Identifying performance obligations is critical to revenue recognition under IFRS 15In our April 2018 edition of Accounting News we discussed the five step model for revenue recognition introduced by IFRS 15 Revenue from Contracts with Customers (IFRS 15): Show
In the May and June 2018 editions we examined the first step of this five step process in greater depth. In this article, we look at the complexities of the second step in the IFRS 15 revenue recognition model. Step two requires the entity to identify the performance obligations in the contract with a customer. This is a critical step in the revenue recognition process because revenue is recognised when (or in some instances as) a performance obligation is satisfied. Failing to correctly identify performance obligations may therefore result in the timing of revenue recognition not complying with the requirements of IFRS 15, and revenue being recognised in the incorrect reporting period. What is a performance obligation?A contract with a customer includes promises to transfer goods or services to the customer. If those goods or services are distinct, the promises are performance obligations and must be accounted for separately. Examples of goods or services that may be promised in a contract with a customer include:
What are ‘distinct’ goods and services?A good or service that is promised to a customer is ‘distinct’ if both of the following criteria are met:
When is the entity’s promise to transfer goods and services ‘separately identifiable’?In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable, the objective is to determine whether the nature of the promise in the contract is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs. This assessment is done from the perspective of the customer. If a promised good or service is not distinct, the entity must combine that good or service with other promised goods or services until it identifies a bundle of goods and/or services that is distinct. Promises are not separately identifiable (i.e. they must be bundled) if any of the following circumstances exist:
The following decision tree summarises the process discussed above and will assist in determining whether goods and services promised in a contract are ‘distinct’: ExampleEntity XYZ has contractually agreed to build a fence at the home of a customer. From an operational perspective, there are likely three stages to the contract:
However, from the perspective of the customer, a completed fence has been promised. In addition:
Given the above there is only one performance obligation in the contract and that is the provision of a completed fence. In future editions of Accounting News, we will examine some real life situations in which the identification of performance obligations can be difficult. Concluding thoughtsThe concept of performance obligations is new, but it is central to ensuring that the timing of revenue recognition is correct. For that reason, it is important that finance teams become familiar with the concept and correctly identify the performance obligations within their company’s contracts with its customers. This will require the finance team to have a much greater understanding of the particular terms and conditions of contracts with customers than has been required in the past. What are the 4 essential elements of a contract?The basic elements required for the agreement to be a legally enforceable contract are: mutual assent, expressed by a valid offer and acceptance; adequate consideration; capacity; and legality.
Which of the following is an agreement by a promise to refrain from pursuing a legal claim against a Promisor?Promissory estoppel is intended to stop the promisor from arguing that an underlying promise should not be legally upheld or enforced.
What are the promises contained in a contract known as?A contract where the parties exchange a promise for a promise is known as a Bilateral Contract, whereas a contract where one party gives a promise and the other party performs an act is known as a Unilateral Contract. These legally enforceable promises may be in writing or oral.
Which of the following is a promise to refrain from doing something you are legally entitled to do?A promise to not do something you are legally entitled to do is good contract consideration only if the contract involves goods, not services. A promise to not do something you are legally entitled to do is good contract consideration only if the contract involves services, not goods.
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