In the April 2018 edition of Accounting News, we discussed the five-step model for revenue recognition introduced by IFRS 15 Revenue from Contracts with Customers:
Step 1 | Identify the contract(s) with the customer | |
Step 2 | Identify the performance obligations in the contract | |
Step 3 | Determine the transaction price | |
Step 4 | Allocate the transaction price to the performance obligations | |
Step 5 | Recognise revenue when a performance obligation is satisfied |
Since then we have included a number of articles on IFRS 15 in Accounting News that cover various issues from the five-step process in greater depth:
Step | Accounting News edition… | |
1 | Identify the contract(s) with the customer | May and June 2018 |
2 | Identify the performance obligations in the contract | July and September 2018 |
3 | Determine the transaction price | November 2018, February 2019, March 2019 and May 2019 |
4 | Allocate the transaction price to the performance obligations | June 2019 |
5 | Recognise revenue when a performance obligation is satisfied |
In our June 2019 Accounting News article we demonstrated how the transaction price, including discounts, is allocated to separate performance obligations. In this article, we continue our examination of Step four and show how variable consideration is allocated to performance obligations.
Variable consideration is consideration that is not fixed. It is estimated in Step three and includes items such as discounts, rebates, refunds, credits, price concessions, etc., as well as amounts that are contingent.
An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items. The promised consideration can also vary if an entity’s entitlement to the consideration is contingent on the occurrence or non-occurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.
IFRS 15, paragraph 51
Variable consideration may be attributable either to:
If allocating to specific part(s) of a contract, variable consideration may be attributed to:
A variable amount of consideration (and subsequent changes to that amount) is allocated entirely to a single performance obligation (or a distinct good or service that forms part of a single performance obligation to transfer a series of distinct goods or services that are substantially the same) if both:
ABC Limited enters into a contract with a customer for two licences of intellectual property (Licences X and Y).
Assume each licence represents a separate performance obligation, which is satisfied at a point in time (the transfer of each licence to the customer). Licence Y is transferred to the customer at inception and Licence X three months later.
The stand-alone selling prices of the licences are:
| $800 |
| $1,000. |
The prices specified in the contract are as follows:
| $800 (fixed amount) |
| Royalty payment of 3% of the selling price of the customer’s future sales of products that use the intellectual property to which Licence Y relates. |
ABC Limited estimates that the amount of sales-based royalties that it will be entitled to in respect of Licence Y (variable consideration) will be approximately $1,000.
ABC Limited then determines the allocation of the transaction price to each of the two licences and concludes that it should be as follows:
The transaction price is allocated as noted above because both of the following conditions apply (IFRS 15, paragraph 85):
In contrast, the allocation of variable consideration will be different if the prices included in a contract do not reflect stand-alone selling prices.
ABC Limited recognises revenue for Licences X and Y as follows:
Licence | When revenue recognised? |
X | On transfer to customer (three months after contract inception) |
Y | When subsequent sales of the customer’s products that use Licence Y take place (IFRS 15, paragraph B63). |
Assume the same facts as for Example one above, except that the prices included in the contract are:
| $300 (fixed amount) |
| Royalty payment of 5% of the selling price of the customer’s future sales of products that use the intellectual property to which Licence Y relates. |
ABC Limited estimates that the amount of sales-based royalties that it will be entitled to in respect of Licence Y will be approximately $1,500.
Licence Y is transferred to the customer at inception and Licence X is transferred three months later.
In this case, although the variable payments relate solely to the transfer of Licence Y (the subsequent royalty payments), allocating the variable consideration only to Licence Y would be inappropriate. This is because allocating $300 to Licence X and $1,500 to Licence Y would not reflect a reasonable allocation based on the stand-alone selling prices of those two licences (i.e. $800 for Licence X and $1,000 for Licence Y).
Fixed consideration
Instead, the fixed amount receivable in respect of Licence X is allocated to the two licences on the basis of their stand-alone selling prices. This allocation is calculated as:
Licence | Allocation of fixed revenue ($300) | |
X | $133 | (800 / 1800) x $300 |
Y | $167 | (1,000 / 1,800) x $300 |
$300 |
ABC Limited then recognises fixed revenue for Licences X and Y as follows:
Licence | When revenue recognised? | How much? |
X | On transfer to customer (three months after inception of contract) | $133 |
Y | On transfer to customer (at inception of contract) | $167 |
$300 |
Sales-based royalties
Recognition of the royalty income allocated to each of the two licences will be deferred to future periods because IFRS 15 requires that royalty income is only recognised when the related product sales take place (IFRS 15, paragraph B63).
In contrast to Example one above, ABC Limited allocates royalty income from Licence Y to Licences X and Y on a relative stand-alone selling price basis.
Although the royalty income relates solely to the transfer of Licence Y, the allocation of the fixed selling price of Licence X, and the estimate of sales-based royalties to be generated by Licence Y, is disproportionate in comparison with the stand-alone selling prices of the two licences, i.e. there was pricing interdependency. This means that some of the royalty income to be generated by Licence Y in fact relates to the sale of Licence X, and some of the licence fee specified in the legal contract as relating solely to Licence X relates in part to the sale of Licence Y.
Assume that in the first month, royalties due from the customer’s first month of sales is $200.
Licence | Allocation of royalties – Month 1 ($200) | |
X | $89 | (800 / 1800) x $200 |
Y | $111 | (1,000 / 1,800) x $200 |
$200 |
ABC Limited then recognises royalty revenue for Licence Y as follows:
Licence | When revenue recognised? | How much? |
X | On transfer to customer (three months after inception of contract) | $89 |
Y | At the end of Month 1 | $111 |
$200 |
The journal entry to record the royalties in Month 1 is:
Dr ($) | Cr ($) | |
Receivable | 200 | |
Revenue - Licence Y1 | 111 | |
Contract liability – Licence X2 | 189 |
Notes: