Step 3 Determining Transaction Price

Step 3 Determining Transaction Price

– is all about correct revenue accounting in respect of the transaction price for the contract as part of IFRS 15 Revenue from contracts with customers. Step 3 Determining Transaction Price

IFRS 15 The revenue recognition standard provides a single comprehensive standard that applies to nearly all industries and has changed revenue recognition quite significant. Step 3 Determining Transaction Price

IFRS 15 introduced a five step process for recognising revenue, as follows:

1. Identify the contract with the customer
2. Identify the performance obligations in the contract
3. Determine the transaction price for the contract
4. Allocate the transaction price to each specific performance obligation
5. Recognise the revenue when the entity satisfies each performance obligation

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INTRO Step 3: Determine the transaction price – The ‘transaction price’ is the amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services to a customer, excluding amounts collected on behalf of third parties – e.g. some sales taxes. To determine this amount, an entity considers multiple factors. [IFRS 15.47]

An entity estimates the transaction price at contract inception, including any variable consideration, and updates the estimate each reporting period for any changes in circumstances. When determining the transaction price, an entity assumes that the goods or services will be transferred to the customer based on the terms of the existing contract, and does not take into consideration the possibility of a contract being cancelled, renewed, or modified. [IFRS 15.49]

In determining the transaction price, an entity considers the following components. [IFRS 15.48]

Variable consideration (and the constraint) An entity estimates the amount of variable consideration to which it expects to be entitled, giving consideration to the risk of revenue reversal in making the estimate	Transaction price	Significant financing component For contracts with a significant financing component, an entity adjusts the promised amount of consideration to reflect the time value of money
Non-cash consideration Non-cash consideration is measured at fair value, if it can be reasonably estimated; if not, an entity uses the stand-alone selling price of the good or service that was promised in exchange for non-cash consideration		Consideration payable to a customer An entity needs to determine whether consideration payable to a customer represents a reduction of the transaction price, a payment for a distinct good or service, or a combination of the two

Customer credit risk is not considered when determining the amount to which an entity expects to be entitled – instead, credit risk is considered when assessing the existence of a contract (see Step 1 Identify the contract with a customer in the link). However, if the contract includes a significant financing component provided to the customer, then the entity considers credit risk in determining the appropriate discount rate to use (see significant financing component below).

An exception exists to the variable consideration guidance for sales- or usage-based royalties arising from licenses of intellectual property (see sales- or usage-based royalties in the link). [IFRS 15.58, IFRS 15.B63]

1. Variable consideration and the constraint

Items such as discounts, rebates, refunds, rights of return, credits, price concessions, incentives, performance bonuses, penalties, or similar items may result in variable consideration. Promised consideration can also vary if it is contingent on the occurrence or non-occurrence of a future event. Variability may be explicit or implicit, arising from customary business practices, published policies or specific statements, or any other facts and circumstances that would create a valid expectation by the customer. [IFRS 15.51–52]

An entity assesses whether, and to what extent, it can include an amount of variable consideration in the transaction price at contract inception. The following decision tree sets out how an entity determines the amount of variable consideration in the transaction price, except for sales- or usage-based royalties from licenses of intellectual property (see sales- or usage-based royalties in the link). [IFRS 15.53, IFRS 15.56, IFRS 15.58]

Link from decision tree above – The expected value or most likely amount, see estimate the amount of variable consideration below

Link from decision tree above – Significant revenue reversal will not subsequently occur, see determine the amount for which it is highly probable that a significantly reversal will not occur (‘the constraint’) below

An entity recognizes a refund liability for consideration received or receivable if it expects to refund some or all of the consideration to the customer. [IFRS 15.55]

IFRS 15 applies the mechanics of estimating variable consideration in a variety of scenarios, some of which include fixed consideration – e.g. sales with a right of return (see sale with a right of return in the link) and customers’ unexercised rights (breakage), see customers’ unexercised rights (breakage) in the link.

Consideration can be deemed to be variable even if the price stated in the contract is fixed

[IFRS 15.BC190–BC194]

The guidance on variable consideration may apply to a wide variety of circumstances. The promised consideration may be variable if an entity’s customary business practices and relevant facts and circumstances indicate that the entity may accept a price lower than what is stated in the contract – i.e. the contract contains an implicit price concession, or the entity has a history of providing price concessions or price support to its customers.

In these cases, it may be difficult to determine whether the entity has implicitly offered a price concession, or whether it has chosen to accept the risk of default by the customer of the contractually agreed-upon consideration (customer credit risk). Entities need to exercise judgment and consider all of the relevant facts and circumstances in making this determination.

A fixed rate per unit of output may be variable consideration

When an entity enters into a contract with a customer for an undefined quantity of output at a fixed contractual rate per unit of output, the consideration may be variable. In some cases there may be substantive contractual terms that indicate a portion of the consideration is fixed – e.g. contractual minimums.

