CLARIFYING THE GREY AREAS
The International Accounting Standards Board issued International Financial Reporting Standard (IFRS) 15 Revenue from Contracts with Customers on 28 May 2014. Singapore adopted it as Financial Reporting Standard (FRS) 115 Revenue from Contracts with Customers on 19 November 2014. Both have equivalent effective dates, that is, they are effective for annual periods beginning on or after 1 January 2018.
One of the key improvements of FRS 115 over FRS 18 Revenue is that based on the five-step model under FRS 115; step four requires the allocation of the transaction price to all performance obligations on the basis of the relative standalone selling prices of each distinct good or service promised in the contract. As a result, regardless of how entities package their multiple deliverables arrangements, the revenue recognition practices for these arrangements across entities within each industry is likely to become more consistent and comparable with one another.
AN EXAMPLE FROM THE TELCO INDUSTRY
In a commonly cited example of a telco company – it was also discussed in an earlier article in this Journal back in September 2015 (reiterated here for ease of exposition) – customers can enter into a two-year contract plan for a monthly subscription fee of $20 and receive a free handset. Under FRS 18, most telco companies would recognise the entire contract value as revenue over the two-year service period without allocating any revenue for delivering the handset at the beginning of the contract. The cost of the handset would be treated as the cost of acquiring the customer. However, under FRS 115, the transaction price of $480 would be allocated to the handset and the two-year contract plan accordingly.
This is not a controversial example if we look at the scope of FRS 115. It is clearly stated in FRS 115 paragraph 6 that an entity shall apply FRS 115 to a contract (other than a contract listed in paragraph 5) only if the counterparty to the contract is a customer. It is further clarified in the same paragraph that a customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.
FRS 115 does not define what an entity’s ordinary activities are. Nevertheless, we would believe that an entity’s ordinary activities should arise from the “ordinary course of business”. We examine further how various dictionaries define “ordinary course of business”. The online BusinessDictionary defines the phrase as “a term for activities that are necessary, normal, and incidental to the business. These are common practices and customs of commercial transactions”. The online Merriam-Webster dictionary provides the following legal definition – “the usual manner and range of a business especially considered in relation to the amount, circumstances, and validity of a particular transfer”.
Coming back to the telco example, selling the handset would likely fall under the usual business transaction of a telco and hence, an output of the entity’s ordinary activities and thus within the scope of FRS 115.
In this article, we would like to take this example further by adding one more “free” item; customers would enter into a two-year contract plan for a monthly subscription fee of $20 and receive a free handset and a free rice-cooker. The pertinent question then becomes, “How would one account for the rice-cooker?”
View 1 Not within scope of FRS 115
Strictly speaking, a telco would not ordinarily be selling rice-cookers. This would not be a usual or normal part of its business and so, the rice-cooker is not an output of the entity’s ordinary activities. Hence, the provision of the rice-cooker falls outside the scope of FRS 115 and should not be a performance obligation. This view is also taken by some respondents to the exposure draft of IFRS 15. In IFRS 15 paragraph BC88, “some respondents suggested that some promised goods or services should be excluded from the scope of IFRS 15 and accounted for as marketing expenses or incidental obligations…” Under this view, the transaction price of $480 would be allocated to the handset and the two-year contract plan accordingly. The cost of the rice-cooker would be treated as the cost of acquiring the customer.
View 2 Within the scope of FRS 115
The accounting standards boards, however, take a different view. In IFRS 15 paragraph BC89, it is stated that “the boards observed that when a customer contracts with an entity for a bundle of goods or services, it can be difficult and subjective for the entity to identify the main goods or services for which the customer has contracted. In addition, the outcome of that assessment could vary significantly depending on whether the entity performs the assessment from the perspective of its business model or from the perspective of the customer. Consequently, the boards decided that all goods or services promised to a customer as a result of a contract give rise to performance obligations because those promises were made as part of the negotiated exchange between the entity and its customer. Although the entity might consider those goods or services to be marketing incentives or incidental goods or services, they are goods or services for which the customer pays and to which the entity should allocate consideration for purposes of revenue recognition”.
IFRS 15 paragraph BC90 goes on to elaborate further that “the boards decided not to exempt an entity from accounting for performance obligations that the entity might regard as being perfunctory or inconsequential. Instead, an entity should assess whether those performance obligations are immaterial to its financial statements as described in IAS 8…”
In other words, the accounting standards boards recognise the difficulties in assessing what constitutes the output of ordinary activities of an entity. To reduce the subjectivity and judgement calls that entities have to make, the boards have taken a stand to say that all goods and services promised to a customer would give rise to performance obligations. This reduces the judgement calls that entities have to make and should aid in enhancing consistency in revenue recognition policies and aid in comparability across entities. Under this view, the transaction price of $480 would be allocated to the rice-cooker, the handset and the two-year contract plan accordingly. However, in such a case, the entity does have the option to invoke FRS 8 Accounting Policies, Changes in Accounting Estimates and Errors and argue that the performance obligation of the rice-cooker is immaterial to its financial statements and hence, is exempt from being regarded as a separate performance obligation under FRS 115.
SUMMARY AND CONCLUSIONS
In a scenario where an entity provides a “free” item that is not an output of an entity’s ordinary activities, it was initially unclear whether it is within the scope of FRS 115. However, to avoid such ambiguity, the accounting standards boards have taken the stand that all goods and services promised to a customer would give rise to performance obligations. Hence, even if it is a “free” item that is not an output of an entity’s ordinary activities, it will still fall within the scope of FRS 115 and is one of the performance obligations to which the transaction price has to be allocated to.
Koh Wei Chern is Associate Professor, Accountancy Programme, School of Business, Singapore University of Social Sciences, and Choo Teck Min is Associate Professor of Accounting, Nanyang Business School, Nanyang Technological University.