5.1 The Five-Step Revenue Model: Steps 1 to 3
Key Takeaways
The core principle of IFRS 15 / AASB 15 requires an entity to recognise revenue to depict the transfer of promised goods or services to customers in an amount reflecting the consideration to which the entity expects to be entitled.
Step 1 requires satisfying five cumulative criteria—contract approval, identified rights, payment terms, commercial substance, and probable collectability—with modifications accounted for as separate contracts, prospectively, or via cumulative catch-up.
Step 2 identifies performance obligations using a two-part distinct test: the good or service must be capable of being distinct AND distinct within the context of the contract (separately identifiable).
Warranties are distinguished between assurance-type warranties (guaranteeing compliance with specifications at transfer, accounted for under IAS 37) and service-type warranties (distinct services accounted for as separate performance obligations under IFRS 15).
Step 3 determines the transaction price by estimating variable consideration using expected value or most likely amount, constrained by the 'highly probable' reversal hurdle, and adjusting for significant financing components (> 12 months), non-cash consideration, and consideration payable to customers.
5.1 The Five-Step Revenue Model: Steps 1 to 3
Core Principle of IFRS 15: An entity recognises revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
IFRS 15 Revenue from Contracts with Customers (incorporated in Australia as AASB 15) establishes a comprehensive, single, control-based model that supersedes previous standard-setting fragmentation (such as IAS 18 Revenue and IAS 11 Construction Contracts). Under prior guidance, revenue recognition hinged on the subjective transfer of significant 'risks and rewards of ownership'. IFRS 15 eliminates this ambiguity by anchoring revenue recognition firmly to the transfer of control across a structured five-step analytical model.
THE FIVE-STEP REVENUE FRAMEWORK
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[STEP 1] [STEP 2] [STEP 3]
Identify Contract Identify Performance Determine Transaction
with Customer Obligations Price
• 5 Criteria • Distinct Goods/Services • Fixed vs Variable
• Combinations • Integration / Bundles • Reversal Constraint
• Modifications • Assurance vs Service • Financing Components
Warranties • Consideration Payable
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[STEPS 4 & 5]
Allocate Transaction Price &
Recognise Revenue (Section 5.2)
Step 1: Identify the Contract with the Customer
Under IFRS 15 paragraph 9, a contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability is a matter of law. Contracts can be written, oral, or implied by an entity's customary business practices.
The Five Contract Criteria
An entity applies IFRS 15 only when a customer agreement meets all five of the following cumulative criteria:
- Parties have approved the contract and are committed: The parties have approved the contract (in writing, orally, or per standard commercial practice) and are committed to performing their respective obligations.
- Identifiable rights: The entity can identify each party's rights regarding the goods or services to be transferred.
- Identifiable payment terms: The entity can identify the payment terms for the goods or services to be transferred (e.g. fixed payment schedule, net 30 days, progress billing).
- Commercial substance: The contract has commercial substance—the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract.
- Probable collectability: It is probable that the entity will collect the consideration to which it will be entitled in exchange for goods or services transferred. In IFRS standards, 'probable' means more likely than not (a greater than 50% probability). In assessing collectability, an entity evaluates only the customer's financial ability and intention to pay when consideration becomes due.
Reassessment and Non-Qualifying Contracts
If a contract meets the five criteria at inception, an entity does not reassess them unless there is an indication of a significant change in facts and circumstances (e.g. dramatic deterioration in customer creditworthiness).
If a contract fails the five criteria at inception:
- The entity continues to monitor the agreement to determine if the criteria are subsequently satisfied.
- Any consideration received from the customer is recognized as a Contract Liability (deposit liability on the balance sheet).
- Consideration received is recognized as revenue only when either:
- The entity has no remaining obligations to transfer goods or services and all (or substantially all) consideration has been received and is non-refundable; or
- The contract has been terminated and the consideration received is non-refundable.
Contract Combination Rules
Under IFRS 15 paragraph 17, an entity must combine two or more contracts entered into at or near the same time with the same customer (or related parties) and account for them as a single contract if any one of the following conditions is met:
- The contracts are negotiated as a package with a single commercial objective;
- The amount of consideration in one contract depends on the price or performance of the other contract; or
- The goods or services promised in the contracts (or some goods/services promised in each) form a single performance obligation.