For contracts with undefined quantities, it is important to appropriately evaluate the entity’s underlying promise to determine how the variability created by the unknown quantity should be treated under IFRS 15. For example, the entity’s underlying promise could be a series of distinct goods or services (see series of distinct goods or services in the link), a stand-ready obligation, or an obligation to provide the specified goods or services. Unknown quantities could also represent customer options for which the entity will need to consider whether a material right exists (see customer options for additional goods or services in the link).

Variable consideration or optional purchases

Different outcomes and disclosure requirements can arise depending on whether an entity concludes that purchases of additional goods or services by a customer are exercises of customer options or variable consideration. Future purchases that are options will be evaluated to determine whether they include a material right. Future purchases that are variable consideration are included in the initial identification of performance obligations, and determination of the transaction price, and may lead to additional estimation and disclosure requirements.

Distinguishing between options and variable consideration will require significant judgment and will require entities to assess the nature of their promise to the customer and evaluate the presently enforceable rights and obligations of the parties to the arrangement.

• Options for additional goods or services: The customer has a present contractual right to purchase additional distinct goods or services. Each exercise of an option is a separate purchase decision and transfer of control of additional goods and services by the entity if the customer is not currently obligated under the contract to do so. Before the customer’s exercise of the option, the vendor is not obligated to provide those goods or services and does not have a right to receive consideration. The customer options need to be evaluated to determine whether they provide the customer with a material right.
• Variable consideration: The contract with the customer obligates the vendor to stand ready to transfer the promised goods or services, and the customer does not make a separate purchase decision for the additional goods or services to be provided by the vendor. The future event that results in additional consideration occurs as the performance obligation is being satisfied (i.e.when control of the goods or services is transferred to the customer).

Volume discounts or rebates may be variable consideration or may convey a material right

Different structures of discounts and rebates may have a different effect on the transaction price. For example, some agreements provide a discount or rebate that applies to all purchases made under the agreement – i.e. the discount or rebate applies on a retrospective basis once a volume threshold is met. In other cases, the discounted purchase price may only apply to future purchases once a minimum volume threshold has been met.

If a discount applies retrospectively to all purchases under the contract once the threshold is achieved, then the discount represents variable consideration. In this case, the entity estimates the volumes to be purchased and the resulting discount in determining the transaction price and updates that estimate throughout the term of the contract.

However, if a tiered pricing structure provides discounts for future purchases only after volume thresholds are met, then the entity evaluates the arrangement to determine whether the arrangement conveys a material right to the customer (see customer options for additional goods or services in the link). If a material right exists, then this is a separate performance obligation, to which the entity allocates a portion of the transaction price. If a material right does not exist, then there are no accounting implications for the transactions completed before the volume threshold is met, and purchases after the threshold has been met are accounted for at the discounted price.

A transaction price denominated in a foreign currency does not constitute variable consideration

When a contract is denominated in a foreign currency, changes in exchange rates may affect the amount of revenue recognized by an entity when it is measured in the entity’s functional currency. However, this does not constitute variable consideration for the purposes of applying IFRS 15 because the variability relates to the form of the consideration (i.e. the currency) and not to other factors. [IFRS 15.68]

Instead, an entity applies the guidance on foreign currency transactions and translation to assess whether and, if so, how to translate balances and transactions denominated in a foreign currency.

Liquidated damages may represent variable consideration or a product warranty

Many contracts contain terms providing for liquidated damages and similar compensation to the customer upon the occurrence or non-occurrence of certain events. These terms may represent variable consideration or a warranty. Judgment is required to determine the appropriate accounting. For further discussion, see warranties in the link. [IFRS 15.51]

1.1 Estimate the amount of variable consideration

When estimating the transaction price for a contract with variable consideration, an entity’s initial measurement objective is to determine which of the following methods best predicts the consideration to which the entity will be entitled. [IFRS 15.53]

Expected value	The entity considers the sum of probability-weighted amounts for a range of possible consideration amounts. This may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.
Most likely amount	The entity considers the single most likely amount from a range of possible consideration amounts. This may be an appropriate estimate of the amount of variable consideration if the contract has only two (or perhaps a few) possible outcomes.

The method selected is applied consistently throughout the contract and to similar types of contracts when estimating the effect of uncertainty on the amount of variable consideration to which the entity will be entitled. [IFRS 15.54, IFRS 15.BC195]

Worked example – Estimate of variable consideration – Expected value

Electronics Manufacturer M sells 1,000 televisions to Retailer R for 500,000 (500 per television). Electronics Manufacturer M provides price protection to Retailer R by agreeing to reimburse Retailer R for the difference between this price and the lowest price that it offers for that television during the following six months. Based on Electronics Manufacturer M’s extensive experience with similar arrangements, it estimates the following outcomes. Price reduction in next six months  Step 3 Determining Transaction Price Probability 0 Step 3 Determining Transaction Price Step 3 Determining Transaction Price 70% 50 Step 3 Determining Transaction Price Step 3 Determining Transaction Price 20% 100 Step 3 Determining Transaction Price Step 3 Determining Transaction Price 10% After considering all relevant facts and circumstances, Electronics Manufacturer M determines that the expected value method provides the best prediction of the amount of consideration to which it will be entitled. As a result, it estimates the transaction price to be 480 per television – i.e. (500 × 70%) + (450 × 20%) + (400 × 10%) – before considering the constraint (see term of the contract in the link).

