Measuring revenue: a new focus on performance obligation

Revenue is one of the most important measures used in assessing an entity’s performance and prospects.

Yet, recognising revenue in contracts is not always straightforward, particularly where the contract extends over several reporting periods.

The Australian Accounting Standards Board (AASB) revenue reporting standards are changing, affecting construction and telecommunications industries along with many others. The new AASB 15 Revenue from Contracts with Customers will take effect on 1 January 2018 (for-profit entities) and 1 January 2019 (not-for-profit entities) replacing AASB 111, AASB 118 and AASB 1004 as well as a number of accounting interpretations.

The focus of revenue recognition is moving from a transfer of risks and rewards to transfer of control, with many entities seeing revenue recognition deferred into later periods than under the existing revenue standards.

For some entities, this means it may no longer be possible to apply the percentage of completion method to their long-term contracts. Up-front fees will no longer be able to be recognised in revenue on receipt of the funds regardless of whether there is a refund obligation. Contracts which provide a refund option will have a portion of revenue deferred until the refund period has passed.

Entities will need to identify performance obligations in the contract which are elements of the contract that the customer can benefit from benefit to the customer and recognise revenue when they are satisfied. They will also need to estimate variable consideration, such as claims, incentives and rebates, at the contract inception and recognise these throughout the period that revenue is recognised.

Careful consideration of AASB 15 should be given to all contracts but in particular those where:

• Customers pay non-refundable upfront fees (e.g. joining, administrative, mobilisation, activation, set-up charges)
• Customers are able to return goods due to a change of mind or a trial period
• Contracts allow variability which may affect the revenue you earn (e.g. claims, bonuses, rebates)
• Customers are offered payments in the form of vouchers or other incentives and loyalty programmes
• There are performance obligations that are not sold separately in the market
• Performance obligations are not clearly identified
• The contract term extends across a financial reporting period
• Business practices generally vary from those documented in a contract.

The following 5-step process will need to be applied for each separate contract with a customer.

Step 1: Identify the contract

To be within the scope of AASB 15, the contract must be an agreement between parties that creates enforceable rights and obligations. Contracts may be written, verbal or implied and must meet each of the following criteria:

• The contract is approved and both parties intend to honour it
• Each party’s rights can be identified
• Payment terms can be identified
• The contract has economic substance (risk, timing or amount of entity’s future cash flows are expected to change)
• The customer has the ability and intent to pay (the entity is likely to collect the consideration).

You will also need to consider customary business practices, such as refunds offered which may not be stated in contracts but given to retain relationships.

Step 2: Identify performance obligations

Under AASB 15, revenue is recognised on what the entity is agreeing to do for the customer (performance obligation) in a contract. Performance obligations are essentially the promises made by an entity to their customers. To meet the definition of performance obligation:

1. The customer must be able to benefit from the good or service either on its own or with other readily available resources and
2. The good or service must be separately identifiable from other goods or services in the contract.

The following will not meet the definition of a performance obligation:

• Payment milestones
• Upfront administrative, joining, activation, mobilisation fees.

Step 3: Determine the transaction price

AASB 15 relies on the expected price. You will need to understand how the contract price could vary and estimate a reasonable consideration then update this estimate at each reporting date.

Where contracts extend across a reporting period and control is transferred over time, you will need to estimate the consideration to be earned and record this estimated amount over the life of the contract. At the end of the contract, report a true-up figure (See Step 5).

Consideration may be variable as set out in the claims and incentives, rebates and returns clauses. You may estimate expected consideration using the most likely amount or a weighted average probability.

Performance obligation allocation is based on the stand-alone selling price of the performance obligation. If this stand-alone price is not available, either through your entity or a competitor, use an estimation technique based on costs and expected margin, or a residual approach.

The allocated transaction price is the amount of revenue that will be recognised when that performance obligation is satisfied.

Step 5: Recognise revenue as performance obligations are satisfied

To recognise revenue under AASB 15, identify the pattern of transfer of control of the performance obligation to the customer. Bear in mind that terms and conditions in contracts can affect the revenue recognition pattern.

If control is transferred at a point in time then revenue is recognised at that point in time, otherwise, revenue can be recognised over the time that control is transferred.

If you are an entity that currently applies the percentage of completion method for revenue recognition, consider whether you meet the criteria to recognise performance obligations over time.

Two standards will apply to revenue of NFP entities: AASB 15 and AASB 1058 Income of NFP entities.

Where NFP contracts are in substance a contract with a customer, then AASB 15 applies. The two criteria which must be met are:

• The contract must be enforceable by legal or equivalent means; and
• The performance obligations included in the contract must be sufficiently specific.

If either of these criteria are not met for an agreement or income stream, apply AASB 1058 for the income.

AASB 1058 requires entities to recognise assets received at the fair value and then identify any related credits on the balance sheet. Any difference between the recorded asset and the credit on the balance sheet is taken to the income statement.

NFP entities will not be able to defer all grant income under AASB 15. They will need to carefully consider the agreement to determine whether it is enforceable and has sufficiently specific performance obligations.

While the AASB 15 will not take effect until next year (or the following year for NFPs) entities need to be prepared for the new reporting requirements.