New revenue recognition requirements under FRS 102 (September 2024)

The periodic review amendments finalised by the Financial Reporting Council (FRC) in March 2024 have begun to take effect. Of course, the two ‘headline’ changes relate to the new lease accounting requirements for lessees under FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland (which do not apply under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime); and revenue recognition under both FRS 102 and FRS 105.

This article considers some of the technical detail that needs to be considered where the new revenue recognition model is concerned.

Five-step model

To recap, within both FRS 102 (September 2024), Section 23 Revenue from Contracts with Customers and FRS 105 (September 2024), Section 18 Revenue from Contracts with Customers is a comprehensive five-step model for recognising revenue. FRS 102 clarifies that the objective of the model is for an entity to recognise revenue to depict the transfer of promised goods or services to a customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

The five-step model works as follows:

• Step 1: Identify the contract(s) with a customer
• Step 2: Identify the performance obligations in the contract
• Step 3: Determine the transaction price
• Step 4: Allocate the transaction price to the performance obligations in the contract
• Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation

Step 1: Identify the contract(s) with a customer

The five-step revenue recognition model is applied to contracts that meet specific criteria (FRS 102, para 23.7) as follows:

1. both parties have approved the contract;
2. rights to goods or services to be transferred can be identified;
3. payment terms are clear;
4. the contract has commercial substance; and
5. the customer has the ability and intention to pay when payment is due.

Contracts with the same customer will generally be treated as separate contracts. However, they may combined where:

1. they are negotiated as a package with a single commercial objective;
2. one contract’s consideration depends on the price or performance of the other; or
3. they form a single performance obligation.

Contract modifications

A contract modification arises where there is a change in scope or price of a contract. Any such modification is treated as a separate contract or as part of the existing contract. This determination then determines the most appropriate accounting treatment set out in FRS 102, paras 23.15 to 23.16.

Step 2: Identify the performance obligations in the contract

A ‘performance obligation’ is a promise to transfer a distinct good or service, or a series of distinct goods or services and is a defined term in the Glossary to FRS 102.

At contract inception, the entity should identify all performance obligations within the contract (eg, the sale of a good and the rendering of a service, such as a maintenance element. This would usually give rise to two separate contracts).

Warranties

Where the entity provides warranties, these are accounted for under FRS 102, Section 21 Provisions and Contingencies. The exception would be where they offer the customer additional services, in which case the additional service is treated as a separate performance obligation under Section 23. To assess whether the warranty is an additional service, FRS 102, para 23.27 outlines the factors that the entity should consider.

Non-refundable upfront fees

If the upfront fee is an advance payment for future goods or services, revenue is only recognised when those future goods or services are provided. Where a non-refundable upfront fee relates to the transfer of a good or service, the entity must evaluate whether to account for the good/service as a separate performance obligation (FRS 102, para 23.30).

Options for additional goods or services

An option to provide a customer with free or discounted goods and/or services may be a material right. A ‘material right’ arises where the contract contains an embedded promise that the customer would not receive if they did not enter into that contract.

Material rights are treated as separate performance obligations. Revenue is recognised when the future goods/services related to the material right is transferred (or the option expires).

Principal versus agent

An entity must determine whether it acts as principal or agent based on the nature of its promise to provide goods/services. It must also consider whether it controls the specified good/service prior to it being transferred to a customer. FRS 102, para 23.38 provides three indicators that an entity is a principal (but they are not conclusive indicators).

Step 3: Determine the transaction price

The ‘transaction price’ is the amount of consideration to which the entity expects to receive in exchange for the goods/services promised to its customer.

Variable consideration

If the consideration includes variable amounts (eg, discounts, rebates, refunds, penalties or performance bonuses), an estimate is made of the variable amount using the expected value or most likely amount. FRS 102, para 23.44 provides more detail on the expected value or most likely amount.

Variable consideration must only be included within the transaction price if the entity concludes that it is highly probable that the entity will be entitled to the cumulative revenue. The term ‘highly probable’ is defined in the Glossary as ‘significantly more likely than probable’.

Any estimates of variable consideration should be updated at each balance sheet date to reflect any change in circumstances.

Sales or usage-based royalties

Where a licence of intellectual property (IP) is the sole or predominant item to which a royalty relates, an entity recognises royalty revenue when (or as) the later of the following events take place:

• the subsequent sale or usage occurs; and
• the performance obligation to which the royalty relates has been satisfied (or partially satisfied).