Worked example – Estimate of variable consideration – Most likely amount

Construction Company C enters into a contract with Customer E to build an asset. Depending on when the asset is completed, Construction Company C will receive either 110,000 or 130,000. Outcome Step 3 Determining Transaction Price Step 3 Determining Transaction Price Consideration Probability Project completes on time Step 3 Determining Transaction Price Step 3 Determining Transaction Price 130,000 90% Project is delayed Step 3 Determining Transaction Price Step 3 Determining Transaction Price 110,000 10% Because there are only two possible outcomes under the contract, Construction Company C determines that using the most likely amount provides the best prediction of the amount of consideration to which it will be entitled. Construction Company C estimates the transaction price – before it considers the constraint (see determine the amount for which it is highly probable that a significantly reversal will not occur (‘the constraint’) below) – to be 130,000, which is the single most likely amount.

All facts and circumstances are considered when selecting estimation method

The use of a probability-weighted estimate, especially when there are binary outcomes, could result in revenue being recognized at an amount that is not a possible outcome under the contract. In such situations, using the most likely amount may be more appropriate. However, all facts and circumstances need to be considered when selecting the method that best predicts the amount of consideration to which an entity will be entitled. [IFRS 15.BC200]

Expected value method – No need to quantify less probable outcomes

The Boards believe that when using a probability-weighted method to estimate the transaction price, a limited number of discrete outcomes and probabilities can often provide a reasonable estimate of the distribution of possible outcomes, and that it may not be necessary for an entity to quantify all possible outcomes using complex models and techniques. [IFRS 15.BC201]

Expected value method – Estimated amount does not need to be a possible outcome for an individual contract

When an entity has a population of similar transactions, it may be appropriate to use this portfolio of data to estimate the transaction price for an individual contract using the expected value method. In this case, the transaction price may be an amount that is not a possible outcome for an individual contract but that is still representative of the expected transaction price.

It is important for an entity to have a sufficiently large number of similar transactions to conclude that the expected value method is the best estimate of the transaction price. Using a portfolio of data to assist in estimating the transaction price for a contract is not the same as applying the portfolio approach (see portfolio approach in the link).

An entity uses judgment to determine whether:

• its contracts with customers are sufficiently similar;
• the contracts with customers from which the expected value is derived are expected to remain consistent with subsequent contracts; and

the volume of similar contracts is sufficient to develop an expected value.

For example, if there are three possible outcomes for the transaction price, then the entity calculates an expected value as follows.

Outcome Step 3 Determining Transaction Price Step 3 Determining Transaction Price	Probability	Weighting
100,000 Step 3 Determining Transaction Price Step 3 Determining Transaction Price	30%	30,000
110,000 Step 3 Determining Transaction Price Step 3 Determining Transaction Price	45%	49,500
130,000 Step 3 Determining Transaction Price Step 3 Determining Transaction Price	25%	32,500
Expected value	100%	112,000

Although 112,000 is not a possible outcome, when the conditions are met, the expected value is appropriate because the entity is really estimating that 30% of the transactions will result in 100,000, 45% of the transactions will result

in 110,000 and 25% of the transactions will result in 130,000 which, in the aggregate, will be representative of the entity’s expectations of the price for each transaction.

A combination of methods may be appropriate

IFRS 15 requires an entity to use the same method to measure a given uncertainty throughout the contract. However, if a contract is subject to more than one uncertainty, then an entity determines an appropriate method for each uncertainty. This may result in an entity using a combination of expected values and most likely amounts within the same contract. [IFRS 15.BC202]

For example, a construction contract may state that the contract price will depend on:

• the price of a key material, such as steel – this uncertainty will result in a range of possible consideration amounts, depending on the price of steel; and
• a performance bonus if the contract is finished by a specified date – this uncertainty will result in two possible outcomes, depending on whether the target completion date is achieved.

In this case, the entity may conclude that it is appropriate to use an expected value method for the first uncertainty, and a most likely amount method for the second uncertainty.

Historical experience may be a source of evidence

An entity may use a group of similar transactions as a source of evidence when estimating variable consideration, particularly under the expected value method. The estimates using the expected value method are generally made at the contract level, not at the portfolio level. Using a group as a source of evidence in this way is not itself an application of the portfolio approach (see portfolio approach in the link). [IFRS 15.53, IFRS 15.56, IFRS 15.79(a), IFRS 15.BC200]

For example, an entity may enter into a large number of similar contracts whose terms include a performance bonus. Depending on the outcome of each contract, the entity will either receive a bonus of 100 or will not receive any bonus. Based on its historical experience, the entity expects to receive a bonus of 100 in 60 percent of such contracts. To estimate the transaction price for future individual contracts of this nature, the entity considers its historical experience and estimates that the expected value of the bonus is 60. This example illustrates that when an entity uses the expected value method, the transaction price may be an amount that is not a possible outcome of an individual contract.

The entity needs to use judgment to determine whether the number of similar transactions is sufficient to develop an expected value that is the best estimate of the transaction price for the contract and whether ‘the constraint’ (see determine the amount for which it is highly probable that a significantly reversal will not occur (‘the constraint’) below) should be applied.

1.2 Determine the amount for which it is highly probable that a significant reversal will not occur (‘the constraint’)

After estimating the variable consideration, an entity may include some or all of it in the transaction price – but only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue will not occur when the uncertainty associated with the variable consideration is subsequently resolved. [IFRS 15.56]

To assess whether – and to what extent – it should apply this ‘constraint’, an entity considers both the: [IFRS 15.57]

• likelihood of a revenue reversal arising from an uncertain future event; and
• potential magnitude of the revenue reversal when the uncertainty related to the variable consideration has been resolved.

In making this assessment, the entity uses judgment, giving consideration to all facts and circumstances – including the following factors, which could increase the likelihood or magnitude of a revenue reversal.

• The amount of consideration is highly susceptible to factors outside the entity’s influence – e.g. volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence.
• The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
• The entity’s experience with (or other evidence from) similar types of contracts is limited, or has limited predictive value.
• The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
• The contract has a large number and a broad range of possible consideration amounts.

This assessment needs to be updated at each reporting date.[IFRS 15.59]

An exception exists for sales- or usage-based royalties arising from licenses of intellectual property (see sales- or usage-based royalties in the link). [IFRS 15.58]

Worked example – Applying the constraint to an investment management contract

Investment Manager M enters into a two-year contract to provide investment management services to its customer Fund N, a non-registered investment partnership. Fund N’s investment objective is to invest in equity instruments issued by large listed companies. Investment Manager M receives the following fees payable in cash for providing the investment management services. Quarterly management fee 2% per quarter, calculated on the basis of the fair value of the net assets at the end of the most recent quarter Performance-based incentive fee 20% of the fund’s return in excess of an observable market index over the contract period Investment Manager M determines that the contract includes a single performance obligation (series of distinct services) that is satisfied over time, and identifies that both the management fee and the performance fee are variable consideration. Before including the estimates of consideration in the transaction price, Investment Manager M considers whether the constraint should be applied to either the management fee or the performance fee. At contract inception, Investment Manager M determines that the cumulative amount of consideration is constrained because the promised consideration for both the management fee and the performance fee is highly susceptible to factors outside its own influence. At each subsequent reporting date, Investment Manager M makes the following assessment of whether any portion of the consideration continues to be constrained. Quarterly management fee Investment Manager M determines that the cumulative amount of consideration from the management fee to which it is entitled is not constrained, because it is calculated based on asset values at the end of each quarter. Therefore, once the quarter finishes the consideration for the quarter is known, Investment Manager M determines that it can allocate the entire amount of the fee to the completed quarters, because the fee relates specifically to the service provided for those quarters. Performance-based incentive fee Investment Manager M determines that the full amount of the performance fee is constrained, and therefore excluded from the transaction price. This is because: the performance fee has a high variability of possible consideration amounts, and the magnitude of any downward adjustment could be significant; although Investment Manager M has experience with similar contracts, that experience is not predictive of the outcome of the current contract because the amount of the current contract because the amount of consideration is highly suspectible to volatility in the market based on the nature of the assets under management; and there are a large number of possible outcomes. As a result, Investment Manager M determines that the revenue recognized during the reporting period is limited to the quarterly management fees for completed quarters. This determination is made each reporting date and could change towards the end of the contract period.

Constraint assessment made against cumulative revenue

When constraining its estimate of variable consideration, an entity assesses the potential magnitude of a significant revenue reversal relative to the cumulative revenue recognized – i.e. for both variable and fixed consideration, rather than on a reversal of only the variable consideration. The assessment of magnitude is relative to the transaction price for the contract, rather than the amount allocated to the specific performance obligation.

