5.2.5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

Revenue should be recognized when the performance obligation has been satisfied. This occurs when the entity has transferred control of an asset to the customer. In this context, an asset includes either goods or services. A service is considered an asset because the customer obtains a benefit from its use, even if only briefly. The performance obligations can be satisfied either at a point in time or over time.

The standard defines control as the ability to direct the use of, and obtain substantially all of the benefits from the asset. (CPA Canada Handbook – Accounting, IFRS 15.33). Benefits are described as future cash flows, and can take the form of either inflows or reductions of outflows. Thus, cash flows can include not only the revenue derived directly from selling the asset, but also savings from using the asset to enhance other assets, or even the settlement of liabilities with the asset.

Many common business transactions result in performance obligations being satisfied at a point in time. This point could also be described as the critical event. For example, when you buy groceries at your local convenience store, the critical event occurs when you exchange cash for possession of the goods. Once you leave the store with the groceries, revenue has been earned by the store. The proprietor no longer has any responsibility for or control over the goods. Other factors that can be considered when determining if control of an asset has been transferred include the transfer of legal title, the transfer of physical possession, the acceptance by the customer of the asset, the entity's entitlement to payment by the customer, and the transfer of significant risks and rewards of ownership. In the example of groceries purchased, the reward is the realization of the cash received from the sale. Prior to the sale, the risk to the vendor is that the food products may pass their sell-by date or may not be saleable due to changes in consumer tastes. Once you have purchased the goods, you are accepting responsibility for consuming the product prior to the sell-by date. Thus, the rewards have been transferred to the seller and the risks have been transferred to the buyer.

Often, the question of control can be answered by looking at a number of the factors identified above. As long as a company possesses the goods and still holds the title to the goods, there is both a risk (i.e., goods could be damaged, stolen, or destroyed) and a reward (i.e., goods can pledged or sold) available to the vendor. Sometimes, a vendor may transfer legal title to the customer but still maintain physical possession of the goods. In late 2000, Nortel Networks Corporation recorded approximately $1 billion of revenue using bill-and-hold transactions. These transactions were recorded as sales, but the company maintained possession of the goods until some later date when the customer requested delivery. In order to promote these types of sales, the company offered several different incentives to its customers. To report these types of transactions, US GAAP required that several conditions be met, including the conditions that the transaction must be requested by the customer and serve some legitimate business purpose. Nortel's actions violated these two conditions, and as such, the company was later required to restate revenues for the fourth quarter by over $1 billion.

The selling of services can create further accounting problems, as there is no longer the obvious transfer of a physical product to indicate completion of the earnings process. When you get a haircut, the service will be completed when you are satisfied with the cut and the barber enters the sale into the cash register. This can still be described as revenue earned at a point in time, as the completion of the haircut can be seen to be a critical event. However, some activities can take longer to complete, and they can even extend over several accounting periods. When a company agrees to provide a service over a period of time that crosses several fiscal years, the problem is to determine in which accounting periods to recognize the revenue. IFRS 15 requires one of three criteria be met to recognize revenue over time:

• The customer simultaneously receives and consumes benefits as the entity performs;
• The entity's performance creates or enhances an asset that the customer controls; or
• The entity's performance does not create an asset with an alternative use to the entity and entity has an enforceable right to payment

(CPA Canada Handbook – Accounting, IFRS 15.35)

When recognizing revenue for a performance obligation that is satisfied over time, it is essential that the entity have a reliable method for measuring progress. These methods should be based on either inputs or outputs. If the entity cannot reasonably measure its progress towards satisfaction of the performance obligation, then revenue should not be recognized. In some cases, although reliable measures of progress are not available, there is still a reasonable expectation that costs incurred will be recovered. In this instance, revenue would be recognized equal to the costs incurred. This is referred to as the zero-margin method. Revenue recognition for long term contracts will be discussed further in Section 5.3.

Accounting for revenue over time can create further problems when both goods and services are delivered. For example, in 2006, Nortel Networks was required to restate its financial statements due to improper accounting of several "multiple element arrangements." Nortel was engaged in many different types of long-term contracts with customers where installation, network planning, engineering, hardware, software, upgrades, and customer-support features were all included in the contract price. The accounting for these contracts was complicated, and the restatement was required because certain undelivered products and services were not considered separate accounting units, as no fair value could be determined for them.