FRS 102 revenue recognition series

Section 23 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations, with this enforceability being a matter of law. Contracts can be written, oral or implied by a company’s customary business practices and may vary across legal jurisdictions.

When a contract does not meet these criteria and a company receives consideration, the company recognises the consideration received as a liability unless one of the following events has occurred in which case the company recognises the consideration received as revenue:

• The entity has no remaining obligations to transfer goods or services and all, or substantially all, of the consideration has been received and is non-refundable;
• The contract has been terminated and the consideration is non-refundable; or
• The five criteria for accounting for a contract in accordance with Section 23 have been met.

Contract modifications

Section 23 defines a contract modification as a change in the scope or price (or both) of a contract, which exists when the parties to a contract approve a modification that either creates new, or changes existing, enforceable rights and obligations.

It goes on to state that a contract modification may exist where there is an approved a change in the scope of the contract even though the parties have not yet determined the corresponding change in price, as the price can be determined by applying the requirements on variable consideration.

Change in scope and price

A company accounts for a contract modification of scope and price prospectively if the goods or services are distinct and retrospectively, by adjusting revenue on a cumulative catch-up basis, if the goods or services are not distinct. The prospective approach involves accounting for the modification as a separate contract, if the price of the contract increases by an amount of consideration that reflects stand-alone selling prices, and as a termination of the existing contract and the creation of a new contract, if the price of the contract does not increase by an amount of consideration that reflects stand-alone selling prices.

This is represented in the following table:

_{Table 1.1: Accounting for a change in contract scope and price}

Change in price only

A company accounts for a contract modification of price only prospectively, as a termination of the existing contract and the creation of a new contract if the goods or services are distinct, and retrospectively, by adjusting revenue on a cumulative catch-up basis, if the goods or services are not distinct.

Key implications

The new legal definition of a contract, and of a contract modification, as well as the new guidance for accounting for contracts and contract modifications may lead to changes in accounting practices.

We recommend that the enforceability of rights and obligations in significant contracts and contract modifications are analysed on a legal basis and that companies consider the need for changes to systems and processes based on the new criteria for accounting for contracts and contract modifications.

Practical considerations

In the construction sector it is common for an entity to sign a framework agreement (or master agreement) with a customer, which stipulates the main principles governing the relationship between the parties. These agreements do not usually stipulate the amounts to be purchased by the customer, which are usually included in separate purchase orders or statements of work at a later date. Thus, the entity must pay close attention to the nature of the reciprocal rights and obligations to determine which agreement constitutes a contract as defined in Section 23.

It is also common practice for framework agreements to detail additional services. Where the customer can decide to acquire these additional services without any negative financial consequences, these do not create enforceable rights and obligations and are therefore not considered to represent a contract.

Further, particular attention should be paid to early termination clauses in a contract that could affect the scope of the contract, in terms of duration or the quantities acquired. If the customer can terminate the contract without having to pay a substantive penalty for the services not yet provided, these services should be treated as optional.

At contract inception, a company assesses the goods or services promised in a contract with a customer and identifies as a performance obligation each promise to transfer to the customer:

• A good or service (or a bundle of goods or services) that is distinct; or
• A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Distinct goods or services

A good or service is distinct if both of the following criteria are met:

The good or service is capable of being distinct:

This means that the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.

Indicators:

• The company regularly sells the good or service separately.

AND

The promise to transfer the good or service is distinct within the context of the contract:

This means that the company’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.

Indicators:

• The company provides a significant service of integrating the goods or services into a bundle of goods or services that represent a combined output(s);
• The goods or services significantly modify or customise each other; or
• The goods or services are highly interdependent or highly interrelated.

Key implications

The identification of performance obligations may involve judgement and is a key step in determining the timing of revenue and profit recognition, as the transaction price is allocated between the performance obligations and revenue is recognised when (or as) the company satisfies each performance obligation. The assessment of whether a good or service is distinct may result in a change in current accounting practices, with a contract being split into different components.

