International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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be accounted for as a performance obligation (e.g. there is a discount for goods or
services provided during the cancellable period that provides the customer with a
material right) (see 5.6 below).24
4.2.1.C
Evaluating the contract term when an entity has a past practice of not
enforcing termination payments
A TRG agenda paper for the October 2014 TRG meeting noted that the evaluation of
the termination payment in determining the duration of a contract depends on
whether the law (which may vary by jurisdiction) would consider past practice as
limiting the parties’ enforceable rights and obligations. An entity’s past practice of
allowing customers to terminate the contract early without enforcing collection of the
termination payment only affects the contract duration in cases in which the parties’
legally enforceable rights and obligations are limited because of the lack of
enforcement by the entity. If that past practice does not change the parties’ legally
enforceable rights and obligations, the contract duration should equal the period
throughout which a substantive termination penalty would be due (which could be
the stated contractual term or a shorter duration if the termination penalty did not
extend to the end of the contract).25
4.2.1.D
Accounting for a partial termination of a contract
We believe an entity should account for the partial termination of a contract (e.g. a
change in the contract term from three years to two years prior to the beginning of
year two) as a contract modification (see 4.4 below) because it results in a change in
the scope of the contract. IFRS 15 states that ‘a contract modification exists when the
parties to a contract approve a modification that either creates new or changes
existing enforceable rights and obligations of the parties to the contract’. [IFRS 15.18].
A partial termination of a contract results in a change to the enforceable rights and
obligations in the existing contract. This conclusion is consistent with TRG agenda
paper no. 48, which states, ‘a substantive termination penalty is evidence of
enforceable rights and obligations throughout the contract term. The termination
penalty is ignored until the contract is terminated at which point it will be accounted
for as a modification’.26
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Consider the following example: An entity enters into a contract with a customer to
provide monthly maintenance services for three years at a fixed price of £500 per
month (i.e. total consideration of £18,000). The contract includes a termination clause
that allows the customer to cancel the third year of the contract by paying a termination
penalty of £1,000 (which is considered substantive for the purpose of this example). The
penalty would effectively result in an adjusted price per month for two years of £542
(i.e. total consideration of £13,000). At the end of the first year, the customer decides to
cancel the third year of the contract and pays the £1,000 termination penalty specified
in the contract.
In this example, the modification would not be accounted for as a separate contract
because it does not result in the addition of distinct goods or services (see 4.4.2 below).
Since the remaining services are distinct, the entity would apply the requirements in
paragraph 21(a) of IFRS 15 and account for the modification prospectively. The
remaining consideration of £7,000 (£6,000 per year under the original contract for the
second year, plus the £1,000 payment upon modification) would be recognised over the
remaining revised contract period of one year. That is, the entity would recognise the
£1,000 termination penalty over the remaining performance period.
4.3 Combining
contracts
In most cases, entities apply the model to individual contracts with a customer.
However, the standard requires entities to combine contracts entered into at, or near,
the same time with the same customer (or related parties of the customer as defined in
IAS 24 – Related Party Disclosures) if they meet one or more of the following criteria:
[IFRS 15.BC74]
(a) the contracts are negotiated as a package with a single commercial objective;
(b) the amount of consideration to be paid in one contract depends on the price or
performance of the other contract; or
(c) the goods or services promised in the contracts (or some goods or services
promised in each of the contracts) are a single performance obligation.
In the Basis for Conclusions, the Board explained that it included the requirements on
combining contracts in the standard because, in some cases, the amount and timing of
revenue may differ depending on whether an entity accounts for contracts as a single
contract or separately. [IFRS 15.BC71].
Entities need to apply judgement to determine whether contracts are entered into at or
near the same time because the standard does not provide a bright line for making this
assessment. In the Basis for Conclusions, the Board noted that the longer the period
between entering into different contracts, the more likely it is that the economic
circumstances affecting the negotiations of those contracts will have changed. [IFRS 15.BC75].