Accounting for Contract Modifications
A contract modification is a change in the scope or price (or both) of a contract approved by the parties. Under IFRS 15 paragraphs 20–21, an entity accounts for a contract modification according to the following decision framework:
| Modification Type | Conditions Required | Accounting Treatment |
|---|---|---|
| 1. Separate Contract | (a) Scope increases due to the addition of promised goods/services that are distinct; AND (b) Price increases by an amount reflecting the standalone selling price (SSP) of the additional goods/services (adjusted for contract circumstances). | Accounted for as a completely new, independent contract. The original contract accounting remains unchanged. |
| 2. Prospective Termination & Replacement | Additional promised goods or services are distinct, but the price does not reflect their standalone selling prices. | Original contract is treated as terminated. Unrecognized consideration from the original contract plus new consideration is allocated to remaining distinct performance obligations prospectively. |
| 3. Cumulative Catch-Up Adjustment | The remaining goods or services are not distinct and form part of a single performance obligation that is partially satisfied at the modification date (e.g. customized construction). | The entity updates the transaction price and measure of progress, adjusting cumulative revenue recognized to date through profit or loss at the modification date. |
| 4. Combined Approach | The modification includes both distinct and non-distinct elements. | The entity evaluates each element separately, applying prospective treatment to distinct goods and cumulative catch-up to non-distinct goods. |
Step 2: Identify Performance Obligations
At contract inception, an entity assesses the goods or services promised in a contract and identifies as a performance obligation each promise to transfer to the customer either:
- A good or service (or bundle of goods or services) that is distinct; or
- A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer (e.g. weekly office cleaning, daily utility supply).
The Two-Part Test for a Distinct Good or Service
A promised good or service is distinct under IFRS 15 paragraph 27 if and only if both of the following criteria are satisfied:
DISTINCT TEST (IFRS 15.27)
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Criterion A: Capable Criterion B: Distinct Within
of Being Distinct Context of Contract
Customer can benefit from the The promise is separately identifiable
good/service on its own or with from other promises in the contract
readily available resources. (not highly integrated).
- Capable of being distinct (Criterion A): The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (such as goods/services sold separately by the entity or third parties, or resources already acquired).
- Distinct within the context of the contract (Criterion B): The promise to transfer the good or service is separately identifiable from other promises in the contract. Indicators that two or more promises are not separately identifiable include:
- Significant integration service: The entity provides a significant service of integrating the promised goods or services into a combined output for which the customer contracted (e.g. constructing a commercial building involves bricklaying, plumbing, and electrical works combined into a single finished facility).
- Significant modification or customization: One or more of the goods or services significantly modifies or customizes other goods or services promised in the contract (e.g. developing proprietary software that heavily customizes an existing operational IT infrastructure).
- Highly interdependent or interrelated: The goods or services are significantly affected by one another; the entity could not fulfill its promise to transfer one good without transferring the other.
Warranties: Assurance-Type vs Service-Type
Contracts frequently provide warranties covering products upon delivery. IFRS 15 distinguishes between two fundamental warranty classes:
| Feature | Assurance-Type Warranty | Service-Type Warranty |
|---|---|---|
| Primary Objective | Assures that the product complies with agreed-upon specifications at delivery. | Provides a distinct service beyond standard specification assurance (e.g. routine servicing, extended repair). |
| Customer Option | Inherent in the product sale; cannot be purchased separately by the customer. | Customer has the option to purchase the warranty separately, or coverage extends beyond industry norms. |
| Statutory Mandate | Typically mandated by consumer protection statutes (e.g. Australian Consumer Law). | Voluntary commercial offering extending beyond legal compliance requirements. |
| Applicable Standard | IAS 37 / AASB 137 Provisions, Contingent Liabilities and Contingent Assets. | IFRS 15 / AASB 15 Revenue from Contracts with Customers. |
| Accounting Treatment | Incurred expense and provision recognized at the point of product transfer: Debit Warranty Expense, Credit Provision for Warranty. | Separate performance obligation: Part of the transaction price is allocated to the warranty and recognized as revenue over the coverage period. |
Exam Tip: If a warranty includes both assurance and service components that cannot reasonably be separated, the entity accounts for both components together as a single service-type performance obligation under IFRS 15.
Step 3: 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, excluding amounts collected on behalf of third parties (e.g. Goods and Services Tax / GST, Value Added Tax / VAT, sales taxes).
