As a result of COVID-19 entities are generally expecting to experience significant declines in revenue and decreases in progress of delivery of performance obligations for long-term contracts. These declines in revenue may arise from decreases in volume and changes in variable consideration.
It is likely that, as a result of changes in the economic environment, customers will seek to modify contracts; it is also possible that the ability of customers to pay for goods may be called into question prior to delivery occurring. The entity may choose to transact in this situation notwithstanding the uncertainty. Both trade receivables and contract assets may also be subject to additional credit risk. Finally, onerous contracts may arise as contracts become loss-making through either a decrease in variable consideration or an increase in contract costs.
Applying the ‘5 step model’
IFRS 15 is based on a core principle that requires an entity to recognise revenue in a manner that depicts the transfer of goods or services to customers and at an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services.
In the current economic climate, entities may more often enter into contracts with customers with a high risk of non-payment. If collecting the consideration is not probable at contract inception, the normal IFRS 15 guidance does not apply. Instead, the supplier recognises revenue only if/when it collects the consideration and has no remaining obligations to perform. In effect, the entity should cash account for transactions of this nature. Generally, once a contract meets the conditions to apply the normal IFRS 15 model, any deterioration in the customer’s ability to pay is accounted for under the expected credit loss model set out in IFRS 9 ‘Financial Instruments’. However, if the customer’s ability to pay deteriorates significantly while the contract is still in progress the entity should reassess whether collection is probable.
Variable consideration is any consideration which is not fixed in the contract. Variable consideration changes can potentially impact the assumptions used in measuring revenue from goods or services which have already been delivered.
For contracts with variable consideration, IFRS 15 requires these factors to be reassessed and if necessary, adjusted at each reporting date for both the best estimate and the (so-called) constraint. Management’s assumptions concerning variable consideration (based on facts and circumstances at the reporting date) will need to be reviewed in the context of COVID-19.
The COVID-19 pandemic may result in entities having to renegotiate customer contracts. Depending on the type of modification, ‘contract modification’ accounting may apply. Where a customer encounters financial difficulty or reduced demand, it may request a contract modification to alter the scope of the contract. If the scope of the contract decreases, or the scope increases but pricing does not change by the stand-alone selling price of that increase, contract modification accounting is applied.
Revenue where significant uncertainty of receipt of payment exists
IFRS 15 also requires an entity to recognise revenue from contracts only where the customer is expected to meet its obligations under the contract. Though management would continue to supply to the customer, revenue should only be recognised when it is probable that the customer will be able to pay the transaction price. In such an instance, the entity should defer recognition of any revenue until collection becomes probable. The costs to fulfil the contract cannot be deferred and should be recognised as incurred as they are not ‘expected to be recovered’. Change in expected contract profitability and/or the customer's ability to pay could affect the recoverability of assets recognised in accordance with IFRS 15.
Contracts that were previously expected to be profitable may become loss-making due to a decrease in variable consideration and/or an increase in contract costs. Contracts in the scope of IFRS 15 are subject to the onerous contract requirements of IAS 37. The accounting for onerous contracts includes creating a provision based on the unavoidable costs of meeting the entity’s obligation under the contract.
Entities must consider whether any of their contracts may have become onerous due to the downturn in the global economy as a result of COVID-19 or an increase in costs to fulfill a contract that may arise from the effect of COVID-19 on working practices. In addition, an entity should review contracts to determine if there are any special terms that may relieve either party to the contract of its obligations under it (Force Majeure).
Recently, the IASB published a clarification to IAS 37 that states that the onerous contract assessment should be based on the directly attributable costs of fulfilling the contract (i.e. not only the incremental costs).