Chapter 7: Practical application issues
Rights of return
An entity might transfer control of a product to a customer and also grant the customer the right to return the product. A right of return often entitles a customer to a full or partial refund of the amount paid or a credit against other purchases, or to exchange one product for another.
A right of return is not a separate performance obligation, but it affects the estimated transaction price for transferred goods. Revenue is only recognized for those goods that are not expected to be returned.
The estimate of expected returns should be calculated in the same way as other variable considerations. The estimate should reflect the amount that the entity expects to repay or credit to customers, using either the expected value method or the most likely amount method, whichever management determines will better predict the amount of consideration to which it will be entitled. The transaction price should include amounts subject to return only if it is highly probable that there will not be a significant reversal of cumulative revenue if the estimate of expected returns changes.
Right of return
Return privileges can manifest in various forms within contracts, encompassing rights such as the ability to return products for any reason, in case they become obsolete, or as part of trade-in agreements for newer products. Sometimes, these privileges are implicit rather than explicitly stated in the contract. Implicit rights may arise from assurances made to customers during the sales process, legal requirements, or customary business practices. These practices typically aim to address both buyer concerns, such as dissatisfaction or technological obsolescence, and seller priorities, including ensuring customer contentment and mitigating risks associated with product distribution. For instance, a producer distributing products through a network of distributors might allow returns within 120 days of the distributor obtaining control of the products. Beyond this period, neither the producer nor the distributors hold further return rights. However, uncertainties may arise, particularly regarding return levels, especially when introducing a new product into the distributor network.
Question
How should the producer recognise revenue in this arrangement?
Answer
The producer must evaluate whether there is a likelihood of a significant reversal of cumulative revenue due to changes in return estimates, based on historical data and other pertinent evidence. This assessment involves determining a threshold level of sales where it’s highly probable that no substantial revenue reversal will occur, necessitating revenue recognition for those sales.
For instance, if the producer initially estimates that 70% of sales can be included in the transaction price without significant revenue reversals, revenue would be recorded for that proportion. It’s crucial for the producer to continually reassess its anticipated return rates at the end of each reporting period to ensure accurate revenue recognition.
When products are sold with a right of return (or services are provided with a right to a refund), the entity will recognize revenue at the amount of consideration to which the entity expects to be entitled. Revenue would not be recognized for products that the entity expects to be returned or services refunded. The entity should raise a refund liability and an asset (with a corresponding adjustment to the cost of sales) representing its right to recover the products from the customer.
Restocking fee
When customers return a product, entities may impose a “restocking fee” to cover various expenses incurred, such as shipping, quality control, and repackaging costs. Sometimes, these fees also serve to deter returns or compensate for the reduced selling price of returned items. Treating a sale with a restocking fee is akin to handling a partial return right and should be accounted for similarly. For items expected to be returned, the entity’s estimated refund liability equals the consideration paid for the goods minus the restocking fee. Consequently, the restocking fee should be factored into the transaction price and recognized when control of the goods transfers to the customer. An asset is then recorded for the entity’s entitlement to recover the goods upon settling the refund liability. Additionally, the entity’s anticipated restocking expenses should be recognized as a deduction from the asset’s carrying amount, reflecting the costs associated with recovering the goods
The refund liability represents the amount of consideration that the entity expects to refund to customers. The refund liability is remeasured at each reporting date to reflect changes in the estimate of returns, with a corresponding adjustment to revenue.
The asset represents the entity’s right to receive goods (inventory) back from the customer when it settles the refund obligation. The asset is initially measured at the carrying amount of the goods at the time of sale, less any expected costs to recover the goods and any expected reduction in value. The returns asset is presented separately from the refund liability. The amount recorded as an asset should be updated for changes in the refund liability and for other changes in circumstances that might suggest an impairment of the asset.
Refund obligation and returns asset
Entity Q sells 1,000 video games to a distributor at a price of C50 per game. The distributor is entitled to return the video games within 180 days of purchase for a full refund, regardless of the reason. The cost of producing each game is C10. Using the expected value method, Entity Q estimates that 6% of the video game sales will be returned, and it is highly likely that returns will not exceed this percentage. Upon transferring control of the video games, Entity Q has no additional obligations.
Question
How should entity Q record this transaction?
