IFRS 15 and ASC 606: The Five-Step Revenue Recognition Model Explained

Why one revenue standard matters

Before 2018, revenue guidance under US GAAP was spread across many industry-specific rules, while IFRS relied mainly on IAS 18 and IAS 11. The result was that similar transactions could be reported very differently depending on the industry or the framework.

IFRS 15 Revenue from Contracts with Customers and its US counterpart, ASC 606, replaced most of that guidance with a single principle: an entity recognises revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration it expects to be entitled to.

IFRS 15 became effective for annual periods beginning on or after 1 January 2018. ASC 606 became effective for public business entities in the same year, with a later date for private companies.

The five steps

Step 1: Identify the contract

A contract exists when the parties have approved it, each party's rights and payment terms can be identified, it has commercial substance, and collection of the consideration is probable. Contracts can be written, oral, or implied by customary business practice.

Step 2: Identify the performance obligations

A performance obligation is a promise to transfer a good or service that is distinct. A good or service is distinct if the customer can benefit from it on its own (or with readily available resources) and the promise is separately identifiable from other promises in the contract.

Step 3: Determine the transaction price

The transaction price is the amount of consideration the entity expects to be entitled to. It includes fixed amounts and estimates of variable consideration such as discounts, rebates, refunds and performance bonuses, but variable amounts are only included to the extent it is highly probable (IFRS) or probable (US GAAP) that a significant reversal will not occur.

Step 4: Allocate the transaction price

When a contract has more than one performance obligation, the transaction price is allocated to each one in proportion to its standalone selling price (SSP), the price at which the entity would sell that good or service separately.

Step 5: Recognise revenue when (or as) obligations are satisfied

Revenue is recognised when control transfers. That can happen at a point in time (for example, delivery of a product) or over time (for example, a service performed across a contract period). Over-time recognition applies when one of three criteria is met, such as the customer simultaneously receiving and consuming the benefits as the entity performs.

Worked example: software licence with support

A software company sells a customer a perpetual licence plus two years of technical support for a single price of $120,000, invoiced and paid upfront. The company also sells these items separately:

Step 2: The licence and the support are distinct, so there are two performance obligations.

Step 4: The $120,000 is allocated on a relative SSP basis:

Step 5: The licence is a right to use the software as it exists when granted, so its revenue is recognised at the point the customer can use it. Support is provided evenly over 24 months, so its revenue is recognised over time.

Journal entry on day one:

Each month for 24 months:

Notice that the discount of $20,000 (the gap between $140,000 SSP and the $120,000 price) is spread proportionately across both obligations rather than being assigned to one of them.

Where IFRS 15 and ASC 606 differ

The core model is the same, but several details differ. The most commonly cited include:

Because "probable" means different things in the two frameworks, the same contract could pass Step 1 under IFRS but fail it under US GAAP.

Common application issues

• Principal versus agent. If the entity controls the good or service before it transfers to the customer, it is a principal and records revenue gross; otherwise it is an agent and records only its commission or fee.
• Contract modifications. A change in scope or price may be treated as a separate contract, a termination and new contract, or part of the existing contract, depending on what is added.
• Significant financing components. If payment timing provides a significant financing benefit, the transaction price is adjusted for the time value of money (with a practical expedient where the gap is one year or less).
• Contract costs. Incremental costs of obtaining a contract, such as sales commissions, are capitalised if they are expected to be recovered.

Application scenarios

Scenario 1: SaaS subscription with an upfront setup fee

Situation. A software company signs a 12-month subscription at $1,000 per month and charges a non-refundable setup fee of $3,000 at the start. Setup involves configuring the customer's account; the customer gets no separate good or service from it.

Analysis. Setup activities that do not transfer a good or service to the customer are not a performance obligation. The $3,000 is an advance payment for the subscription and is recognised over the period the customer benefits, here the 12-month term (or longer if the fee gives the customer a material right to renew without paying it again).

Scenario 2: Construction contract recognised over time

Situation. A contractor builds a warehouse on the customer's land for a fixed price of $1,000,000. Estimated total costs are $800,000. At year end, costs incurred are $320,000.

Analysis. The customer controls the asset as it is built, so revenue is recognised over time. Using a cost-to-cost input method, progress is $320,000 ÷ $800,000 = 40%.

If total estimated costs later exceed the contract price, the expected loss is recognised immediately as an onerous contract (IAS 37 under IFRS; ASC 605-35 loss guidance under US GAAP).

Scenario 3: Retailer sales with a right of return

Situation. A retailer sells 100 units at $50 each (cost $30 each). Customers can return goods within 30 days, and experience shows about 5% are returned.

Analysis. Revenue is recognised only for goods not expected to be returned. A refund liability is recorded for expected returns, and an asset is recognised for the right to recover the returned goods.

Summary

The five-step model turns revenue recognition into a structured sequence of judgements: what was promised, what it is worth, and when control passes. Most of the effort in practice goes into Steps 2 and 4, identifying distinct obligations and estimating standalone selling prices, because those decisions shape the timing of revenue across the whole contract.

This article is for general educational purposes and reflects the author's understanding of the standards at the date shown. Always refer to the authoritative text of the standards and seek professional advice for specific situations.