Have You Ever Faced These Challenges?
- A customer’s financial position deteriorated significantly after contract signing, yet revenue continued to be recognised because a signed contract was in place — only for the auditors to raise a collectability concern at year-end
- A transaction was agreed verbally and revenue was recognised, but the customer later denied that any commitment had been made
- Your entity enters into a master agreement and separate purchase orders simultaneously — and you are unsure whether these should be combined and treated as a single contract
What You Will Learn From This Article
- How to assess collectability at contract inception — and what happens when a customer’s credit position deteriorates afterwards
- The three conditions that require multiple contracts to be combined
- How to handle a contract that does not meet all five criteria — and when revenue recognition can begin
Who This Article Is For
- Finance and accounting professionals responsible for assessing revenue recognition at contract inception
- Practitioners in industries with elevated credit risk or complex contract structures (construction, real estate, emerging market operations)
- USCPA, ACCA, or CPA candidates working through the IFRS 15 revenue recognition framework
Why Step 1 Is the Foundation of Everything That Follows
The five-step model in IFRS 15 is sequential. If Step 1 is not satisfied — that is, if no contract exists within the scope of IFRS 15 — the entity cannot proceed to Steps 2 through 5, and no revenue can be recognised under the standard.
Despite this, Step 1 is frequently treated as a formality in practice. The assumption that a signed contract automatically satisfies all five criteria is a common and potentially costly error. This article examines what IFRS 15 actually requires at Step 1, and where practitioners most often encounter difficulty.
What Is a Contract Under IFRS 15?
IFRS 15 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations (IFRS 15.10).
Three points deserve emphasis.
First, the contract does not need to be in writing. Oral agreements and arrangements implied by customary business practice qualify, provided they are legally enforceable under the applicable jurisdiction.
Second, enforceability is a legal concept, not merely a commercial one. Whether rights and obligations are enforceable depends on the laws and regulations of the relevant jurisdiction. In cross-border transactions, this requires careful consideration — an arrangement that is legally binding under English law may not carry the same enforceability under another legal system.
Third, where either party has an unconditional right to terminate the contract without compensating the other party, the enforceable portion of the contract is limited to the goods or services already committed to. The remaining portion may not constitute a contract for IFRS 15 purposes until further commitments are made.
The Five Criteria for Contract Identification
For a contract to be within the scope of IFRS 15, all five of the following criteria must be met simultaneously (IFRS 15.9). Satisfying four out of five is not sufficient — if any single criterion is not met, the contract falls outside the model and no revenue can be recognised.
Criterion 1: Approval and Commitment
The parties have approved the contract — whether in writing, orally, or in accordance with customary business practice — and are committed to performing their respective obligations.
The word “committed” is important. Approval alone is not enough. Where there are early indicators that a party is unlikely to perform — for example, a customer who has already communicated financial difficulties or operational constraints — the commitment criterion warrants careful assessment.
Criterion 2: Identification of Each Party’s Rights
The rights of each party regarding the goods or services to be transferred can be identified.
In practice, this means the contract must make clear what the entity is obliged to transfer and what the customer has the right to receive. Ambiguous scope — particularly common in consulting, technology, and professional services engagements — can make this criterion difficult to satisfy. Vague statements of work or letters of intent that do not clearly define deliverables may not meet this threshold.
Criterion 3: Identification of Payment Terms
The payment terms for the goods or services to be transferred can be identified.
The amount, timing, and mechanism of payment must be determinable from the contract. Contracts that include variable consideration (rebates, bonuses, penalties) still satisfy this criterion provided the mechanism for determining the variable amount is specified, even if the ultimate amount is uncertain at inception.
Criterion 4: Commercial Substance
The contract has commercial substance — meaning that the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract.
This criterion exists to prevent revenue inflation through transactions that lack genuine economic substance. Round-trip transactions — where an entity sells an asset to a counterparty and simultaneously agrees to repurchase it at a similar price — are the classic example of an arrangement that may lack commercial substance. Such arrangements do not give rise to revenue under IFRS 15.
Criterion 5: Probable Collection of Consideration
It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
This is the criterion most frequently underestimated in practice, and the one that generates the most audit scrutiny. Several points are worth emphasising.
The assessment considers both ability and intention to pay. A customer may have the financial capacity to pay but display behaviour suggesting an unwillingness to do so. Both dimensions must be evaluated.
The threshold is “probable”, not “certain”. IFRS 15 does not require certainty of collection. However, where there is significant doubt about a customer’s ability or intention to pay, the criterion is not met.
