FASB Topic 606/IFRS 15 has multiple impacts
•Under the new guidance, FASB has eliminated the requirement that an entity must have vendor-specific objective evidence (VSOE) of fair value to avoid revenue deferral for software transactions.
•An entity will now be able to allocate a portion of the transaction price to each obligation based on its standalone selling price, even if VSOE of fair value cannot be established.
Steps to determine standalone selling prices include:
Determine the item’s relative value to the total value of the goods and services
Determine how much the item would sell for if sold alone to similar customers
If not sold alone, estimation is appropriate by:
• Adjusted market assessment approach
• Expected cost plus a margin approach
• Residual approach
If the license is not distinct, companies will need to determine whether the performance obligation (which includes the promised license) is a performance obligation that is satisfied over time or satisfied at a point in time.
Terminologies used in these guidelines
Performance Obligation - A promise to delivery good or service under a contract with a customer qualifies as a performance obligation if the good or service is ‘distinct’.
Standalone Selling Price - The price at which an entity would sell a good or service separately to a customer.
Contract Asset - Recognized Revenue is more than the Invoiced Amount.
Contract Liability - Invoiced Amount is more than Recognized Revenue.
Why is it important?
Looking at the above data, it seems obvious that Company B has a better Return on Investment. It is in fact 4 times more than company A and therefore, a better place for in investment.
Now let us do a deeper dive and consider other facts:
Both companies have one contract.
Company A’s contract is of 10,00,000 to be delivered in 5 years. The invoicing has been done upfront and full payment received. But the revenue is recognized only to the extent obligations are delivered, making it 2,00,000 per year.
Company B’s contract is of 5,00,000 to be delivered in 5 years. Invoicing has been done upfront and full payment received. Revenue is recognized based upon invoicing although the full obligations are not delivered
Analyzing the above information, it’s revealed that Company A is performing better than company B. The financial figures are misleading.
In this use case, both companies followed different revenue accounting principals and therefore, a comparison result was misleading.
With new accounting standards, comparison between two or more entities is possible when both maintain the same principal.
IFRS(International Financial Reporting Standard) 15 is a standard that lays down the rule to recognize and report Revenue from Contracts with Customers. It specifies how and when to recognize revenue as well as requiring entities to provide users of financial statements with more informative, relevant disclosures.
5 step model of the IFRS15/FASB topic 606 guidelines
The 5 step model comprises of the following:
Here are the details of each step involved in this model:
Illustration with examples
An example from Telecommunications Industry.
• Device sold for 1000 CAD, with 3 months free data subscription. • Full amount settled at initiation of the contract. • Device delivered immediately. • Data service provided over the contracted period of 3 months.
The company usually sells the device @ 1000 CAD. The monthly subscription price of Data services is CAD 100.
Step 1: Identify Contract:
This contract is entered with a customer and following are the terms of the same: • Device sold under contract at 1000 CAD, with 3 months free data subscription. • Full amount settled at initiation of the contract. • Device delivered immediately. • Data service provided over the contracted period of 3 months.
Step 2: Identify Performance Obligations:
This contract has two POBs (Performance Obligations) one delivery of device and the second one providing of data service over the period of 3 months.
Step 3: Determine Transaction Price
Transaction price for this contract is CAD 1000
Step 4: Allocate the price to performance obligations:
We have identified 2 POBs in this contract. The transaction price should be allocated between these 2 POBs in the ratio of their standalone selling price (SSP). As defined in IFRS 15, the SSP is the price at which an entity would sell a good or service separately to a customer.
The SSP for device is CAD 1000 and for the 3 months subscription is CAD 300. Hence, the allocation amount for the Device will be CAD 769.23 and for 3 months subscription will be CAD 230.77.
Step 5: Recognize Revenue as the performance obligations are fulfilled
We have identified 2 POBs in this contract. The transaction price should be allocated between these 2 POBs in the ratio of their standalone selling price (SSP). As defined in IFRS 15, the SSP is the price at which an entity would sell a good or service separately to a customer.
The SSP for device is CAD 1000 and for the 3 months subscription is CAD 300. Hence, the allocation amount for the Device will be CAD 769.23 and for 3 months subscription will be CAD 230.77.
Another example from Telecommunications Industry.
• Device sold with 3 months free data subscription. • The customer is invoiced CAD 300 on a monthly basis for three months • Device delivered immediately. • Data service provided over the contracted period of 3 months.
The company usually sells the device @ 1000 CAD. The monthly subscription price of Data services is CAD 100.
Step 1: Identify Contract
This contract is entered with a customer and following are the terms of the same: • Device sold with 3 months free data subscription. • The customer is invoiced CAD 300 on a monthly basis for three months • Device delivered immediately. • Data service provided over the contracted period of 3 months.
Step 2: Identify Performance Obligations:
This contract has two POBs (Performance Obligations) one delivery of device and the second one related to providing of data service over the period of 3 months.
Step 3: Determine Transaction Price
Transaction price for this contract is CAD 900
Step 4: Allocate the price to Performance Obligations
We have identified 2 POBs in this contract. The transaction price should be allocated between these 2 POBs in the ratio of their standalone selling price (SSP). As defined in IFRS 15, the SSP is the price at which an entity would sell a good or service separately to a customer.
The SSP for device is CAD 1000 and for the 3 months subscription is CAD 300. Hence, the allocation amount for the Device will be CAD 692.308 and for 3 months subscription will be CAD 207.692.
Step 5: Recognize revenue as the performance obligations are fulfilled:
The revenue for the Device POB will be recognized as and when the device is delivered, which in our case is in the 1st month. Revenue relating to Subscription POB will be recognized over the period of 3 months equally as and when it gets fulfilled.
At the end of 1st month there will be a Contract Asset of CAD 461.539, as the revenue recognized is more than the invoiced amount