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Negotiating multiple contracts at the same time is not sufficient evidence to
demonstrate that the contracts represent a single arrangement for accounting
purposes. In the Basis for Conclusions, the Board noted that there are pricing
interdependencies between two or more contracts when either of the first two criteria
(i.e. the contracts are negotiated with a single commercial objective or the price in
one contract depends on the price or performance of the other contract) are met, so
the amount of consideration allocated to the performance obligations in each contract
may not faithfully depict the value of the goods or services transferred to the customer
if those contracts were not combined.
The Board also explained that it decided to include the third criterion (i.e. the goods or
services in the contracts are a single performance obligation) to avoid any structuring
opportunities that would effectively allow entities to bypass the requirements for
identifying performance obligations. [IFRS 15.BC73]. That is, an entity cannot avoid
determining whether multiple promises made to a customer at, or near, the same time
need to be bundled into one or more performance obligations in accordance with Step 2
of the model (see 5 below) solely by including the promises in separate contracts.
IFRS 15 provides more requirements on when to combine contracts than the legacy
requirements in IAS 18. IAS 18 indicated that the recognition criteria should be applied
to two or more transactions on a combined basis ‘when they are linked in such a way
that the commercial effect cannot be understood without reference to the series of
transactions as a whole’. [IAS 18.13].
The IFRS 15 contract combination requirements are similar to the requirements that
were in IAS 11, but there are some notable differences. IAS 11 allowed an entity to
combine contracts with several customers, provided the relevant criteria for
combination were met. In
contrast, the contract combination requirements in IFRS 15
only apply to contracts with the same customer or related parties of the customer.
Unlike IFRS 15, IAS 11 did not require that contracts be entered into at or near the
same time.
IAS 11 also required that all criteria be met before contracts could be combined, while
IFRS 15 requires that one or more of its criteria to be met. The criteria for
combination in the two standards are similar. The main difference is the criterion in
paragraph 17(c) of IFRS 15, which considers a performance obligation across different
contracts. In contrast, IAS 11 considered concurrent or sequential performance.
[IFRS 15.17(c), IAS 11.9(c)].
Overall, the criteria are generally consistent with the underlying principles in the legacy
revenue standards on combining contracts. However, since IFRS 15 explicitly requires
an entity to combine contracts if one or more of the criteria in paragraph 17 of IFRS 15
are met, some entities that have not combined contracts in the past may need to do so.
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4.3.1
Portfolio approach practical expedient
Under the standard, the five-step model is applied to individual contracts with
customers, unless the contract combination requirements discussed in 4.3 above are
met. However, the IASB recognised that there may be situations in which it may be
more practical for an entity to group contracts for revenue recognition purposes rather
than attempt to account for each contract separately. Specifically, the standard includes
a practical expedient that allows an entity to apply IFRS 15 to a portfolio of contracts
(or performance obligations) with similar characteristics if the entity reasonably expects
that application of this practical expedient will not differ materially from applying
IFRS 15 to the individual contracts (or performance obligations) within the portfolio.
Furthermore, an entity is required to use estimates and assumptions that reflect the size
and composition of the portfolio. [IFRS 15.4].
As noted above, in order to use the portfolio approach, an entity must reasonably expect
that the accounting result will not be materially different from the result of applying the
standard to the individual contracts. However, in the Basis for Conclusions, the Board
noted that it does not intend for an entity to quantitatively evaluate every possible
outcome when concluding that the portfolio approach is not materially different.
Instead, they indicated that an entity should be able to take a reasonable approach to
determine the portfolios that would be representative of its types of customers and that
an entity should use judgement in selecting the size and composition of those portfolios.
[IFRS 15.BC69].
Application of the portfolio approach will likely vary based on the facts and
circumstances of each entity. An entity may choose to apply the portfolio approach to
only certain aspects of the new model (e.g. determining the transaction price in Step 3).
See 4.1.6.A above for a discussion on how an entity would assess collectability for a
portfolio of contracts.
4.4 Contract
modifications
Parties to an arrangement frequently agree to modify the scope or price (or both) of
their contract. If that happens, an entity must determine whether the modification it is
accounted for as a new contract or as part of the existing contract. Generally, it is clear
when a contract modification has taken place, but in some circumstances that
determination is more difficult. To assist entities when making this determination, the
standard states ‘a contract modification is a change in the scope or price (or both) of a
contract that is approved by the parties to the contract. In some industries and
jurisdictions, a contract modification may be described as a change order, a variation or
an amendment. A contract modification exists when the parties to a contract approve a
modification that either creates new or changes existing enforceable rights and
obligations of the parties to the contract. A contract modification could be approved in
writing, by oral agreement or implied by customary business practices. If the parties to
the contract have not approved a contract modification, an entity shall continue to apply
this Standard to the existing contract until the contract modification is approved.’