The assessment is made at contract inception. The entity evaluates collectability based on conditions existing at the time the contract is entered into — not at a later date.
Subsequent deterioration in a customer’s credit position does not trigger revenue reversal. If collectability was probable at inception but the customer’s financial position subsequently deteriorates, the entity does not reverse previously recognised revenue. Instead, any impairment is recognised as a credit loss under IFRS 9, separately from revenue.
Practical Issues in Applying Step 1
Issue 1: Reassessment of Contracts That Initially Fail the Criteria
Where one or more of the five criteria are not met at contract inception, the entity cannot apply the five-step model and cannot recognise revenue. However, the contract does not simply disappear.
IFRS 15.14 requires the entity to reassess the contract on an ongoing basis. If conditions change such that all five criteria are subsequently met, the entity begins applying the five-step model from that point forward.
In the interim, where the entity has already received consideration from the customer, that consideration is recognised as a liability only when one of the following conditions is met (IFRS 15.15):
- The entity has no remaining obligations to transfer goods or services, and substantially all of the consideration received is non-refundable
- The contract has been terminated and the consideration received is non-refundable
Until either condition is met, the consideration received is recognised as a liability — but not as a contract liability in the IFRS 15 sense, since the contract has not yet met the recognition criteria.
Issue 2: Contract Combinations
IFRS 15.17 requires two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) to be combined and accounted for as a single contract if any one of the following conditions is met:
- The contracts are negotiated as a package with a single commercial objective
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract
- The goods or services promised in the contracts (or some of the goods or services) constitute a single performance obligation under the principles of Step 2
A common practical scenario: An entity enters into a framework agreement with a customer establishing general terms and conditions, alongside a separate purchase order for a specific delivery. Even though these are legally separate documents, they may need to be combined if they were negotiated together and form part of a single commercial arrangement.
The consequence of combining contracts can be significant: the combined contract may contain different performance obligations, a different transaction price, or a different allocation than if each contract were assessed independently.
Issue 3: Contract Modifications
A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties. IFRS 15.18–21 sets out three ways in which a modification may be accounted for:
| Treatment | When it applies |
|---|---|
| New separate contract | The modification adds distinct goods or services at a price that reflects their standalone selling price |
| Termination of existing contract and creation of a new contract | The remaining goods or services are distinct, but the modification price does not reflect standalone selling price |
| Modification of existing contract (cumulative catch-up) | The remaining goods or services are not distinct from those already transferred |
A frequent source of difficulty in IT and professional services: When a client requests additional development work mid-project (scope creep), the entity must determine whether this constitutes a new separate contract, a modification of the existing contract, or something in between. The answer depends on whether the additional work is priced at standalone selling price and whether it is distinct from the original deliverables.
Decision Framework for Step 1
The following sequence of questions provides a practical framework for applying Step 1:
① Does a legally enforceable agreement exist? → No: IFRS 15 does not apply. Consider whether other standards are relevant.
② Are all five criteria met? → Yes: Proceed to Step 2. → No: Do not recognise revenue. Reassess periodically. Treat any consideration received as a liability (subject to IFRS 15.15).
③ Were multiple contracts entered into simultaneously or near-simultaneously with the same customer? → Yes: Assess whether combination is required under IFRS 15.17.
④ Has the contract been modified? → Yes: Determine the appropriate accounting treatment under IFRS 15.18–21.
Comparison with Japanese GAAP
Japan’s domestic revenue recognition standard (ASBJ Accounting Standard No. 29, issued 2018) is substantially converged with IFRS 15 at Step 1. The five criteria, the contract combination requirements, and the contract modification framework are all consistent.
One area of practical difference relates to the availability of certain simplifications and practical expedients that ASBJ introduced alongside the core standard. These are not available under IFRS 15 and are relevant only to entities reporting under Japanese GAAP.
Summary
The key takeaways from Step 1 are as follows:
- All five criteria must be met simultaneously. A signed contract does not automatically satisfy all five.
- Collectability is assessed at contract inception, based on the customer’s ability and intention to pay. Subsequent deterioration is addressed through IFRS 9 impairment, not revenue reversal.
- Where criteria are not met, the contract is not extinguished — it must be reassessed on an ongoing basis.
- Contract combination is required where multiple contracts with the same customer form part of a single commercial arrangement.
- Contract modifications require careful classification — the accounting treatment differs significantly depending on whether the modification gives rise to a new contract, replaces the existing contract, or adjusts it.
The next article in this series examines Step 2: identifying the performance obligations within the contract — arguably the most judgement-intensive step in the entire model.
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