5.2 The Five-Step Revenue Model: Steps 4 & 5

5.2 The Five-Step Revenue Model: Steps 4 & 5

Core Principle of Allocation & Recognition: The transaction price must be apportioned among distinct performance obligations in proportion to what the entity would charge customers for each item on a standalone basis. Revenue is recognized only as the customer acquires control of the promised economic resources.

Once the performance obligations are identified (Step 2) and the transaction price is determined (Step 3), an entity must operationalize the final two steps of the model:

• Step 4: Allocate the transaction price to the performance obligations.
• Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation.

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Step 4: Allocate the Transaction Price

The fundamental allocation rule in IFRS 15 paragraph 73 requires an entity to allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price (SSP) basis determined at contract inception.

Determining Standalone Selling Prices

The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer.

                         STANDALONE SELLING PRICE HIERARCHY
                                         │
               ┌─────────────────────────┴─────────────────────────┐
               ▼                                                   ▼
       Observable Price                                   Estimated Price
 (Direct sale in similar context)                 (When observable price is missing)
                                                           │
                      ┌────────────────────────────────────┼────────────────────────────────────┐
                      ▼                                    ▼                                    ▼
           Adjusted Market Assessment             Expected Cost Plus Margin              Residual Approach
           (Evaluate market & competitor           (Forecast direct/indirect             (Total price less observable
            pricing with adjustments)               costs + appropriate markup)           SSPs; strictly restricted)

1. Observable Standalone Price (Best Evidence): The observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.
2. Estimation Methods (when observable price is unavailable):
   • Adjusted Market Assessment Approach: The entity evaluates the commercial market in which it sells goods or services and estimates the price that a customer in that market would be willing to pay, referencing competitor prices for similar goods/services adjusted for entity-specific costs and margins.
   • Expected Cost Plus a Margin Approach: The entity forecasts its expected costs of satisfying the performance obligation and adds an appropriate commercial profit margin for that good or service.
   • Residual Approach (Strictly Restricted): The entity calculates the standalone selling price by subtracting the sum of observable standalone selling prices of other promised goods or services from the total transaction price. Under paragraph 79(c), the residual approach is permitted only if:
     • The entity sells the same good or service to different customers at widely differing prices (the selling price is highly variable); or
     • The entity has not yet established a price for that good or service and it has not previously been sold on a standalone basis (the selling price is uncertain).

Allocating Contractual Discounts and Variable Consideration

• Discounts (IFRS 15.81–83): A customer receives a discount when the sum of standalone selling prices exceeds the promised consideration. Discounts are allocated proportionately to all performance obligations in the contract, unless observable evidence demonstrates that the discount belongs entirely to one or more specific obligations (e.g. the entity regularly sells goods A and B together at a bundled discount, while good C is sold at its full standalone selling price).
• Variable Consideration (IFRS 15.85): Variable consideration is allocated entirely to a specific performance obligation (or to a distinct good/service forming part of a series) only if:
  1. The variable payment terms relate specifically to the entity's efforts to satisfy that particular performance obligation; and
  2. Allocating the variable amount entirely to that obligation depicts the amount of consideration to which the entity expects to be entitled upon satisfaction.
• Inception Lock-in Rule: Standalone selling prices are established at contract inception and are never reallocated to reflect subsequent changes in standalone selling prices. Any subsequent revisions to the transaction price (e.g. resolving variable consideration) are allocated across performance obligations on the same relative SSP basis established at contract inception.

Step 5: Recognise Revenue as Performance Obligations Are Satisfied

An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service (an asset) to a customer. An asset is transferred when the customer obtains control of that asset.

The Definition of Control

Under IFRS 15 paragraph 33, 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 also includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, the asset.

Benefits of an asset are potential cash inflows or reductions in cash outflows that can be obtained directly or indirectly, such as by:

• Using the asset to produce goods or provide services;
• Using the asset to enhance the value of other assets;
• Using the asset to settle liabilities or reduce expenses;
• Selling, pledging, or exchanging the asset; or
• Holding the asset.

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Over Time vs Point in Time Recognition

For each performance obligation, an entity determines at contract inception whether it satisfies the obligation over time or at a point in time.

The Three Criteria for Over-Time Recognition

Under IFRS 15 paragraph 35, an entity transfers control of a good or service over time, and therefore recognizes revenue over time, if any one (or more) of the following three criteria is met:

Detailed Analysis of Criterion 3 Requirements

Criterion 3 requires meeting two distinct, conjunctive tests:

1. No Alternative Use Test: An asset does not have an alternative use if the entity is either:
   • Contractually restricted from redirecting the asset to another customer (enforceable contractual restriction); or
   • Practically restricted from redirecting the asset because it would incur significant economic loss (e.g. requiring massive physical rework costs or selling at a deep salvage discount).
2. Enforceable Right to Payment for Performance Completed to Date:
   • At all times throughout the contract duration, if the contract is terminated by the customer for reasons other than the entity's failure to perform, the entity must be entitled to an amount that at least compensates it for performance completed to date.
   • The payment must cover all costs incurred to date plus a reasonable profit margin (not merely recovery of out-of-pocket costs or a nominal forfeit deposit).

If none of the three over-time criteria are met, the performance obligation is satisfied at a Point in Time.

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Measuring Progress for Over-Time Obligations

For each performance obligation satisfied over time, an entity recognizes revenue by measuring progress toward complete satisfaction. The objective is to depict the entity's performance in transferring control of goods or services.

