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Chapter 4: Determining the transaction price
The transaction price in a contract reflects the amount of consideration that an entity expects to be entitled to in exchange for goods or services transferred. The transaction price includes only those amounts to which the entity has rights under the present contract and excludes amounts collected on behalf of third parties. The consideration promised in a contract with a customer might include fixed amounts, variable amounts, or both. Contractually stated prices for goods or services might not represent the amount of consideration that an entity expects to be entitled to as a result of its customary business practices with customers.
Determining the transaction price could become complex when a contract includes any of the following:
- Variable consideration.
- A significant financing component.
- Non-cash consideration.
- Consideration is payable to a customer.
Management should assume that the contract will be fulfilled as agreed upon, and not canceled, renewed, or modified, when determining the transaction price. The transaction price also generally does not include estimates of consideration from the future exercise of options for additional goods and services because, until a customer exercises that right, the entity does not have a right to consideration. An exception is provided, as a practical alternative, for customer options meeting certain criteria that allow management to estimate goods or services to be provided under the option when determining the transaction price.
The transaction price is generally not adjusted to reflect the customer’s credit risk. An exception exists where the arrangement contains a significant financing component, as the financing component is determined using a discount rate that reflects the customer’s creditworthiness.
Impairment losses relating to a customer’s credit risk (that is, impairment of a contract asset or receivable) are measured based on the guidance in IAS 39/IFRS 9. Management needs to consider whether billing adjustments are a modification of the transaction price or a credit adjustment (that is, a write-off of an uncollectable amount). A downward modification of the transaction price reduces the amount of revenue recognized, while a credit adjustment is an impairment assessed under IAS 39 / IFRS 9.
Variable consideration
Variable consideration is common and takes various forms, including (but not limited to) price concessions, volume discounts, rebates, refunds, credits, incentives, performance bonuses, and royalties. An entity’s past business practices can cause consideration to be variable if there is a history of providing discounts or concessions after goods are sold. Consideration is also variable if the amount that an entity will receive is contingent on a future event occurring or not occurring, even though the amount itself is fixed. Example 20 of the revenue standard illustrates this concept.
Common form of variable consideration
Variable consideration is included in contracts with customers in a number of different forms. The following are examples of types of variable consideration commonly found in customer arrangements.
Price concessions
Price concessions entail adjustments to the amount invoiced to a customer, typically occurring after the initial contract terms are established. Such concessions are granted for various reasons. For instance, a vendor might agree to a reduced payment compared to the contracted amount to incentivize the customer to settle outstanding dues and continue patronizing future offerings. Alternatively, concessions may be extended in response to customer dissatisfaction with the product or service, excluding issues covered by warranties.
Management must evaluate the probability of offering price concessions to customers when determining the transaction price. If an entity anticipates or habitually grants price concessions, it should reduce the transaction price to reflect the anticipated consideration after the concession is applied.
Prompt payment discounts
Customer purchases often entail discounts for early payment. For instance, an entity might propose a 2% discount if an invoice is settled within 10 days of receipt. In such cases, a portion of the consideration is contingent upon the customer’s timely payment, leading to uncertainty regarding whether the discount will be availed. Consequently, management must estimate the consideration it anticipates receiving due to this incentive. Past experiences with comparable customers and transactions should inform this assessment, aiding in determining the expected number of customers likely to qualify for the discount.
Volume discounts
Contracts with customers frequently incorporate volume discounts, which serve as incentives to encourage additional purchases and foster customer loyalty. These discounts typically necessitate a customer to procure a specified quantity of goods or services, following which the price is either reduced prospectively for future purchases or retroactively reduced for all acquisitions. Regarding prospective volume discounts, their evaluation should ascertain whether they confer a material right upon the customer. Contracts featuring retroactive volume discounts involve variable consideration, as the transaction price for current purchases remains uncertain until it is determined whether the customer’s acquisitions surpass the threshold to qualify for the discount. Both types of volume discounts usually lead to revenue deferral if the customer is anticipated to avail the discount.
Moreover, management must heed the constraint on variable consideration associated with retroactive volume discounts. If the total units expected to be sold cannot be estimated, management should include at least the minimum price per unit in the estimated transaction price at contract inception. This inclusion aligns with the objective of the constraint, as it substantially reduces the likelihood of significant reversals in the cumulative revenue recognized. Additionally, management should contemplate whether amounts exceeding the minimum price per unit are constrained or should be encompassed in the transaction price. Continuous updates to the estimate of the total sales volume are necessary until the uncertainty surrounding retroactive volume discounts is resolved.
Rebates
Rebates represent a common sales incentive method wherein customers initially pay the full price for goods or services upon contract inception, subsequently receiving a cash rebate at a later date, often tied to an aggregate level of purchases. In such scenarios, management must factor in the anticipated sales volume and expected rebates to determine the revenue recognition for each sale. Consideration in these cases is variable, contingent upon the volume of qualifying transactions.
Moreover, rebates are frequently offered based on individual consumer transactions, such as rebates associated with the purchase of a kitchen appliance, contingent upon the customer’s submission of a rebate request to the seller. The uncertainty surrounding the number of customers who will redeem the offer, commonly termed as ‘breakage,’ renders the consideration for the appliance sale variable.
Management may be able to estimate expected rebates if the entity has a history of offering similar rebates on analogous products. However, estimating anticipated rebates can pose challenges in other scenarios, such as when introducing a new rebate program, targeting a new customer base, or launching a new product line. Nonetheless, it might be feasible to acquire marketplace data for comparable transactions, deemed sufficiently robust for predictive purposes and utilized by management in estimating rebates.
To determine the transaction price, management must estimate the rebate amount. Only when it is highly probable that a significant reversal in cumulative recognized revenue will not occur with changes in rebate estimates should amounts related to rebates be incorporated into the transaction price. In cases where the anticipated rebate amount cannot be reasonably estimated, management still needs to assess whether a minimum amount of variable consideration should remain unconstrained.
Regular updates to the rebate estimate are imperative at each reporting date, reflecting any additional information that becomes available.
Pricing based on an index or market
Consideration tied to an index or market price at a specified future date could constitute a type of variable consideration. Contracts may link consideration to various indices, such as consumer price indices or financial benchmarks like the S&P 500 or FTSE 100, or to market prices of financial instruments or commodities.
Initially, management must determine if the arrangement includes a derivative, necessitating accounting under relevant financial instruments guidance (e.g., a ‘fixed price’ contract not qualifying for the ‘own use’ exemption in IFRS 9). Additionally, management should assess whether to apply financial instruments guidance if the entity has fulfilled its performance obligation, recorded a financial asset, yet the consideration remains tied to future market prices (e.g., a provisionally priced commodity contract). Variability in pricing or value accounted for under financial instruments guidance doesn’t affect transaction price measurement under the revenue standard (i.e., recognized revenue amount).
For contracts with variable consideration based on an index or market price (within IFRS 15 scope), exercising judgment is necessary when applying the constraint. Such arrangements are common in asset management and broker-dealer sectors, where fees fluctuate based on market or asset performance. These arrangements often exhibit factors indicating the need for constraint on variable consideration. These factors may include susceptibility to external factors beyond the entity’s control (e.g., market volatility, investment duration), limited predictive value from past experiences, a wide range of potential consideration amounts in the contract, and prolonged uncertainty resolution periods. The presence of these factors usually signals the need to constrain all or a portion of the fees until uncertainty is resolved, as illustrated in Example 25 of the revenue standard.
Price based on a formula
A contract may involve variable consideration when pricing is determined by a formula or a contractual rate per unit of outputs, and the quantity of outputs remains undefined. In such cases, the transaction price fluctuates based on an unknown quantity of outputs. For instance, a hotel management entity might engage in an agreement to manage properties on behalf of a client over a five-year period. In this scenario, the consideration is contingent upon a defined percentage of daily receipts. The variability in consideration arises from the calculation based on daily receipts. The commitment to the customer involves providing management services throughout the contract’s duration, distinguishing it as a contract with variable fees rather than an option for future purchases.
Periods after a contract expires but prior to renewal
There are scenarios where an entity continues to fulfill obligations under a contract with a customer after its expiration while negotiating an extension or renewal. During these negotiations, changes to pricing or other terms may be proposed, often retroactively affecting the period between the original contract’s expiration and the finalization of the new one. Determining the enforceability of obligations prior to contract finalization requires judgment, along with assessing the revenue to be recognized during this interim period.
If enforceable obligations exist before the new contract is finalized, management must estimate the transaction price. This estimation involves considering potential renewal terms, including whether adjustments will be applied retroactively or prospectively. Any anticipated adjustments resulting from renegotiated terms should be evaluated under the variable consideration guidance, including constraints on variable consideration.
This situation contrasts with contract modifications where the transaction price isn’t initially expected to be variable but changes due to future events.
Price protection and price matching
Price protection clauses enable customers to receive refunds if a seller reduces the price of a product to other customers within a specified timeframe. These clauses ensure that customers are not charged more than others during this period. Similarly, price matching provisions require sellers to refund a portion of the transaction price if a competitor lowers its price on a comparable product. Both types of provisions introduce variability into an agreement, as adjustments to the stated transaction price may occur later.
Furthermore, certain arrangements offer price protection only for goods remaining in a customer’s inventory. In such cases, management must estimate the number of units covered by the price protection guarantee to determine the transaction price, as reimbursement does not apply to units already sold by the customer.
Guarantees (including service level agreements)
Contracts with customers may include guarantees provided by the vendor, which need to be accounted for according to relevant guidance. Guarantees falling under the scope of IAS 39/IFRS 9 should be treated in accordance with that guidance. However, guarantees not covered by other standards must be assessed to determine if they affect the transaction price variability.
For instance, a vendor might assure a reseller customer of a minimum margin on sales to its own customers, with consideration paid if this margin isn’t achieved. Such guarantees don’t meet the criteria of financial guarantee contracts under IAS 39/IFRS 9. Since they aren’t addressed by other standards, the variable consideration guidance applies due to the uncertainty they create in the transaction price.
Service level agreements (SLAs) are common guarantees in customer contracts. SLAs often involve assurances regarding product or service performance or warranty service response times. They’re frequently utilized by sellers of critical products or services where any failure or interruption could be detrimental to the customer. For example, a vendor might guarantee a certain network uptime percentage or maximum service call response times. SLAs might also include penalty clauses for breaches of these guarantees.
The accounting treatment depends on the SLA’s terms and conditions. SLAs functioning as warranties are accounted for accordingly. For example, an SLA obligating equipment repair to restore it to specified production levels might be considered a warranty. SLAs not constituting warranties, and potentially leading to customer payments, involve variable consideration.
Penalties and liquidated damages
Provisions within contracts that stipulate cash payments to the customer in case of contractual non-compliance or failure to meet agreed-upon specifications, such as penalties and liquidated damages, are typically categorized as variable consideration. These provisions are distinct from warranty clauses that obligate a vendor to repair or replace a product that fails to perform as anticipated.
Customer rebates
Entity K sells electric razors to retailers at C50 per unit. Each electric razor package contains a rebate coupon allowing end consumers to redeem C10 per unit. Entity K estimates that between 20% and 25% of eligible rebates will be redeemed, drawing from its experience with similar programs and redemption rates available in the marketplace for analogous initiatives.
Consequently, Entity K determines that the transaction price should factor in a 25% rebate redemption assumption, as this is the proportion for which it is highly likely that a significant reversal of cumulative revenue will not arise if rebate estimates alter.
Question
How should entity K determine the transaction price?
Answer
Entity K accounts for sales to the retailer with a transaction price of C47.50 (calculated as C50 minus 25% of C10). The variance between the per unit cash selling price to retailers and the transaction price is documented as a liability for anticipated cash consideration to be provided to the end customer. Entity K will revise its estimate of the rebate and transaction price at each reporting date should there be any alterations in redemption rate estimates.
Does an entity need to consider the variability caused by fluctuations in foreign currency exchange rates in applying the variable consideration constraint?
No, fluctuations in exchange rates do not constitute variable considerations because the variability pertains to the form of the consideration (i.e., the currency) rather than other factors. Consequently, alterations in foreign currency exchange rates should not be factored in when applying the constraint on variable consideration.
Price protection guarantee
A manufacturer agrees to sell goods to a retailer for C1,000 and includes a price protection clause in the contract. Under this clause, the manufacturer will refund the retailer for any discrepancy between the sale price and the lowest price offered to any customer within the subsequent six months. This provision aligns with similar price protection clauses offered previously, and the manufacturer considers its past experience to be indicative for this contract. Management anticipates a 5% price reduction during the price protection period. Consequently, management determines that there is a high likelihood that significant revenue reversal will not occur even if estimates are adjusted.
Question
How should the manufacturer determine the transaction price?
Answer
The transaction price is adjusted to C950, considering the expected reimbursement of C50. This anticipated payment to the retailer is included in the transaction price determined at the inception of the contract, representing the amount the manufacturer expects to receive after factoring in the price protection. Consequently, the manufacturer will record a liability equal to the variance between the invoice price and the adjusted transaction price, reflecting the cash expected to be refunded to the retailer. The manufacturer will continue to reassess its estimate of expected reimbursement at each reporting date until the uncertainty is clarified.
Profit margin guarantee
Entity L sells a collection of summer apparel to a department store for C1 million. As part of its customary practice, Entity L routinely refunds a portion of its sales prices at the conclusion of each season to assist its department store clients in maintaining minimum sales margins. Through past experience, Entity L has determined that it typically refunds around 10% of the invoiced amount on average. Entity L has also determined that variable consideration is not restricted in such situations.
Question
What is the transaction price in this arrangement?
Answer
Entity L’s practice of guaranteeing a minimum margin for its customers results in variable consideration. The transaction price in this arrangement is C900,000, calculated as the amount that entity L bills the department store (C1 million) less the estimated refund to provide the department store its minimum margin (C100,000).
Entity L will update its estimate at each reporting period until the uncertainty is resolved.
Service level agreement
A software company enters into a one-year contract with a customer to provide access to its Software-as-a-Service (SaaS) platform for a C1 million annual fee. Included in the contract is a guarantee that the SaaS platform will maintain a 99.99% uptime during the year, or the customer will be entitled to a partial refund of the annual fee. Based on its experience, the software company refunds on average approximately 5% of the annual fee under this guarantee. The software company has also concluded that variable consideration is not constrained in these circumstances.
Question
What is the transaction price in this arrangement?
