Step Four – Allocating the transaction price (variable consideration) to performance obligations when recognising revenue

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.

What is ‘variable consideration’?

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

How is variable consideration allocated to performance obligations?

Variable consideration may be attributable either to:

  • The entire contract, or
  • Specific part(s) of the contract.

If allocating to specific part(s) of a contract, variable consideration may be attributed to:

  • One or more, but not all, performance obligations. For example, a bonus may be contingent on the vendor transferring a good or service within a specified period of time
  • One or more, but not all, distinct goods or services promised in a series of distinct goods or services that forms part of a single performance obligation. This would apply if, for example, the consideration promised for the second year of a two-year maintenance service contract will increase based on movements in CPI.

When is variable consideration allocated to a single performance obligation?

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:

  • The terms of a variable payment relate specifically to the vendor’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
  • The allocation of the variable amount in its entirety to a performance obligation or distinct good or service is consistent with the objective that the selling price is allocated to each performance obligation in order to reflect the consideration to which the vendor expects to be entitled in exchange for the good or service.

Example one (Based on IFRS 15 Illustrative Example 35 – Case A)

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:

  • Licence X
$800
  • Licence Y        
$1,000.

The prices specified in the contract are as follows:

  • Licence X        
$800 (fixed amount)
  • Licence Y                 
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.

Allocation of transaction price to Licence X and Y

ABC Limited then determines the allocation of the transaction price to each of the two licences and concludes that it should be as follows:

  • Licence X - $800
  • Licence Y - The variable royalty payment.

The transaction price is allocated as noted above because both of the following conditions apply (IFRS 15, paragraph 85):

  • The variable payment relates solely to the transfer of Licence Y (the subsequent royalty payments), and
  • The fixed amount of consideration for Licence X, and the estimated amount of sales-based royalties for Licence Y, are equivalent to their stand-alone selling prices (i.e. consistent with the allocation objective in IFRS 15, paragraph 73).

In contrast, the allocation of variable consideration will be different if the prices included in a contract do not reflect stand-alone selling prices.

Timing of revenue recognition

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).

Example two (Based on IFRS 15 Illustrative Example 35 – Case B)

Assume the same facts as for Example one above, except that the prices included in the contract are:

  • Licence X
$300 (fixed amount)
  • Licence Y
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.

Allocation of transaction price to Licence X and Y

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:

  1. Performance obligation satisfied at inception of contract
  2. Performance obligation satisfied three months after inception of contract