When determining the transaction price, an entity evaluates five specific factors:
TRANSACTION PRICE DETERMINATION
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Variable Consideration The Reversal Significant Financing Non-Cash Consideration
& Estimation Constraint Component Consideration Payable to
(Expected Value vs (Highly probable no (Discounting if term (Measured at Customer
Most Likely Amount) significant reversal) > 12 months) fair value) (Reduction of price)
1. Variable Consideration
Consideration can vary due to discounts, volume rebates, performance bonuses, penalties, price concessions, prompt payment discounts, or rights of return. An entity must estimate variable consideration using one of two methods, choosing the method that better predicts the entitled amount:
- Expected Value Method: The sum of probability-weighted amounts in a range of possible consideration outcomes. This method is appropriate when an entity has a large volume of contracts with similar characteristics.
- Most Likely Amount Method: The single most likely amount in a range of possible outcomes (e.g. the contract has only two possible outcomes: achieving a binary milestone bonus or missing it).
2. The Constraint on Variable Consideration
To prevent the premature recognition of revenue that might later reverse, IFRS 15 paragraph 56 imposes a strict statutory constraint:
Variable consideration is included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty is resolved.
- In IFRS, 'highly probable' is a significantly higher hurdle than 'probable' (more likely than not). IFRS 15 gives no percentage; the assessment considers both the likelihood and the magnitude of a possible revenue reversal (IFRS 15.57).
- Factors indicating significant reversal risk:
- Consideration is highly susceptible to factors outside entity influence (e.g. market volatility, weather conditions, regulatory decisions).
- The uncertainty is not expected to be resolved for a long period.
- The entity has limited historical experience with similar contracts.
- The entity has a commercial practice of offering concessions or changing payment terms.
3. Significant Financing Component
If the timing of payments agreed to by the parties provides the customer or the entity with a significant benefit of financing the transfer of goods or services, the entity must adjust the promised consideration for the effects of the time value of money.
- Objective: Reflect the cash selling price that the customer would have paid at the time of transfer.
- Discount Rate: The rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception (reflecting customer credit characteristics and collateral).
- Accounting Mechanics:
- Customer financed (deferred payment): Revenue is recognized at the present value of the consideration; interest revenue is recognized over the credit period using the effective interest method under IFRS 9.
- Entity financed (advance payment): A contract liability is recognized at cash receipt; interest expense is accreted over the advance period until performance is satisfied.
- Practical Expedient (IFRS 15.63): An entity is not required to adjust for a significant financing component if the period between performance (transfer of good/service) and customer payment is one year or less (12 months or less).
4. Non-Cash Consideration
When a customer promises consideration in a form other than cash (e.g. equity shares, advertising services, property, plant, and equipment):
- The entity measures non-cash consideration at fair value under IFRS 13 Fair Value Measurement.
- If fair value cannot be reasonably estimated, the entity measures consideration indirectly by reference to the standalone selling price of the goods or services promised to the customer.
5. Consideration Payable to a Customer
Consideration payable includes cash amounts paid (or expected to be paid) to the customer, credits, slotting fees to retail supermarkets, or cooperative advertising allowances:
- General Rule: Treated as a reduction of the transaction price (and thus a reduction of revenue) at the later of when performance occurs or when the entity promises to pay.
- Exception: If the payment to the customer is in exchange for a distinct good or service transferred by the customer to the entity, the entity accounts for the purchase in the same way as any other vendor procurement up to fair value. Any excess paid above the fair value of the distinct good or service reduces the transaction price.
Worked Technical Scenario: Steps 1 to 3
Scenario Background
On 1 January 2026, Apex Industrial Solutions Ltd enters into a contract with Zenith Logistics Ltd to deliver a customized automated sorting conveyor system and provide ongoing commercial services. The contract specifications include:
- Conveyor Hardware & Base Installation: Apex delivers automated machinery and performs standard base installation. The machinery can operate on standard conveyor software and is frequently sold separately for $850,000. Zenith's internal technicians are capable of installing the base equipment, but Zenith contracts Apex to install it for $50,000.
- Proprietary Logistics Control Integration: Apex provides customized algorithmic control software that links the conveyor directly to Zenith's automated enterprise warehouse network. Apex spent $120,000 developing this software, which significantly modifies the operational capabilities of the conveyor system.
- Extended Service Warranty: Apex provides a 3-year extended maintenance and repair service for $90,000, commencing after the statutory 1-year assurance warranty expires.
- Performance Bonus: The contract price includes a fixed amount of $1,100,000 plus an incentive bonus of $100,000 if the facility achieves full operational throughput by 30 June 2026. Management estimates an 80% probability of meeting the deadline and a 20% probability of a 2-week delay due to port congestion.