Answer
Entity Q should recognize revenue of C47,000 (C50 × 940 games) and cost of sales of C9,400 (C10 × 940 games) when control of the games transfers to the distributor. Additionally, Entity Q should recognize an asset of C600 (C10 × 60 games) for expected returns and a liability of C3,000 (6% of the sales price) for the refund obligation. The returns asset will be presented and assessed for impairment separately from the refund liability. Entity Q will need to evaluate the returns asset for impairment and adjust its value if impairment occurs.
Exchange rights
No adjustment to the transaction price is made for exchange rights where a customer can exchange one product for another of the same type, quality, condition, and price. A right to exchange an item that does not function as intended for one that is functioning properly is a warranty and not a right of return.
Warranties
Entities often provide customers with a warranty in connection with the sale of a good or service. The nature of a warranty can vary across entities, industries, products, or contracts. Warranties might be written in the contract, or they might be implicit as a result of either customary business practices or legal requirements.
Compensation and warranty
Terms that stipulate cash payments to the customer, like liquidated damages for breaching the contract terms, are typically treated as variable consideration rather than warranties. However, cash payments to customers may be classified as warranties in specific cases, such as direct reimbursements to cover costs paid by the customer to a third party for repairing a product.
Is the right to return a defective product in exchange for cash or credit accounted for as an assurance-type warranty or a right of return?
A return made in exchange for cash or credit is typically treated as a right of return. However, if customers are provided with the choice to return a defective item for cash, credit, or a replacement product, management needs to estimate the anticipated returns for cash or credit as part of its handling of estimated returns. Returns exchanged for a replacement product are addressed under the warranty provisions.
Other warranties provide a customer with a service in addition to the assurance that the product will function as expected. The service provides a level of protection beyond defects that existed at the time of sale. Judgment will often be required to determine whether a warranty provides assurance or an additional service. The additional service provided in a warranty is accounted for as a promised service in the contract and therefore a separate performance obligation, assuming the service is distinct from other goods and services in the contract.
An entity that cannot reasonably account for a service element of a warranty separate from the assurance element should account for both together as a single performance obligation that provides a service to the customer.
Assessing whether a warranty is a performance obligation
Entity R enters into a contract with a customer to sell a smart phone and provide a one-year warranty against both manufacturing defects and customerinflicted damages (for example, dropping the phone into water). The warranty cannot be purchased separately.
Question
How should entity R account for the warranty?
Answer
This arrangement involves several components: (1) the smart phone itself; (2) a product warranty covering manufacturing defects; and (3) a repair and replacement service for damages inflicted by the customer. Entity R would address the product warranty according to existing guidance on warranties, recognizing both an expense and a liability for anticipated repair or replacement expenses. For the repair and replacement service, delineated as protection against customer-inflicted damages, Entity R would treat it as a distinct performance obligation, acknowledging revenue as it fulfills this obligation. In cases where Entity R cannot feasibly distinguish between the product warranty and the repair and replacement service, they would amalgamate the two warranties into a single performance obligation.
An entity should consider the following factors when assessing whether a warranty that is not sold separately provides a service that should be accounted for as a separate performance obligation:
- Whether the warranty is required by law. In that case, the existence of that law indicates that the promised warranty is not a performance obligation. This is because such requirements typically exist to protect customers from the risk of purchasing defective products.
- The length of the warranty coverage period. The longer the coverage period, the more likely it is that the promised warranty is a performance obligation.
- The nature of the tasks that the entity promises to perform. If an entity must perform specified tasks to assure that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), those tasks are unlikely to give rise to a performance obligation.
Accounting for the lapse of warrants
An instance exempt from IFRS 15’s scope involves when an entity issues warrants, options on its own shares, for cash. These warrants qualify as equity instruments per IAS 32, and thus, the funds received upon issuance were credited to equity. If the warrants expire without being exercised, no revenue recognition occurs.
According to the Conceptual Framework for Financial Reporting, income, including revenue and gains, excludes contributions from equity holders. The issuance of warrants represents a transaction with equity holders. Even if an equity holder forfeits their claim on the entity’s assets, the equity contribution doesn’t convert into income. Instead, amounts related to warrants classified as equity instruments may be transferred to another equity account, like contributed surplus, upon expiration.
Non-refundable upfront fees
An entity might charge customers a fee at or near the inception of a contract. These upfront fees are often non-refundable and could be labelled as fees for set-labeledss, activation, initiation, joining or membership.
