5.4 IFRS 15 Contract Costs and Specific Revenue Transactions

5.4 IFRS 15 Contract Costs and Specific Revenue Transactions

Why a second revenue section: Section 5.3 built the five-step model. The FR syllabus goes further and names four specific transaction types — principal versus agent, repurchase agreements, bill-and-hold arrangements and consignment arrangements — plus a separate outcome on the recognition of contract costs. These are the scenarios examiners reach for when they want a two-mark question that separates candidates who know the five steps from candidates who understand what control actually means.

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1. Contract Costs: When a Cost Becomes an Asset

IFRS 15 does something unusual for a revenue standard: it contains its own asset recognition rules. The logic is that if revenue is recognised as control transfers, the costs incurred to win and to deliver the contract should be matched against that revenue rather than expensed on the day the cheque is written.

Two distinct categories exist, with different tests.

A. Incremental Costs of Obtaining a Contract

  DEFINITION: costs that the entity would NOT have incurred
              if the contract had NOT been obtained.
              The classic example is a SALES COMMISSION payable
              only on signature.

  TREATMENT:  Recognise as an ASSET if the entity expects to
              RECOVER them.

  EXPEDIENT:  May be expensed immediately if the amortisation
              period would be ONE YEAR OR LESS.

Costs that would have been incurred regardless of whether the contract was won — the bid team's salaries, legal due diligence on a tender, travel to a pitch meeting — are not incremental and are expensed as incurred. The single exception is where such costs are explicitly chargeable to the customer whether or not the contract is obtained, in which case they may be capitalised.

[!WARNING] The examiner's favourite variant. A scenario gives you a $60,000 commission payable only on winning a contract and $25,000 of tender preparation costs incurred whether or not the contract was won. Only the $60,000 is incremental. Candidates who capitalise the full $85,000 lose the mark.

B. Costs to Fulfil a Contract

Before applying IFRS 15's fulfilment cost rules, check whether another standard already governs the cost. Inventory falls under IAS 2, plant under IAS 16, intangibles under IAS 38. Only if no other standard applies does IFRS 15 take over, and then all three of the following must be met:

Costs that must be expensed as incurred:

• General and administrative costs, unless explicitly chargeable to the customer under the contract;
• Costs of wasted materials, labour or other resources not reflected in the contract price;
• Costs that relate to performance obligations already satisfied;
• Costs that cannot be distinguished between satisfied and unsatisfied performance obligations.

C. Amortisation and Impairment

A capitalised contract cost asset is amortised on a systematic basis consistent with the transfer of the goods or services to which it relates — for a five-year service contract, over five years, not immediately. It is tested for impairment: an impairment loss is recognised to the extent the carrying amount exceeds the remaining consideration expected in exchange for the goods or services, less the remaining costs of providing them.

Worked example — contract costs

Kingsbury Systems wins a four-year IT managed-service contract on 1 January 20X6. It incurs:

• Sales commission payable only on signature: $48,000
• Bid preparation costs incurred whether or not the contract was won: $30,000
• Design and migration work performed in January 20X6 to configure the customer's environment, creating a platform used to deliver the service across all four years, expected to be recovered through the contract price: $120,000
• Rectification of a configuration error caused by Kingsbury's own engineers, not recoverable from the customer: $14,000

Incremental cost of obtaining the contract:
  Commission                       $48,000   -> ASSET (amortised over 4 years = $12,000 p.a.)
  Bid preparation                  $30,000   -> EXPENSE (not incremental)

Costs to fulfil the contract:
  Design and migration platform   $120,000   -> ASSET (direct, creates a resource, recoverable)
                                                  (amortised over 4 years = $30,000 p.a.)
  Rectification of own error       $14,000   -> EXPENSE (wasted resources, not in contract price)

Profit or loss charge in 20X6 in respect of these costs:
  Bid preparation                  $30,000
  Rectification                    $14,000
  Amortisation of commission       $12,000
  Amortisation of fulfilment asset $30,000
                                   -------
                                   $86,000
Contract cost assets carried forward at 31 December 20X6:
  ($48,000 - $12,000) + ($120,000 - $30,000) = $36,000 + $90,000 = $126,000

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2. Principal versus Agent: The Control Question Restated

Section 5.3 introduced this test; it is repeated here because the same control logic drives every transaction in this section. The entity is a principal if it controls the specified good or service before it is transferred to the customer, and recognises gross revenue. It is an agent if its performance obligation is to arrange for another party to provide the goods or services, and it recognises net revenue — the fee or commission.

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3. Repurchase Agreements

A repurchase agreement is a contract in which an entity sells an asset and also promises, or has the option, to repurchase it. The accounting turns entirely on who holds the right and at what price.

A. Forward (seller is obliged to repurchase) or Call Option (seller has the right to repurchase)

The customer does not obtain control, because it is constrained in its ability to direct the use of, and obtain substantially all the benefits from, the asset. There is therefore no sale. Two outcomes:

  Repurchase price < original selling price   -->  LEASE (IFRS 16)
  Repurchase price >= original selling price  -->  FINANCING ARRANGEMENT

Under the financing arrangement treatment:

• The entity continues to recognise the asset;
• It recognises a financial liability for the consideration received;
• It recognises the difference between the consideration received and the repurchase price as interest expense over the period.