An entity applies a single progress method for each performance obligation and applies it consistently to similar contracts. Progress methods are broadly classified into Input Methods and Output Methods.

Input Methods vs Output Methods

Critical Adjustments to Input Methods

When applying the cost-to-cost input method, an entity must adjust costs incurred to ensure they reflect genuine performance:

1. Abnormal Inefficiencies and Wasted Costs: Costs of abnormal amounts of wasted material, idle labor, or other resources that do not contribute to satisfying the performance obligation are expensed immediately as incurred and excluded from both the numerator and denominator of the progress fraction.
2. Uninstalled Materials: When a customer obtains control of major materials or equipment prior to installation (e.g. specialized elevators delivered to a construction site months before installation), including their cost in the standard cost-to-cost formula would prematurely accelerate margin recognition. Under paragraph B19, if the entity is merely an installer and did not manufacture the goods, the entity:
   • Excludes the uninstalled material cost from the progress calculation;
   • Recognizes revenue for the uninstalled materials strictly equal to their cost (a 0% profit margin) upon delivery of control to the customer.

Point-in-Time Transfer Indicators

When a performance obligation is not satisfied over time, control transfers at a point in time. Under IFRS 15 paragraph 38, an entity evaluates the following non-exhaustive indicators of control transfer:

• Present right to payment: The entity has an enforceable present right to payment for the asset.
• Legal title transferred: The customer has legal title to the physical asset.
• Physical possession transferred: The customer has physical possession of the asset.
• Significant risks and rewards transferred: The customer bears the significant economic risks (obsolescence, damage) and rewards of ownership.
• Customer acceptance: The customer has formally inspected and accepted the asset.

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Worked Technical Scenario: Steps 4 & 5

Scenario Background

On 1 February 2026, Meridian Marine Engineering Ltd signs a fixed-price contract for $18,000,000 with Pacific Transit Authority to deliver a bespoke hybrid passenger catamaran, conduct specialized crew navigation training, and provide a 2-year maintenance support agreement.

Step 4: Standalone Selling Price Allocation

Management identifies three distinct performance obligations. Standalone selling prices are evaluated as follows:

• Catamaran Construction: No direct observable standalone price exists. Meridian applies the expected cost plus a margin approach: estimated construction cost of $12,000,000 plus a standard commercial shipyard margin of 25% = $15,000,000.
• Crew Navigation Training: Meridian regularly provides this training separately to commercial operators for $1,000,000 (observable standalone price).
• 2-Year Maintenance Agreement: Meridian estimates standalone market price using the adjusted market assessment approach at $4,000,000.

$$\text{Total Sum of Standalone Selling Prices} = \$15,000,000 + \$1,000,000 + \$4,000,000 = \$20,000,000$$ $$\text{Total Contract Discount} = \$20,000,000 - \$18,000,000 = \$2,000,000 \quad (10\% \text{ overall bundle discount})$$

Because there is no observable evidence that the $2,000,000 discount relates specifically to one obligation, it is allocated proportionately based on relative standalone selling prices:

Step 5: Over-Time Progress Measurement with Uninstalled Materials

For the Catamaran Construction obligation (allocated transaction price: $13,500,000):

• Over-Time Test: The catamaran is custom-designed for Pacific Transit Authority's unique shallow-draft waterways and cannot be sold to another operator without massive engineering alterations (no alternative use). The contract legally entitles Meridian to cost plus a 15% margin if terminated by the customer without cause. Criterion 3 is met: revenue is recognized over time.
• Progress Method: Meridian uses the cost-to-cost input method. Total estimated construction costs are $12,000,000 (the same estimate used for the standalone selling price).

Year 1 Performance (Financial Year Ended 31 December 2026)

• Cumulative construction costs incurred to date: $4,700,000.
• This includes $1,200,000 for specialized hybrid lithium battery banks delivered to the shipyard on 15 November 2026. Control of the batteries passed to Pacific Transit Authority upon delivery, but installation into the hull will not occur until April 2027. Meridian did not manufacture the battery banks.
• Adjustment for Uninstalled Materials: Meridian must exclude the $1,200,000 uninstalled battery costs from the progress fraction:

$$\text{Adjusted Costs Incurred} = \$4,700,000 - \$1,200,000 = \$3,500,000$$ $$\text{Adjusted Total Estimated Costs} = \$12,000,000 - \$1,200,000 = \$10,800,000$$ $$\text{Progress Percentage} = \frac{\$3,500,000}{\$10,800,000} = 32.4074\%$$ $$\text{Adjusted Allocable Transaction Price} = \$13,500,000 - \$1,200,000 = \$12,300,000$$ $$\text{Revenue from Progress} = 32.4074\% \times \$12,300,000 = \$3,986,111$$ $$\text{Revenue from Uninstalled Materials (at 0\% margin)} = \$1,200,000$$ $$\textbf{Total Year 1 Revenue Recognized} = \$3,986,111 + \$1,200,000 = \textbf{\$5,186,111}$$ $$\textbf{Year 1 Cost of Sales Recognized} = \textbf{\$4,700,000}$$ $$\textbf{Year 1 Gross Margin} = \$5,186,111 - \$4,700,000 = \textbf{\$486,111}$$

By isolating uninstalled materials, Meridian prevents premature recognition of profit margin on the battery banks while faithfully depicting the progress of shipyard fabrication.