An entity, needs to analyze each arrangement involving upfront fees to determine whether the fee relates to the transfer of a promised good or service. It should not rrecognizerevenue upon receipt of an upfront fee, even if it is non-refundable if the fee does not relate to the satisfaction of a performance obligation. The non-refundable fee is an advance payment for future goods or services and should be included in the transaction price and allocated to the separate performance obligations identified in the contract. It is recognized as revenue as the performance obligations are satisfied.
Upfront fee allocated to separate performance obligations
Entity S engages in a contract with entity T for the licensing and development of a drug compound. The terms entail Entity S to conduct research and development (R&D) services aimed at obtaining regulatory approval for the drug compound. In exchange, Entity S receives an initial payment of C50 million, along with fees for the R&D services and milestone-based payments upon achieving predetermined milestones. Entity S determines that the agreement consists of two distinct performance obligations: (1) the license of the intellectual property; and (2) the provision of R&D services. No other obligations are present within the agreement.
Question
How should entity S allocate the consideration in the arrangement, including the C50 million upfront fee?
Answer
At the onset of the contract, Entity S is tasked with ascertaining the transaction price, incorporating both fixed and variable components. The fixed consideration encompasses the upfront fee, while the variable consideration comprises the R&D service fees and milestone-based payments, which are estimated according to applicable principles. Upon determining the overall transaction price, Entity S proceeds to allocate this amount between the two performance obligations outlined in the agreement.
Entities sometimes perform set-up or mobilization activities at or near contract inception to be able to fulfill the obligations in the contract. These activities could involve system preparation, hiring of additional personnel, or mobilization of assets to where the service will take place. Non-refundable fees charged at the inception of an arrangement are often intended to compensate the entity for the cost of these activities. Set-up or mobilization efforts might be critical to the contract, but they typically do not satisfy performance obligations, as no good or service is transferred to the customer. They are disregarded in the measure of progress for performance obligations satisfied over time if they do not depict the transfer of services to the customer. Management should consider whether such costs might be capitalized as fulfillment costs.
Accounting for upfront fees when a renewal option exists
Contracts that include an upfront fee and a renewal option often do not require a customer to pay another upfront fee when the customer renews the contract. The renewal option in such a contract might provide the customer with a material right, as discussed. The revenue recognition period for upfront fees, in arrangements where the customer receives a renewal option, might extend beyond the initial contractual period.
How to determine the appropriate amount to allocate to the material right?
An entity that provides a customer with a material right should determine its stand-alone selling price and allocate a portion of the transaction price to that right, because it is a separate performance obligation. Alternatively, transactions that meet the requirements can apply the practical alternative for contract renewals discussed, and the entity can estimate the total transaction price based on the expected number of renewals. Management should consider both quantitative and qualitative factors to determine whether an upfront fee provides a material right when a renewal right exists.
For example, management should consider the difference between the amount the customer pays upon renewal and the price a new customer would pay for the same service. An average customer life that extends beyond the initial contract period could also be an indication that the upfront fee incentivises customers to renew the contract.
Activity
Entity U operates health clubs. Entity U enters into contracts with customers for one year of access to any of its health clubs. The entity charges an annual membership fee of C60 as well as a C150 non-refundable joining fee. The joining fee is to compensate, in part, for the initial activities of registering the customer. Customers can renew the contract each year and are charged the annual membership fee of C60 without paying the joining fee again. If customers allow their membership to lapse, they are required to pay a new joining fee.
Question
Should entity U account for the non-refundable joining fees?
Answer
The customer does not have to pay the joining fee if the contract is renewed and has therefore received a material right. That right is the ability to renew the annual membership at a lower price than the range of prices typically charged to newly joining customers. The joining fee is included in the transaction price and allocated to the separate performance obligations in the arrangement, which are providing access to health clubs and the option to renew the contract, based on their stand-alone selling prices. Entity U’s activity of registering the customer is not a service to the customer and therefore does not represent satisfaction of a performance obligation. The amount allocated to the right to access the health club is recognised over the first year, and the amount allocated to the renewal right is recognised when that right is exercised or expires. As a practical alternative to determining the stand-alone selling price of the renewal right, entity U could allocate the transaction price to the renewal right by reference to the future services expected to be provided and the corresponding expected consideration.
For example, if entity U determined that a customer is expected to renew for an additional two years, the total consideration would be C330 (C150 joining fee and C180 annual membership fees). Entity U would recognise this amount as revenue as services are provided over the three years. See paragraph 11.205 onwards for further discussion about the practical alternative and customer options.