[IFRS 15.18].
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The standard goes on to state ‘a contract modification may exist even though the parties
to the contract have a dispute about the scope or price (or both) of the modification or
the parties have approved a change in the scope of the contract but have not yet
determined the corresponding change in price. In determining whether the rights and
obligations that are created or changed by a modification are enforceable, an entity shall
consider all relevant facts and circumstances including the terms of the contract and
other evidence.’ [IFRS 15.19]. If the parties to a contract have approved a change in the
scope of the contract but have not yet determined the corresponding change in price,
an entity shall estimate the change to the transaction price arising from the modification
in accordance with the requirements for estimating and constraining estimates of
variable consideration. [IFRS 15.19].
These requirements illustrate that the Board intended these requirements to apply more
broadly than only to finalised modifications. That is, IFRS 15 indicates that an entity may
have to account for a contract modification prior to the parties reaching final agreement
on changes in scope or pricing (or both). Instead of focusing on the finalisation of a
modification, IFRS 15 focuses on the enforceability of the changes to the rights and
obligations in the contract. Once an entity determines the revised rights and obligations
are enforceable, it accounts for the contract modification.
The standard provides the following example to illustrate this point. [IFRS 15.IE42-IE43].
Example 28.11: Unapproved change in scope and price
An entity enters into a contract with a customer to construct a building on customer-owned land. The contract
states that the customer will provide the entity with access to the land within 30 days of contract inception.
However, the entity was not provided access until 120 days after contract inception because of storm damage
to the site that occurred after contract inception. The contract specifically identifies any delay (including force
majeure) in the entity’s access to customer-owned land as an event that entitles the entity to compensation
that is equal to actual costs incurred as a direct result of the delay. The entity is able to demonstrate that the
specific direct costs were incurred as a result of the delay in accordance with the terms of the contract and
prepares a claim. The customer initially disagreed with the entity’s claim.
The entity assesses the legal basis of the claim and determines, on the basis of the underlying contractual
terms, that it has enforceable rights. Consequently, it accounts for the claim as a contract modification in
accordance with paragraphs 18-21 of IFRS 15. The modification does not result in any additional goods and
services being provided to the customer. In addition, all of the
remaining goods and services after the
modification are not distinct and form part of a single performance obligation. Consequently, the entity
accounts for the modification in accordance with paragraph 21(b) of IFRS 15 by updating the transaction
price and the measure of progress towards complete satisfaction of the performance obligation. The entity
considers the constraint on estimates of variable consideration in paragraphs 56-58 of IFRS 15 when
estimating the transaction price.
Once an entity has determined that a contract has been modified, the entity determines
the appropriate accounting treatment for the modification. Certain modifications are
treated as separate stand-alone contracts (discussed at 4.4.1 below), while others are
combined with the original contract (discussed at 4.4.2 below) and accounted for in that
manner. In addition, some modifications are accounted for on a prospective basis and
others on a cumulative catch-up basis. The Board developed different approaches to
account for different types of modifications with an overall objective of faithfully
depicting an entity’s rights and obligations in each modified contract. [IFRS 15.BC76].
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The following figure illustrates these requirements.
Figure 28.4:
Contract modifications
Have the parties approved a
No
Continue to account for the existing
modification that changes the
scope or price (or both) of the
contract and do not account for the
contract?*
contract modification until approved.
Yes
Is the contract modification for additional goods or services
that are distinct and at their stand-alone selling price?**
No
Yes
Account for the new goods or services
as a separate contract.
Update the transaction price and measure of
Are the remaining goods
No
progress for the single performance
or services distinct from
obligation (recognise change as a cumulative
those already provided?
catch-up to revenue).
Both Yes and No
Yes
Treat the modification as a termination of
Update the transaction price and allocate it to