Revenue and Contracts

Variable consideration arises when the amount the entity will receive depends on FUTURE EVENTS — discounts, rebates, refunds, performance bonuses, penalties, royalties, etc.

Step 3 of IFRS 15 (determine transaction price) requires estimating variable consideration.

Two methods to estimate (use whichever better predicts):

1. Expected value: probability-weighted sum of possible amounts. Best when entity has many similar contracts.
2. Most likely amount: single most probable amount. Best when there are only a few possible outcomes.

The CONSTRAINT on variable consideration:

• Include in transaction price ONLY to the extent it is HIGHLY PROBABLE that a SIGNIFICANT REVERSAL of cumulative revenue won't occur when uncertainty resolves
• "Highly probable" = significantly more than "more likely than not" but less than "virtually certain"
• Factors suggesting constraint applies:
  • Amount susceptible to factors outside entity's influence (market, third-party actions)
  • Long uncertainty period
  • Limited experience with similar contracts
  • Broad range of possible amounts

Worked example — volume rebate (variable consideration):

Wholesaler sells products to Retailer. Pricing: £100/unit base. Rebate of £10/unit applies if annual purchases exceed 1,000 units. At Q1, Retailer has bought 200 units. Based on history, Wholesaler estimates 70% probability annual volume exceeds 1,000.

Approach — expected value:

• Expected price per unit: 70% × £90 + 30% × £100 = £63 + £30 = £93/unit
• Q1 revenue: 200 units × £93 = £18,600
• Refund liability for the £7/unit difference between billed (£100) and recognised (£93): 200 × £7 = £1,400

Constraint check:

• Is it HIGHLY PROBABLE no significant reversal? Need to consider risk of reversal.
• If similar contracts have shown reliable pattern (e.g., 95% accuracy in historical estimates): less constraint risk
• If new market or unreliable estimates: constrain to lower amount

Reassessment at each reporting date:

• Update estimate of variable consideration each period
• Changes recognised in revenue (cumulative catch-up)
• Final settlement when variability resolves

Sales-based royalties on licences — special exception:

• For royalties from licences of IP: recognise only WHEN sales/usage occur (not upfront estimation)
• Common in software, music, publishing, pharma licensing

If the timing of payment from customer differs SIGNIFICANTLY from when goods/services are transferred, there is an implicit financing element. IFRS 15 requires this to be SEPARATED from revenue.

When is financing significant?

• Difference between contractual amount and cash sales price for the goods/services
• Combined effect of expected length of time between transfer and payment, AND prevailing interest rates
• Generally if payment is received MORE THAN ONE YEAR before/after transfer

Practical expedient:

• If period between transfer and payment is ONE YEAR OR LESS: NO need to adjust for financing
• Common — most retail and short-term contracts unaffected

Mechanics:

Customer pays in advance (entity has financing benefit):

• Initial: recognise contract liability (cash received)
• Over time: increase contract liability with implicit interest expense
• At delivery: revenue = contract liability balance

Customer pays in arrears (customer has financing benefit):

• Initial: recognise revenue at present value of future payment
• Over time: contract asset accrues interest income
• At payment: receivable settled at face value

Discount rate to use:

• Rate that would apply between entity and customer at contract inception
• Reflects entity's creditworthiness (advance) or customer's (arrears)
• NOT the risk-free rate

Worked example — customer pays in arrears:

Entity sells equipment for £100,000 deliverable today; customer pays in 2 years. Implicit rate: 6%.

• Cash sales price (PV): £100,000 / 1.06² = £88,999.64
• Year 0 (delivery): Revenue £88,999.64; Receivable £88,999.64
• Year 1: Interest income £5,339.98; receivable £94,339.62
• Year 2: Interest income £5,660.38; receivable £100,000. Cash received £100,000.

Common scenarios: long-term construction contracts; subscription services with significant prepayment; licensing arrangements with deferred fees; real estate with long-dated payment terms.

A contract modification is a CHANGE in scope or price of an existing contract approved by both parties. IFRS 15 prescribes three different treatments.

Approach 1: Treat as a SEPARATE CONTRACT.

• Conditions: scope INCREASES due to addition of distinct goods/services AND price increases by amount reflecting STANDALONE SELLING PRICE
• Treatment: original contract continues unchanged; modification accounted for separately

Approach 2: Treat as TERMINATION + NEW CONTRACT.

• Conditions: remaining goods/services are DISTINCT from those already transferred
• Treatment: original contract effectively terminated for remaining performance; allocate REMAINING transaction price (original residual + modification) to remaining performance obligations based on relative standalone selling prices

Approach 3: Treat as CONTINUATION (cumulative catch-up).