Bill-and-hold arrangements
Bill-and-hold arrangements arise when a customer is billed for goods that are ready for delivery, but the entity does not ship the goods to the customer until a later date.
Entities should assess whether control has transferred to the customer, even though the customer does not have physical possession of the goods. Additional criteria have to be met for a customer to have obtained control of the product in addition to the criteria related to determining when control transfers in other situations. For a customer to have obtained control of a product in a bill and-hold arrangement, the following criteria should be met:
- the bill-and-hold arrangement should have substance;
- the product should be identified separately as belonging to the customer;
- the product currently should be ready for physical transfer to the customer; and
- the entity cannot have the ability to use the product or to direct it to another customer.
What do the bill-and-hold criteria mean?
A bill-and-hold arrangement should have substance. A substantive purpose could exist, for example, if the customer requests the bill-and-hold arrangement because it lacks the physical space to store the goods, or if goods previously ordered are not yet needed due to the customer’s production schedule. The goods should be identified as belonging to the customer, and they cannot be used to satisfy orders for other customers. Substitution of the goods for use in other orders indicates that the goods are not controlled by the customer, and so revenue should not be recognised until the goods are delivered or the criterion is satisfied. The goods should also be ready for delivery upon the customer’s request. A customer that can redirect or determine how goods are used, or that can otherwise benefit from the goods, is likely to have obtained control of the goods. Limitations on the use of the goods, or other restrictions on the benefits that the customer can receive from those goods, indicate that control of the goods might not have transferred to the customer.
Bill-and-hold arrangement: Industrial products industry
Entity V orders a drilling pipe from entity W. Entity V requests the arrangement be on a bill-and-hold basis because of the frequent changes to the timeline for developing remote gas fields and the long lead times needed for delivery of the drilling equipment and supplies. Entity W has a history of billand-hold transactions with entity V and has established standard terms for such arrangements. The pipe, which is separately warehoused by entity W, is complete and ready for shipment. Entity W cannot utilise the pipe or direct the pipe to another customer once the pipe is in the warehouse. The terms of the arrangement require entity V to remit payment within 30 days of the pipe being placed into entity W’s warehouse. Entity V will request and take delivery of the pipe when it is needed.
Question
When should entity W recognise revenue?
Answer
Entity W should recognise revenue when the pipe is placed into its warehouse, because control of the pipe has transferred to entity V. This is because entity V asked for the transaction to be on a bill-and-hold basis (which suggests that the reason for entering the bill-and-hold arrangement is substantive), entity W is not permitted to use the pipe to fulfil orders for other customers, and the pipe is ready for immediate shipment at the request of entity V. Entity W should also evaluate whether a portion of the transaction price should be allocated to the custodial services (that is, whether the custodial service is a separate performance obligation).
Bill-and-hold arrangement: Retail and consumer industry
Entity X enters into a contract during 20X6 to supply 100,000 video game consoles to a retailer. The contract contains specific instructions from the retailer about where the consoles should be delivered. Entity X should deliver the consoles in 20X7 at a date to be specified by the retailer. The retailer expects to have sufficient shelf space at the time of delivery. As at 31 December 20X6, entity X has inventory of 120,000 game consoles, including the 100,000 relating to the contract with the retailer. The 100,000 consoles are stored with the other 20,000 game consoles, which are all interchangeable products; however, entity X will not deplete its inventory below 100,000 units.
Question
When should entity X recognise revenue for the 100,000 units to be delivered to the retailer?
Answer
Entity X should not recognise revenue until the bill-and-hold criteria are met, or if entity X no longer has physical possession and all of the other criteria related to the transfer of control have been met. Although the reason for entering into a bill-and-hold transaction is substantive (lack of shelf space), the other criteria are not met, because the game consoles produced for the retailer are not separated from other products.
Where an entity has transferred control of the goods and met the bill-and-hold criteria to recognize revenue it should consider whether it is providing custodial services in addition to providing the goods. If so, a portion of the transaction price should be allocated to each of the separate performance obligations (that is, the goods and the custodial service).