Practical considerations:

Distinct within the context of the contract

The assessment of whether a good or service is distinct within the context of the contract is based on the idea of “separable risks”. In this context, the individual goods or services in a bundle would not be distinct if the risk that an entity assumes to fulfil its obligation to transfer one of those promised goods or services to the customer is a risk that is inseparable from the risk relating to the transfer of the other promised goods or services in that bundle.

In practice, particularly for the first and second indicator, this means that Section 23 requires an entity to assess whether there is a significant “transformative relationship” between two or more items in the process of fulfilling the contract (e.g. an installation service that significantly modifies a machine in order to adapt it to the customer’s production line – the various activities involved in producing and installing the machine would constitute a single performance obligation) rather than simply a “functional relationship” (eg a printer cannot function without an ink cartridge). If there is a transformative relationship between two or more items, these items shall be treated as not distinct within the context of the contract.

Low-value revenue streams

Section 23 has no recognition exemption for performance obligations that the entity deems to be immaterial at contract level. Thus, the materiality principle shall be applied at the level of the financial statements, to determine whether it is necessary to recognise certain performance obligations separately.

It is generally appropriate to set a threshold (a percentage of contract revenue) below which performance obligations may be deemed to be immaterial, meaning they do not need to be recognised separately. For example, this could be the case for relatively insignificant handling and transportation activities carried out after control of the good has been transferred to the customer. However, this should be assessed on a case-by-case basis.

Section 23 provides companies with a choice on whether to recognise as an asset, the incremental costs of obtaining a contract with a customer if the company expects to recover those costs. Incremental costs are those that a company would not have incurred if the contract had not been obtained, for example: a sales commission. Other costs are recognised as an expense when incurred, unless they are explicitly chargeable to the customer.

If a company adopts a policy of capitalising the incremental costs to obtain a contract, as a practical expedient, where the amortisation period of the asset that would otherwise have been recognised is one year or less, costs may be expensed as incurred.

For those companies with reporting obligations under IFRS, it should be noted that this may be a GAAP difference, as IFRS reporters are required to recognise the costs as an asset (if the criteria are met), whereas FRS 102 provides the company with the choice to capitalise or not (subject to following consistent treatment across similar types of expenditure).

This is represented in the following table:

_{Table 1.2: Accounting for incremental costs of obtaining a contract}

Key implications

Section 23 may result in changes to the capitalisation of the costs of obtaining a contract. Whether or not it will result in changes to companies will depend on their current accounting practices and, in particular, the costs they are currently capitalising. Any changes to the costs companies capitalise may have implications for systems and processes, as well as reported figures.

Practical considerations

For those companies opting to capitalise incremental costs of obtaining a contract, care is needed with regard to the nature of certain costs. In respect of success fees, these might meet the definition of capitalisable incremental cots to obtain a contract. However, where a commission paid to a salesman reflecting a target based on the total turnover contracted over a given period (e.g. a year), this does not meet the definition of an incremental cost to obtain a contract because it cannot be directly associated with a specific contract. It is therefore essential to properly understand how any commission paid is calculated.

Section 23 states that an amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or because the consideration is contingent on the occurrence or non-occurrence of a future event.

Section 23 requires a company to estimate an amount of variable consideration by using one of the following two methods, depending on which the entity expects to better predict the amount of consideration to which it will be entitled:

• The expected value:
  • Being the sum of probability-weighted amounts in a range of possible consideration amounts. This is appropriate for a large number of contracts with similar characteristics; or
• The most likely amount:
  • Being the single most likely outcome of the contract. This is appropriate for a contract with only two possible outcomes.

The company then includes in the transaction price some or all of the amount of variable consideration estimated, only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur.

What increases the likelihood or magnitude of a revenue reversal?

