Lots to think about when determining the transaction price under IFRS 15
In the May 2018 edition of Accounting Alert we discussed the five-step model for revenue recognition introduced by IFRS 15 Revenue from Contracts with Customers (“IFRS 15”):
In the mid-June 2018 and late June 2018 editions of Accounting Alert we examined the first step of that five-step process in greater depth, and in the July 2018 and September 2018 editions of Accounting Alert we looked at the complexities of the second step. In this article, we look at the difficulties associated with the third step of the five step model.
Determining the transaction price in a contract with a customer
Step three of the five-step IFRS 15 model requires the entity to determine the transaction price, which IFRS 15 defines as the “amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties”.
The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. When determining the transaction price, the entity needs to consider the effects of all of the following:
- Variable consideration
- The existence of a significant financing component in the contract
- Non-cash consideration
- Consideration payable to a customer.
The amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties and other similar items. In addition, the promised consideration can vary if an entity’s entitlement to the consideration is contingent on the occurrence or non-occurrence of a future event (for example, an amount of consideration would be variable if either a product was sold with a right of return, or a fixed amount was promised as a performance bonus on achievement of a specified milestone).
The entity must estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:
- The expected value method (the sum of probability-weighted amounts) – this method is generally used if the entity has a large number of contracts with similar characteristics (e.g. retailers)
- The most likely amount (i.e. the single most likely outcome of the contract) – this method is generally used if the contract has only two possible outcomes (e.g. an entity either achieves a performance bonus or does not).
IFRS 15 imposes a reversal constraint on the amount of variable consideration which can be recognised. Variable consideration can be included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
A significant financing component in the contract
In determining the transaction price, the entity must adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. The table below outlines the impact of a significant financing component:
As a practical expedient, the entity does not need to adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer, and when the customer pays for that good or service, will be one year or less.
Where the transaction price includes non-cash consideration, the entity must measure that non-cash consideration at fair value. If the fair value of the non-cash consideration cannot be reasonably estimated, the entity must measure it indirectly, by reference to the stand-alone selling price of the goods or services promised to the customer in exchange for the consideration.
Consideration payable to a customer
Consideration payable to a customer includes:
- Cash amounts that the entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer)
- Credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer).
Consideration payable to a customer is generally accounted for as a reduction of the transaction price and, therefore, of revenue. However, occasionally it may be accounted for as a separate transaction (and not a reduction in revenue) if the vendor is acquiring distinct goods and services from the customer.
In many instances, determining the transaction price in a contract with a customer is a relatively straightforward process. However, where part of the transaction price is variable and subject to the reversal constraint, or contracts include significant financing components, non-cash consideration, or consideration payable to customers, finance teams will need to apply considerable professional judgement in determining the transaction price. Judgements made in such circumstances could significantly impact the timing of revenue recognition.