• Conditions: remaining goods/services NOT distinct from those already transferred
• Treatment: adjust revenue cumulatively as if the modification had existed at contract inception. Recalculate cumulative revenue based on revised transaction price and progress.
• Common for long-term construction contracts where additional work integrates with existing

Worked example — Approach 3 (construction):

Bridge construction for £10m. After 50% complete (£5m revenue recognised), client requests structural reinforcements adding £3m and 20% to total work.

• Reinforcements integrated → not distinct → Approach 3
• New transaction price: £13m
• New total work: 120% of original
• Old progress: 50% × £10m = £5m
• New progress: 50% / 120% = 41.67% of new total
• Revised cumulative revenue: 41.67% × £13m = £5,417k
• Adjustment to current period: £417k positive

Identifying which approach applies:

1. Distinct + standalone price → Approach 1 (separate contract)
2. Distinct but NOT at standalone price → Approach 2 (termination + new)
3. NOT distinct from existing → Approach 3 (continuation)

Warranties under IFRS 15:

Indicators a warranty is service-type:

• Customer can purchase the warranty SEPARATELY (option)
• Length of warranty exceeds typical industry warranty
• Warranty includes additional services (e.g., regular maintenance)
• Local laws don't require provision of such warranty

Returns:

If customer has the right to return goods:

• RECOGNISE REFUND LIABILITY for the amount expected to be refunded
• RECOGNISE ASSET for the right to recover products on return
• Net effect: revenue recognised excludes expected returns; inventory partially "reserved"

Worked example — returns:

Retailer sells 1,000 units at £50 each (cost £30 each). Expects 5% to be returned.

• Revenue recognised: £50,000 − (5% × £50,000) = £47,500
• Refund liability: £2,500
• Asset (right to recover): £30 × 50 = £1,500
• Cost of sales: £30,000 − £1,500 = £28,500

Consignment arrangements:

• Manufacturer ships to dealer but RETAINS CONTROL — no transfer until end customer purchase
• Indicators: manufacturer can require return; dealer pays only when goods sold; can return without significant cost
• Inventory still on manufacturer's books; revenue recognised when end customer purchases

Bill-and-hold arrangements:

Customer takes title; goods stay at seller's premises. Revenue recognised before physical delivery if ALL FOUR criteria met:

1. SUBSTANTIVE reason for arrangement (e.g., customer's storage limitations, NOT seller's convenience)
2. Goods SEPARATELY IDENTIFIABLE as belonging to the customer
3. Goods CURRENTLY READY for physical transfer
4. Seller cannot direct goods to others or otherwise use them

If any criterion not met: revenue deferred until physical delivery. Year-end "pre-delivery" arrangements scrutinised.

Principal vs agent:

• If entity CONTROLS goods/services before transfer: PRINCIPAL — gross revenue
• If entity ARRANGES for goods to be provided by another party: AGENT — net revenue (commission)
• Indicators of principal: primary responsibility for fulfilling promise; inventory risk; discretion in pricing
• Critical for revenue PRESENTATION (gross vs net)

A multi-element arrangement contains MULTIPLE PERFORMANCE OBLIGATIONS. Allocate transaction price to each based on relative standalone selling prices.

"Distinct" requires both:

1. The customer can BENEFIT from the good/service (alone or with readily available resources)
2. The promise to transfer is SEPARATELY IDENTIFIABLE from other promises

Indicators of separability:

• Entity does not provide a SIGNIFICANT INTEGRATION SERVICE
• Good/service does not significantly modify or customise another
• Good/service is not highly INTERDEPENDENT

If goods/services are NOT distinct: combine into a single performance obligation.

Methods to estimate standalone selling price:

1. Adjusted market assessment: examine market prices
2. Expected cost plus margin: cost + reasonable margin
3. Residual approach (limited use): only when standalone price highly variable or uncertain

Worked example — bundled package:

Tech bundle:

• Hardware: standalone £10,000
• Software (1-year): standalone £4,000
• Implementation: standalone £3,000
• Support (1-year): standalone £2,000
• Bundled price: £15,000 (20% discount on £19,000 standalone)

Allocation (proportional discount):

• Hardware: £10,000 × 78.95% = £7,895 (point in time at delivery)
• Software: £4,000 × 78.95% = £3,158 (depends — right-to-use or right-to-access)
• Implementation: £3,000 × 78.95% = £2,368 (point in time at completion)
• Support: £2,000 × 78.95% = £1,579 (over time, straight-line)

Material rights:

• If contract gives customer an OPTION to acquire additional goods/services FREE OR AT A DISCOUNT not available without the contract
• Treat as SEPARATE performance obligation
• Allocate transaction price to it
• Common: loyalty programs, software upgrade rights

Loyalty programs example:

• Points earned in current sale; redeemable for future purchases
• Allocate transaction price between current sale and the points (FV of expected redemption)
• Defer revenue allocated to points until redemption (or expiry)

Long-term contracts: recognise OVER TIME or AT A POINT IN TIME?