Government vaccine stockpile programs
Vaccine manufacturers might participate in government vaccine stockpile programs that require the manufacturer to hold a certain amount of vaccine inventory for use by a government at a later date. Control transfer should be assessed against the bill-and-hold criteria in the standard, considering, for example, whether the stockpile inventory is separately identified as belonging to the customer and the impact of any requirement to rotate the inventory. Management will also need to consider whether the government has return rights and whether there are other performance obligations within the arrangement, such as the storage, maintenance and shipping of vaccines. SEC reporters should apply the SEC’s interpretative release, which states that vaccine manufacturers should recognise revenue and provide the appropriate disclosures when vaccines are placed into US government stockpile programs because control of the vaccines has transferred to the customer (the government) and the criteria for recognising revenue in a bill-and-hold arrangement are satisfied. This interpretation is only applicable to childhood disease vaccines, influenza vaccines, and other vaccines and countermeasures sold to the US government for placement in the Strategic National Stockpile.
Consignment arrangements
Some entities ship goods to another party (such as a dealer or distributor) but retain control of the goods until a predetermined event occurs. These are known as consignment arrangements. Revenue is not recognized upon delivery of a product if the product is held on consignment. A consignment sale differs from a sale with a right of return or put right. The customer has control of the goods in a sale with a right of return and can decide whether to put the goods back to the seller.
Management should consider the following indicators to evaluate whether an arrangement is a consignment arrangement:
- the product is controlled by the entity until a specified event occurs (such as the sale of the product to a customer of the dealer, or until a specified period expires);
- the entity can require the return of the product or the transfer of the product to a third party (such as another dealer); or
- the dealer does not have an unconditional obligation to pay for the product.
Repurchase rights
Repurchase rights are an obligation or right to repurchase a good after it is sold to a customer. Repurchase rights could be included within the sales contract, or in a separate arrangement with the customer. The repurchased good could be the same asset, a substantially similar asset, or a new asset of which the originally purchased asset is a component.
Other arrangements that are not repurchase rights
Some arrangements do not include a repurchase right, but instead provide a guarantee in the form of a payment to the customer for the deficiency, if any, between the amount received in a resale of the product and a guaranteed resale value. The guidance on repurchase rights does not apply to these arrangements because the entity does not reacquire control of the asset. The guarantee payment should be accounted for in accordance with the applicable guidance on guarantees.
There are three forms of repurchase rights:
- A seller’s obligation to repurchase the good (a forward).
- A seller’s right to repurchase the good (a call option).
- A customer’s right to require the seller to repurchase the good (a put option).
An arrangement to repurchase a good that is negotiated between the parties after transferring control of that good to a customer is not a repurchase agreement. The customer is not obligated to resell the goods to the entity as part of the initial contract. The subsequent decision to repurchase the item does not affect the customer’s ability to direct the use of or obtain the benefits of, the good.
Example
Repurchase agreements (1)
An entity enters into a contract with a customer for the sale of a tangible asset on 1 January 20X7 for CU1 million.
Case A – Call option: financing
The contract includes a call option that gives the entity the right to repurchase the asset for CU1.1 million on or before 31 December 20X7.
Control of the asset does not transfer to the customer on 1 January 20X7 because the entity has a right to repurchase the asset and therefore the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Consequently, in accordance with [IFRS 15:B66(b)], the entity accounts for the transaction as a financing arrangement, because the exercise price is more than the original selling price. In accordance with [IFRS 15:B68], the entity does not derecognise the asset and instead recognises the cash received as a financial liability. The entity also recognises interest expense for the difference between the exercise price (CU1.1 million) and the cash received (CU1 million), which increases the liability.
On 31 December 20X7, the option lapses unexercised; therefore, the entity derecognises the liability and recognises revenue of CU1.1 million.
Sales with a right of refusal retained by the vendor
When a vendor sells an asset to a customer, the sales contract may provide that if, at some point in the future, the customer receives a bona fide offer to sell the asset to a third party and the customer plans to accept that offer, the original vendor can exercise an option to repurchase the asset by matching the offer made by the third party. This is often referred to as a ‘right of first refusal’.
IFRS 15:B66 states that “if an entity has an obligation or a right to repurchase the asset (a forward or call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset”.
If a vendor retains a right of first refusal, this would not, on its own, prevent the customer from obtaining control of the asset.
A right of first refusal as described above allows the vendor to influence who the customer subsequently sells the asset to but not whether, when or for how much such a sale is made. As such, the vendor’s right does not limit the customer’s ability to direct the use of the asset, or to obtain substantially all the remaining benefits from the asset.
