Fifth step of the five step model introduced by IFRS 15 is recognizing revenue as and when performance obligations are satisfied. An entity satisfies a performance obligation when promised good or service is transferred to the customer. Goods and services are assets, even if only momentarily. An asset is transferred when the customer obtains control of that asset.
What is control of an asset? Control of an asset is the ability to direct the use of that asset and the ability to obtain substantially all of the remaining benefits from that asset. Control also includes the ability to prevent others from obtaining benefits from that asset. For example, a state owned road is being used by a company to deliver goods from its factory. The company is obtaining benefit of the road but it cannot prevent others from using the road, hence the company has no control over that road and it is not the company’s asset.
Having discussed the definition of control, let’s get back to satisfaction of performance obligations. There are two categories. Either the performance obligations are satisfied at a point in time or the performance obligations are satisfied over time.
Performance obligations satisfied at a point in time
Some performance obligations are satisfied at a point in time and for recognizing revenue, an entity should consider when control of the goods or services is transferred to the customer. Besides that, an entity should consider the following indicators of transfer of control:
- The entity has a present right to payment for the asset
- The customer has legal title of the asset
- The entity has transferred physical possession of the asset to the customer
- The customer has significant risks and rewards of ownership of the asset
- The customer has accepted the asset
Above scenarios are mere indicators and the entity should come to a conclusion regarding satisfaction of performance obligation and recognition of revenue only after assessing whether control of the asset (good or service) has been transferred to the customer or not.
Performance obligations satisfied over time
When goods or services are transferred continuously, and the customer has control over the goods or services transferred to date, it means that performance obligations are satisfied over time; for example contract for the usage of internet services for 6 months etc. Accordingly, revenue should be recognized over time by measuring progress towards complete satisfaction of the performance obligation. An entity shall apply a single method of measuring progress for a performance obligation and shall apply that method consistently to similar performance obligations and in similar circumstances.
Methods of measuring progress
An entity can use output methods as well as input methods to measure progress of performance obligation.
As the name suggests, output factors such as finished goods / results achieved are used to measure progress. Following are some of the methods that can be used to measure progress:
- Surveys of works performed
- Contract Milestones approach
- Units produced compared to total units to be produced (as a percentage)
As the name suggests, input factors such as labour hours, machine hours etc. are used to measure progress. Following are some of the methods that can be used to measure progress:
- Cost incurred compared to total cost to be incurred (as a percentage)
- Labour hours used compared to total labour hours to be used (as a percentage)
- Machine hours used compared to total machine hours to be used (as a percentage)
IFRS 15 requires that an entity shall recognize revenue for a performance obligation satisfied overtime only if the entity can reasonably measure its progress. If reliable information necessarily required for applying appropriate method of measuring progress is not available, it means that the entity would not be able to reasonably measure progress of a performance obligation.
If an entity cannot measure progress reliably, but expects to recover the costs incurred in satisfying a performance obligation, the entity should recognize revenue only to the extent of the costs incurred.