Specified level of confidence included in constraint requirements

The inclusion of a specified level of confidence – ‘highly probable’ – clarifies the notion of whether an entity expects a significant revenue reversal. The use of existing defined terms should improve consistency in application between preparers, and reduce concerns about how regulators and users will interpret the requirement. This is an area of significant judgment, and entities will need to align their judgmental thresholds, processes, and internal controls with these new requirements. Documenting these judgments will also be critical. [IFRS 15.BC209]

Constraint introduces an element of prudence

The constraint introduces a downward bias into estimates, requiring entities to exercise prudence before they recognize revenue – i.e. they have to make a non-neutral estimate. This exception to the revenue recognition model, and to the Boards’ respective conceptual frameworks’ requirement to make neutral estimates, reflects the particular sensitivity with which revenue reversals are viewed by many users and regulators. [IFRS 15.BC207]

3. Significant financing component

To estimate the transaction price in a contract, an entity adjusts the promised amount of consideration for the time value of money if that contract contains a significant financing component. [IFRS 15.60]

The objective when adjusting the promised amount of consideration for a significant financing component is to recognize revenue at an amount that reflects what the cash selling price of the promised good or service would have been if the customer had paid cash at the same time as control of that good or service transferred to the customer. The discount rate used is the rate that would be reflected in a separate financing transaction between the entity and the customer at contract inception. [IFRS 15.61]

To make this assessment, an entity considers all relevant factors – in particular the:

• difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services;
• combined effect of the expected length of time between the entity transferring the promised goods or services to the customer and the customer paying for those goods or services; and
• prevailing interest rates in the relevant market.

A contract does not have a significant financing component if any of the following contractual or (non-contractual) customary business practice exists. [IFRS 15.62]

Contractual or (non-contractual) customary business practice	Example
An entity receives an advance payment, and the timing of the transfer of goods or services to a customer is at the discretion of the customer	A prepaid phone card or customer loyalty points
A substantial portion of the consideration is variable, and the amount or timing of the consideration is outside the customer’s or entity’s control Step 3 Determining Transaction Price Step 3 Determining Transaction Price	A transaction whose consideration is a sales- based royalty
The difference between the amount of promised consideration and the cash selling price of the promised goods or services arises for non-finance reasons Step 3 Determining Transaction Price Step 3 Determining Transaction Price	Protection against the counterparty not completing its obligations under the contract

IFRS 15 indicates that:

• an entity should determine the discount rate at contract inception, reflecting the credit characteristics of the party receiving credit; and
• the discount rate should not generally be updated for a change in circumstances. [IFRS 15.64]

As a practical expedient, an entity is not required to adjust the transaction price for the effects of a significant financing component if, at contract inception, the entity expects the period between customer payment and the transfer of goods or services to be one year or less. [IFRS 15.63]

For contracts with an overall duration greater than one year, the practical expedient applies if the period between performance and payment for that performance is one year or less.

The financing component is recognized as interest expense (when the customer pays in advance) or interest income (when the customer pays in arrears), and is presented separately from revenue from customers. [IFRS 15.65]

Worked example – Time value of money in a multiple-element arrangement

Product Company B enters into a contract with Customer C to deliver Product X and Product Y for 150,000 payable up-front. Product X will be delivered in two years and Product Y will be delivered in five years. Product Company B determines that the contract contains two performance obligations that are satisfied at the points in time at which the products are delivered to Customer C. Product Company B allocates the 150,000 to Products X and Y at an amount of 37,500 and 112,500 respectively – i.e. based on their relative stand-alone selling prices. Product Company B concludes that the contract contains a significant financing component and that a financing rate of 6% is appropriate based on Product Company B’s credit-standing at contract inception. Product Company B accounts for the contract as follows. Contract inception Recognize a contract liability for the payment of 150,000 Years 1 and 2 Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price During the two years from contract inception until the transfer of Product X, recognize interest expense of 9,000 and 9,540(a) on 150,000 at 6% for Years 1 and 2, respectively, for a cumulative interest expense of 18,540 Recognize revenue of 42,135(b) for the transfer of Product X Years 3, 4 and 5 Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Recognize annual interest expense of 7,584, 8,039, 8,522(c) for Years 3, 4, and 5, respectively, based on the contract liability at the beginning of Year 3 of 126,405(d) Recognize revenue of 150,550(e) for the transfer of Product Y Notes (a) Calculated as 150,000 ×.06 for Year 1 and 159.000 x.06 for Year 2. (b) Calculated as 37,500 + 4,635, being the initial allocation to Product X plus Product X’s portion of the interest for Years 1 and 2 of the contract (37,500 ÷ 150,000 x 18,540). (c) Calculated as 126,405 ×.06 = 7,584; (126,405 + 7,584) x.06 = 8,039; and (126,405 + 7,584 + 8,039) x.06 = 8,522. (d) Calculated as 150,000 + 18,540 – 42,135, being the initial contract liability plus interest for two years less the amount derecognized from the transfer of Product X. (e) Calculated as 126,405 + 24,145, being the contract liability balance after two years plus interest for three years.

Worked example – Determining whether an arrangement has a significant financing component – Payment in advance

Technology Company T signs a three-year, non-cancellable agreement with Customer C to provide hosting services. Customer C may elect to either pay: 140 per month (total payment is 5,040); or 4,200 at the beginning of the contract term, with no additional monthly payments. The contract includes a financing component. The difference in pricing between option (a) and option (b) indicates that the contractual payment terms under option (b) have the primary purpose of providing Technology Company T with financing. The cash-selling price is the monthly fee of 140 because it reflects the amount due when the monthly hosting services are provided to Customer C. A comparison of the payment terms between options (a) and (b) indicates the total cumulative interest of 840 and an implied discount rate of 13%. Technology Company T considers if factors indicating that a significant financing component does not exist apply in this case and concludes that they do not. Technology Company T determines that the financing component is significant because the difference between the cumulative cash-selling price of 5,040 and the financed amounts of 4,200 is 840, or approximately 20% of the financed amount. Therefore, an adjustment to reflect the time value of money will be needed if the customer elects option (b) to pay at the beginning of the contract. Technology Company T evaluates whether the implied discount rate of 13% is consistent with the market rate of interest for companies with the same credit rating as its own. Assuming that it is, Technology Company T recognizes revenue of 5,040 ratably over the contract term as the performance obligation is satisfied and interest expense of 840 using the effective interest method. The amount of interest expense to recognize each period is based on the projected contract liability, which decreases as services are provided and increases for the accrual of interest. Below is one example interest calculation under the effective interest method. Period Contract liability – Beginning of month Transaction price/ Delivery of service Interest expense at 1.083% (Monthly rate – 13% ÷ 12) Contract liability – End of month Calc. A B (A – B) X 1.083% = C A – B + C 1 4,200 140 44 4,104 2 4,104 140 43 4,007 3 4,007 140 42 3,909 4 3,909 140 41 3,810 5 3,810 140 40 3,710 zz zz zz zz – Continues each period 36 140 140 – – If, in the above example, the implied discount rate of 13% is determined to be an above-market rate, then the transaction price would be adjusted to reflect a market rate, based on Technology Company T’s creditworthiness. The difference between the implied discount rate and the market rate would represent a discount granted to the customer for purposes other than financing.

Worked example – Determining whether an arrangement has a significant financing component – Payment in arrears

Manufacturer A enters into a contract to provide equipment to Customer C priced at 2,000,000. Customer C is a start-up entity with limited cash and Manufacturer A agrees that Customer C would pay for the equipment over two years by monthly installments of 92,000. The contract includes a financing component. The difference in pricing between the selling price of 2,000,000 and the total of the monthly payments of 2,208,000 (24 x 92,000) indicates that the contractual payment terms have the primary purpose of providing Customer C with financing. The cash-selling price is 2,000,000 because it reflects the amount due at the point the equipment is transferred to Customer C. A comparison of the cash selling price and the total payments to be received indicates the total cumulative interest of 208,000 and an implied interest rate of 9.7%. Technology Company T considers if factors indicating that a significant financing component does not exist apply in this case and concludes that they do not. Manufacturer A determines that the financing component is significant because the difference between the cash-selling price of 2,000,000 and the total promised consideration of 2,208,000 is 208,000, or approximately 10% of the financed amount. Therefore, an adjustment to reflect the time value of money is needed. Manufacturer A evaluates whether the implied interest rate of 9.7% is consistent with the market rate of interest for companies with the same credit-standing as Customer C. Assuming that it is, Manufacturer A recognizes revenue of 2,000,000 upon delivery of the equipment – i.e. as the performance obligation is satisfied – and interest income on a monthly basis using the effective interest method. The amount of interest income for each month is based on the balance of the receivable for equipment sold, which decreases as payments are received. Below is one example interest calculation under the effective interest method. Period Receivable – Beginning of month Monthly payment – End of the month Interest expense at 0.81% (Monthly rate – 9.7% ÷ 12) Receivable – End of month Calc. A B (A – B) X 0.81% = C A – B + C 1 2,000,000 92,000 16,143 1,924,143 2 1,924,143 92,000 15,531 1,847,674 3 1,847,674 92,000 14,913 1,770,587 4 1,770,587 92,000 14,291 1,692,878 5 1,692,878 92,000 13,664 1,614,542 zz zz zz zz – Continues each period 24 91,263 92,000 737 – If, in the above example, the implied interest rate of 9.7% is determined to be a below-market rate, then the transaction price would be adjusted to reflect a market rate, based on Customer C’s creditworthiness. The difference between the implied interest rate and the market rate would represent a discount granted to the customer for purposes other than financing.

Assessment is undertaken at the individual contract level

An entity determines the significance of the financing component at an individual contract level, rather than at a portfolio level. The individual contract level for a particular customer could consist of more than one contract if the contract combination criteria in IFRS 15 are met. However, the Boards believe that it would be unduly burdensome to require an entity to account for a financing component if the effects of the financing component are not material to the individual contract, but the combined effects for a portfolio of similar contracts would be material to the entity as a whole. An entity should apply judgment in evaluating whether a financing component is significant to the contract. [IFRS 15.BC234]

No significant financing component if the timing of transfer of goods or services is at the customer’s discretion

Customers pay for some types of goods or services in advance – e.g. prepaid phone cards, gift cards, and customer loyalty points – and the transfer of the related goods or services to the customer is at the customer’s discretion. In these cases, the contracts do not include a significant financing component, because the payment term does not relate to a financing arrangement. Also, the Boards believe that the costs of requiring an entity to account for the financing component in these situations would outweigh any perceived benefits, because the entity would not know – and would therefore have to continually estimate – when the goods or services will transfer to the customer.