Vendor has an obligation to take back or a right to recall a product after a specified date
Some contracts (e.g. for the supply of perishable goods) permit or require the vendor to remove (and sometimes replace) products if, by a specified date, they have not yet been sold or otherwise consumed by the customer. For example, a pharmaceutical company may be required to take back drugs which have not been sold by a certain date for health and safety reasons. Similarly, a supplier of fresh produce to a supermarket may have an obligation or a right to take back the produce from the supermarket after a certain date (or in case of legitimate safety concerns) to ensure end customers are sold only fresh produce, so as to retain customer loyalty to the supplier’s brand. In such circumstances, the vendor does not have an unconditional obligation or right to repurchase the products at any time from the customer; rather, the vendor only reacquires the products after the specified date, if they have not yet been sold or otherwise consumed.
IFRS 15:B66 requires, in part, that “if an entity has an obligation or a right to repurchase the asset (a forward contract or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset”.
In the circumstances under consideration, the customer is free to sell, consume, or otherwise direct the use of the product until the specified date. In other words, the vendor’s call option in these circumstances is a protective right to recall the goods after the specified date, which does not preclude the customer from directing the use of the asset (e.g. selling or otherwise consuming it) before that date.
The same analysis will apply if, on reacquiring products that have passed the specified date, the vendor provides the customer with replacement products, rather than giving a cash refund. Because the condition of the replacement products is not the same as the condition of the goods reacquired, the guidance in IFRS 15 (establishing that some exchanges should not be treated as returns) does not apply.
Therefore, irrespective of whether a refund or replacement products are provided, the supplier will need to account for its obligation or right to reacquire products as a sale with a right of return as described in IFRS 15.
Sales of commodities with a repurchase agreement over that commodity at its prevailing market price at the date of repurchase
When an entity sells an asset but has an obligation or a right to repurchase the asset (a forward or a call option), IFRS 15 states that the customer “does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset”. Instead, IFRS 15 states that the contract is accounted for either as a lease (if the repurchase price of the forward or call option is less than the original selling price) or as a financing arrangement (if the exercise price of the forward or call option is equal to or more than the original selling price). The accounting treatment of a repurchase at market price (so, potentially either above or below the original selling price) is not specifically addressed.
For these purposes, IFRS 15 states that the repurchased asset “may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component”.
The guidance in IFRS 15 does not, in all cases, preclude treatment as a sale when an entity sells a quantity of a commodity to a customer, but has an obligation or a right to repurchase an equivalent amount of that commodity (i.e. an asset that is substantially the same as that originally sold) at the prevailing market price for that commodity.
The statement in IFRS 15, in the context of a forward or call option, that control has not passed “because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset” suggests that the requirements of that paragraph are based upon the existence of such a limitation. Similarly, IFRS 15 refers to the boards’ decision to require this accounting ‘[i]f an entity enters into a contract with a repurchase agreement and the customer does not obtain control of the asset‘ (emphasis added).
As acknowledged in IFRS 15, in circumstances in which substantially the same asset is readily available in the marketplace (which may be the case for a commodity), an agreement to repurchase at the prevailing market price may not constrain the customer’s ability to direct the use of, and obtain substantially all the benefits from, an asset.
Accordingly, it is important to consider whether the seller’s obligation or right to repurchase does limit the customer’s ability in this way. This will depend on a careful analysis of the specific facts and circumstances.
- If the customer is in any way limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset (e.g. through a condition requiring any subsequent sale by the customer to include a call option enabling it to buy back the commodity for return to the entity), the contract should not be accounted for as a sale but instead according to its nature (for example, as a lease or financing arrangement). Consideration should also be given to whether the contract includes any other element, such as payment for transport of the commodity, which should be accounted for separately.
- If there is compelling evidence that the customer is not limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset, such that control of the asset has clearly transferred to the customer, the contract should be accounted for as a sale in accordance with IFRS 15.
Before concluding that recognition of a sale is appropriate, it will be necessary to make a robust assessment of the terms of the arrangement and of other relevant facts and circumstances against the indicators listed in IFRS 15 (including legal title to and physical possession of the assets). In particular, for the customer to have genuinely obtained control of the commodity in question, it must be the case that the customer could readily source equivalent commodity assets at the appropriate time and in the appropriate location to satisfy the requirements of the forward or call option and that the price to be paid is demonstrably equivalent to the prevailing market price at the date of settlement such that the customer has genuinely obtained substantially all economic benefits of the commodity.
If the repurchase agreement requires delivery in a location without alternative sources of the commodity, the customer may be economically compelled to simply deliver the same commodity back to the entity and, as such, will not have obtained control of the asset.