Answer
The assurance of platform availability introduces variable consideration. Consequently, the transaction price in this scenario amounts to C950,000 (C1 million annual fee minus the estimated 5% refund). The software company will have to revise its projection of the refund at each reporting interval until the uncertainty surrounding it is clarified.
Claims for additional cost reimbursement
It’s common for certain industries, like engineering and construction, to issue claims to customers for additional contract compensation when there are changes in the contract’s scope. These claims, which are enforceable under existing contract terms but lack a determined price, are treated as variable consideration. For instance, an entity might file a claim due to unforeseen costs, believing the contract allows for recovering such overruns. Consequently, the estimated amount collectible by the entity is factored into the transaction price if it’s highly likely that there won’t be significant reversals in cumulative revenue when uncertainties are resolved. Conversely, when parties are in negotiations for a contract modification that isn’t yet enforceable in terms of scope or price, it shouldn’t be accounted for until it’s approved. Example 9 of the revenue standard illustrates this scenario.
Activity
A contractor agrees to launch a satellite for a customer under a contract valued at C250 million, with an expected duration of three years for completion. The contractor assesses that the performance obligation will be fulfilled over time. After one year from contract initiation, the contractor faces substantial costs surpassing initial estimates, attributable to delays caused by the customer. Consequently, the contractor initiates a claim against the customer to recoup a portion of the excess costs. While the claims process is still underway, the contractor determines that the claim is legally binding according to the terms of the contract.
Question
How should the contractor account for the claim?
Answer
The contractor needs to revise the transaction price to reflect its determination of having a legally enforceable claim. Since the claim amount constitutes variable consideration, the contractor should incorporate into the transaction price the estimated amount it anticipates receiving, considering any constraints outlined in the variable consideration guidance. When applying the constraint on variable consideration, the contractor should consider factors such as its past experience with similar claims, the expected duration until the claim is resolved, and the degree to which external factors may impact the final amount receivable.
Is consideration variable if pricing is fixed but the quantity is variable?
Question
If a contract contains a promise to provide an unspecified quantity of outputs, but the contractual rate per unit is fixed, is the consideration variable?
Answer
Yes, typically. Consider a scenario where a commitment is made to deliver a service at a fixed hourly rate, yet the total hours needed to fulfill this commitment may vary. Determining whether such an arrangement entails a variable fee or merely allows the customer to procure a fluctuating quantity of goods or services might necessitate some judgment. For more insights into making this distinction, refer to paragraph 11.70 and subsequent sections.
Does compensation for delays or cancellations represent variable consideration?
In September 2019, the IFRS Interpretations Committee (IFRS IC) released a decision on legislation granting customers entitlement to compensation for flight delays or cancellations. This legislation imposes a binding obligation on the entity to provide compensation to the customer. The IFRS IC noted that the entity commits to transporting the customer from a defined origin to a specific destination within a designated timeframe. In the event of the entity’s failure to fulfill this service, the customer is entitled to compensation. Consequently, the compensation constitutes a component of the consideration and does not fall under the scope of IAS 37 as an obligation.
Management estimates, and includes in the transaction price at contract inception, the amount of variable consideration to which it expects to be entitled.
Estimating variable consideration
Management should use all reasonably available information to make its estimate. Judgments made in assessing variable consideration should be disclosed.
The revenue standard provides two methods for estimating variable consideration: the expected value method; or the most likely amount method.
The method used is not a policy choice. Management should use the method that it expects will best predict the amount of consideration based on the terms of the contract. One method is applied consistently throughout the contract.
A combination of the methods can be used, as a single contract can include more than one form of variable consideration. For example, a contract might include both a bonus for achieving a specified milestone and a bonus calculated based on the number of transactions processed. Management might need to use the most likely amount method to estimate one bonus and the expected value method to estimate the other if the underlying characteristics of the variable consideration are different. Example 21 of the revenue standard illustrates this concept.
Expected value method
The expected value method estimates variable consideration based on the range of possible outcomes and the probabilities of each outcome. The estimate is the probability-weighted amount based on those ranges. The expected value method might be most appropriate when an entity has a large number of contracts that have similar characteristics. An entity is likely to have better information about the probabilities of various outcomes where there are a large number of similar transactions. Evidence or experience from other similar contracts can be used to estimate variable consideration. This does not necessarily mean that the portfolio practical expedient has been applied.
Estimate using a ‘portfolio of data’ and the portfolio practical expedient
When estimating variable consideration using the expected value method, an entity relies on evidence from comparable contracts, often referred to as a “portfolio of data.” It’s important to note that this approach differs from applying the optional portfolio practical expedient, which allows entities to apply guidance to a group of contracts sharing similar traits. While considering past experiences with analogous transactions, an entity might not necessarily be utilizing the portfolio practical expedient.
Deciding whether a portfolio approach may be used
Some companies handle a large volume of customer contracts and offer a wide range of product combinations, such as those in the telecommunications industry with various handset and usage plan options. For these firms, applying certain aspects of IFRS 15, like allocating transaction prices to individual performance obligations based on stand-alone selling prices, on a contract-by-contract basis would require substantial effort. Moreover, their information technology systems may have limitations in capturing relevant data.
Entities must assess if they qualify to utilize a portfolio approach under IFRS 15. However, the standard doesn’t explicitly outline how to (1) assess “similar characteristics” or (2) ensure that applying a portfolio approach yields materially similar outcomes compared to applying the standard at the contract or performance obligation level. Consequently, companies must exercise significant judgment in determining if contracts or performance obligations grouped into portfolios share sufficiently similar characteristics at a detailed level to expect materially consistent results from the chosen portfolio approach.
When segregating contracts or performance obligations with similar traits into portfolios, entities should apply objective criteria related to specific contracts or performance obligations and their accounting implications. In determining similarity, entities may focus on characteristics with significant accounting effects under IFRS 15, affecting revenue recognition timing or amount. The importance of characteristics for assessing similarity varies depending on each entity’s circumstances. However, practical limitations, such as system capabilities, may influence how portfolios are structured.
Below is a table listing objective criteria entities might consider when evaluating if specific contracts or performance obligations share similar characteristics in line with IFRS 15. Since any IFRS 15 requirement could have significant consequences for a particular portfolio of contracts, the provided list isn’t exhaustive.
Objective criteria Example Contract deliverables Mix of products and services, options to acquire additional goods and services, warranties, promotional programmes Contract duration Short-term, long-term, committed or expected term of contract Terms and conditions of the contract Rights of return, shipping terms, bill and hold, consignment, cancellation privileges and other similar clauses Amount, form and timing of consideration Fixed, time and material, variable, upfront fees, non-cash, significant financing component Characteristics of the customers Size, type, creditworthiness, geographical location, sales channel Characteristics of the entity Volume of contracts that include the different characteristics, historical information available Timing of transfer of goods or services Over time or at a point in time
Estimating variable consideration – performance bonus with multiple outcomes
A contractor agrees to construct an asset for C100,000 under a contract with a customer, with an additional performance bonus of C50,000 contingent upon timely completion. The bonus amount diminishes by 10% each week past the agreed completion date. The contract terms resemble those of prior contracts the contractor has executed, and management deems this experience predictive for the current contract. Employing the expected value method, the contractor assesses probabilities: a 60% chance of meeting the completion deadline, a 30% chance of being one week overdue, and a 10% chance of being two weeks behind schedule.
Question
How should the contractor determine the transaction price?
Answer
The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled for the work performed.
Probability-weighted Consideration
C150,000 (fixed fee plus full performance bonus) × 60% C90,000
C145,000 (fixed fee plus 90% of performance bonus) × 30% C43,500
C140,000 (fixed fee plus 80% of performance bonus) × 10% C14,000
Total probability-weighted consideration C147,500
The aggregate transaction price amounts to C147,500, derived from the probability-weighted estimate. The contractor will revise this estimate at each reporting date. It’s important to note that this example does not address the potential requirement to limit the estimate of variable consideration incorporated into the transaction price. Depending on the specifics of individual contracts, entities may need to restrict their estimate of variable consideration, even if they utilize the expected value method to establish the transaction price.
Application of the portfolio approach – example Entity A provides various combinations of handsets and usage plans to its customers through two-year contracts. It presents two handset options: an older model, provided at no cost (with a stand-alone selling price of CU250), and a newer model offering enhanced features, available for CU200 (with a stand-alone selling price of CU500). Additionally, two usage plans are offered: a 400-minute plan priced at CU40 per month, and an 800-minute plan priced at CU60 per month (matching the stand-alone selling price for each plan).
The table below illustrates the possible product combinations and the allocation of consideration for each under IFRS 15.
Product combination
Total transaction
price
Revenue on handset
Revenue on usage
CU CU* % of total contract
revenue
CU % of total contract
revenue
Customer A Old handset, 400 minutes 960 198 21 762 79 Customer B Old handset, 800 minutes 1,440 213 15 1,227 85 Customer C New handset, 400 minutes 1,160 397 34 763 66 Customer D New handset, 800 minutes 1,640 423 26 1,217 74 *
In this example, the proportion of the total transaction price allocated to handset revenue is determined by comparing the stand-alone selling price for the phone to the total of the stand-alone selling prices of the components of the contract.
Customer A: (CU250/(CU250+CU960) × CU960) = CU198
Customer B: (CU250/(CU250+CU1,440) × CU1,440) = CU213
Customer C: (CU500/(CU500+CU960) × CU1,160) = CU397
Customer D: (CU500/(CU500+CU1,440) × CU1,640) = CU423
As illustrated in the table, the impact on the financial statements varies across different product combinations. Each of the four customer contracts possesses distinct characteristics, making it challenging to establish that Entity A “reasonably expects” the financial statement effects of applying the guidance to the portfolio (comprising all four contracts) to be materially consistent with those of applying the guidance to each contract individually. The percentage of contract consideration allocated to the handset varies from 15% to 34% across the different product combinations. Entity A might find this range too broad for implementing a portfolio approach; in such a case, some degree of segregation would be necessary. Alternatively, Entity A could consider establishing two portfolios: one for older handsets and another for newer handsets. With this alternative approach, Entity A would need to conduct further analysis to evaluate whether the accounting implications of employing two portfolios instead of four would lead to materially different financial statement effects.
Assessing whether use of a portfolio approach produces a materially different outcome to applying guidance at a contract level
The scenarios described are relatively straightforward, but in practice, the contracts depicted could entail additional layers of complexity, including (1) varying contract durations, (2) diverse call and text messaging plans, (3) different pricing structures (e.g., fixed or usage-based pricing), (4) assorted promotional programs, options, and incentives, and (5) contract modifications. Accounting for such contracts might be further complicated by the swift evolution of product offerings.
Typically, the more precise the criteria an entity employs to segregate its contracts or performance obligations into portfolios (i.e., the “greater” the level of disaggregation), the simpler it should be for the entity to conclude that the outcomes of applying the guidance to a particular portfolio are not materially different from those of applying the guidance to each individual contract (or performance obligation) within the portfolio. However, further disaggregation into distinct sub-portfolios is likely to enhance the overall accuracy of estimates only if those sub-portfolios exhibit differing characteristics. For instance, segregating based on geographical location might not be advantageous if similar product and service combinations with similar terms and conditions are marketed to a comparable customer base in various geographic regions. Similarly, segregating based on whether contract terms permit returns might be unnecessary if returns are not anticipated to be significant
Although IFRS 15 does not mandate a quantitative assessment of whether using a portfolio approach would yield materially different outcomes from applying the guidance at the contract or performance obligation level, an entity should be able to justify why it reasonably expects the two outcomes to be materially consistent. The entity can accomplish this through various means depending on its specific circumstances (subject to the constraints of a cost-benefit analysis). Such approaches may include, but are not limited to, the following:
- data analytics based on reliable assumptions and underlying data (internally- or externally-generated) related to the portfolio;
- a sensitivity analysis that evaluates the characteristics of the contracts or performance obligations in the portfolio and the assumptions used to determine a range of potential differences in applying the different approaches; and
- a limited quantitative analysis, supplemented by a more extensive qualitative assessment that may be performed when the portfolios are disaggregated.
Typically, some level of objective and verifiable information would be necessary to demonstrate that using a portfolio approach would not result in a materially different outcome. An entity may also wish to (1) consider whether the costs of performing this type of analysis potentially outweigh the benefits of accounting on a portfolio basis, and (2) assess whether it is preferable to invest in systems solutions that would allow accounting on an individual contract basis.
Application of a portfolio approach to part of a customer base – example
Entity A owns two subsidiaries, Entities B and C, both of which have numerous contracts with customers sharing similar characteristics. Entity B, lacking computer systems for contract-by-contract revenue recognition, has opted for a portfolio approach under IFRS 15 in handling revenue from these contracts. On the other hand, Entity C possesses a system facilitating contract-by-contract revenue recognition and thus has not chosen the portfolio approach.
In its consolidated financial statements, Entity A is allowed to utilize a portfolio approach to account for Entity B’s customer contracts, provided Entity A reasonably anticipates that this approach’s effects would not substantially deviate from applying IFRS 15 on a contract-by-contract basis. This is true even though Entity A applies contract-by-contract revenue recognition to Entity C’s customer contracts.
The requirement in IFRS 15 for consistent application, including the use of practical expedients, to contracts with similar characteristics and under similar circumstances does not supersede the overarching principle of materiality. The practical expedient in IFRS 15 is applicable only if there is a reasonable expectation that employing a portfolio approach would not result in materially different financial statement effects compared to applying IFRS 15 to individual contracts within that portfolio. Consequently, entities may prepare consolidated financial statements employing a combination of approaches because the resulting accounting impacts are not expected to differ materially.
Management should consider and quantify all possible outcomes when using the expected value method. However, considering all possible outcomes could be both costly and complex. A limited number of discrete outcomes and probabilities can, in many cases, provide a reasonable estimate of the distribution of possible outcomes.
The most likely amount method
The most likely amount method estimates variable consideration based on the single, most likely amount in a range of possible consideration amounts. This method might be the most predictive if the entity will receive one of only two (or a small number of) possible amounts. This is because the expected value method could result in an amount of consideration that is not one of the possible outcomes.
Estimating variable consideration: performance bonus with two outcomes
A contractor agrees to construct a manufacturing facility for a client with a contract value of C250 million, with an additional C25 million award fees if the project is finished by a set deadline. The project is anticipated to span three years. Drawing on its extensive experience in similar projects, the contractor is confident that there’s a 95% probability of completing the project successfully and meeting the deadline. The award fee is binary, meaning it’s either fully received upon timely completion or not received at all if the deadline is missed.
