IFRS 15 Series Episode 2: Identifying the contract
This episode is sequel to our previous blog post which introduced us to the 5 steps in revenue recognition as required by IFRS 15.
Before we delve in, it is important to note that lease contracts, insurance contracts, financial instruments and non-monetary exchanges between entities in the same line of business to facilitate sales to customers are out of scope of the standard.
Here are some questions to jolt us as we proceed.
Have you ever considered how a company records money received as grant from a government? – as Revenue?
How about identifying who a customer is for a record label who just signed an upcoming artist? – The artist or the apple subscribers?
How are these accounted for by a Company?
IFRS 15 provides clarification to these and many more.
A Contract according to IFRS 15 is ‘an agreement between two or more parties that creates enforceable rights and obligations.’ Note that not all agreements have enforceable rights and obligations.
In identifying a Contract according to IFRS 15, there are certain criteria any agreement must meet before being considered as a valid contract. Listed below are the 5 criteria required by IFRS 15 for an agreement to be considered a contract:
- Agreement must have been approved by all parties involved
- Rights of each party is identified
- Payment terms are identified
- The contract has commercial substance
- Collectability of consideration is probable
Let’s examine each of these as brief and comprehensive as possible:
Contracts are not mandated to be written, signed and sealed. They can be Written, Oral or Implied. A contract may be Written – where parties to the contract have to sign physical documents drafted with respect to the contract. It may be Oral – Like the mechanic contracted to service your car. This might not require any document, just word of mouth. Contracts may also be Implied – This may be based on previous or customary relationship with a customer(s). For example, if customers get a bottle of coke on every purchase made in your store, it means you have an implied contract with your customers. Approval is a function of mutual understanding between/among the parties to the contract. However, a contract does not exist if both parties to the contract can terminate a wholly unperformed contract without compensating the other party for such termination.
Rights of each party must be identified. A contract cannot exist if goods or services are based on assumptions. Each party must know her right and obligation at the point of agreeing to the contract. For example, a book vendor has the right to receive payment for any book sold to a customer, so also does the customer have a right to the books bought.
The parties should agree to the payment terms for the goods or services to be transferred. This includes credit period given to customers and payment method allowed to customers. This needs to be established so that a customer does not arbitrarily decide to pay for goods/services by means of other goods/services or delay payment unduly.
All agreements that do not have commercial substance is not considered to be a contract according to IFRS 15. Commercial substance means the risk, timing or amount of future cash flows to the parties to the contract is expected to change as a result of the contract. Whether it’s a Good-for-Cash transaction or a Good-for-Good transaction, contracts having commercial substance will affect future cash flows of all parties to the contract.
Collectability of consideration is probable only if the customer has the ability and intention to pay the amount of consideration to which the entity will be entitled in exchange for the goods or services that will be transferred to the customer. Just as Economists define effective demand, collectability measures the capability and willingness of a customer to make payment for goods/services. However, collectability is not hinged on the total transaction price stated in the contract because the entity may offer the customer a price concession. This arises where consideration is variable. Detailed explanations and calculations will be made on this in subsequent episodes to this Standard.
Once the 5 criteria are satisfied, we have identified our contract, what next?
Find out in the next episode.
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