Sales which include a contingent call option
As discussed, the presence of a right to repurchase an asset generally precludes an entity’s customer from obtaining control of that asset and therefore generally precludes the entity from recognising revenue from the sale of that asset. This conclusion is based on the notion that the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. In the case of a contingent repurchase option, it will therefore be important for an entity to consider whether the contingency related to the call option limits the customer’s ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Specifically, when determining whether a contingent call option affects the customer’s ability to control the asset, the entity should consider whether the triggering of the contingency is within the control of the entity or the customer’s control.
Repurchase options that are contingent on factors within the entity’s control would generally imply that the customer has not obtained control of the asset. In such cases, the entity should account for the contract as a lease or financing arrangement in a manner consistent with the guidance in IFRS 15:B66. Alternatively, repurchase options that are contingent on factors within the customer’s control may imply that the customer has the ability to determine whether the call option may be exercised. For example, if an entity can repurchase an asset sold to a customer only in the event that the customer terminates the contract for convenience (i.e. the entity does not have a right to terminate the contract), the triggering of the call option is within the customer’s control. In this scenario, the entity may reasonably conclude that the customer obtains control of the asset even though there is a contingent call option.
Example
Repurchase agreements (2)
An entity enters into a contract with a customer for the sale of a tangible asset on 1 January 20X7 for CU1 million.
Case B – Put option: lease
Instead of having a call option, the contract includes a put option that obliges the entity to repurchase the asset at the customer’s request for CU900,000 on or before 31 December 20X7. The market value is expected to be CU750,000 on 31 December 20X7.
At the inception of the contract, the entity assesses whether the customer has a significant economic incentive to exercise the put option, to determine the accounting for the transfer of the asset (see [IFRS 15:B70 to B76]). The entity concludes that the customer has a significant economic incentive to exercise the put option because the repurchase price significantly exceeds the expected market value of the asset at the date of repurchase. The entity determines there are no other relevant factors to consider when assessing whether the customer has a significant economic incentive to exercise the put option. Consequently, the entity concludes that control of the asset does not transfer to the customer, because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.
In accordance with [IFRS 15:B70 to B71], the entity accounts for the transaction as a lease in accordance with IFRS 16 Leases [(or, for an entity that has not yet adopted IFRS 16, IAS 17)].
1. Forwards and call options
An entity that transfers a good and retains a substantive forward repurchase obligation or call option (that is, a repurchase right) should not recognize revenue when the good is initially transferred to the customer, because the repurchase right limits the customer’s ability to control the good. While some such provisions might be deemed to lack substance based on specific facts and circumstances, in general a negotiated contract te,rm is presumed to be substantive.
The accounting for an arrangement with a forward or a call option depends on the amount that the entity can or is required to pay to repurchase the good. The likelihood of exercise is not considered in this assessment. The arrangement is accounted for as either of the following:
- a lease, if the repurchase price is less than the original sales price of the asset, and upon adoption of IFRS 16, the arrangement is not part of a sale-leaseback transaction (in which case, the entity is the lessor); or
- a financing arrangement, if the repurchase price is equal to or more than the original sales price of that good (in which case, the customer is providing financing to the entity).
For the analysis, the comparison of the repurchase price to the original sales price of the good should include the effect of the time value of money, including contracts with terms of less than one year.
An entity that enters into a financing arrangement continues to recognize the transferred asset and recognizes a financial liability for the consideration received from the customer. The entity recognizes any amounts that it will pay upon repurchase over what it initially received as interest expense over the period between the initial agreement and the subsequent repurchase. Processing or holding costs might need to be deducted in some situations. The entity de-recognises the liabilide-recognizesises revenue if it does not exercise a call option so that it expires. Example 62 (Case A) of the revenue standard illustrates a similar scenario.
2. Put options
A put option allows a customer, at its discretion, to require the entity to repurchase a good and indicates that the customer has control over that good. The customer has the choice of retaining the item, selling it to a third party, or selling it back to the entity.
