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Revenue recognition

Date recorded:

The IASB and FASB continued their discussions from the 17 February meeting on onerous performance obligations. At that meeting, the Boards had tentatively decided that the onerous performance test should be performed at the contract level (considering the remaining performance obligations in the contract) rather than at the individual performance obligation level as proposed in ED/2010/6 Revenue from Contracts with Customers.

During this meeting, the Boards discussed:

  • whether to exclude contracts entered into as a "loss leader" (a contact entered into at a loss with the intention of profitable margins on future contracts with the customer)
  • what costs should be included in the onerous test and in measuring an onerous performance liability.

Exception for "loss-leader" contracts

In considering whether to exclude contracts entered into as a "loss leader", the staffs raised two alternatives. The first alternative would apply the onerous test only after contract inception such that only adverse changes in circumstances since execution of the contract are identified. The second alternative would exclude contracts identified as loss leaders from the onerous test at inception of the contract.

However, the Boards had little interest in providing an exception for "loss leader" contracts (only one IASB member and no FASB members expressed support). One IASB Board member raised an alternative model of recognising an intangible asset for loss leading arrangements, but that also received little support. Several Board members raised the issue that the Boards had tentatively allowed for contracts that meet specific criteria to be combined but could not support allowing linkage between an existing contract and a potential future contract.

Costs included in the onerous contract test

ED/2010/6 proposed that the onerous contract test consider 'the costs that relate directly to satisfying the performance obligation'. The exposure draft provided that those costs would include direct labour, direct materials, allocations of costs that relate to the contract, costs explicitly chargeable to the customer under the contract, and other costs incurred because of entering into the contract.

However, some comment letter respondents expressed concern with the proposals and felt that only incremental costs to fulfil performance obligations should be included in the onerous contract test. Additionally, some comment letter respondents had concerns over application of the test to individual contracts not designed to recover all the directly attributable costs of fulfilling the performance obligation (e.g. the purchase of a single airline ticket and the entire cost of operating the flight being considered 'the costs that relate directly to satisfying the performance obligation').

The staffs proposed that the costs to be included in the onerous contract test would be the lower of 1) the costs that relate directly to the contracts (the exposure draft proposal) and 2) the amount that would be incurred to pay as compensation for cancelling the contract.

The Boards generally supported the portion of the staff proposal not to consider only incremental costs as part of the onerous test contract but to allow for contract breakage. However, the Boards were less supportive of approaching the recognition and measurement of onerous contracts as a lower of test. Several members of both Boards felt management's intent should drive the determination and that the loss to be incurred is what should be recognised, whether that is the onerous costs for the remaining performance obligation or the costs involved to terminate the contract if that decision is made. The Boards also felt that once a contract is terminated, the contract would move outside of revenue recognition and into accounting for contingencies (IAS 37 or FAS 5).

The Boards tentatively agreed that for purposes of (a) determining if a contract is onerous and (b) the amount of the onerous liability, an entity should consider the costs that "directly" relate to satisfying the contract. However, an entity would use the amount that would be incurred to cancel the contract if all of the following conditions are met:

  1. the entity has the right to cancel the contract with the customer
  2. the settlement terms are explicit in the contract
  3. he entity makes a decision to cancel the contract, and
  4. the entity communicates that decision to the customer.

The Boards tentatively decided that the cancellation of the contract would be within the scope of IAS 37 rather than the revenue recognition standard when the settlement terms are not explicit in the contract.

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