Question

1. You are The Chief Finance Officer for your company Blue Label Inc. and a Fellow of the local accountancy body, The Zambia Institute of Chartered Accountants (ZICA).   You have just received an invitation from ZICA requesting you to be one of the presenters at a workshop organized by the institute to fulfill its mandate of enhancing professional competence in its members amid many new standards that have evolved in the recent past. Your specific role will be to talk about the evolution of IFRS 15 Revenue from Contracts with Customers. The workshop organizer has asked you to send your presentation beforehand for review by a relevant official.

Required:

Write briefing notes to the organizer that explain the following in relation to IFRS 15 Revenue from Contracts with Customers:

1. The five step revenue recognition criteria (using simple illustrations as far as possible)

2. Recognition and measurement requirements for:

1. sale and repurchase arrangements;
2. Consignment inventory and
3. Bill and hold arrangements (use simple illustrations as far as possible).

         

Answer 1

IFRS 15, Revenue from Contracts with customers.

Presented by

Mr X

The Chief Finance Officer

Blue Label Inc

Presented

In connection with a workshop conducted by

Zambia Institute of Chartered Accountants

i. The five steps of revenue recognition criteria.

IFRS 15 establishes the principles that an entity applies when reporting information about the nature, amount, timing and uncertainty of revenue and cash flows from a contract with a customer. Applying IFRS 15, an entity recognizes revenue to depict the transfer of promised goods or services to the customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Within the new standards, there are five steps outlined for revenue recognition.

1. Identify the contract with a customer.

This step will typically be straightforward for franchisors because they have a written franchise agreement in place that specifies the parties, each party's rights and obligations, and the payment terms. The agreement will also have "commercial substance," meaning the cash flows of both parties are expected to change as a result of the contract. Franchisors must take the additional step of determining collectability based on its credit underwriting of the franchisee.

2- Identify the performance obligations in the contract.

Performance obligations are promises in a contract to transfer to customer goods or services that are distinct.

1. Determine the transaction price.

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. If the consideration promised in a contract includes a variable amount, an entity must estimate the amount of consideration to which it expects to be entitled in exchange for transferring the promised goods or services to a customer. For example, while an artist appoints a trading agency to sell his works for a price prescribed by the artist.

1. Allocate the prices to the performance obligations

The allocation of the price will be on the basis of the relative stand-alone selling prices of each distinct good or service promised in the contract as mentioned in step 2.

1. Recognize revenue.

When a performance obligation is satisfied by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For a performance obligation satisfied over time, an entity would select an appropriate measure of progress to determine how much revenue should be recognized as the performance obligation is satisfied.

ii. Revenue recognition through the sale of a product as per IFRS 15

Paragraph 31 of IFRS 15: “an entity shall recognize revenue when the entity satisfies the performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when the customer obtains control of that asset.” Paragraph 33 of IFRS 15: “Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of and obtaining the benefits from, an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways.” Paragraph 38 of IFRS 15 requires an entity to consider indicators of the transfer of control, which include, but are not limited to, the following:

a. “the customer has a present right to payment……

b. the customer has legal title to the asset……

c. the customer has obtained physical possession of the asset…

d. the customer has significant risks and rewards of ownership…..

e. the customer has accepted the asset

For example, Cosmetics Co, a consumer products company, uses a Costco, a supermarket chain, to supply its products to the end customers. • Costco receives the legal title and is required to pay for the products on receipt. • Costco has no right of return to CosmeticsC0.

Ø When does the consumer products company recognise revenue in accordance with IFRS 15?

ü Revenue is recognised by Cosmetics Co when control of the products is transferred. Costco has physical possession, legal title and a present obligation to pay for the asset at the time of receipt of the products. These are all indicators that control is transferred when the products are delivered to the retailer.

iii. Repurchase or right to return as per IFRS 15

Paragraph 10 of IFRS 15: “A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral or implied by an entity’s customary business practices. The practices and processes for establishing contracts with customers vary across legal jurisdictions, industries and entities. An entity shall consider those practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations.” A right of return is not a separate performance obligation, but it affects the estimated transaction price for transferred goods. Revenue is only recognised for those goods that are not expected to be returned. The estimate of expected returns should be calculated in the same way as other variable consideration. a) The estimate should reflect the amount that the entity expects to repay or credit customers, using either the expected value method or the most likely amount method. b) The transaction price should include amounts subject to return only if it is highly probable that there will not be a significant reversal of cumulative revenue if the estimate of expected returns changes. Paragraph B21 of IFRS 15 requires entities to account for sales with a right of return recognising all of the following:

a) “Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)

b) A refund liability

c) An asset (and the corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.”

For example, WatchCo uses a wholesale network to supply its products to end-customers. • WatchCo sells 100 watches to a retailer for $50 each. The cost of each watch is $10. • WatchCo estimates, based on the expected value method, that 6% of watches sold will be returned, and it is highly probable that returns will not be higher than 6%. • WatchCo has no further obligations after transferring control of the watches. Situation A – Retailer has a contractual right to return the watches for a full refund for a contractually defined period.