- Financing Terms: Zenith will pay $500,000 upon contract signing on 1 January 2026, and the remaining balance on 31 December 2027 (a 24-month deferral). The market borrowing rate reflecting Zenith's credit standing is 8% per annum.
Step 1: Contract Qualification & Modification Assessment
- Five Criteria Test: Written contract, clear rights and payment terms, commercial substance established, and Zenith has prime creditworthiness (collectability probable). Contract is fully qualifying under IFRS 15 paragraph 9.
Step 2: Identification of Performance Obligations
- Analysis of Promises:
- Conveyor Hardware + Base Installation + Integration Software: Although the conveyor hardware is capable of being distinct, in this specific contract Apex provides a significant service of integrating the software and hardware into Zenith's customized enterprise network. The software significantly modifies the conveyor. Therefore, under paragraph 29, the conveyor hardware, base installation, and proprietary integration software are not separately identifiable within the context of the contract. They combine into a single performance obligation: Integrated Logistics Sorting Solution.
- Statutory 1-Year Warranty: Assurance-type warranty guaranteeing compliance with specifications. Accounted for under IAS 37 as a cost provision, not a performance obligation.
- 3-Year Extended Maintenance: Service-type warranty providing distinct repair services over 3 years. This is a separate performance obligation: Extended Maintenance Service.
Step 3: Determining the Transaction Price
- Fixed Consideration: $1,100,000.
- Variable Consideration Evaluation:
- Using the most likely amount method (binary outcome), the bonus is $100,000.
- Constraint Assessment: Because potential delays depend on external port congestion (outside Apex's control), Apex cannot conclude that it is highly probable that a significant reversal will not occur. Therefore, the $100,000 bonus is constrained to $0 at contract inception.
- Total unadjusted nominal consideration = $1,100,000.
- Significant Financing Component Adjustment:
- Cash timing: $500,000 received 1 January 2026; $600,000 due 31 December 2027 (24 months later). The 12-month practical expedient cannot be applied.
- Present value of deferred payment at 8%:
Apex recognizes a transaction price of $1,014,403 at contract inception. Over the 2-year financing period, Apex will accrete $85,597 ($600,000 - $514,403) as interest income under IFRS 9 using the effective interest method.
An entity enters into a contract to construct a specialized industrial warehouse for $10,000,000 over two years. Twelve months into the contract, the customer requests a design modification to add an adjoining refrigeration wing for an additional $2,400,000. The refrigeration wing is structurally and operationally integrated with the central warehouse systems, and its standalone selling price would normally be $2,800,000. How should the entity account for this contract modification under IFRS 15?
As a cumulative catch-up adjustment updating total expected contract revenue and costs, because the remaining goods and services are not distinct from those already transferred.
As a separate contract, because the price increase exceeds $2,000,000 and represents genuine commercial consideration.
As a prospective termination of the old contract and creation of a new contract, because the additional wing was priced at a discount to its normal standalone price.
As an expense adjustment under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, because modifications to existing construction contracts represent executory warranty commitments.
Under IFRS 15, when is a promised good or service considered 'distinct', thereby constituting a separate performance obligation?
When the customer can benefit from it on its own or with readily available resources, and the promise is separately identifiable within the contract.
Whenever the contract provides a legally binding assurance that the good will perform free from manufacturing defects for at least 12 months after delivery.
When the entity regularly manufactures the good in-house rather than subcontracting its production to third-party engineering vendors or assemblers.
Whenever the customer signs a separate purchase order and the item is invoiced independently on commercial billing schedules.
On 1 January 2026, an entity enters into a contract to deliver specialized machinery to a customer for $1,210,000 payable on 31 December 2027 (in two years). Control of the machinery transfers on 1 January 2026. The contract includes a significant financing component, and the market discount rate reflecting the customer's credit risk is 10% per annum. The entity does not apply the 12-month practical expedient. How should the transaction price and revenue be recognized on 1 January 2026, and what is the accounting treatment across 2026 and 2027?
Recognize revenue of $1,210,000 on 1 January 2026, with no interest income recognized over the two-year credit period.
Recognize revenue of $1,000,000 on 1 January 2026, and recognize interest income of $100,000 in 2026 and $110,000 in 2027 under the effective interest method.
Recognize revenue of $1,100,000 on 1 January 2026, and recognize interest expense of $110,000 over the two-year financing term under the effective interest method.
Recognize revenue of $1,210,000 on 31 December 2027 when the cash consideration is physically collected from the customer at the end of the two-year credit term.
Sections you finish are checked off in the contents.