First step of the five step model introduced by IFRS 15 is identifying contract with customer. Contract is an agreement between two or more parties that creates enforceable rights and obligations. IFRS 15 has prescribed the criteria for identifying contracts and an entity shall apply this standard only if the criteria for identifying the contract is met. Following is the criteria:
- Approval of contract – the parties to the contract have approved the contract and are committed to perform their respective obligations. Contract may be written, verbal or implied by the entity’s customary business practices;
- Rights of each party can be identified – the entity can identify each party’s rights (e.g. customer’s right is the receipt of goods or services, whereas the entity’s right is the receipt of consideration);
- Payment terms can be identified – the entity can identify the payment terms such as mode of payment, credit period etc.;
- Commercial substance – the contract has commercial substance. By commercial substance, it is meant that the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract; and
- Collectability of consideration is probable – it is probable that the entity will collect the consideration in exchange for goods or services to be transferred. To evaluate whether collectability of consideration is probable, the entity should consider the customer’s ability and intention to pay the consideration.
What is the status of contract which can be terminated by either party?
Even if the criteria for identification of contract is met, the contract still does not exist if each party to the contract has an enforceable right to terminate a wholly unperformed contract without compensating the other party. A contract is wholly unperformed if the entity has not yet transferred goods or services to the customer and the entity has neither received, nor is entitled to receive any consideration.
What should an entity do if criteria for identifying the contract is not met?
An entity should continue to assess the contract to determine whether the criteria for identification of contract is subsequently met. Meanwhile, if the entity receives any consideration, the entity should recognize this consideration as liability (unearned income) until the criteria for identification of contract is met. However, the entity should recognize the consideration received as revenue if either of the following events has occurred:
- The entity has transferred the goods or services and has received all, or substantially all of the consideration from the customer and the consideration received is non-refundable; OR
- The contract has been terminated and the consideration received from customer is non-refundable