Limited examples provided of when payments have a primary purpose other than financing

Determining whether a difference between the amount of promised consideration and the cash selling price of the goods or services arises for reasons other than the provision of finance requires judgment. An entity considers all relevant facts and circumstances, including whether the difference is proportionate to any other reason provided. Also, it may be more common for the difference to be for a reason other than financing when payments are received in advance of the delivery of goods or services. [IFRS 15.BC233(c)]

In some circumstances, a payment in advance or arrears on terms that are typical for the industry and jurisdiction may have a primary purpose other than financing. For example, a customer may withhold an amount of consideration that is payable only on successful completion of the contract or the achievement of a specified milestone. The primary purpose of these payment terms, as illustrated in Example 27 of IFRS 15, may be to provide the customer with assurance that the entity will perform its obligations under the contract, rather than provide financing to the customer. [IFRS 15.IE141–IE142 Example 27]

Although it seems that the Boards are attempting to address retention payments in the construction industry with these observations, it is unclear how this concept might apply to other situations. The Boards explicitly considered advance payments received by an entity during their redeliberations – e.g. compensating the entity for incurring up-front costs – but decided not to exempt entities from accounting for the time value of money effect of advance payments.

Accounting for long-term and multiple-element arrangements with a significant financing component may be complex

Determining the effect of the time value of money for a contract with a significant financing component can be complex for long-term or multiple-element arrangements. In these contracts:

• goods or services are transferred at various points in time;
• cash payments are made throughout the contract; and
• there may be a change in the estimated timing of the transfer of goods or services to the customer.

If additional variable elements are present in the contract – e.g. contingent consideration – then these calculations can be even more sophisticated, involving significant cost and complexity for preparers.

In addition, an entity will need to have appropriate processes and internal controls to handle these potential complexities in assessing whether a significant financing component exists and, if so, developing the appropriate calculations and estimates.

Using an interest rate that is explicitly specified in the contract may not be appropriate

It may not be appropriate to use an interest rate that is explicitly specified in the contract, because the entity might offer below-market financing as a marketing incentive. Consequently, an entity applies the rate that would be used in a separate financing transaction between the entity and its customer that does not involve the provision of goods or services. [IFRS 15.BC239–BC241]

This can lead to practical difficulties for entities with large volumes of customer contracts and/or multinational operations, because they will have to determine a specific discount rate for each customer, class of customer, or geographical region of customer.

Presentation of interest income as revenue is not precluded

IFRS 15 does not preclude an entity from presenting interest income (when it has provided financing to the customer) as a type of revenue if the interest represents income arising from ordinary activities – e.g. entities that have significant lending operations. [IFRS 15.BC247]

Advance payments will affect EBITDA

When an entity receives an advance payment that includes a significant financing component, it increases the amount of revenue recognized, with a corresponding increase to interest expense. This change results in an increase to EBITDA, which may affect compensation and other contractual arrangements.

Application of the practical expedient with multiple performance obligations

In a contract with two or more performance obligations, identifying the period between customer payment and the transfer of goods or services may present challenges, especially when the performance obligations are satisfied at different points in time and consideration is paid over time or all at once.

In some contracts that include consideration paid over time, one performance obligation is completed in the early stages of a contract, while a second performance obligation continues for an extended period of time. In such cases, the entity generally allocates each payment received to both performance obligations in the contract on a pro-rata basis to calculate the financing component and determine whether the practical expedient applies (rather than allocating payments to a single performance obligation until it has been fully paid, as would be the case with a FIFO allocation).

In other contracts, consideration includes an up-front payment and performance obligations are completed consecutively over time. An entity evaluates all relevant evidence, including termination clauses, to determine whether it is appropriate for an up-front cash payment to be allocated to the first performance obligation when determining whether the practical expedient can be applied at the contract level.

A contract with an implied interest rate of zero may contain a financing component

When the consideration to be received for a good or service with extended payment terms is the same as the cash selling price, the implied interest rate is zero. However, a significant financing component may still exist.

For example, retailers sometimes offer a promotional incentive that allows customers to buy items such as furniture and pay the cash selling price two years after delivery. Judgment is required to evaluate whether in these circumstances an entity is offering a discount or other promotional incentive for customers who pay the cash selling price at the end of the promotional period equal to the financing charge that would otherwise have been charged in exchange for financing the purchase.

If the entity concludes that financing has been provided to the customer, then the transaction price is reduced by the implicit financing amount and interest income is accreted. The implicit financing amount is calculated using the rate that would be used in a separate financing transaction between the entity and its customer.

