,000 x 93.75%= $2,812.50|
Lastly, according to IFRS recognition of revenue, a company recognizes revenue when the performance obligation has been satisfied by transferring the promised good or service to the customer. Hence, it is when the customer obtains control of the promised good or service that the performance obligation has been satisfied. Therefore, in this case, ABC Company will recognize revenue once it has delivered the custom-made kitchen cabinet to Mr. Peter because that is when Mr. Peter obtains control of the goods.