Step Four - Allocating the transaction price 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:

Since then we have included a number of articles on IFRS 15 in Accounting News:

• In the May and June 2018 editions we examined the first step of the five step process in greater depth
• In the July and September 2018 editions we looked at the complexities of the second step of the five step process
• In the November 2018, February 2019, March 2019 and May 2019 editions we looked at the third step of the five step process. 

In this article, we examine Step four of the IFRS 15 five-step model.

What is step four?

When a contract with a customer contains more than one performance obligation, Step four of the five-step IFRS 15 model requires the entity to allocate the transaction price (determined in Step three) to the performance obligations (identified in Step two) on the basis of relative stand-alone selling price.

What is the stand-alone selling price?

The stand-alone selling price may be, but is not always, the price stated on a price list or the price stated in a contract. This is because vendors may grant discounts on list prices, or may not sell the distinct good or services separately from other goods or services.

What if the stand-alone selling price is not available?

If stand-alone selling price is not available, the entity must estimate the stand-alone selling price by using an approach that maximises the use of observable inputs and must apply estimation methods consistently in similar circumstances.

Suitable methods for estimating the stand-alone selling price of a good or service include (but are not limited to) the following:

Adjusted market assessment approach

The adjusted market assessment approach involves the entity evaluating the market in which it sells goods or services, and estimating the price that a customer in that market would be willing to pay for those goods or services. This might also include referring to prices from the entity’s competitors for similar goods or services, and adjusting those prices as necessary to reflect the entity’s costs and margins.

Expected cost plus a margin approach

Using the expected cost plus margin approach, the entity estimates the costs of satisfying the performance obligation, and then adds an appropriate margin.

Residual approach

The residual approach involves the entity:

• Estimating the stand-alone selling price by reference to the total transaction price, and then deducting
• The sum of the observable stand-alone selling prices of other goods or services promised in the contract.

An entity may only use the residual approach if one of the following criteria is met:

• The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (i.e. the selling price is highly variable because a representative stand-alone selling price is not discernible from past transactions or other observable evidence), or
• The entity has not yet established a price for that good or service and the good or service has not previously been sold on a stand-alone basis (i.e. the selling price is uncertain).

In some circumstances, a combination of methods is used to estimate the stand-alone selling prices of the goods or services promised in the contract if two or more of those goods or services have highly variable or uncertain stand-alone selling prices.  For example, an entity may:

1. Use a residual approach to estimate the aggregate stand-alone selling price for those promised goods or services with highly variable or uncertain stand-alone selling prices, and then
2. Use another method to estimate the stand-alone selling prices of the individual goods or services relative to that estimated aggregate stand-alone selling price.

Allocation of discounts

Where a customer receives a discount for purchasing a bundle of goods or services, the entity must allocate the discount proportionately to all performance obligations in the contract (which means that it is allocating the transaction price on the basis of the relative stand-alone selling prices).

However, if there is observable evidence that the entire discount relates to only one or more, but not all, performance obligations in a contract, the discount is allocated to those performance obligations.

EXAMPLE ONE (Based on IFRS 15 Illustrative Example 33)

Company A sells products X, Y and Z for the following stand-alone prices:

• Product X - $50
• Product Y - $25
• Product Z - $75.

Company A enters into a contract with a customer to sell one of each of products X, Y and Z for $100 in total.

The performance obligations for each of the products will be satisfied at different times.  The revenue recognised on the sale of each of the products is calculated as follows:

Note that the formula used to calculate revenue recognised in each calculation in the table above is:

EXAMPLE TWO Based on IFRS 15 Illustrative Example 34 – Case A)

Company B sells products U, V and W for the following stand-alone prices:

• Product U - $40
• Product V - $55
• Product W - $45.

In addition, Company B regularly sells products V and W together for $60.

Company B enters into a contract with a customer to sell one of each of products U, V and W for $100. The performance obligations for each of the products will be satisfied at different times. 

The standalone selling price for all three products is $140 ($40 + $55 + $45). 

As noted in Example one above, the entire discount of $40 would ordinarily be allocated to Products U, V and W based on their relative stand-alone selling prices. However, because Company B regularly sells Products V and W together for $60 and Product U for $40, it has evidence that the entire discount should be allocated to the promises to transfer Products V and W.

The revenue recognised on the sale of each of the products is calculated as follows:

Note that the formula used to calculate revenue recognised for Products V and W in the table above is:

EXAMPLE THREE (Based on IFRS 15 Illustrative Example 34 – Case B)

Company C sells products Q, R and S for the following stand-alone prices:

• Product Q - $40
• Product R - $55
• Product S - $45.

In addition, Company C regularly sells products R and S together for $60.

Company C also sells Product X, but it stand-alone selling price varies between $15 and $45, depending on which customer it is being sold to. 

Company C enters into a contract with a customer to sell one of each of products Q, R, S and X for $130. The performance obligations for each of the products will be satisfied at different times. 

Because Company C regularly sells Products R and S together for $60 and Product Q for $40, as illustrated in Example two above, it has evidence that $100 should be allocated to those three products (with $40 to be allocated to Product Q and $60 to be allocated to Products R and S on the basis of their stand-alone selling prices). 

Using the residual approach, Company C would then allocate $30 to Product X.  In this instance, the use of the residual approach is appropriate because Company C sells Product X to different customers for a broad range of amounts and because the residual amount of $30 is within the range of observable selling prices for Product X.

The revenue recognised on the sale of each of the products is calculated as follows:

Note that the formula used in the calculations of revenue for Products R and S in the table above is:

Concluding Thoughts

Where performance obligations in a contract with a customer are satisfied at different points in time, allocation of the transaction amount to each performance obligation has the potential to be tricky, particularly where a discount has been provided in relation to a bundle of goods and/or services.  As with all aspects of accounting for revenue under IFRS 15, finance teams will need to understand the contracts that sales teams enter into to ensure that the timing of revenue recognition reflects the terms and conditions of those contracts.