Article:

IFRS 15 for the TMT industries – Contracts that have variable consideration

27 June 2018

The amount of consideration specified in a TMT contract may be fixed, variable, or a combination of fixed and variable amounts.

Contracts often contain clauses which can give rise to variations in the amount of consideration receivable by the vendor.  For example, for a media company, a bonus payment might be receivable if a production or advertisement has been completed before a specified date, with penalties being deducted from the sales price if completion is late. These clauses give rise to what IFRS 15 calls ‘variable consideration’. 

When consideration is variable, IFRS 15 limits the amount that can be recognised.  This means that revenue is prevented from being recognised unless it is highly probable that there will be no subsequent reversal in the amount recognised (for example, because the criteria that were expected to be met for a bonus payment are not, in fact, satisfied).  This may result in later recognition of revenue and profit in comparison with current accounting. There is no specific guidance on what ‘highly probable’ is but this is generally thought to be around 75-80%.

The vendor estimates the amount of variable consideration to which it is entitled to in exchange for the transfer of the promised goods or services by using one of two possible estimation methods, namely the ‘expected value method’ or the ‘most likely amount’. Once a method has been selected, it must be applied consistently throughout the term of each contract.

Expected value method

The expected value is the sum of the probability-weighted amounts in a range of possible consideration amounts. This may be an appropriate approach if the vendor has a large number of contracts which have similar characteristics.

Most likely amount

The most likely amount is the single most likely amount in a range of possible consideration amounts (i.e. the single most likely outcome of the contract). This may be an appropriate approach if a contract has two possible outcomes, such as a performance bonus which will, or will not, be received.

The approach which is chosen is not intended to be a free choice, with the approach chosen for each contract being the one which is expected to provide a better prediction of the amount of consideration to which a vendor expects to be entitled. In circumstances where there are a large number of similar contracts,  the ‘expected value’ over the portfolio is likely to be the appropriate method, but  when there are only two possible outcomes (for example, a bonus payment will or will not be received), the ‘most likely outcome’ method is likely to be appropriate.

Performance bonuses - Example (using expected value method)

Background

A customer engages Media Co. to assist with creating an advertising campaign for $1,000,000. If the promotion is finalised on time, Media Co. will receive a performance bonus of $100,000. This amount reduces by $10,000 for every week Media Co. is late.

Estimated completion date Probability
On time 25%
One week late 25%
Two weeks late 20%
Three weeks late 20%
Four weeks late 10%

Question
What is the transaction price?

Answer
We would use the expected value method in this example because using the most likely amount would violate the significant reversal principle (i.e. no one scenario is in excess of 75-80% and hence would most likely result in a reversal). Using the expected value method, we would use the probability-weighted expected consideration to calculate the expected revenue.

Estimated completion time   Probability-weighted consideration
$
On time 25% x ($1,000,000 + $100,000) 275,000
One week late 25% x ($1,000,000 + $90,000) 272,500
Two weeks late 20% x ($1,000,000 + $80,000) 216,000
Three weeks late 20% x ($1,000,000 + $70,000) 214,000
Four weeks late 10% x ($1,000,000 + $60,000) 106,000
  Total transaction price 1,083,500

Current practice under IAS 11/IAS 18

The common practice under IAS 11/IAS 18 would be to recognise revenue when it is probable it will be received; this often results in significant reversals. The new standard allows revenue recognition only when it is highly probable that there will not be a significant reversal in revenue.

Penalties - Example (using most likely outcome method)

Background

Software Co. enters into a contract to build a software application for $100,000. If the application is not completed on time, there will be a $20,000 penalty. Software Co. has built similar applications before and there is a 90% chance that the software will be completed on time.

Question
What is the transaction price?

Answer
There are only two possible solutions:

  • $100,000 if the application is completed on time, or
  • $80,000 if the application is not completed on time.

In this scenario the most likely amount method better predicts the amount of consideration. Therefore, the transaction price is $100,000. Selecting this amount would mean it is highly probable that there would not be a significant reversal in revenue because the historical compliance with the deadline is 90% (in excess of 75-80%).

Current practice under IAS 11/IAS 18

The current practice would be to account for the revenue as $100,000 and then $20,000 as an expense if it was incurred.

Practical implications on systems and processes 

Some of the practical implications on systems and processes for Media Co. and Software Co. Include:

  • Determining the probabilities of estimated completion dates tied to performance bonuses and penalties
  • Determining the probability of defects and warranties tied to penalties
  • Selecting the appropriate estimation method for calculating variable consideration.