Satisfaction of performance obligations

Satisfaction of performance obligations is how an entity must recognize revenue under IFRS 15.

Before the issuance of IFRS 15, income recognition was based on IAS 18.

This standard established that an entity could recognize income to the extent that a company transferred the risks and benefits associated with the transferred assets.

However, as of the entry into force of IFRS 15, an entity must recognize income from the sale of goods and services based on the satisfaction of performance obligations.

Now, what are performance obligations?

IFRS 15 recognizes the income based on contracts; these contracts have rights and obligations.

Inside these agreements, an entity can identify different goods and services and obligations between clients and suppliers.

In this way, the main factor in identifying a performance obligation under IFRS 15 is to establish whether these goods or services set in the contract are different or equal.

If, for example, ten products are identified within a contract, of which six are the same, and four products are different, this means that within this contract there are five performance obligations, made up of four different products, and the last group is made up of 6 equal products.

However, it is important to explain what it means for an asset to be distinct in IFRS 15 context.

Paragraph 27 of this standard establishes that a product is different if the two criteria shown below are met:

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 (ie the good or service is capable of being distinct); and

b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (ie the
promise to transfer the good or service is distinct within the context of the contract).

In addition to paragraph 27, paragraph 29 of this same standard is necessary to review.

There it establishes that when evaluating whether an entity’s commitments to transfer goods or services to the customer are separately identifiable according to the paragraph 27 (b), an entity must evaluate the following requirements:

a) the entity provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted.

b) One or more of the goods or services significantly modifies or customises, or are significantly modified or customised by, one or more of the other goods or services promised in the contract.

c) The goods or services are highly interdependent or highly interrelated.

In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract.

Example of performance obligations:

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A company signs a contract with a customer to sell two products. 

On the one hand, specialized machines, and on the other hand, telecommunication equipment.

The machine is sold together with a staff training service.

There is no other supplier in the market that provides a training service with these characteristics.

Besides, the other asset included in the contract is telecommunications equipment that is sold together with a maintenance service every six months.

This service is preventive; that is, the fact that this maintenance is not carried out does not mean that the equipment cannot continue to function.

How many performance obligations are there within the contract?

Within the contract, there are three performance obligations shown below;

Obligation 1: Sale of the specialized machine together with the staff training service:

Obligation 2: Sale of telecommunications equipment

Obligation 3: Sale of maintenance service

The sale of the machine and the training service are not separately identifiable. 

This is evidenced by the interdependence that exists between the transfer of the asset and the training service associated with the use of the machine.

In other words, there is evidence that if the personnel is not trained in the operation of this asset, this machine couldn’t’ be used.

On the other hand, the sale of telecommunications equipment and maintenance do not have a demonstrated interdependence.

That is, it is evident that the equipment can function without the need for maintenance service; therefore, two performance obligations are identified.

Identifying performance obligations is critical to determining how the income must be recognized under IFRS 15.

How are performance obligations satisfied?

The obligations are satisfied as follows:

Satisfaction of performance obligations

Over time

Performance obligations over time present 3 scenarios: as shown in the following graph:

Satisfaction of performance obligations1

The client simultaneously receives and consumes the benefits.

 In this type of obligation, an entity will recognize income as it delivers the goods or services to the customer:

For example, a technology company signs a contract with a bank for three years for a value equivalent to 2 million to provide the data processing service.

If the contract meets all the requirements set out in paragraph 9 of IFRS 15, an entity will recognize an account receivable and contract liability of 2 million.

And to the extent that the entity provides the service to the bank, it must reduce the liability and recognize the income from ordinary activities.

The entity’s performance creates or enhances an asset:

In this type of obligation, the client controls the progress related to the satisfaction of the goods or services delivered. 

For example, if an entity signs a contract with a client to construct a hotel, the entity estimates that the project will last five years and will be developed on land that the client owns.

At the end of year 2, the progress of the work is 30%.

That is, the entity must recognize revenue equal to 30% of the total income agreed in the contract.

The performance of an entity does not create an asset with an alternative use.

To understand this last scenario, let’s look at the following example:

An entity hires an accounting firm to provide an opinion on the reasonableness of the company’s financial statements.

The contract establishes that if the client cancels the agreement and hires another company to provide the same service, this entity must pay a penalty of 20% of the total income agreed between the parties to provide the service.

The 20% penalty received by the accounting firm is close to the profit margin that this entity has in similar contracts.

When the work is 60% complete, the client decides to terminate the contract and seek another job.

Thus, the nature of the service is such that the client obtains the benefits of the entity’s performance only when it receives the professional opinion of the accounting firm.

Consequently, the entity concludes that the customer does not simultaneously receive or consume the benefits associated with the service provision.

That is, the criterion in paragraph 35 (a) is not met.

However, when evaluating the criteria in paragraph 35 (c), the entity concludes that the development of the professional opinion does not create an asset with an alternative use for the entity because the professional opinion relates to facts and circumstances specific to the customer. 

Therefore, there is a practical limitation on the entity’s ability to transfer the asset to another customer.

This means that the entity has an enforceable right to receive payments for its completed performance to date, plus a reasonable margin close to the profit margin of other contracts.

In other words, the accounting firm must recognize an income from activities ordinary equivalent to a 20% penalty charged to the client for the unilateral termination of the contract.

At a point in time

If an entity concludes that after analyzing a contract, none of the requirements in paragraph 35 of IFRS 15 are met, the performance obligation is satisfied at a certain point in time.

An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria are met:

(a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (see paragraphs B3–B4);

(b) the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced (see paragraph B5); or

(c) the entity’s performance does not create an asset with an alternative use to the entity (see paragraph 36) and the entity has an enforceable right to payment for performance completed to date (see paragraph 37).

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