B. Put Option (customer has the right to require the entity to repurchase)

[!TIP] Read section 2.1's Meridian crane example alongside this. That scenario — an "outright sale" with a call option priced to deliver a 6% annual return to the buyer — is a textbook financing arrangement. It is also the clearest illustration in the whole syllabus of substance over legal form.

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4. Bill-and-Hold Arrangements

A bill-and-hold arrangement is one in which the entity bills a customer for a product but retains physical possession until a later date, typically because the customer lacks storage space or its own production schedule is not ready.

Revenue may be recognised on a bill-and-hold basis only if the customer has obtained control, which requires all four of the following:

  1. SUBSTANTIVE REASON
     The reason for the arrangement must be substantive -- for example,
     the CUSTOMER requested it. A reason invented by the seller to hit
     a period-end revenue target is not substantive.

  2. SEPARATELY IDENTIFIED
     The product must be identified separately as belonging to the customer.

  3. READY FOR TRANSFER
     The product must be currently READY for physical transfer to the
     customer.

  4. NO SELLER USE
     The entity cannot have the ability to use the product or to direct
     it to another customer.

If all four are met, the entity must also consider whether the custodial service it provides is a separate performance obligation, to which part of the transaction price is allocated.

[!WARNING] Criterion 4 is the one that is usually failed in exam scenarios. If the goods remain in general warehouse stock, indistinguishable from other inventory, and could be shipped to whichever customer orders next, the seller retains the ability to redirect them and no sale has occurred.

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5. Consignment Arrangements

In a consignment arrangement, goods are delivered to a dealer or distributor for onward sale to end customers. Delivery alone proves nothing; the question is whether the dealer has obtained control.

Three indicators that the arrangement is a consignment, so control has not passed and no revenue is recognised on delivery:

1. The product is controlled by the entity until a specified event occurs — typically the sale of the product to a customer of the dealer — or until a specified period expires;
2. The entity is able to require the return of the product or to transfer it to a third party;
3. The dealer does not have an unconditional obligation to pay for the product, although it may be required to pay a deposit.

The consigned goods remain in the seller's inventory, measured under IAS 2, and revenue is recognised only when the dealer sells them on.

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6. Worked Example: Four Transactions, One Control Test

Scenario — Fenwick Industrial plc, year ended 31 December 20X6

1. On 1 October 20X6 Fenwick sold a specialist press to Harbury Co for $800,000 and simultaneously entered into an agreement giving Fenwick the right to repurchase it on 30 September 20X8 for $924,800. The press had a carrying amount of $560,000 and an expected market value of $700,000 at the repurchase date.
2. On 20 December 20X6 Fenwick invoiced Cranmore Co $300,000 for machinery that Cranmore asked Fenwick to hold until its new factory was commissioned in February 20X7. The machinery was crated, labelled with Cranmore's name and order number, stored in a segregated bay, complete and ready to ship, and could not be sold to anyone else.
3. On 1 November 20X6 Fenwick delivered $450,000 of tooling (cost $270,000) to Dunmore Distribution. Dunmore pays Fenwick only as and when it sells each item to an end customer, may return unsold tooling at any time, and Fenwick may recall the tooling at any point.
4. Fenwick paid a $9,000 commission to the salesperson who secured the Cranmore order, payable only because the order was won. The related revenue is recognised in December 20X6.

Analysis

Journal entries for transaction 1 (year ended 31 December 20X6)

1 October 20X6 -- receipt of consideration
  Dr Cash                                            $800,000
     Cr Financial liability                                    $800,000
  (The press is NOT derecognised; no revenue and no disposal profit arises)

31 December 20X6 -- three months of interest
  Interest for the full 24 months = $924,800 - $800,000 = $124,800
  Charge for 3 months (straight-line illustration) = $124,800 x 3/24 = $15,600
  Dr Finance cost                                     $15,600
     Cr Financial liability                                     $15,600

Also: depreciation on the press continues, because Fenwick still controls it.

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7. Common Exam Traps

[!WARNING] Trap 1: Recognising a disposal profit on a repurchase agreement. Candidates see cash of $800,000 against a carrying amount of $560,000 and book a $240,000 gain. There is no sale, no derecognition and no gain — only a liability and a finance cost.

[!WARNING] Trap 2: Expensing all contract costs on principle. IFRS 15 requires capitalisation of incremental acquisition costs and qualifying fulfilment costs. "Prudence" is not a reason to expense them.

[!WARNING] Trap 3: Recognising consignment revenue because the goods have left the warehouse. Physical delivery is not control. Look for the right of return, the recall right and the absence of an unconditional obligation to pay.

[!TIP] One question answers all four transaction types: has control passed? Work through who can direct the use of the asset, who obtains substantially all the remaining benefits, who bears the risk of the asset falling in value, and whether the buyer has an unconditional obligation to pay. If the answer is not clearly "the customer", there is no sale.