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|
In the May and June 2018 editions we examined the first step of that five- step process in greater depth, and in the July and September 2018 editions we looked at the complexities of the second step. In this article, we look at the difficulties associated with the third step of the five step model.
Step three of the five-step IFRS 15 model requires the entity to determine the transaction price, which IFRS 15 defines as the ‘amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties’.
The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. When determining the transaction price, the entity needs to consider the effects of all of the following:
The amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties and other similar items. In addition, the promised consideration can vary if an entity’s entitlement to the consideration is contingent on the occurrence or non-occurrence of a future event (for example, an amount of consideration would be variable if either a product was sold with a right of return, or a fixed amount was promised as a performance bonus on achievement of a specified milestone).
The entity must estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:
IFRS 15 imposes a ‘reversal constraint’ on the amount of variable consideration which can be recognised. Variable consideration can be included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
In determining the transaction price, the entity must adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. The table below outlines the impact of a significant financing component:
|If the payment is…||That in effect means…||Which results in…|
|In arrears||The vendor is providing finance to its customer||Finance income and a reduction in revenue|
|In advance||The vendor is borrowing funds from its customer||Finance expense and increased revenue|
As a practical expedient, the entity does not need to adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer, and when the customer pays for that good or service, will be one year or less.
Where the transaction price includes non-cash consideration, the entity must measure that non-cash consideration at fair value. If the fair value of the non-cash consideration cannot be reasonably estimated, the entity must measure it indirectly, by reference to the stand-alone selling price of the goods or services promised to the customer in exchange for the consideration.
Consideration payable to a customer includes:
Consideration payable to a customer is generally accounted for as a reduction of the transaction price and, therefore, of revenue. However, occasionally these may be accounted for as a separate transaction (and not a reduction in revenue) if the vendor is acquiring distinct goods and services from the customer.
In many instances, determining the transaction price in a contract with a customer is a relatively straightforward process. However, where part of the transaction price is variable and subject to the ‘reversal constraint’, or contracts include significant financing components, non-cash consideration or consideration payable to customers, finance teams will need to apply considerable professional judgement in determining the transaction price, and these judgements could significantly impact the timing of revenue recognition.