Situation B – Retailer has no contractual right, but WatchCo has a customary business practice where returns have been made and accepted.

Ø How should WatchCo recognise revenue in accordance with IFRS15?

ü Situation A

Revenue is recognised when the watches are delivered and a liability deducted from revenue for expected returns. Simultaneously, an asset is recognised for the watches expected to be returned, reducing the cost of sales. Recognition occurs on the transfer of control to the wholesaler. The returns asset will be presented and assessed for impairment separately from the refund liability. WatchCo will need to assess the returns asset for impairment and adjust the value of the asset if it is impaired.

Revenue: Sales price per unit × units (excluding those expected to be returned) $50 × 100*(1 − 0.06) watches = $4,700 Cost of sales: Cost × units (excluding those expected to be returned) $10 × 94 watches = $940 Asset: Former carrying amount x units expected to be returned $10 × 6 watches = $60 Liability: Return ratio x units sold x sales price per unit 6% x 100 watches × $50 = $300 for the refund obligation.

ü Situation B

WatchCo has a customary business practice of accepting returns which should be considered part of the terms of the contracts with its customers. The right of return is accounted for in the same manner as in situation A.

iv. Consignment inventory and IFRS 15

Consignment arrangements are where an entity ships goods to a distributor but retain control of the goods until a predetermined event occurs. Revenue is not recognised on delivery of the goods to another party if the delivered products are held on consignment. Paragraph B77 of IFRS 15: “When an entity delivers a product to another party (such as a dealer or a distributor) for sale to end-customers, the entity shall evaluate whether that other party has obtained control of the product at that point in time. A product that has been delivered to another party may be held in a consignment arrangement if that other party has not obtained control of the product. Accordingly, an entity shall not recognise revenue upon delivery of the product to another party if the delivered product is held on consignment.” Paragraph B78 of IFRS 15: “Indicators that an arrangement is a consignment arrangement include, but are not limited to, the following:

a) the product is controlled by the entity until a specified event occurs, such as the sale of the products to a customer of the dealer or until a specified period expires;

b) the entity is able to require the return of the products or transfer the products to a third party (such as another dealer); and

c) the dealer does not have an unconditional obligation to pay for the products (although it might be required to pay a deposit).”

For example: GardenfurnishingsCo provides teak furniture to a garden centre on a consignment basis. The products are immediately proposed for sale in the garden centre. • GardenfurnishingsCo retains title to the products until they are sold to the end-customer. • The garden centre does not have an obligation to pay GardenfurnishingsCo until a sale occurs, and any unsold products can be returned to GardenfurnishingsCo. • GardenfurnishingsCo also retains the right to take back any unsold products, or to transfer unsold products to another retailer. • Once the garden centre sells the products to the end-customer, GardenfurnishingsCo has no further obligations, and the retailer has no further return rights.

Ø When does GardenfurnishingsCo recognise revenue in accordance with IFRS 15?

ü GardenfurnishingsCo should recognise revenue once the garden centre sells the product to the end-customer. Although the garden centre has physical possession of the products, it does not take title, only a right to sell, and it does not have an unconditional obligation to pay GardenfurnishingsCo. GardenfurnishingsCo retains the right to call back the products. Therefore, revenue is not recognised when the goods are delivered to the garden centre in accordance with the guidance in paragraphs B77 and B78 of IFRS 15. GardenfurnishingsCo should also assess whether it is the principal to the transaction with the end-customer. If this is the case, it would recognise revenue in the amount that was received from the end-customer, and the amount retained by the garden centre would be recognised as commission expense (see also Section VI).

v. Bill and hold arrangement as per IFRS 15.

Bill-and-hold arrangements arise when a customer is billed for goods that are ready for delivery, but the entity does not ship the goods to the customer until a later date. Entities must assess in these cases whether control has transferred to the customer, even though the customer does not have physical possession of the goods. Revenue is recognized when control of the goods transfers to the customer. Paragraph B81 of IFRS 15 presents the following additional criteria that all need to be met in order for the customer to have obtained control in a bill-and-hold arrangement: a) the reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement); b) products must be identified separately as belonging to the customer; c) products currently must be ready for physical transfer to the customer; and d) products cannot be used or directed to another customer.

For example Consoles AG, a video game company enters into a contract to supply 100,000 video game consoles to a retailer, Durbin, branded with Durbin’s logo, to be delivered by the end of the year. • The contract contains specific instructions from the retailer about where the consoles should be delivered. • The retailer expects to have sufficient shelf space at the time of delivery. • As of year-end, Consoles AG has shipped 60,000 units and the remaining 40,000 inventory of Durbin-branded consoles have been produced, packed and are ready for transport. However, the retailer asks for the shipment to be held, due to lack of shelf space.

Ø When should Consoles AG recognise revenue for the 100,000 units to be delivered to the retailer?

ü At the year-end, Consoles AG should recognise revenue for all 100,000 units, because all of the criteria exist for the control of the units to have transferred to Durbin. Since the goods are branded, they can not be directed to another customer, they are clearly identified as belonging to Durbin, and the reason for entering into the transaction is substantive (that is, lack of shelf space).