Question
How should the contractor determine the transaction price?
Answer
The contractor may appropriately employ the most likely amount method to estimate the variable consideration. Consequently, the contract’s transaction price stands at C275 million, comprising the fixed contract price of C250 million alongside the C25 million award fee. This estimation necessitates regular updates on each reporting date.
Constraint on variable consideration
There is a constraint on the amount of variable consideration to be included in the transaction price. An entity includes some or all of an amount of variable consideration only to the extent that, probably, a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
The assessment of whether variable consideration should be constrained is largely a qualitative one that has two elements: the potential magnitude of a change in estimate; and the likelihood of a change in estimate.
Factors to consider when assessing whether variable consideration should be constrained (that is, it could increase the magnitude or the likelihood of a revenue reversal) include, but are not limited to the following:
- The amount of consideration is highly susceptible to factors outside the entity’s influence.
- The uncertainty about the amount of consideration is not expected to be resolved for a long period.
- The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
- The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
- The contract has a large number and a broad range of possible consideration amounts.
Factors to consider when assessing the variable consideration constraint
Amount is highly susceptible to external factors Variable consideration can be greatly influenced by factors outside of the entity’s control. For instance, consideration tied to market movements, like the value of a fund linked to stock exchange prices, is subject to external forces. Additionally, the actions or decisions of third parties, such as customers, can impact variable consideration. Despite these external factors, an entity may possess predictive information enabling it to conclude that variable consideration is not constrained in certain scenarios.
Uncertainty is not expected to be resolved in the near-term Extended periods until uncertainty is resolved can complicate the determination of a reasonable range of outcomes. Over time, new variables may arise, affecting the outcome and making it challenging to assert that a significant revenue reversal is highly improbable. Conversely, a shorter resolution period may make it easier for management to conclude that variable consideration is not constrained. Nonetheless, all circumstances must be evaluated, as in some cases, a longer resolution period may facilitate such a conclusion.
Entity’s experience is limited or of limited predictive value An entity with limited experience may struggle to predict the likelihood or extent of revenue reversals if variable consideration estimates change. In such cases, the entity might rely on alternative evidence, such as competitor contracts or market data, to gauge potential outcomes. However, the predictive value of this evidence must be carefully assessed by management.
Entity offers price concessions or changes payment terms Even if a contract initially stipulates fixed terms, subsequent price concessions or adjustments may be customary. Consistent practices of offering narrow-range concessions can facilitate consideration estimation. Conversely, broad-ranging concessions may pose challenges in predicting revenue reversals.
Contract has numerous or wide ranges of consideration amounts Contracts encompassing numerous potential outcomes over a broad range may present difficulty in determining whether consideration should be constrained. However, if management has substantial experience with similar contracts, especially those with multiple outcomes, revenue may not require constraint. For instance, a contract featuring a significant performance bonus with binary outcomes may not necessitate revenue constraint if management is well-versed in handling such contracts.
Consideration is constrained
The land owner sells a parcel of land to a developer for C1 million and retains a clause entitling them to 5% of any future sales price exceeding C5 million for the developed land. Despite having limited predictive value due to the volatile nature of the real estate market, the land owner’s past experiences with similar contracts are deemed unreliable. This unpredictability stems from the market’s influence, which lies beyond the land owner’s control. Moreover, the uncertainty regarding future sales is expected to persist as the developer currently lacks immediate plans to sell the land
Question
Should the land owner include variable consideration in the transaction price?
Answer
The transaction price at contract inception remains at C1 million, with no variable consideration included. There’s a lack of confidence that a significant reversal of cumulative revenue won’t happen due to potential changes in the estimate of the future consideration from the land sale. Therefore, the landowner refrains from including any variable consideration in the transaction price. They will continuously reassess their estimate, applying the constraint, at each reporting date until the uncertainty surrounding the future sale of the land is resolved. This reassessment also involves deliberating whether any minimum amount should be recorded.
Multiple forms of variable consideration
Entity M has contracted to construct a production facility for a manufacturer at a cost of C10 million. The agreement also includes two performance bonuses: Bonus A of C2 million if the facility is completed within six months, and Bonus B of C1 million if the facility obtains a specified environmental certification upon completion. Entity M anticipates that completing the facility will take a minimum of eight months, but it is confident that it will obtain the environmental certification, given its track record of achieving similar certifications on previous projects.
Question
How should entity M determine the transaction price?
Answer
The transaction price for Entity M’s contract amounts to C11 million. Regarding the two performance bonuses, Entity M should evaluate each form of variable consideration independently. Bonus A, totaling C2 million if the facility is completed within six months, is not factored into the transaction price. Entity M does not deem it highly probable that there won’t be a significant reversal in cumulative revenue recognized. However, Bonus B, amounting to C1 million contingent upon the facility obtaining a specified environmental certification, is included in the transaction price. Entity M has determined, based on the most likely outcome, that there won’t be a significant reversal in cumulative revenue recognized. Entity M will continue to reassess its estimate at each reporting date until the uncertainty surrounding Bonus B is resolved.
Application of the constraint on variable consideration when using the expected value method
Entity L is a law firm that offers various legal services to its customers. For some services (‘Specific Services’), entity L will only collect payment from its customer if the customer wins the case. The payment for entity L in each case is C1,000. Management has determined that revenue for these services should be recognised over time. Entity L has a group of 1,000 similar contracts on homogeneous cases that include Specific Services. Management’s experience with contracts with similar characteristics to this group over the last five years is that 60% of entity L’s customers won their cases, and success rates varied between 50% and 70% on a monthly basis throughout the period. Management has used this data to conclude that it is ‘highly probable’ that it would collect payment in 50% of cases. Management believes that the expected value approach provides a better prediction of the transaction price than the most likely amount.
Question
How should entity L determine the transaction price?
Answer
Entity L’s management leverages data from past contracts to estimate the transaction price and to implement the constraint on variable consideration. Consequently, management incorporates C500,000 (equivalent to C500 per contract) of the variable consideration into the transaction price. Their experience with previous transactions provides substantial evidence supporting the conclusion that there wouldn’t be a significant revenue reversal if C500 is assumed as the transaction price for each contract. In reaching this determination, management maintains consistency in estimating the transaction price and applying the variable consideration constraint guidance.
Utilising a portfolio of data allows for estimating the transaction price and applying the constraint on variable consideration, wherein the estimated transaction price may not align with a potential outcome of individual contracts. Nonetheless, this remains a nuanced field, requiring judgement in each instance to determine the optimal approach for estimating the transaction price and applying the constraint. All indicators outlined in IFRS 15 should be assessed, with no single factor being conclusive.
Milestone payments
A biotech company licenses a drug compound, currently in Phase II development, to a pharmaceutical firm, alongside providing clinical trial services. Apart from an initial payment, the biotech company stands to gain additional compensation: milestone A, amounting to C25 million upon Phase II clinical trial completion, and milestone B, totaling C50 million upon regulatory approval of the drug compound. Milestone A is deemed probable as the biotech company holds extensive experience in clinical trial services within similar arrangements, and the drug compound has already cleared Phase I clinical trials. However, significant uncertainties loom overachieving regulatory approval, contingent upon the decisions and actions of a third party. The biotech company has determined that these milestone payments fall beyond the scope of financial instrument guidance.
Question
How should the biotech company determine the transaction price?
Answer
Both milestone payments represent variable consideration. The C25 million tied to milestone A should be factored into the transaction price since it’s highly likely that future revenue recognition won’t entail significant reversals once the milestone’s uncertainty is resolved. Conversely, the C50 million linked to milestone B would likely be deemed constrained by the biotech company. Factors such as the current developmental stage of the drug compound, uncertainties surrounding regulatory approval, and the influence of external factors on approval outcomes support this determination. Hence, the biotech company would exclude the C50 million associated with milestone B from the transaction price at contract inception. Updates to estimates for both milestones will be necessary at each reporting date until the uncertainties related to each milestone are resolved.
Variable consideration is not constrained if the potential reversal of cumulative revenue recognized is not significant. Management should assess the significance at the contract level (rather than the performance obligation level or about the financial position of the entity). They should therefore consider revenue recognized to date from the entire contract when evaluating the significance of any potential reversal of revenue.
Management should consider not only the variable consideration in an arrangement but also any fixed consideration, to assess the possible significance of a reversal of cumulative revenue. This is because the constraint applies to the cumulative revenue recognized for the contract, and not just to the variable portion of the consideration.
An entity needs to include a minimum amount of variable consideration in the transaction price if there is an amount that is not constrained.
Recording minimum amounts
The constraint on variable consideration may be applicable to certain portions, rather than all, of an estimated variable consideration. In cases where management determines that an amount is not constrained, even if other portions are, the entity must include a minimum amount of variable consideration in the transaction price. This minimum amount should reflect the sum for which it is highly probable that no significant reversal in cumulative revenue recognized will occur once the uncertainty is resolved. Management may need to incorporate this minimum amount into the transaction price, regardless of whether a minimum threshold is explicitly stated in the contract. Additionally, even if a minimum amount is specified in the contract, there may still be variable consideration beyond that minimum threshold for which it is highly probable that no significant revenue reversal will occur if estimates change.
Determining a minimum amount
Entity N engages in a contract with a manufacturer to renovate its HVAC system. The manufacturer agrees to pay Entity N a fixed amount of C200,000, along with an additional C5,000 for every 10% reduction in annual costs within the first-year post-refurbishment. Entity N anticipates achieving a 20% reduction in the manufacturer’s costs. Despite this estimation, Entity N considers the constraint on variable consideration and determines that it’s highly likely that estimating a 10% cost reduction won’t lead to a significant reversal of cumulative revenue recognized. This decision is grounded in Entity N’s experience of consistently achieving at least this level of cost reduction in similar contracts, although not always reaching the 20% mark.
Question
How should entity N determine the transaction price?
Answer
The transaction price at contract inception is C205,000, calculated as the fixed consideration of C200,000 plus the estimated minimum variable consideration of C5,000 that will be received for a 10% reduction in customer costs. Entity N will update its estimate at each reporting date until the uncertainty is resolved.
Changes in the estimate of variable consideration
Management should revise its estimates of variable consideration at each reporting date throughout the contract period. Any changes in the transaction price are allocated to all performance obligations in the contract, unless the variable consideration relates only to one or more, but not all, of the performance obligations.
Re-assessment of estimated volume discounts
On January 1, 20X8, Entity J enters into a one-year contract with a customer to deliver water treatment chemicals. The contract stipulates that the price per container will be adjusted retroactively once the customer reaches certain sales volumes, defined as follows:
- Price per container:
- Cumulative sales volume:
- C100: 0-1,000,000 containers
- C90: 1,000,001–3,000,000 containers
- C85: 3,000,001 containers and above
Volume is determined based on sales during the calendar year. There are no minimum purchase requirements. Entity J estimates that the total sales volume for the year will be 2.8 million containers, based on its experience with similar contracts and forecast sales to the customer.
In the first quarter ended March 31, 20X8, Entity J sells 700,000 containers to the customer for a contract price of C100 per container. During the second reporting period ended June 30, 20X8, Entity J sells 800,000 containers of chemicals. The customer commences a new water treatment project during the second quarter of the year, which increases its need for chemical supplies. In light of this new project, Entity J increases its estimate of total sales volume to 3.1 million containers at the end of the second reporting period. As a result, Entity J will be required to retroactively reduce the price per container to C85.
Question
How should entity J account for the change in estimate?
Answer
Entity J should update its calculation of the transaction price to reflect the change in estimate. The updated transaction price is C85 per container based on the new estimate of total sales volume. Consequently, entity J recognises revenue of C64.5 million for the quarter ended 30 June 20X8, calculated as follows: Total consideration C85 per container × 800,000 containers sold in Q2 C68,000,000 Less: C5 per container (C90 – C85) × 700,000 containers sold in Q1 (C3,500,000) C64,500,000 The cumulative catch-up adjustment reflects the amount of revenue that entity J would have recognised if, at contract inception, it had had the information that is now available. Entity J will continue to update its estimate of the total sales volume at each reporting date until the uncertainty is resolved.
Subsequent re-assessment of variable consideration previously constrained
The landowner sells land to a developer for C1 million, with an additional entitlement of 5% of any future sales price of the developed land exceeding C5 million. However, the landowner assesses that its experience with similar contracts isn’t predictive due to the unpredictable nature of the real estate market’s future performance, making the variable consideration highly susceptible to external factors beyond its control. Moreover, the uncertainty isn’t expected to be resolved promptly, as the developer currently lacks plans to sell the land.
Two years later, land prices have notably appreciated in the market, and the landowner estimates that it’s highly probable there won’t be a significant reversal of cumulative revenue related to C100,000 of variable consideration, based on sales of comparable land in the area. Additionally, the developer is actively marketing the land for sale.
Question
How should the land owner account for the change in circumstances?
Answer
The landowner must revise the transaction price to encompass C100,000 of variable consideration, where it’s deemed highly likely that there won’t be a substantial reversal of cumulative revenue recognized. This estimate will be continuously reassessed at each reporting date until the uncertainty is resolved, potentially resulting in upward or downward adjustments.
Royalties received in exchange for licenses of intellectual property (IP)
There is an exception for the recognition of revenue relating to licenses of IP with sales- or usage-based royalties. Revenue is recognized at the later of when (or as) the subsequent sale or usage occurs and when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied).
Existence of a significant financing component
An entity adjusts 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 provides either the customer or the entity with a significant benefit of financing. A significant financing component might exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract. A significant financing component might exist in an arrangement when a customer makes an advance payment because the entity requires financing to fulfill its obligations under the contract that it would otherwise need to obtain from a third party.
Can a significant financing component relate to one or more, but not all, of the performance obligations in a contract?
It is conceivable. Under certain conditions, it may be justifiable to assign a substantial financing element to one or more, albeit not all, of the performance obligations within a contract. Such evaluation typically demands discernment. Managers should contemplate whether it’s suitable to employ the principles governing discount allocation or variable consideration allocation by analogy.
Single payment stream for multiple performance obligations satisfied at different times
It might not be clear, in these circumstances, whether the timing difference between performance and payment is greater than 12 months. Management should apply judgement to assess whether cash payments relate to a specific performance obligation based on the terms of the contract. It might be appropriate to allocate the payments received between the multiple performance obligations in the event payments are not tied directly to a particular goods or service.
An entity recognizes revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transferred to the customer (that is, the cash selling price).