IFRS 15 criteria for OVER-TIME recognition (any ONE met):

1. Customer simultaneously receives and consumes the benefits as the entity performs (e.g., cleaning services, monthly subscriptions)
2. Entity's performance creates or enhances an asset that the customer CONTROLS as the asset is created (e.g., construction on customer's land)
3. Entity's performance does NOT create an asset with alternative use, AND entity has enforceable RIGHT TO PAYMENT for performance to date (e.g., custom-built asset, software designed to spec)

If NO criterion met: recognise revenue AT POINT IN TIME (when control transfers).

Measuring progress for over-time recognition:

• Output methods: results achieved (units delivered, milestones, surveys)
• Input methods: resources consumed (cost-based — most common; hours worked)

Cost-based input method:

• Progress = costs incurred to date / total expected costs
• Apply to total contract revenue to determine cumulative revenue
• Period revenue = cumulative this period − cumulative previous period
• Exclude wasted materials/inefficient costs

Worked example — long-term construction:

Custom factory; total contract £20m; total estimated costs £15m. Year 1 costs £6m; Year 2 costs £6m; Year 3 costs £3m.

Onerous contracts:

• If expected costs > expected revenue: RECOGNISE FULL EXPECTED LOSS IMMEDIATELY
• IAS 37 onerous contract provision
• Asymmetry: profit over time; losses immediately when foreseen

Contract assets and liabilities:

• Revenue recognised > amount billed: CONTRACT ASSET
• Amount billed > revenue recognised: CONTRACT LIABILITY (deferred revenue)
• Distinguished from receivables (unconditional right)

Variations and claims:

• Include in transaction price only if highly probable to be approved (constraint applies)
• Bonuses/penalties: estimate and constrain
• Stage payments / retentions: don't change revenue timing — affect cash flow only

IFRS 17 Insurance Contracts replaced IFRS 4 effective 1 January 2023.

Why IFRS 17?

• IFRS 4 was a "stop-gap" allowing local GAAP for insurance contracts
• IFRS 17 brings comparability, transparency, and economic accuracy
• Major change for insurance industry

Scope:

• Insurance contracts: one party (issuer) ACCEPTS SIGNIFICANT INSURANCE RISK from another (policyholder)
• Insurance risk: risk of LOSS due to specified uncertain future event
• Excludes: warranties (IFRS 15); financial guarantees (IFRS 9); employee benefits (IAS 19)
• Investment contracts with discretionary participation features (DPF) — also in scope

Three measurement models:

1. General Model (Building Block Approach — BBA):

Default model. Three building blocks:

• Fulfilment cash flows: PV of future cash inflows and outflows on the contract
• Risk adjustment for non-financial risk: compensation for bearing uncertainty
• Contractual Service Margin (CSM): unearned profit. Released to P&L over coverage period as services provided.

Liability = fulfilment cash flows + risk adjustment + CSM

CSM key features:

• Represents PROFIT to be recognised as services delivered
• If contract issued at LOSS at inception: NO CSM (immediate loss recognition)
• Recalibrated each period (favourable changes increase CSM; unfavourable absorb until loss)
• Released to P&L based on COVERAGE UNITS

2. Premium Allocation Approach (PAA) — simplification:

• For SHORT-DURATION contracts (coverage period ≤ 1 YEAR) OR where similar to General Model
• Simpler — similar to unearned premium approach
• Premium received reduced over coverage period; claims and expenses recognised when incurred
• NO CSM concept
• Common for: motor insurance, general property, short-term liability

3. Variable Fee Approach (VFA) — direct participation:

• Contracts with DIRECT PARTICIPATION FEATURES — substantial share of return goes to policyholder
• Entity's share = "variable fee" = entity's share of underlying items minus other fulfilment cash flows
• Common for: unit-linked contracts, with-profits contracts

Contract boundary:

• Determines what cash flows are within the contract for measurement
• Boundary = point at which entity has substantive right to terminate or amend pricing significantly

Coverage units:

• Reflect SERVICES provided in each period
• CSM released proportionally to coverage units
• Examples: number of insured years; expected claims; service hours

Aggregation:

• Contracts grouped into PORTFOLIOS (similar risks managed together)
• Within portfolio: GROUPS based on profitability at inception (onerous; profitable) and same year of issue (annual cohorts)
• Measurement at GROUP level

Presentation:

• Insurance revenue: services rendered in period (CSM release + risk adjustment + insurance service expenses recovered)
• Insurance service expense: claims, expenses, changes in fulfilment cash flows other than financial
• Insurance finance income/expense: changes from time value of money — separate from insurance service result

Major impact on insurers:

• Significant implementation cost
• Different timing of profit recognition (CSM spreads profits over coverage)
• More transparency on profitability
• More volatility from changing estimates
• Banks/conglomerates with insurance subsidiaries also affected