• The amount of consideration is highly susceptible to factors outside the entity’s influence.
• The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
• The entity’s experience with similar types of contracts is limited or has limited predictive value.
• The entity has a practice of offering a broad range of price concessions or changing payment terms / conditions of similar contracts in similar circumstances.
• The contract has a large number and broad range of possible consideration amounts.

Key implications

The requirement to estimate the amount of variable consideration, using one of two methods, and then constrain that estimate may lead to changes in accounting practices. We recommend that companies consider the need for changes to systems and processes to ensure compliance with the new requirements. The impact of any changes to reported figures should be assessed, as well as the need to communicate such changes to key stakeholders.

Practical considerations

It is not always easy to identify when an amount of variable consideration is present. Even when the price stated in the contract is fixed, the contract price may include one or more items of variable consideration, for example a price reduction of up to x% of the stated price in the contract if liquidated damages are upheld.

In addition, whilst most terms relating to considerations are explicitly stated in the contract, they may otherwise arise from an entity’s customary business practices, published policies or specific statements that lead the customer to expect that the entity will accept an amount of consideration that is less than the price stated in the contract.

Lastly, an often difficult area for an entity is the necessity to distinguish between a warranty and a bonus or penalty linked to the performance of the asset, with the latter being considered a form of variable consideration.

A company recognises revenue when (or as) the company satisfies a performance obligation. A performance obligation is satisfied by transferring control of a promised good or service to a customer, with control being the ability to direct the use of, and obtain substantially all of the remaining benefits from, the promised good or service.

Recognising revenue at a point in time or over time

At contract inception, a company determines whether it satisfies the performance obligation over time or at a point in time. The performance obligation is satisfied over time, and therefore revenue is recognised over time, if one of the following three criteria are met:

• The customer simultaneously receives and consumes the benefits provided by the company’s performance as the company performs, e.g. routine or recurring services; or
• The company’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or
• The company’s performances creates an asset which does not have an alternative use to the company, and the company has an enforceable right to payment for performance completed to date.

If none of these criteria are met, then the performance obligation is satisfied at a point in time, and therefore revenue is recognised at a point in time.

Key implications

The determination of whether a company recognises revenue over time or at a point in time may result in a change in current accounting practices, with a change from recognising revenue over time to at a point in time or at a point in time to over time. In particular, we expect the second part of the third criterion, relating to the company having an enforceable right to payment for performance completed to date, to cause the most problems for companies.

However, we note that where the customer has no right to terminate the contract for a reason other than the entity’s failure to perform as promised, that there will be a right to payment for performance to date, and thus this element of the criteria is satisfied.

Where the customer has the right to terminate a contract for any reason other than the entity’s failure to perform as promised, it becomes relevant to consider what the entity would be entitled to obtain from the customer under the contract for work completed to date. There are two factors to consider here, both of which require some amount of judgement, being:

• The amount of the compensation, which should reflect the selling price of the goods or services transferred to date, for example recovery of the entity’s costs to date plus a reasonable profit margin; 
• The assessment of the level of completed performance to date throughout the contract.

Measuring progress

A company recognises revenue over time by measuring the progress towards complete satisfaction of that performance obligation. A company applies a single method of measuring progress for each performance obligation satisfied over time and the company applies that method consistently to similar performance obligations and in similar circumstances. The requirement to apply a single method of measuring progress for a given performance obligation is also applicable to a combined performance obligation, i.e. one that contains multiple non-distinct goods or services. In circumstances where the identification of a single method of measuring progress towards completion is problematic, this might, in some cases, be an indicator that the assessment and identification of performance obligations was incorrect and that some goods and services are in fact distinct.

At the end of each reporting period, a company re-measures its progress towards complete satisfaction of that performance obligation, with any changes being accounted for as a change in accounting estimate.

Practical consideration

There is a practical expedient in Section 23 where the company has the right to consideration from a customer that corresponds to the company’s performance completed to date, for example when an entity bills a fixed amount for each hour of service provided. In such cased, the company may recognise revenue in the amount to which the company has a right to invoice.