The amount of revenue recognized differs from the amount of cash received from the customer when an entity determines that a significant financing component exists. Revenue recognized will be less than cash received for payments that are received in arrears of performance because a portion of the consideration received will be recorded as interest income. Revenue recognized will exceed the cash received for payments that are received in advance of the performance because interest expense will be recorded and will increase the amount of revenue recognized. Examples 26 and 29 of the revenue standard illustrate this concept.
Interest income or interest expense resulting from a significant financing component should be presented separately from revenue from contracts with customers. (An entity might present interest income as revenue in circumstances in which interest income represents an entity’s ordinary activities.)
Interest income or interest expense is recognized only if a contract asset (or receivable) or a contract liability has been recognized and is determined based on guidance contained in IAS 39/IFRS 9.
Identifying a significant financing component
The determination of whether a financing component is significant should be made at the contract level. A determination is not required of the effect on the financial statements of all contracts collectively. Further, management does not need to consider the effects of the financing component if the effect would not materially change the amount of revenue that would be recognized under the contract. While an entity is not required to recognize the financing effects if they are immaterial at the contract level, an entity is not precluded from accounting for a financing component that is not significant.
Should an entity presume a significant financing component does not exist in cases where the stated interest rate is zero?
In cases where the indicated interest rate is zero, such as in interest-free financing arrangements, where the consideration over the arrangement period matches the cash selling price, it’s important not to immediately dismiss the presence of a financing component. All pertinent details should be carefully assessed, including determining if the cash selling price accurately reflects the price that would be paid in the absence of financing.
The following factors should be considered when assessing whether there is a significant financing component in a contract with a customer:
- the difference between the amount of promised consideration and the cash selling price of the promised goods or services; and
- the combined effect of both of the following:
- the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services; and
- the prevailing interest rates in the relevant market.
A significant financing component does not exist in all situations where there is a time difference between when consideration is paid and when the goods or services are transferred to the customer. Factors that indicate that a significant financing component does not exist are as follows: a. The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.
- A substantial amount of the consideration promised by the customer is variable, and the variability is not substantially within the control of the customer or the entity.
- The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference.
Timing of control transfer is at the customer’s discretion
An entity does not need to consider the effects of the financing component when the timing of performance is at the discretion of the customer. This is because the purpose of these types of contracts is not to provide financing.
One example is the sale of a gift card or a prepaid phone card. The customer uses the gift card or the prepaid phone card at his or her discretion, which could be in the near term or take an extended period. Similarly, customers who purchase goods or services and are simultaneously awarded loyalty points, or other credits that can be used for free or discounted products in the future, decide when those credits are used.
Consideration is variable and based on future events
A significant financing component does not exist if a substantial amount of consideration to be received is variable and might not be resolved for an extended period. The substance of the arrangement is not financing if the amount or timing of the variable consideration is determined by an event that is outside the control of the parties to the contract.
Timing difference arises for reasons other than financing
The purpose behind payment terms that stipulate payments before or after performance, or the variance between the pledged consideration and the cash selling price, could extend beyond financing provisions. If the primary aim of these terms isn’t to offer significant financing benefits to either party, then the impact of a financing component might not be relevant. Evaluating whether there are legitimate reasons for the timing discrepancy, besides financing, often involves exercising judgment. Examples 27 and 30 of the revenue standard provide illustrations of this principle.
Any variance between the consideration and the cash selling price should reasonably correspond to the rationale behind the difference. Essentially, management must ensure that the difference between the cash selling price and the actual price charged in the arrangement doesn’t encompass both a motive unrelated to financing and financing itself.
Prepayment with intent other than to provide financing
Entity O manufactures a limited-edition whiskey that it releases annually just before the Christmas season. In November 20X4, a retailer commits to paying Entity O to ensure a supply for the December 20X5 release. Entity O mandates payment upon placing the order, as it cannot assure production levels without it. There are no early payment discounts offered. This upfront payment enables the retailer to advertise its stock to customers and allows Entity O to regulate its production volumes.
Question
Is there a significant financing component in the arrangement between entity O and the retailer?
Answer
The agreement between Entity O and the retailer does not involve a significant financing component. The upfront payment is intended to ensure future whiskey supply, rather than serving as a means of providing finance to either Entity O or the retailer.
Significant financing component practical expedient
A practical expedient is available when, at the start of a contract, the time between providing a promised good or service and receiving payment for it will be one year or less. This expedient focuses on the timing of delivering goods or services in relation to when payment is received, rather than the contract’s duration. It applies regardless of whether the contract lasts more than 12 months, as long as the gap between performance and payment is 12 months or less.
However, this expedient cannot be used to overlook the impact of financing in the initial 12 months of a longer-term agreement containing a substantial financing component.
Contract contains a financing but the period of the financing is less than one year
Question
Can an entity use the practical expedient to disregard the effects of a significant financing when a contract is explicit that it contains a financing, but the period of the financing is less than one year?
Answer
Yes. The entity can elect to apply the practical expedient if the difference between the timing of performance and the timing of payment is one year or less.
An entity that chooses to apply the practical expedient should apply it consistently to similar contracts in similar circumstances. It should also disclose the use of the practical expedient.
Determining the discount rate
Management should adjust the contract consideration to accommodate the significant financing component, using a discount rate that mirrors the rate utilized in a distinct financing transaction between the entity and its customer. This rate ought to reflect the credit risk associated with obtaining financing within the arrangement, whether by the customer or the entity. Post contract inception, the discount rate should not be revised. This principle is exemplified in Example 28 of the revenue standard.
When considering the credit risk of each customer, revenue recognition for contracts with similar terms may vary if the customers’ credit profiles differ. Some contracts explicitly include a financing component. The explicit rate in such contracts should be evaluated to determine if it mirrors a prevailing rate for a comparable transaction or if a more representative rate should be implied. A below-market rate does not adequately reflect the financing aspect of the contract with the customer.
There is no specific guidance on computing adjustments to the transaction price due to the financing component (i.e., the interest income or expense). Entities should refer to applicable guidance in IAS 39/IFRS 9 to determine the appropriate accounting treatment.
Explicit contractual interest rate
Entity P enters into an arrangement with a customer for the financing of a new sofa purchase. Entity P is running a promotion that offers all customers 1% financing. The 1% contractual interest rate is significantly lower than the 10% interest rate that would otherwise be available to the customer at contract inception (that is, the contractual rate does not reflect the credit risk of the customer). Entity P concludes that there is a significant financing component present in the contract.
Question
What discount rate should entity P use to determine the transaction price?Answer
Entity P should use a 10% discount rate to determine the transaction price. It would not be appropriate to use the 1% rate specified in the contract, as it represents a marketing incentive and does not reflect the credit characteristics of the customer.
Implicit discount rate
Entity Q enters into an agreement with a customer to provide a five-year gym membership. Upfront consideration paid by the customer is C5,000. Entity Q also offers an alternative payment plan with monthly billings of C100 (total consideration of C6,000 over the five-year membership term). The membership is a single performance obligation that entity Q satisfies rateably over the five-year membership period. Entity Q determines that the difference between the cash selling price and the monthly payment plan (payment over the performance period) indicates that a significant financing component exists in the contract with the customer. Entity Q concludes that the discount rate that would be reflected in a separate transaction between the two parties at contract inception is 5%.
Question
What is the transaction price in this arrangement?
Answer
Entity Q should determine the transaction price using the discount rate that would be reflected in a separate financing transaction (5%). This rate is different from the 7.4% imputed discount rate used to discount payments that would have been received over time (C6,000) back to the cash selling price (C5,000). Entity Q calculates monthly revenue of C94.35 using a present value of C5,000, a 5% annual interest rate, and 60 monthly payments. Entity Q records a contract liability of C5,000 at contract inception for the upfront payment, that will be reduced by the monthly revenue recognition of C94.35 and increased by interest expense recognised. Entity Q will recognise revenue of C5,661 and interest expense of C661 over the life of the contract.
Explicit and implicit promises in a contract
An entity, a manufacturer, sells a product to a distributor (ie its customer) who will then resell it to an end customer.
Case A – Explicit promise of service
In the contract with the distributor, the entity commits to providing maintenance services at no extra cost to any party that purchases the product from the distributor. Although the entity delegates the actual performance of these services to the distributor and compensates them accordingly, payment is only made if the end customer utilizes the maintenance services.
This contract encompasses two distinct promises: (a) the product itself and (b) the maintenance services. The entity evaluates each promise’s separateness in line with IFRS 15, determining that both the product and maintenance services meet the criteria. Since the entity routinely sells the product independently, it suggests that customers can derive benefits from it alone. Similarly, customers can gain value from the maintenance services alongside the product they’ve already acquired..
Moreover, the entity concludes that the promises to provide the product and maintenance services are distinct, based on IFRS 15 principles and factors. These elements aren’t combined into a single item in the contract, nor do they enhance each other’s functionality. Additionally, they don’t alter or customize one another, and they aren’t highly interdependent or interrelated. The entity can fulfill each promise independently, even if the other isn’t involved. Furthermore, the entity notes that the provision of maintenance isn’t crucial for the product to continue offering substantial benefits to the customer. Consequently, the entity divides the transaction price between the two performance obligations: the product and the maintenance services.
Case B – Implicit promise of service
The entity has a history of offering maintenance services at no extra charge to end customers who purchase its product from the distributor. Although the entity doesn’t explicitly promise these services during negotiations with the distributor, and the final contract lacks specific terms regarding them, the entity considers, at contract inception, that it implicitly commits to providing maintenance services as part of the negotiated exchange with the distributor. This implicit promise stems from the entity’s customary business practice of providing such services, creating reasonable expectations among its customers, including the distributor and end customers.
As a result, the entity evaluates whether the promise of maintenance services constitutes a performance obligation. Following similar reasoning as in Case A, the entity determines that the product and maintenance services represent distinct performance obligations.
Case C – Services are not a promised service
In the contract with the distributor, the entity does not commit to providing any maintenance services, nor does it have a customary practice of offering such services. Therefore, there is no implicit promise or expectation of maintenance services created by the entity’s business practices or policies. The entity simply transfers control of the product to the distributor, completing the contract.
Subsequently, before the product sale to the end customer, the entity offers maintenance services to any party purchasing the product from the distributor, without additional promised consideration. This offer is not part of the distributor contract at inception, as per IFRS 15 guidelines, since the entity neither explicitly nor implicitly commits to providing maintenance services to the distributor or end customers. Consequently, the entity does not recognize the promise to provide maintenance services as a performance obligation. Instead, any obligation to provide such services is accounted for under IAS 37, which deals with provisions, contingent liabilities, and contingent assets.
While maintenance services are not part of the current contract, the entity would assess in future contracts whether its business practices imply a promise to provide maintenance services.
Accounting for purchases of virtual items in online games
Many developers of online games offer customers free access to play these games, hosting the software for them instead of licensing it. These arrangements are typically treated as service agreements, known as hosted software as a service, because customers cannot take possession of the software associated with the games.
To enrich the gaming experience, developers may offer customers the option to purchase virtual goods or services, such as consumables (like virtual groceries) or durables (such as a virtual house), along with virtual currency that can be used to buy other virtual items. These purchases enhance the gaming experience, with some items being consumed immediately while others are enjoyed over time, yet still impacting the overall gameplay.
Developers are generally not bound by contract to keep games available or maintain customer accounts indefinitely, but they often inform customers before shutting down a game as a customary practice. This practice implies an ongoing promise to provide hosting services after a customer buys a virtual item, ensuring they can continue to enjoy the enhanced gaming experience. While not contractually obligated to continue hosting, developers have established a customary business practice of ongoing hosting and advance notifications.
IFRS 15 recognizes that contracts may include promises implied by business practices or policies that create a valid expectation of service provision. In this context, developers implicitly promise to provide hosting services after virtual item purchases, ensuring continued access to the enhanced gaming experience. When determining revenue recognition, developers should consider whether benefits are provided over time or at a point in time, aligning with the period of customer benefit from the purchased virtual items. Immediate revenue recognition may not be suitable if benefits are enjoyed over time, necessitating careful consideration of the revenue recognition period and pattern.
The following may be relevant factors for an entity to consider in making this assessment.
- Whether the nature of the implied promise is to provide an enhanced gaming experience through the hosted service over time or to enable the player to consume virtual items.
- The period over which the enhanced gaming experience is provided if the benefits are consumed throughout the hosting period (e.g. user life, game life).
- The life span over which, or number of times, the virtual item may be accessed or used.
- Whether the virtual item must be used immediately or may be stored for later use.
- How and over what period the virtual item benefits the customer’s gaming experience (e.g. a consumable such as a virtual meal that is used immediately versus a durable that allows a player to” level up” within the game in such a way that the increased performance continues to enhance the gaming experience).
- Whether the benefit of purchasing the virtual item on the customer’s gaming experience is temporary or permanent.
Assessing whether a pre-production activity forms part of the delivery of a promised good or service
In certain long-term supply arrangements, an entity may need to conduct pre-production activities like upfront engineering and design before delivering goods to the customer. These activities often span over time due to their nature.
If a pre-production activity directly transfers a good or service to the customer as it progresses, revenue recognition aligns with the activity’s completion. This activity could either constitute a standalone performance obligation or be part of a larger obligation.
However, if the pre-production activity doesn’t transfer a good or service to the customer as it progresses, revenue recognition doesn’t occur during the activity
An entity should identify the nature of its promise(s) to the customer in order to determine whether the pre-production activity represents either:
- a promised good or service (or part of a promised good or service) that transfers to the customer; or
- a fulfilment activity that does not transfer a good or service to the customer.
In making this determination, an entity will need to exercise judgment. Apart from the guidelines on identifying performance obligations, the entity might refer to the guidance on satisfying a performance obligation over time.
A situation where a performance obligation is fulfilled over time arises when the customer both receives and consumes the benefits of the entity’s performance simultaneously as the entity performs. If the customer derives benefits while the entity carries out the pre-production activity, it suggests that the activity constitutes a performance obligation or is part of one. When assessing whether the condition in IFRS 15 is met, it could be useful to consider whether another entity would need to substantially redo the pre-production activities to fulfill the remaining obligation to the customer. For this evaluation, it should be assumed that the other entity wouldn’t have access to any asset controlled by the entity if the contract were terminated.
Another situation where a performance obligation is satisfied over time occurs when the entity’s performance generates or enhances an asset controlled by the customer during the asset’s creation or enhancement process. If the pre-production activity results in the creation or enhancement of an asset controlled by the customer during the process, it indicates that the activity forms part of a performance obligation or is one.