Refund liabilities

Refund liabilities are recognised when an entity expects to refund some, or all, of the consideration back to its customer. A refund liability is measured at the amount of consideration received to which the entity does not expect to be entitled.

Sales with rights of return

For contracts containing a right of return, revenue is recognised only for goods expected not to be returned.

The entity recognises a refund liability for consideration to be paid on expected returns. A refund asset is recognised for returned products.

At each balance sheet date, the entity must update its assessment of products expected to be returned.

Time value of money

Where payment is deferred beyond normal business terms or is financed (by the entity) at a rate of interest that is not market rate, the arrangement constitutes a financing arrangement. The entity adjusts the promised amount of consideration for the effects of the time value of money. Interest revenue is recognised in accordance with Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues. Interest revenue is presented separately from revenue.

The effect of the time value of money need not be reflected if the entity expects (at contract inception) that the customer will pay for the goods/services within 12 months or less.

Non-cash consideration

Non-cash consideration is measured at fair value. If fair value cannot be estimated, the consideration is measured based on the stand-alone selling price of the promised goods/services.

Consideration payable to a customer

Consideration payable to a customer is accounted for as a reduction of the transaction price. The exception to this would be where the payment to the customer is in exchange for a distinct good or service that the customer transfers to the entity.

The reduction in revenue is accounted for when (or as) the later of either of the following events take place:

• the entity recognises revenue for the transfer of the related goods/services to the customer; and
• the entity pays or promises to pay the consideration (even where payment is conditional on a future event).

Step 4: Allocate the transaction price to the performance obligations in the contract

The transaction price is allocated to each performance obligation in proportion to the stand-alone selling prices of the goods/services within each performance obligation.

The stand-alone selling prices are based on observable prices or suitable estimation methods. Such estimation methods include the ‘adjusted market assessment approach’, ‘expected cost plus a margin approach’ or a ‘residual approach’.

Discounts

Discounts and/or variable consideration are allocated to performance obligations based on relative stand-alone selling prices, unless another basis better reflects the entity’s entitlement to consideration.

Changes in transaction price

Changes in transaction price are allocated to performance obligations based on the same basis as those at contract inception. Hence, the entity does not reallocate the transaction price to reflect changes in stand-alone selling prices post-contract inception.

Changes in transaction price arising due to a contract modification are dealt with separately and adjustments are made to performance obligations based on the nature of the modification. FRS 102, para 23.77 specifies the accounting treatments for such changes.

Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation

Revenue is recognised over time or at a point in time.

Over time

A performance obligation satisfies over time when any one of the following criteria are met:

• the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
• the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or
• the entity’s performance does not create an asset with alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

Revenue is recognised by applying a measure of progress. The most common and appropriate methods are outlined in FRS 102, para 23.102.

At a point in time

Where a performance obligation is not satisfied over time, the entity satisfies the performance obligation at a point in time.

The point in time is determined by assessing when control of the asset passes to the customer. This will require the entity considering various indicators of control being transferred, which include (but are not limited to) the following:

• the entity has a present right to payment for the asset;
• the customer has legal title to the asset;
• the customer has physical possession of the asset;
• the customer has the significant risks and rewards of ownership of the asset; and
• the customer has accepted the asset.

Licences

To determine whether the licence transfers over time or at a point in time, the entity must consider whether the nature the licence provides the customer with:

• a right to access the IP; or
• a right to use the IP.

A licence that provides a right to access the IP transfers over time. In this case, the entity selects an appropriate method to measure its progress in satisfying the performance obligation over time.

A licence that provides the customer with a right to use the IP transfers at the point in time at which the licence is granted. Consequently, the entity applies the control indicators in FRS 102, paras 23.85 to 23.89 to determine the point in time at which the licence transfers to the customer.

Conclusion

The five-step model in FRS 102 does contain its inherent complexities. Preparers should keep in mind that the revenue recognition requirements in FRS 102, Section 23 and FRS 105, Section 18 are completely new. In some cases, the new requirements may result in different revenue profiles than under the previous edition of FRS 102. There are also prescriptive requirements for transactions involving (among other things) non-refundable upfront fees and income arising from licensing and royalties.

Category: Accounting and standards, Audit