A. Combination of contracts
When applying the first step of the five step model, i.e. identifying the contract with customer, an entity should consider whether two or more contracts need to be combined into a single contract for its accounting. IFRS 15 has specified the criteria when contracts should be combined. Two or more contracts entered at or near the same time with the same customer should be combined and treated as a single contract for their accounting if one or more of the following criteria is met:
- The contracts are negotiated as a package with a single commercial objective;
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract; or
- The goods or services (or some goods or services) promised in the contracts are a single performance obligation. Genius intellectual
Example
An entity enters into two separate contracts with a vendor.
Contract A – Sale of machinery for a consideration of $ 80,000
Contract B – Installation of machinery for a consideration of $10,000 (stand-alone price is $ 20,000)
These contracts are negotiated with a single commercial objective of installation of machinery. Prices of these two contracts are also inter dependent as evident from the reduced consideration of Installation charges. Therefore, for accounting of the above two contracts, these contracts should be treated as a single contract with two performance obligations.
B. Contract Modifications
Contract modification is a change in the scope or price or both of a contract that is approved by the parties to the contract. It is also called variation order, change order and amendment. However, it must be noted that approval of the modification by the parties to the contract is a must, and if the modification is not approved, an entity should continue to account for the existing contract in the manner in which it was being accounted for.
Examples
- Increasing the quantum of work or increasing the goods to be supplied
- Extending a building being constructed
- Adding elevators in a building being constructed
Contract modification to be considered as a separate contract
An entity shall account for a contract modification as a separate contract if both of the following conditions are present:
- The scope of the contract increases because of addition of goods or services that are distinct; and
- The price of the contract increases by an amount of consideration that reflects the stand-alone selling prices of additional goods or services (or any adjustments to the stand-alone selling prices such as discount offered as the company would save some selling costs).
Contract modification NOT to be considered as a separate contract
If the contract modification is not to be considered as a separate contract, an entity shall account for a contract modification in any of the following ways which is relevant:
- If the remaining goods or services to be transferred after the contract modification are distinct, an entity shall account for the modification as termination of the existing contract and creation of a new contract. Transaction price of the new contract will be the sum of two things; (a) the remaining amount of revenue of the original contract which is not yet recognized; and (b) the consideration promised as part of the contract modification;
- If the remaining goods or services to be transferred after the contract modification are not distinct, an entity shall account for the modification as a part of the existing contract. The effect that the contract modification has on the transaction price is recognized as an adjustment in revenue at the date of the modification on cumulative catch-up basis.
C. Variable Consideration
Consideration promised in a contract may be fixed or variable. Consideration can vary due to discounts, rebates, price concessions, performance bonuses, penalties for late delivery etc. or the consideration may be contingent on happening of a future event. If there is a component of variable consideration in the contract, then the entity would need to estimate the amount of consideration to which the entity will be entitled in exchange of transferring goods or services to the customer.
Variability of consideration may be explicitly stated in the contract, but in addition to the terms of the contract, an entity should evaluate whether there is any implied variability in the consideration. The consideration will be variable if the following circumstances exist:
- the customer has a valid expectation arising from the entity’s customary business practices, published policies or statements that the entity will offer a discount or price concession, or the entity will accept an amount of consideration that is less than the price stated in the contract; or
- other facts and circumstances indicate that entity will offer a price concession to the customer
Methods to estimate variable consideration
The Expected Value: The probability-weighted average amount of all possible consideration amounts is called the expected value. Applying The Expected Value method to estimate variable consideration is appropriate if an entity has a large number of contracts with similar characteristics. The entity can use its historical data to work out probabilities for calculation of the expected value.
The Most Likely Amount: Single most likely amount in a range of possible consideration amounts. Applying The Most Likely Amount method to estimate variable consideration is appropriate if the contract has only two possible outcomes. (E.g. an entity either suffers late delivery penalty or not.)
Constraining estimates of variable consideration
Another concept introduced by IFRS 15 is constraining estimate of variable consideration. An entity should include in the transaction price the amount of variable consideration only to the extent that it is highly probable that “a significant reversal in the amount of cumulative revenue will not occur” when the uncertainty is subsequently resolved.
Reassessment of variable consideration
At the end of each reporting period, an entity should reassess and update the estimated transaction price to reflect changes in the uncertainty associated with the variable consideration. An entity should allocate this change in transaction price to the performance obligations on the same basis on which transaction price was allocated initially.
D. Incremental costs of obtaining a contract
Incremental costs of obtaining a contract with a customer are those costs which an entity incurs to obtain a contract and that would not have incurred if the contract had not been obtained. Such costs should be recognized as an asset if the entity expects to recover these costs. As a practical expedient, an entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period is one year or less.
Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained should be expensed as incurred.
Example
An entity is incurring entertainment costs on meetings and negotiations held with prospective customers and it has also offered sales commission for sales agent conditional upon winning the contract.
Sales commission to be recorded as contract asset, as it is incremental cost of obtaining the contract and it would not have been incurred if the contract was not awarded to the entity.
Entertainment expenses to be recorded as expense as these costs are incurred regardless of whether contract negotiations are successful and contract is won or not.
E. Costs to fulfill a contract
If the cost incurred to fulfill a contract are not within the scope of another standard such as IAS 2, IAS 16 etc., an entity shall recognize these costs as an asset if the following criteria is met:
- Costs are directly related to the contract
- Costs incurred generate resources which will be used in satisfying the performance obligations
- Costs are expected to be recovered
Examples of costs that relate directly to a contract may include direct material cost, direct labor cost or allocation of costs that relate directly to the contract with the customer.
Amortization of contract assets
Contract asset recognized whether by capitalization of incremental costs of obtaining a contract or costs to fulfill a contract shall be amortized in a manner that is consistent with the transfer of goods or services to the customer.
Impairment of contract assets
An impairment loss of the contract asset must be recognized in the income statement to the extent that the carrying amount of the contract asset exceeds remaining net benefit to be realized from the customer. Formula for calculating impairment loss is as follows:
| Amount in USD | ||
| Carrying amount of contract asset | xxx | |
| Less | ||
| Expected remaining amount of consideration | xxx | |
| Expected costs to be incurred | (xxx) | |
| Remaining net benefit to be realized | (xxx) | |
| Impairment loss | xxx | |
When the conditions of contract have improved, a reversal of impairment loss should be recognized. However, while recording the reversal of impairment, it must be kept in mind that the revised carrying amount of the asset should not exceed the historical carrying amount of the asset (cost of contract asset net of amortization, had there been no impairment)
F. Portfolio Approach
The five step model introduced by IFRS 15 is for the accounting of individual contracts. However, as a practical expedient, IFRS 15 has allowed entities to apply this model to a portfolio of contracts with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying this standard to the portfolio would not differ materially from applying this standard to the individual contracts that constitute the portfolio.
Imagine an entity that has millions of small contracts with customers, for example, telecom companies. It would be impractical to account for each contract individually. In such circumstances, portfolio approach can be used. An entity would need to exercise judgement in establishing the size, composition and number of portfolios. Following are some of the factors that may be considered when establishing portfolios:
- Types of customers (individuals, corporate etc.)
- Types of contracts
- Duration of the contracts
- Payment terms of the contracts