For instance, consider a scenario where an entity contracts with a customer to develop and manufacture a new product. As part of this process, the entity undertakes engineering and development activities. The contract specifies that the resulting intellectual property (patents) will be owned by the customer. Consequently, the entity concludes that the engineering and development activities produce an asset controlled by the customer during creation. Therefore, these activities transfer a good or service to the customer over time and constitute part of the performance obligation(s) in the contract.
Assessing whether shipping and handling activities constitute a fulfilment activity or a service
Shipping and handling tasks conducted prior to the customer gaining control of the associated product are considered fulfillment activities. However, once control of a product has been passed to the customer, any shipping and handling services rendered relate directly to the customer’s product, suggesting that the entity is offering a service to the customer. This concept is elucidated through the ensuing examples.
Shipping activities occurring before control of goods transfers to the customer
Entity A is a furniture retailer. Under IFRS 15, it recognizes revenue for the sale of goods when the goods are delivered to the customer which is the point at which control over the good is transferred to the customer. Entity A charges extra for shipping and handling if the customer requires delivery services.
In this case, delivery necessarily occurs before control of the goods transfers to the customer. Accordingly, Entity A’s shipping and handling activities represent fulfilment activities (and not a separate service provided to the customer). This is so regardless of how the delivery fees are charged to the customer. For example, they could be billed separately (e.g. the entity adds on the delivery cost to the price of the goods sold if the customer requires delivery) or they could be included in the price of the products sold (e.g. the same piece of furniture would be sold for CU100 if the customer picks up the item from the factory itself, for CU103 if the customer requires delivery to China and CU110 for deliveries to South America).
Shipping activities as fulfilment activities or distinct performance obligation
In Entity A’s contracts with its customers, the identification of performance obligations and the timing of revenue recognition hinge on specific circumstances. The determination of whether shipping and handling activities constitute fulfillment activities, or a distinct performance obligation also depends on the facts at hand.
For instance, Entity A might conclude that:
- The construction and assembly of the rig at the customer site form a single performance obligation, with control transferring only upon the rig’s completion, commissioning, and customer approval at the site. Here, shipping activities occur before control is transferred, thus constituting fulfillment activities.
- The construction, shipping, and assembly of the rig at the customer site constitute a single performance obligation, with control gradually transferring over time. In this scenario, shipping and handling activities aren’t considered a separate performance obligation but are factored into determining the contract’s progress.
- The construction, shipping, and assembly each represent distinct performance obligations, with control transferring over time for each obligation. In such cases, a portion of the contract’s consideration is allocated to shipping activities, and revenue is recognized upon their completion.
Non-cash consideration
Any non-cash consideration received from a customer needs to be included when determining the transaction price. Non-cash consideration is measured at fair value. This is consistent with the measurement of other consideration that takes account of the value of what the selling entity receives, rather than the value of what it gives up. Example 31 of the revenue standard illustrates this concept.
Management might not be able to reliably determine the fair value of non-cash consideration. In that situation, the value of the noncash consideration received should be measured indirectly by reference to the stand-alone selling price of the goods or services provided by the entity.
The fair value of non-cash consideration can be variable. Changes in the fair value of non-cash consideration can relate to the form of the consideration or to other reasons. For example, an entity might be entitled to receive equity of its customer as consideration, and the value of the equity could change before it is transferred to the entity. Changes in the fair value of non-cash consideration that are due to the form of the consideration are not subject to the constraint on variable consideration. Non-cash consideration that is variable for reasons other than only the form of the consideration is included in the transaction price but is subject to the constraint on variable consideration. Where the change relates to both the form of consideration and to the entity’s performance, an entity should apply judgement to determine how to account for the variability.
Variable for other reasons than the form of the consideration
Entity S has entered a contract to construct a machine for a manufacturer, with an additional bonus stipulating the receipt of 10,000 shares of the manufacturer’s common stock if the machine is delivered within six months. However, Entity S lacks a track record of completing similar machine builds within this timeframe, preventing it from determining with high probability that no significant revenue reversal will take place. Additionally, there is no derivative included in this arrangement.
Question
How should entity S account for the non-cash bonus?
Answer
Entity S must take into account the guidance on variable consideration, particularly because the consideration is contingent upon whether the machine is delivered by a specific date. However, Entity S should not initially include the shares in the transaction price due to the constraint on variable consideration. Instead, Entity S should continuously reassess its estimate in each reporting period to determine if and when the shares should be recognized in the transaction price.
Non-cash consideration could be provided by a customer to an entity to assist in completion of the contract. For example, a customer might contribute goods or services to facilitate an entity’s fulfilment of a performance obligation. An entity should include the customer’s contribution of goods or services in the transaction price as non-cash consideration only if the entity obtains control of those goods or services. Assessing whether the entity obtains controls of the contributed goods or services could require judgement.
Materials provided by customer to facilitate fulfilment
The manufacturer engages in a contract with a customer to manufacture a machine. As part of the agreement, the customer pays C1 million to the manufacturer and provides materials worth C500,000 for use in the machine’s development. The customer plans to deliver the materials approximately three months after the commencement of machine development. Based on the manufacturer’s assessment, it gains control of the materials upon delivery by the customer, as it retains the option to utilize the materials for alternative projects.
Question
How should the manufacturer determine the transaction price?
Answer
The manufacturer should include the fair value of the materials in the transaction price, because it obtains control of them. The transaction price of the arrangement is therefore C1.5 million.
Processing arrangements
Entity A and Entity B enter into an agreement wherein Entity A processes raw copper provided by Entity B into finished wire. Entity B supplies raw copper valued at C500,000 to Entity A, which is utilized in the wire fabrication process. Additionally, Entity B pays Entity A C1 million in cash for the services rendered. Throughout the process, Entity B maintains ownership of the copper being processed. There are no specific provisions regarding property, plant, and equipment, and Entity B determines that the arrangement does not constitute a lease agreement.
Question
How should entity A determine the transaction price?
Answer
Entity A would probably determine that it is offering a processing service for the copper and does not gain control of the copper in this agreement. As a result, Entity A should exclude the fair value of the raw materials from the transaction price. In certain scenarios, discernment may be necessary to ascertain whether an entity gains control of customer-provided materials. If an entity determines that it does gain control, it will likely integrate the fair value of the non-cash consideration into the transaction price.
Consideration payable to a customer
An entity may offer, or anticipate offering, consideration to its customer, often in the form of discounts or refunds on goods or services provided. When such consideration involves a variable amount, the entity should estimate the transaction price, considering whether the estimate of variable consideration is constrained. Determining whether there is an implicit promise to provide consideration to a customer, warranting earlier recognition of the obligation, requires the exercise of judgment.
Management should assess whether payments to customers are associated with a revenue contract, even if they do not coincide temporally with a revenue transaction. These payments might still be economically linked to a revenue contract. For instance, such a payment could signify a modification to the transaction price within a customer contract. Accordingly, management must exercise judgment in identifying payments to customers that are economically tied to a revenue contract.
Payment to a customer’s customer in the distribution chain
When an entity makes payments either directly to its customer or to another party further down the distribution chain (referred to as the “customer’s customer”), the assessment and accounting treatment of these payments are the same as those made directly to the entity’s customer. This holds true if the recipients of the payments are purchasing the entity’s goods and services.
Payment to reseller’s customer
Entity T sells televisions to a retailer that the retailer sells to end customers. Entity T runs a promotion during which it will pay a rebate to end customers that purchase a television from the retailer.
Question
How should entity T account for the rebate payment to the end customer?
Answer
Entity T should account for the rebate in the same manner as if it were paid directly to the retailer. Payments to a customer’s customer within the distribution chain are accounted for in the same way as payments to a customer.
Payment to an end consumer that does not purchase the entity’s goods or services
Entities may offer cash incentives to end consumers who are not their direct customers and do not participate in purchasing the entities’ goods or services within the distribution chain. To handle such situations effectively, management should initially determine whether the end consumer qualifies as the entity’s customer, which may involve exercising judgment.
Additionally, management should evaluate whether the payment to the end consumer is mandated by the contractual terms between the entity and its customer. In such instances, the payment to the end consumer is treated as consideration payable to the customer since it is being made on behalf of the customer.
Agent’s payment to end consumer
Entity U sells airline tickets to end consumers on behalf of an airline. Entity U concludes that it is acting as an agent in the airline ticket sale transactions. Entity U offers a C10 coupon to end consumers in order to increase the volume of airline ticket sales on which it earns a commission.
Question
How should entity U account for the coupon offered to end consumers?
Answer
Entity U should begin by identifying its customer or customers to ascertain whether the coupons constitute consideration payable to a customer. If Entity U determines that the end consumers are its customers, or if it determines that the end consumers are not its customers but is making the payment on behalf of the airline (its customer), then the coupons are recognized as a reduction of its agency commission. This is because Entity U does not receive a distinct good or service in exchange for the payment. On the other hand, if the coupons do not represent consideration payable to a customer, they would typically be recorded as a marketing expense.
Settlement payments made to customers
Entities may find themselves obligated to make payments to customers to resolve legal disputes, claims, or other conflicts. These payments typically constitute consideration payable to a customer and are recorded as a reduction of revenue since the entity does not receive any distinct good or service in return. The nature of such payments may sometimes blur the distinction between past and future transactions. Cash payments made to settle disputes often represent adjustments to the transaction price of a completed contract, reflecting a concession related to past transactions. In such cases, these payments are promptly recognized as revenue adjustments.
Alternatively, a cash payment may serve as an inducement for the customer to engage in a new contract. For instance, in settling a class action lawsuit, an entity might issue coupons to a broad customer base, usable for future purchases. Whether these coupons are considered incentives for new contracts or adjustments to past transaction prices depends on the circumstances and may involve significant judgement. Payments related to ongoing contracts are typically treated as modifications to those contracts.
Payments to customers that exceed the transaction price
In certain scenarios, a payment to a customer, not exchanged for a distinct good or service, might surpass the transaction price outlined in the current contract. Deciding how to account for this excess payment, often termed as ‘negative revenue’, involves exercising judgement. Management should thoroughly grasp the rationale behind making the payment and the contractual rights and obligations associated with it. Entities should transparently disclose any significant judgements made in this regard.
Determining the accounting treatment for the surplus payment, including when to recognize it in income and how to present it in the income statement, necessitates assessing whether the payment has implications for other ongoing or past contracts with the same customer. If revenue has been recognized from previous contracts with the same customer, the excess payment might signify a modification to the transaction price of those contracts. Additionally, management should evaluate whether the payment pertains to anticipated future contracts.
For instance, entities sometimes make advance payments to customers to cover costs associated with vendor changes or to secure exclusivity for future purchases, even if they lack enforceable rights to these payments. Payments related to future contracts could qualify as assets, and if capitalized, they would be amortized as a deduction from future revenues generated from that customer. The recoverability of such assets should be assessed based on expected future revenues from the customer.
If the excess payment is not linked to any other contracts, including past or anticipated future contracts, management should analyze the essence of the payment to determine its appropriate presentation. For instance, management may decide to treat the excess payment as an expense if the arrangement ceases to constitute a contract with a customer when the transaction price becomes negative. An illustrative example below demonstrates the accounting treatment when payments to a customer exceed the transaction price.
Activity
The entity sells 1,000 products to a retailer for a total consideration of C100,000. However, as an emerging business seeking favorable placement in the retailer’s store, the entity makes a one-time payment of C150,000 to the retailer. This payment is not made in exchange for a distinct good or service, and at the time of payment, the entity has no other past or current contracts with the retailer. While the entity hopes to sell more products to the retailer in the future, it does not currently anticipate any specific future contracts with the retailer.
Question
How should the entity account for the payment to the retailer?
Answer
The entity should treat the payment as a reduction of the transaction price of the contract with the retailer, as no distinct good or service is received in exchange. Since the entity has determined that the excess amount of C50,000 (C100,000 contract price less C150,000 payment) is not associated with any other contracts with the retailer, it should be accounted for based on the substance of the payment. In this scenario, the entity would likely recognize the C50,000 excess payment as an expense.
Payments to customers in the form of equity instruments
An entity may exchange its equity instruments for distinct goods and services, a scenario governed by IFRS 2. However, under IFRS 15, payments to customers where no distinct goods or services are received are not limited to cash transactions. Consequently, we interpret that the fair value of shares issued to a customer in such instances should be treated as a reduction of revenue. Since IFRS 15 doesn’t stipulate a specific measurement date for non-cash consideration, management must exercise judgment to establish the measurement date.
An entity recognises the reduction of revenue when (or as) the later of either of the following events occurs:
- the entity recognises revenue for the transfer of the related goods or services to the customer; or
- the entity pays or promises to pay the consideration. That promise might be implied by the entity’s customary business practices.
Implied promise to pay consideration to a customer
Management needs to evaluate whether a payment it anticipates giving to a customer, such as a rebate, qualifies as a price concession when reviewing the contract terms. Price concessions fall under variable consideration and should be estimated, taking into account the constraint on variable consideration. Additionally, if there’s an implied payment to the customer, it should be recognized even if the entity hasn’t explicitly communicated its intent to make the payment. Determining whether an entity intends to provide a customer payment as a price concession and whether such payment is implied by the entity’s customary practices may require judgment.
Activity
Entity V sells coffee products to a retailer. On 1 December 20X1, entity V decides that it will issue coupons directly to end consumers that provides a C1 discount on each bag of coffee purchased. Entity V has a history of providing similar coupons. Entity V delivers a shipment of coffee to the retailer on 28 December 20X1 and recognises revenue. Entity V offered the coupons to end consumers on 2 January 20X2 and it reasonably expects that the end consumers will use the coupons to purchase products already shipped to the retailer. Entity V will reimburse the retailer for any coupon redeemed by end consumers.
Question
When should entity V record the revenue reduction for estimated coupon redemptions?
Answer
Entity V needs to adjust the transaction price to account for estimated coupon redemptions when it records revenue upon transferring the coffee to the retailer on December 28, 20X1. Despite not yet communicating the coupon offering, Entity V typically provides coupons as part of its business practice and intends to offer coupons related to this shipment, constituting a form of price concession. Thus, Entity V should handle the coupons in accordance with the guidance on variable consideration.
Income statement classification of payments to a customer
Consideration payable to a customer is recorded as a reduction of the arrangement’s transaction price, thereby reducing the amount of revenue recognised, unless the payment is for a distinct good or service received from the customer. Consideration paid for a distinct good or service is accounted for in the same way as the entity accounts for other purchases from suppliers. Example 32 of the revenue standard illustrates this concept.