The accounting for an arrangement with a put option depends on the amount that the entity is required to pay when the customer exercises the put option, and whether the customer has a significant economic incentive to exercise its right. An entity accounts for a put option as:
- a financing arrangement, if the repurchase price is equal to or more than the original sales price and more than the expected market value of the asset (in which case, the customer is providing financing to the entity);
- a lease, if the repurchase price is less than the original sales price and the customer has a significant economic incentive to exercise that right, and upon adoption of IFRS 16, the arrangement is not part of a sale-leaseback transaction (in which case, the entity is the lessor);
- a sale of a product with a right of return, if the repurchase price is less than the original sales price and the customer does not have a significant economic incentive to exercise its right; or
- a sale of a product with a right of return, if the repurchase price is equal to or more than the original sales price, but less than or equal to the expected market value of the asset, and the customer does not have a significant economic incentive to exercise its right.
Decision tree to be considered when accounting for put options
An entity that enters into a financing arrangement continues to recognize the transferred asset and recognizes a financial liability for the consideration received from the customer. The entity recognizes any amounts that it will pay upon repurchase over what it initially received as interest expense (over the term of the arrangement) and, in some situations, as processing or holding costs.
Similar to forwards and call options, the comparison of the repurchase price to the original sales price of the good should include the effect of the time value of money, including the effect on contracts whose term is less than one year. An entity de-recognizes the liability and recognizes revenue if the put option lapses are unexercised.
Significant economic incentive to exercise a put option
The accounting for certain put options requires management to assess at contract inception whether the customer has a significant economic incentive to exercise its right. A customer that has a significant economic incentive to exercise its right is effectively paying the entity for the right to use the good for some time (similar to a lease).
How should a trade-in credit be accounted for under IFRS 15?
A trade-in credit is a right offered by a seller that allows the customer to trade in a purchased product for a credit against the purchase price of a new product in the future. The seller has an obligation to repurchase the asset at the customer’s request. That obligation is contingent on the customer purchasing a new asset. A trade-in credit could be viewed as: a. a put option held by the customer under which the seller can be required to repurchase the product at the customer’s request IFRS 15 apply to put options; or b. a call option held by the customer that permits the customer to purchase a new product in exchange for consideration that will be partly non-cash – IFRS 15 apply to such call options, and the entity would need to consider whether the arrangement contains a material right. The accounting treatment under these two approaches might be significantly different, as summarised below:
Question
How should a trade-in right be accounted for under IFRS 15?
Answer
Determining whether the put option guidance or the material right guidance applies requires judgement and depends on each transaction’s circumstances. An entity is required to assess the substance of the arrangement and to exercise judgement when determining which approach applies. The entity should determine whether the substance of the trade-in credit is to enable the customer to return the ‘old’ asset, or to promote sales of the ‘new’ asset. The following factors indicate that the put option guidance might be applicable: Whether the entity also leases the same assets through operating lease contracts. Where an entity also leases the same assets, judgement is required to determine whether the substance of the trade-in and leasing arrangements are significantly different. Leasing or selling second hand assets for more than scrap value as a separate activity might suggest that the trade-in credit is an incentive for the customer to return the ‘old’ asset. Significance of the expected residual value of the used asset relative to the stand-alone selling price of the new asset. A significant residual value implies that the ‘predominant’ right is the put option, because the entity would be inclined to recover the ‘old’ asset and sell it on the secondary market. An insignificant residual value might suggest that the predominant component is a call option of the customer (the option to buy a new asset) and the trade-in credit is an incentive to sell a new asset. Limitations on the customer’s ability to access the secondary market on the same conditions as the entity. Limited access to the secondary market might indicate that the customer gives more importance to the put option because there is no other outlet for the old asset. A volatile or illiquid secondary market might indicate that the customer sees more value in the put option.
Management should consider various factors in its assessment, including the following:
- How the repurchase price compare to the expected market value of the good at the date of repurchase?
- The amount of time until the right expires.
Put option accounted for as a right of return
Entity A sells machinery to a manufacturer for C200,000. The manufacturer can require entity A to repurchase the machinery in five years for C75,000. The market value of the machinery at the repurchase date is expected to be greater than C75,000. Entity A offers the manufacturer the put option because an overhaul is typically required after five years. Entity A can overhaul the equipment, sell the refurbished equipment to a customer, and receive a significant margin on the refurbished goods. Assume that the time value of money would not affect the overall conclusion.
Question
Should entity A account for this transaction as a sale with a return right, a lease or a financing transaction?
Answer
Entity A should account for the arrangement as the sale of a product with a right of return. The manufacturer does not have a significant economic incentive to exercise its right, since the repurchase price is less than the expected market value at the date of repurchase. Entity A should account for the transaction in a way that is consistent with the model discussed (rights of return).
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