No distinct good or service received
A producer sells energy drinks to a retailer, a convenience store. The producer also pays the retailer a fee to ensure that its products receive prominent placement on store shelves (that is, a slotting fee).
Question
How should the producer account for the slotting fees paid to the retailer?
Answer
The producer should reduce the transaction price for the sale of the energy drinks by the amount of slotting fees paid to the retailer. The producer does not receive a good or service that is distinct in exchange for the payment to the retailer.
Management also needs to assess whether the consideration that it pays for distinct goods or services from its customer represents the fair value of those goods or services. Consideration paid, that is in excess of the fair value of the goods or services received, reduces the transaction price of the arrangement with the customer, because the excess amount represents a discount to the customer.
Payment for a distinct service
Entity W has a contract to sell 1,000 phones to a retailer for C100,000. Additionally, the contract entails an advertising arrangement where Entity W is obligated to contribute C10,000 for a specific advertising promotion facilitated by the retailer. This promotion entails the placement of advertisements on strategically positioned billboards and in local advertising mediums. Notably, Entity W had the option to engage a third-party service provider to deliver comparable advertising services at a cost of C10,000.
Question
How should entity W account for the payment to the retailer for advertising?
Answer
Entity W should treat the payment to the retailer in line with its other transactions for advertising services. The payment from Entity W to the retailer represents consideration for a specific service provided by the retailer, which holds fair value. This advertising service is distinct because Entity W could have alternatively enlisted a third party, who is not its customer, to perform similar services. Importantly, the transaction price for the sale of the phones remains at C100,000 and is unaffected by the payment made to the retailer.
Payment for a distinct service in excess of fair value
Entity W sells 1,000 phones to a retailer for C100,000. The contract includes an advertising arrangement that requires entity W to pay C10,000 towards a specific advertising promotion that the retailer will provide. The retailer will provide the advertising on strategically located billboards and in local advertisements. Entity W could have elected to engage a third party to provide similar advertising services at a cost of C8,000.
Question
How should entity W account for the payment to the retailer for advertising?
Answer
The payment made by Entity W, amounting to C8,000, which represents the fair value of the advertising service, is accounted for in a manner consistent with other advertising service purchases. This payment is considered as consideration for a distinct service. However, the portion of the payment exceeding the fair value of the services, totaling C2,000, is treated as a reduction of the transaction price for the sale of the phones. Consequently, the adjusted transaction price for the sale of the phones amounts to C98,000.
Advertising allowance
A manufacturer contracts to sell toys to a retailer, agreeing to offer the retailer an advertising allowance equivalent to 3% of the retailer’s total purchases. This allowance is payable at the end of each quarter. The retailer has full discretion over how to use the allowance and is not obligated to provide the manufacturer with documentation detailing its utilization.
Question
How should the manufacturer account for the advertising allowance?
Answer
In this scenario, the manufacturer is likely to determine that it doesn’t obtain a separate product or service in return for the payment made to the retailer. The payment essentially functions as a discount on the retailer’s purchases. Consequently, the manufacturer should recognize the allowance as a deduction from the transaction price of the toys sold to the retailer.
An entity that is not able to determine the fair value of the goods or services received should account for all of the consideration paid or payable to the customer as a reduction of the transaction price, since it is unable to determine the portion of the payment that is a discount provided to the customer.
Allocating the transaction price to separate performance obligations
The transaction price should be allocated to each separate performance obligation, or distinct good or service, so that revenue is recorded at an amount that depicts the amount of consideration that the entity expects to be entitled to in exchange for transferring the promised goods or services.
The transaction price should be allocated to each performance obligation based on the relative stand-alone selling prices of the goods or services being provided to the customer. (There is specific guidance when allocating discounts or variable consideration).
Other considerations when allocating the transaction price
Other considerations related to allocating transaction prices are discussed below:
When the transaction price exceeds the sum of stand-alone selling prices, it suggests the customer is paying a premium for purchasing the goods or services together. This could indicate that the stand-alone selling prices are underestimated, or additional performance obligations exist. If a premium persists after further assessment, it’s allocated to the performance obligations based on relative stand-alone selling prices.
Non-refundable upfront fees, like joining or activation fees, are common in many contracts. Entities should evaluate whether these fees satisfy a performance obligation. If not, because no goods or services are transferred, none of the transaction price should be allocated to these activities. Instead, the upfront fee is included in the transaction price allocated to the performance obligations.
There’s no “contingent revenue cap” where the transaction price is allocated to all performance obligations regardless of additional goods or services provided before payment. For instance, in a wireless service agreement with a free phone, the transaction price is allocated to both the phone and the service, despite payment being made as services are rendered. Concerns about payment are addressed in the collectability assessment or customer acceptance evaluation.
Determining stand-alone selling price
An entity determines the stand-alone selling price of each distinct good or service underlying each performance obligation at contract inception to allocate the transaction price to each performance obligation.
The best evidence of stand-alone selling price is the price that an entity charges for that good or service when the entity sells it separately in similar circumstances to similar customers. A contractually stated price or list price for a good or service might be, but should not be presumed to be, the stand-alone selling price of the good or service. An entity’s customary business practices should be considered, including adjustments to list prices, when determining the stand-alone selling price of an item.
Stand-alone selling prices are directly observable
Entity X sells boats and provides mooring facilities for its customers. Entity X sells the boats for C30,000 each and provides mooring facilities for C5,000 per year. Entity X concludes that the goods and services are distinct and accounts for as separate performance obligations. Entity X enters into a contract to sell a boat and one year of mooring services to a customer for C32,500.
Question
How should entity X allocate the transaction price of C32,500 to the performance obligations?
Answer
Entity X should allocate the transaction price of C32,500 to the boat and the mooring services based on their relative stand-alone selling prices as follows:
Boat: C27,857 (C32,500 × (C30,000/C35,000))
Mooring services: C4,643 (C32,500 × (C5,000/C35,000))
The allocation results in the C2,500 discount being allocated proportionately to the two performance obligations.
Can an entity use a range of prices when determining the stand-alone selling prices of individual goods or services?
When determining stand-alone selling prices for individual goods or services, an entity may utilize a range of prices, provided it reflects reasonable pricing for each product or service as if sold independently to similar customers. While the allocation guidance doesn’t explicitly mention using a range, doing so aligns with the allocation objective. Judgment is necessary to establish an appropriate range of stand-alone selling prices.
If an entity opts for a range, it could consider the contractual price as the stand-alone selling price if it falls within that range. However, there may be instances where the contractual price falls outside the established range. In such cases, entities should consistently apply a method to determine the stand-alone selling price within the range for that specific good or service. For example, they might choose the midpoint of the range or the outer limit closest to the stated contractual price.
Use of a range when estimating stand-alone selling prices
Entity X sells boats and provides mooring facilities for its customers. It sells the boats on a stand-alone basis for C29,000–C32,000 each, and it provides mooring facilities for C5,000 per year. Entity X concludes that the goods and services are distinct, and it accounts for them as separate performance obligations. Entity X enters into a contract to sell a boat and one year of mooring services to a customer. The stated contract prices for the boat and the mooring services are C31,000 and C1,500, respectively.
Question
How should entity X allocate the total transaction price of C32,500 to each performance obligation?
Answer
The contract price for the boat (C31,000) falls within the range that entity X established for stand-alone selling price; therefore, entity X could use the stated contract price for the boat as the stand-alone selling price in the allocation:
Boat: C27,986 (C32,500 × (C31,000 / C36,000))
Mooring services: C4,514 (C32,500 × (C5,000 / C36,000))
If the contract price for the boat did not fall within the range (for example, the boat was priced at C28,000), entity X would need to determine a price within the range to use as the stand-alone selling price of the boat in the allocation, such as the midpoint. Entity X should apply a consistent method for determining the price within the range to use the stand-alone selling price.
The stand-alone selling price needs to be estimated or derived by other means if the good or service is not sold separately.
The relative stand-alone selling price of each performance obligation is determined at contract inception. The transaction price is not reallocated after contract inception to reflect subsequent changes in standalone selling prices.
Stand-alone selling price not directly observable
The stand-alone selling price of an item that is not directly observable should be estimated. The method used should result in an estimate that faithfully represents the price that an entity would charge for the goods or services if they were sold separately, and it should result in the allocation of the transaction price meeting the allocation objective of the standard.
Management should consider all information that is reasonably available and should maximise the use of observable inputs when estimating the stand-alone selling price.
The method used to estimate the stand-alone selling prices should be applied consistently to similar arrangements. Suitable methods include, but are not limited to:
- Adjusted market assessment approach.
- Expected cost plus a margin approach.
- Residual approach, in limited circumstances.
Are there instances where an entity could assert that it is unable to estimate stand-alone selling price?
No. The revenue standard requires an entity to estimate stand-alone selling price for each distinct good or service in an arrangement. The residual approach can only be used if specific criteria are met.
Adjusted market assessment approach
A market assessment approach considers the market in which the good or service is sold and estimates the price that a customer in that market would be willing to pay. Management might consider a competitor’s pricing for similar goods or services in the market and adjust for entity-specific factors.
What factors should be considered when adopting an adjusted market assessment approach?
Entity-specific factors influencing stand-alone selling prices include market position, expected profit margin, customer or geographic segments, distribution channel, and cost structure. For instance, a higher market share might lead to lower prices due to increased volumes, while smaller market shares may necessitate higher margins for profitability. Consideration of customer bases across different geographies is crucial, as pricing variations can arise from factors like distribution costs.
Market conditions play a significant role, including supply and demand dynamics, competition levels, market perception, trends, and geography-specific factors. A single product or service may have varied stand-alone selling prices across different markets. For instance, urban and rural areas may yield different prices for similar goods. In highly competitive markets, entities may need to lower prices to remain competitive, while they can command higher prices in less competitive markets. Marketing strategies may also influence pricing decisions, with entities willing to accept lower prices in certain markets.
Brand perception is another determinant, as entities with prestigious brands may charge higher margins than lesser-known counterparts. Discounts offered for stand-alone sales should be factored in when estimating selling prices. For example, if an entity frequently offers discounts below the list price, using the list price as the stand-alone selling price may not be appropriate. Consideration should also be given to any established practices of providing price concessions. Entities with a history of concessions must determine a suitable range of stand-alone prices when estimating selling prices.
The relevance of each data point varies based on an entity’s circumstances, location, and other factors. Certain information may hold more significance depending on the context. Therefore, careful evaluation and consideration of relevant factors are essential in determining stand-alone selling prices.
Expected cost plus a margin
An expected cost plus a margin approach requires an entity to forecast its expected costs of satisfying a performance obligation, and then add an appropriate margin for that good or service.
What factors should be considered when adopting an expected cost plus a margin approach?
Costs included in the estimate should be consistent with those that an entity would normally consider in setting stand-alone prices. Both direct and indirect costs should be considered, but judgement is needed to determine the extent of costs that should be included. Internal costs, such as research and development costs that the entity would expect to recover through its sales, might also need to be considered. Factors to consider, when assessing if a margin is reasonable, could include: Margins achieved on stand-alone sales of similar products. Market data related to historical margins within an industry. Industry sales price averages. Market conditions. Profit objectives
Stand-alone selling prices are not directly observable
The aim is to identify the factors and circumstances influencing the pricing an entity could set in a specific market. Assessing an appropriate margin often requires judgment, especially when adequate historical data is lacking or when a product or service hasn’t previously been sold independently. Determining a reasonable margin typically involves evaluating both entity-specific and market-related factors.
For example, when Entity Y enters into an agreement with Entity Z to provide a license and research services, each treated as distinct performance obligations, and neither typically sold separately, Entity Y might consider several factors in estimating the stand-alone selling prices:
- License: The method for determining the stand-alone selling price depends on factors such as the rights associated with the license and the stage of technology development. For licenses without comparable sales, projected cash flows could inform the estimation, especially for licenses already in use or expected to be exploited soon. In early-stage licenses lacking reliable revenue forecasts, a cost-plus approach might be more suitable. The chosen approach relies on factual circumstances and the availability of pricing information.
- Research Services: A cost-plus approach, factoring in the effort required for the research services, could determine the stand-alone selling price. This approach might consider expenses for full-time equivalent (FTE) employees and anticipated resource commitments. Key judgment areas include selecting FTE rates, estimating profit margins, and comparing with similar market offerings.
Residual approach
The residual approach involves deducting from the total transaction price the sum of the estimated or observable stand-alone selling prices of other goods and services in the contract, to estimate a stand-alone selling price for the remaining goods or services. This approach can be used in very limited circumstances to determine the stand-alone selling price of performance obligations in an arrangement.
When the residual approach can be used
The residual approach can only be used when the entity sells the same good or service to different customers for a broad range of prices, making them highly variable, or when the entity has not yet established a price for a good or service because it has not been previously sold
Estimating stand-alone selling price (residual approach)
A seller enters into a contract with a customer to sell products A, B and C for a total transaction price of C100,000. On a stand-alone basis, the seller regularly sells product A for C25,000 and product B for C45,000. Product C is a new product that has not been sold previously, has no established price, and is not sold by competitors in the market. Products A and B are not regularly sold together at a discounted price. Product C is delivered on 1 March, and products A and B are delivered on 1 April.
Question
How should the seller determine the stand-alone selling price of product C?
Answer
The seller can use the residual approach to estimate the stand-alone selling price of product C, because the seller has not previously sold or established a price for product C. Prior to using the residual approach, the seller should assess whether any other observable data exists to estimate the stand-alone selling price.
For example, although product C is a new product, the seller might be able to estimate a stand-alone selling price through other methods, such as using expected cost plus a margin. The seller has observable evidence that products A and B sell for C25,000 and C45,000 respectively, for a total of C70,000. The residual approach would result in an estimated stand-alone selling price of C30,000 for product C (C100,000 total transaction price less C70,000).
The circumstances where the residual approach can be used are intentionally limited. Before using the residual approach, management should consider whether another method provides a reasonable estimate of the stand-alone selling price
Estimating stand-alone selling price: residual approach is not appropriate
A software company enters into a contract with a customer to license software and provide post-contract customer support (PCS) for a total transaction price of C1.1 million. The software company regularly sells PCS for C1 million on a stand-alone basis. The software company also regularly licenses software on a stand-alone basis for a price that is highly variable, ranging from C500,000 to C5 million.
Question
Can the software company use the residual approach to determine the stand-alone selling price of the software licence?
Answer
No. Because the seller has observable evidence that PCS sells for C1 million, the residual approach results in a nominal allocation of selling price to the software licence. As the software is typically sold separately for C500,000 to C5 million, this is not an estimate that faithfully represents the price of the software licence if it was sold separately. As such, the allocation objective of the standard is not met, and the software company should use another method to estimate the stand-alone selling price of the licence.
Additional considerations if a residual approach is used
Arrangements could include three or more performance obligations, with more than one of the obligations having a stand-alone selling price that is highly variable or uncertain. A residual approach can be used, in this situation, to allocate a portion of the transaction price to those performance obligations with prices that are highly variable or uncertain, as a group. Management will then need to use another method to estimate the individual stand-alone selling prices of those obligations. The revenue standard does not provide specific guidance about the technique or method that should be used to make this estimate.
Management still needs to compare the results obtained using a residual approach to all reasonably available observable evidence, to ensure that the method meets the objective of allocating the transaction price based on stand-alone selling prices. Allocating little or no consideration to a performance obligation suggests that the method used might not be appropriate, because a good or service that is distinct is presumed to have value to the purchaser.
Allocating discounts
A customer receives a discount for purchasing a bundle of goods or services if the sum of the stand-alone selling prices of those promised goods or services in the contract exceeds the promised consideration in a contract. Discounts are typically allocated to all of the performance obligations in an arrangement based on their relative stand-alone selling prices, so that the discount is allocated proportionately to all performance obligations. Example 34 of the revenue standard illustrates these concepts.
It might be appropriate, in some instances, to allocate the discount to only one or more performance obligations in the contract rather than to all performance obligations. The following conditions should be met in order to allocate a discount to one or more, but not all, performance obligations:
- the entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a stand-alone basis;
- the entity also regularly sells, on a stand-alone basis, a bundle (or bundles) of some of those distinct goods or services at a discount to the stand-alone selling prices of the goods or services in each bundle; and
- the discount attributable to each bundle of goods or services described in (b) is substantially the same as the discount in the contract.
Allocating a discount
A retailer enters into an arrangement with its customer to sell a chair, a couch and a table for C5,400. The retailer regularly sells each product on a stand-alone basis: the chair for C2,000, the couch for C3,000, and the table for C1,000. The customer receives a C600 discount (C6,000 sum of standalone selling prices less C5,400 transaction price) for buying the bundle of products. The chair and couch will be delivered on 28 March and the table on 3 April. The retailer regularly sells the chair and couch together as a bundle for C4,400 (that is, at a C600 discount to the stand-alone selling prices of the two items). The table is not normally discounted.
Question
How should the retailer allocate the transaction price to the products?
Answer
The retailer has observable evidence that the C600 discount should be allocated to only the chair and couch. The chair and couch are regularly sold together for C4,400, and the table is regularly sold for C1,000. The retailer would therefore allocate the C5,400 transaction price as follows: Chair and couch: C4,400 Table: C1,000 If, however, the table and the couch in the above example were also regularly discounted when sold as a pair, it would not be appropriate to allocate the discount to any combination of two products. The discount would instead be allocated proportionately to all three products.
A discount will typically be allocated only to bundles of two or more performance obligations in an arrangement. Allocation of an entire discount to a single item is expected to be rare
If a discount is allocated to one or more but not all of the performance obligations, the discount is allocated before using the residual approach (if applicable) to estimate the stand-alone selling price of a good or service.
Allocating a discount and applying the residual approach
A seller enters into a contract with a customer to sell products A, B and C for a total transaction price of C100,000. On a stand-alone basis, the seller regularly sells product A for C25,000 and product B for C45,000. Product C is a new product that has not been sold previously, has no established price, and is not sold by competitors in the market. Products A and B are regularly sold as a bundle for C60,000 (that is, at a C10,000 discount). The seller concludes that the residual approach is appropriate for determining the stand-alone selling price of product C.
Question
How should the seller allocate the transaction price between products A, B and C?
Answer
The seller regularly sells products A and B together for C60,000, so it has observable evidence that the C10,000 discount relates entirely to products A and B. Therefore, the seller would allocate C60,000 to products A and B. Using the residual approach, C40,000 would be allocated to product C (C100,000 total transaction price less C60,000).
Allocating variable consideration
Variable consideration is generally allocated to all performance obligations in a contract, based on their relative stand-alone selling prices. However, similar to a discount, there are criteria for assessing whether variable consideration is attributable to one or more, but not all, of the performance obligations in an arrangement. This allocation guidance is a requirement, not a policy election.
Does an entity have to perform a relative stand-alone selling price allocation to conclude that the allocation of variable consideration to one or more, but not all, performance obligations is consistent with the allocation objective?
The stand-alone selling price serves as the primary method for determining if the allocation objective is achieved. However, alternative methods might be applicable in specific scenarios. While a relative stand-alone selling price allocation could be employed to evaluate the fairness of the allocation, it’s not obligatory. In cases where there is no explicit direction on alternative methods, entities will need to exercise judgment to ensure that the allocation yields a reasonable outcome.
Which guidance should an entity apply to determine how to allocate a discount that causes the transaction price to be variable?
Variable discounts, such as mail-in rebates, are considered variable consideration within a contract. For instance, an electronic store may offer a customer a bundle of products including a television, speakers, and a DVD player at their individual selling prices, along with a C50 mail-in rebate on the total purchase. This C50 discount is variable because it relies on the customer redeeming the rebate.
Entities must initially apply the guidance for allocating variable consideration to such variable discounts. If the criteria for allocating variable consideration are not met, entities should then assess whether the criteria for allocating a discount are applicable. It’s possible for a contract to include both variable and fixed discounts, and the guidance on allocating a discount should be followed for any fixed discount present.
An entity might have the right to additional consideration upon early delivery of a particular product in an arrangement that includes multiple products. Allocating the variable consideration to all of the products in the arrangement might not reflect the substance of the arrangement in this situation.
Variable consideration (and subsequent changes in the measure of that consideration) should be allocated entirely to a single performance obligation only if both of the following criteria are met:
- the terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service); and
- allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective when considering all of the performance obligations and payment terms in the contract.
A series of distinct goods or services is accounted for as a single performance obligation if it meets certain criteria. Where a contract includes a series accounted for as a single performance obligation and also includes an element of variable consideration, management should consider the distinct goods or services (rather than the series) for the purpose of allocating variable consideration. In other words, the series is not treated as a single performance obligation for the purpose of allocating variable consideration. Management should apply the guidance in IFRS 15 to determine whether variable consideration should be allocated entirely to a distinct good or service within a series.
Allocating variable consideration to a series: performance bonus
Entity A has entered into a three-year contract to supply air conditioning to an office building operator, utilizing its exclusive geo-thermal heating and cooling system. As part of the agreement, Entity A is eligible for a semi-annual performance bonus if the customer’s heating and cooling costs decrease by at least 10% compared to the previous expense. This comparison occurs every six months, using the average of the most recent six months against the same period in the prior year. Entity A treats the continuous provision of distinct services over the contract’s duration as a single performance obligation fulfilled over time.
Initially, Entity A refrains from including any variable consideration linked to the performance bonus in the transaction price for the first six months of service. This decision stems from its belief that a significant reversal of cumulative recognized revenue might occur if there’s a change in the estimate of customer cost savings. However, at the conclusion of the first six months, the customer’s costs have indeed decreased by 12% compared to the previous period, making Entity A eligible for the performance bonus.
Question
How should entity A account for the performance bonus?
Answer
Entity A must allocate the performance bonus to the specific services it pertains to, typically the related six-month period, if management determines that this aligns with the allocation objective. Assuming this alignment, Entity A would recognize the performance bonus, representing the change in the estimate of variable consideration, immediately. This is because it relates to distinct services that have already been provided. It would not be suitable to distribute the change in variable consideration across the entire performance obligation, i.e., recognizing the amount over the full three-year contract duration.
Allocating variable consideration to a series: pricing varies based on usage
Entity B engages in a two-year contract with a customer, where Entity B undertakes the processing of all transactions on the customer’s behalf. Although the customer is obliged to utilize Entity B’s system for all transactions, the exact volume of transactions remains uncertain. Entity B levies a monthly fee, determined as C0.03 per transaction processed within the month. Entity B determines that its commitment entails a series of discrete monthly processing services and treats the entire two-year contract as a unified performance obligation.
Question
How should entity B allocate the variable consideration in this arrangement?
Answer
Entity B needs to allocate the variable monthly fee to the specific monthly service it pertains to, ensuring that the results align with the allocation objective. Determining if the allocation objective is met entails exercising judgment. It involves assessing whether the fees are priced consistently throughout the contract and whether the rates are in line with the entity’s pricing practices for similar customers.
In evaluating the allocation objective, Entity B should scrutinize various factors. For instance, if the rate per transaction processed fluctuates throughout the contract, Entity B must delve into the reasons behind these variations to gauge the reasonableness of allocating each month’s fee to the corresponding service. Factors to consider include whether the rates adhere to market norms and whether rate changes are substantial and linked to changes in value delivered to the customer.
If, for example, the terms of the contract are structured to front-load revenue recognition without commensurate value provided, this would indicate a failure to meet the allocation objective. Additionally, management should assess whether contracts with decreasing prices entail future discounts necessitating revenue deferral.
Allocating variable consideration to a series: contract with an upfront fee
The entity, in this scenario, engages in a contract to furnish a cloud-based solution for payroll processing spanning one year. Since the customer cannot access the software at any point during the hosting period, no licensing terms are involved in the contract. The entity levies an upfront charge of C1 million alongside a monthly fee of C2 for each employee’s payroll managed via the cloud platform. Should the customer opt for contract renewal, a similar upfront fee would be applicable.
The entity discerns its commitment as a sequence of discrete monthly services, thereby treating the entire one-year contract as a singular performance obligation. For the initial quarter of the year, the payroll processing fees are C50,000 for January, C51,000 for February, and C52,000 for March.
Question
How should the entity recognise revenue from this arrangement?
Answer
The entity must establish an appropriate measure of progress for recognizing the upfront fee of C1 million, likely employing a time-based measure, such as ratable recognition over the contract term. Additionally, the variable monthly fees should be allocated to the distinct monthly service they correspond to. For instance, C50,000 should be allocated to January, C51,000 to February, and C52,000 to March. This allocation aligns with the objective, as the C2 monthly fee per employee remains consistent throughout the contract, and the variable consideration can be attributed to the specific monthly payroll processing service in January, February, and March.
Under this approach, the upfront fee is evenly spread over time, whereas the variable fee remains un-spread. However, this does not imply the use of multiple measures of progress. Instead, a single time-based measure of progress is utilized for the entire contract. The allocation of the variable fee to specific time periods adheres to the allocation guidance stipulated in IFRS 15, ensuring consistency and accuracy in revenue recognition.
Allocating subsequent changes in transaction price
The estimate of variable consideration is updated at each reporting date, potentially resulting in changes to the transaction price after inception of the contract. Any changes to the transaction price (excluding those resulting from contract modifications, as discussed) are allocated to the performance obligations in the contract on the same basis as at contract inception (that is, based on the stand-alone selling prices determined at contract inception).
Changes in the amount of variable consideration that relate to one or more specific performance obligations will be allocated only to that (those) performance obligation(s).
Change in transaction price
On 1 July, a contractor enters into an arrangement to build an addition onto a building, re-pave a parking lot, and install outdoor security cameras for C5,000,000. The building of the addition, the parking lot paving, and installation of security cameras are distinct, and are accounted for as separate performance obligations. The contractor can earn a C500,000 bonus if it completes the building addition by 1 February. The contractor will earn a C250,000 bonus if it completes the addition by 1 March. No bonus will be earned if the addition is completed after 1 March. The contractor allocates the transaction price, on a relative stand-alone price basis, before considering the potential bonus as follows:
Building addition: C4,000,000
Parking lot: C600,000
Security cameras: C400,000
The contractor anticipates completing the building addition by 1 March and allocates an additional C250,000 to just the building addition performance obligation, resulting in an allocated transaction price of C4,250,000. The contractor concludes that this result is consistent with the allocation objective in these circumstances. At 31 December, the contractor determines that the addition will be completed by 1 February and therefore changes its estimate of the bonus to C500,000. The contractor recognises revenue on a percentage of completion basis, and 75% of the addition was completed as at 31 December.
Question
How should the contractor account for the change in estimated bonus as at 31 December?
Answer
As at 31 December, the contractor should allocate an incremental bonus of C250,000 to the building addition performance obligation, for a total of C4,500,000. The change to the bonus estimate is allocated entirely to the building addition because the variable consideration criteria discussed in paragraph 11.145 onwards were met. The contractor should recognise C3,375,000 (75% × C4,500,000) as revenue on a cumulative basis for the building addition as at 31 December.
A change in the transaction price allocated to satisfied performance obligations is recognised as revenue immediately on a cumulative catch-up basis. A change in the amount allocated to a performance obligation that is satisfied over time is also adjusted on a cumulative catch-up basis. The result is either additional or less revenue in the period of change for the satisfied portion of the performance obligation. The amount related to the unsatisfied portion is recognised as that portion is satisfied over time.
An entity’s stand-alone selling prices might change over time. Changes in stand-alone selling prices differ from changes in the transaction price. Entities should not reallocate the transaction price for subsequent changes in the stand-alone selling prices of the goods or services in the contract
Example
Determining whether goods or services are distinct
Case A – Distinct goods or services
An entity, operating as a software developer, engages in a contract with a customer encompassing the transfer of a software license, execution of an installation service, and provision of unspecified software updates and technical support over a two-year period. Each component of the contract is also sold individually by the entity. The installation service entails customizing web screens for various user types (e.g., marketing, inventory management, and IT), a task routinely undertaken by other entities without significantly altering the software’s functionality. Notably, the software remains operational without the updates and technical support.
In accordance with IFRS 15, the entity evaluates the promised goods and services to determine their distinctiveness. It recognizes that the software is delivered upfront and remains functional independently of the updates and support. The customer can derive benefit from both the updates and the software license provided at the outset. Consequently, the criterion in IFRS 15 is satisfied.
Furthermore, the entity applies the principle and factors outlined in IFRS 15, affirming that each promise to transfer a good or service is distinctly identifiable from the others. This determination considers that although the entity integrates the software into the customer’s system, the installation services do not significantly impede the customer’s ability to utilize the software license, given their routine nature and availability from alternate providers. Likewise, the software updates do not substantially impact the customer’s ability to use the software during the license period.
Additionally, none of the promised goods or services significantly alter or customize each other, nor does the entity provide a substantial integration service to merge the software and services into a unified output. Consequently, the software and associated services are not highly interdependent or interrelated, as the entity can fulfill its commitments to provide the initial software license independently of subsequent promises regarding installation, updates, or technical support.
On the basis of this assessment, the entity identifies four performance obligations in the contract for the following goods or services:
- (a) the software licence;
- (b) an installation service;
- (c) software updates; and
- (d) technical support.
The entity applies IFRS 15 to determine whether each of the performance obligations for the installation service, software updates and technical support are satisfied at a point in time or over time. The entity also assesses the nature of the entity’s promise to transfer the software licence in accordance with the standard.
Case B – Significant customisation
The goods and services outlined in this scenario are identical to those in Case A, with the exception that the contract stipulates significant customization of the software as part of the installation service, enabling it to interface with other customized software applications used by the customer. While other entities can provide this customized installation service, the entity assesses the promised goods and services to determine their distinctiveness.
Initially, the entity evaluates whether each promised good or service meets the criterion, as outlined in Case A. It determines that the software license, installation, software updates, and technical support all satisfy this criterion. Subsequently, the entity examines whether the criterion is met by assessing the principle and factors detailed in IFRS 15.
The entity notes that the contractual terms involve a commitment to provide a significant integration service by customizing the licensed software to integrate it into the existing software system, as specified in the contract. Essentially, the entity utilizes both the license and the customized installation service as inputs to deliver the combined output, which is a functional and integrated software system, as per the contract specifications. Since the service significantly modifies and customizes the software, the entity concludes that the promise to transfer the license cannot be distinguished separately from the customized installation service, thereby failing to meet the criterion in IFRS 15. Consequently, the software license and the customized installation service are not distinct.
Applying the same analysis as in Case A, the entity determines that the software updates and technical support remain distinct from the other promises outlined in the contract.
Based on this assessment, the entity identifies three performance obligations in the contract for the following goods or services:
- (a) software customization (which comprises the license for the software and the customized installation service);
- (b) software updates; and
- (c) technical support.
The entity determines whether each performance obligation is satisfied at a point in time or over time.
Case C – Promises are separately identifiable (installation)
An entity enters into an agreement with a customer to supply a piece of equipment along with installation services. The equipment is fully functional without any need for customization or alteration. The installation process required is straightforward and could be carried out by several other service providers. In the contract, the entity identifies two distinct promises: (a) providing the equipment, and (b) conducting the installation. To ascertain whether each promised good or service is distinct, the entity evaluates the criteria outlined in IFRS 15.
It concludes that both the equipment and the installation satisfy the criterion specified in IFRS 15(a). The customer can derive benefits from the equipment either independently by using it directly or by reselling it for a value greater than its scrap value. Additionally, the customer can benefit from the installation services either in conjunction with other readily available resources, such as installation services offered by alternative providers, or together with other resources obtained from the entity, namely the equipment.
The entity further determines that its promises to transfer the equipment and to provide the installation services are each separately identifiable (in accordance with IFRS 15(b)). The entity considers the principle and the factors in IFRS 15:29 in determining that the equipment and the installation services are not inputs to a combined item in this contract. In this case, each of the factors in IFRS 15:29 contributes to, but is not individually determinative of, the conclusion that the equipment and the installation services are separately identifiable as follows:
- (a) The entity is not providing a significant integration service. That is, the entity has promised to deliver the equipment and then install it; the entity would be able to fulfil its promise to transfer the equipment separately from its promise to subsequently install it. The entity has not promised to combine the equipment and the installation services in a way that would transform them into a combined output.
- (b) The entity’s installation services will not significantly customize or significantly modify the equipment.
- (c) Although the customer can benefit from the installation services only after it has obtained control of the equipment, the installation services do not significantly affect the equipment because the entity would be able to fulfil its promise to transfer the equipment independently of its promise to provide the installation services. Because the equipment and the installation services do not each significantly affect the other, they are not highly interdependent or highly interrelated.
On the basis of this assessment, the entity identifies two performance obligations in the contract for the following goods or services:
- (i) the equipment; and
- (ii) installation services.
The entity applies IFRS 15 to determine whether each performance obligation is satisfied at a point in time or over time.
Case D – Promises are separately identifiable (contractual restrictions)
Assuming the same scenario as in Case C, with the additional stipulation that the customer is obligated by contract to utilize the entity’s installation services.
The contractual mandate for the customer to utilize the entity’s installation services does not alter the assessment of whether the promised goods and services are distinct. This is because the requirement to use the entity’s installation services does not modify the inherent characteristics of the goods or services, nor does it alter the entity’s commitments to the customer.
Despite the customer’s obligation to employ the entity’s installation services, both the equipment and the installation services remain capable of being distinct, and the entity’s pledges to provide the equipment and the installation services are individually identifiable (i.e., they each meet the criterion specified in IFRS 15. The entity’s evaluation in this respect aligns with that of Case C.
Case E – Promises are separately identifiable (consumables)
An entity engages in a contract with a customer to supply off-the-shelf equipment, operational without significant customization, and specialized consumables for use with the equipment at specified intervals over the next three years. While the consumables are exclusively produced by the entity, they are separately sold by the entity as well.
The entity determines that the customer can benefit from both the equipment and the readily available consumables. The consumables are deemed readily available as they are routinely sold separately by the entity (e.g., through refill orders to prior equipment purchasers). Thus, the customer can derive benefits from the consumables alongside the initially transferred equipment. Therefore, both the equipment and the consumables are individually capable of being distinct in accordance with IFRS 15.
Furthermore, the entity concludes that its commitments to provide the equipment and the consumables over the three-year duration are separately identifiable according to IFRS 15. It assesses that the equipment and the consumables are not inputs to a combined item in the contract. This decision is based on the entity not providing a significant integration service to merge the equipment and consumables into a unified output. Additionally, neither the equipment nor the consumables undergo significant customization or modification due to the other. Lastly, the entity determines that the equipment and consumables are not highly interdependent or interrelated as they do not significantly impact each other. Although the consumables’ benefits are realized only after acquiring control of the equipment and are essential for the equipment’s operation, each does not have a significant effect on the other. The entity could fulfill its obligations independently, meaning it could supply the equipment even if the customer did not purchase consumables and provide consumables even if the customer obtained the equipment separately.
On the basis of this assessment, the entity identifies two performance obligations in the contract for the following goods or services:
(a) the equipment; and
(b) the consumables.
The entity applies IFRS 15 to determine whether each performance obligation is satisfied at a point in time or over time.
Determining whether equipment and installation services are capable of being distinct
An entity might engage in a contract with a customer wherein it agrees to furnish equipment to the customer and offer installation services for that equipment, with the entity being the exclusive provider of those installation services. Although the installation service is exclusively available from the entity, it doesn’t automatically lead to the conclusion that the installation service satisfies the criteria outlined in IFRS 15 (i.e., the good or service is capable of being distinct).
While the absence of alternative providers for a good or service is a consideration for the entity in determining if the good or service is distinct under IFRS 15, it is not the sole determinant. This point is exemplified in Case C and Case E of the examples provided. These cases establish that the ‘readily available’ criterion in IFRS 15 can be met when goods or services are obtainable from other providers or exclusively from the entity itself.
IFRS 15 defines a readily available resource as a good or service that is “sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity.” Therefore, even if a good or service is solely available from a specific entity, it still meets the criterion in IFRS 15 if that good or service is either sold separately by the entity or has already been obtained by the customer.
Entities must exercise judgment in determining whether a promise to provide a good or service, alongside other goods or services, is capable of being distinct in line with IFRS 15. They should also consider the second criterion in IFRS 15, i.e., whether the goods or services are distinct within the context of the contract.
No exemption from accounting for goods or services considered to be perfunctory or inconsequential
An entity may engage in a contract where it commits to providing Product A and Item B to a customer. Both Product A and Item B meet the criteria outlined in IFRS 15 to be considered distinct, and they do not satisfy the conditions specified in IFRS 15 (indicating they do not form a series of substantially similar distinct goods or services with a consistent transfer pattern to the customer).
Item B could represent a substantive promise within the agreement, such as free maintenance for Product A over a two-year period, or it could be inconsequential, such as participation in a joint committee, delivery of an installation or training manual, a straightforward installation process involving only unpacking and plugging in, or a basic inspection service.
All goods or services pledged to a customer under a contract trigger performance obligation, as they are integral to the negotiated exchange between the entity and its customer. Despite the entity possibly perceiving some of these goods or services as promotional incentives or minor aspects, they are goods or services for which the customer incurs costs, necessitating allocation of consideration for revenue recognition purposes if they fulfill the performance obligation criteria.
Even if Item B is considered trivial or insignificant, it cannot be disregarded. Instead, the entity must evaluate whether the performance obligation is immaterial to its financial statements, as outlined in IAS 8.
Example
Goods and services are not distinct
Case A – Significant integration service
An entity, acting as a contractor, engages in a contract to construct a hospital for a customer. The entity assumes overall project management responsibilities and identifies various goods and services to be provided, encompassing engineering, site preparation, foundation laying, procurement, structural construction, plumbing and electrical work, equipment installation, and finishing tasks.
Each of the promised goods and services is capable of standing alone, as per IFRS 15(a). The customer can derive benefit from these goods and services either independently or in conjunction with other readily available resources. This is evident from the entity’s regular practice, or that of its competitors, of selling many of these goods and services separately to other customers. Moreover, the customer could potentially gain economic value from each individual good or service by using, consuming, selling, or retaining them.
However, despite the distinct capability of the goods and services, they are not separately identifiable in line with IFRS 15(b), based on the factors outlined in IFRS 15:29. This is because the entity delivers a significant integration service, amalgamating the various goods and services (inputs) into the hospital structure (the combined output) specified in the contract.
Given that neither of the criteria outlined in IFRS 15 is met, the goods and services are not considered distinct. Consequently, the entity accounts for all the goods and services under the contract as a single performance obligation.
Case B – Significant integration service
The entity engages in a contract with a customer that entails the delivery of numerous units of a sophisticated and customised device. Per the contract terms, the entity must establish a manufacturing process tailored to produce the specified units. These units are uniquely designed based on the customer’s proprietary specifications, which were developed under a separate agreement not associated with the current transaction. Managing the entire contract falls under the entity’s responsibility, necessitating the coordination and execution of various tasks such as material procurement, subcontractor oversight, and manufacturing, assembly, and testing activities.
Upon evaluating the contract commitments, the entity determines that each individual device is capable of standing alone, as the customer can derive benefits from each unit independently, given its standalone functionality.
However, the entity recognizes that its core commitment lies in providing a service encompassing the production of all contracted devices to meet the customer’s specifications. Acting as the overall project manager, the entity integrates diverse goods and services into its overarching service, culminating in the delivery of the specified devices. Consequently, the devices and the myriad goods and services involved in their production are not distinctly identifiable, as they are inherently interconnected and interdependent due to the entity’s substantial integration service. Any alteration in one aspect of the entity’s activities significantly impacts the other facets involved in fabricating the complex, specialised devices. Given this high degree of interdependence, the criteria for distinctiveness are not met, and thus, the goods and services promised in the contract are treated as a single performance obligation.
Identifying separate performance obligations – legal restrictions – example
Entity A, a pharmaceutical firm, provides Customer B with an exclusive and non-transferable license to manufacture and market Drug X within a specified geographical area. Additionally, Entity A supplies Customer B with the primary active ingredient necessary for Drug X production. Due to patent protection, Customer B is compelled to procure the active ingredient solely from Entity A, as Entity A is the exclusive supplier and does not routinely sell the active ingredient to other clients without similar license agreements. Customer B is obligated to remit a fixed fee for each unit of Drug X sold to its end consumers, covering both the licensing royalties and the active ingredient’s cost.
The licensing arrangement and the supply agreement constitute a singular performance obligation. Customer B cannot leverage the license for Drug X production and marketing without access to the active ingredient supply. Since Entity A is the sole source from which Customer B can obtain the active ingredient, there are no alternative resources readily accessible for Customer B to benefit from the license. Thus, the requirement outlined in IFRS 15(a) is not fulfilled. Consequently, the license and supply agreement are not distinct and are treated as a unified performance obligation under IFRS 15.
Assessing whether a warranty is a separate performance obligation
As deliberated even if a customer lacks the choice to acquire a warranty independently, the warranty constitutes a distinct performance obligation if it offers the customer a service beyond the entity’s assurance that the goods or services provided will operate as intended or adhere to agreed specifications.
Example
Warranties
An entity, functioning as a manufacturer, offers its customers a warranty along with the purchase of a product. This warranty ensures that the product meets specified requirements and will function as promised for one year from the date of purchase. Additionally, the contract grants the customer the right to receive up to 20 hours of training services on operating the product at no extra cost.
The entity evaluates the goods and services outlined in the contract to determine if they are distinct and thus constitute separate performance obligations. Both the product and training services are deemed capable of being distinct, as per IFRS 15(a) & 28, since customers can benefit from the product independently of the training services and can also derive benefits from the training services in conjunction with the product, which is regularly sold separately.
Next, the entity assesses whether its promises to provide the product and training services are separately identifiable, as required by IFRS 15(b) and 29. It finds that there’s no significant integration service involved in combining the training services with the product, nor do they significantly modify or customize each other. Furthermore, they are not highly interdependent or interrelated, as the entity can fulfill its promise to provide the product independently of later providing the training services.
Consequently, the entity concludes that its commitments to provide the product and training services are distinct and separately identifiable, giving rise to two distinct performance obligations.
Finally, the entity examines the promise to offer a warranty and determines that it merely assures the customer that the product will function as intended for one year. According to IFRS 15:B28 to B33, this warranty does not provide any additional goods or services beyond this assurance. Therefore, the entity does not treat it as a performance obligation and accounts for it according to the guidelines in IAS 37.
As a result of this assessment, the entity allocates the transaction price between the two performance obligations (product and training services) and recognizes revenue as each obligation is fulfilled
Assurance-type warranty accounted for under IAS 37 – example
In accordance with customary business practices, a luggage manufacturer provides all customers with a non-optional one-year warranty that covers only manufacturing defects.
This warranty does not represent a separate performance obligation; it only provides assurance that the luggage will function as intended because it complies with agreed-upon specifications. This is an ‘assurance-type’ warranty which should be accounted for under IAS 37. No portion of the transaction price is allocated to the warranty.