3. Non-cash consideration IFRS 15

Non-cash consideration received from a customer is measured at fair value. If an entity cannot make a reasonable estimate of the fair value, then it refers to the estimated selling price of the promised goods or services. [IFRS 15.66–67]

Estimates of the fair value of non-cash consideration may vary. Although this may be due to the occurrence or non-occurrence of a future event, it can also vary due to the form of the consideration – e.g. variations due to changes in the price per share if the non-cash consideration is an equity instrument. [IFRS 15.68]

When the fair value of non-cash consideration varies for reasons other than the form of the consideration, those changes are reflected in the transaction price and are subject to the guidance on constraining variable consideration.

Non-cash consideration received from the customer to facilitate an entity’s fulfillment of the contract – e.g. materials or equipment – is accounted for when the entity obtains control of those contributed goods or services. [IFRS 15.69]

Constraint does not apply when variation is due to the form of non-cash consideration

The Boards believe that the requirement to constrain estimates of variable consideration applies regardless of whether the amount received will be cash or non-cash consideration. They therefore decided to constrain variability in the estimate of the fair value of non-cash consideration if that variability relates to changes in the fair value for reasons other than the form of the consideration – i.e. changes other than the price of the non-cash consideration. If the variability is because of the entity’s performance – e.g. a non-cash performance bonus – then the constraint applies. If the variability is because of the form of the non-cash consideration – e.g. changes in the stock price – then the constraint does not apply and the transaction price is not adjusted. [IFRS 15.BC251–BC252]

The determination of whether a change in fair value was caused by the form of the non-cash consideration or other reasons, and the determination of how to allocate fair value changes between those affecting transaction price and those that do not, may be challenging in some situations.

Measurement date of share-based payments received by an entity is not specified

The general principles covering non-cash consideration include accounting for share-based payments received by an entity in exchange for goods or services. However, the IASB’s version of IFRS 15 does not specify when to measure non-cash consideration. Therefore, there may be diversity in views about whether to measure the consideration: [IFRS 15.BC254]

• when the contract is entered into; or
• when or as the performance obligation is satisfied.

When the terms of an equity-based compensation arrangement change after the measurement date, the incremental portion of the change in fair value is not considered revenue.

4. Consideration payable to a customer

Consideration payable to a customer includes cash amounts that an entity pays or expects to pay to the customer, or to other parties that purchase the entity’s goods or services from the customer. Consideration payable to a customer also includes credits or other items – e.g. a coupon or voucher – that can be applied by the customer against the amount owed to the entity or to other parties that purchase the entity’s goods or services from the customer. [IFRS 15.70]

An entity evaluates the consideration payable to a customer to determine whether the amount represents a reduction of the transaction price, a payment for distinct goods or services, or a combination of the two.

If the entity cannot reasonably estimate the fair value of the good or service received from the customer, then it accounts for all of the consideration payable to the customer as a reduction of the transaction price. [IFRS 15.71]

[IFRS 15.70–72]

Worked example – Payments to customers – Reduction in the transaction price

[IFRS 15.IE160–IE162 Example 32] Consumer Goods Manufacturer M enters into a one-year contract with Retailer R to sell goods. Retailer R commits to buy at least 1,500 worth of the products during the year. Manufacturer M also makes a nonrefundable payment of 15 to Retailer R at contract inception to compensate Retailer R for the changes that it needs to make to its shelving to accommodate Manufacturer M’s products. Manufacturer M concludes that the payment to Retailer R is not in exchange for a distinct good or service, because Manufacturer M does not obtain control of the rights to the shelves. Consequently, Manufacturer M determines that the payment of 15 is a reduction of the transaction price. Manufacturer M accounts for the consideration paid as a reduction of the transaction price when it recognizes revenue for the transfer of the goods.

Worked example – Payments to customers – Variable consideration

Company C contracts with Retailer X and delivers goods on December 15, Year 1. On January 20, Year 2, Company C offers coupons in a newspaper to encourage retail sales of the goods sold to Retailer X. Company C agrees to reimburse Retailer X for coupons redeemed. Company C offered similar coupons in the prior years. Company C would likely determine that the transaction price for the goods sold on December 15, Year 1 included variable consideration, given its history of offering coupons. Conversely, if Company C had not offered coupons in prior years and did not expect to offer any coupons at contract inception, then it would recognize the amount payable to the retailer as an adjustment to revenue when it communicated to Retailer X its intention to reimburse Retailer X for any redeemed coupons.

Payments to distributors and retailers may be for distinct goods or services

Consumer goods companies often make payments to their distributors and retailers. In some cases, the payments are for identifiable goods or services – e.g. co-branded advertising. In these cases, the goods or services provided by the customer may be distinct from the customer’s purchase of the seller’s products.

If the entity cannot estimate the fair value of the good or service received from the customer, then it recognizes the payments as a reduction of the transaction price. If the payments to customers exceed the fair value of the good or service provided, then any excess is a reduction in the transaction price.

No specific guidance on slotting fees

Slotting fees are payments made to a retailer in exchange for product placement in the retailer’s store. Although IFRS is silent on how to account for slotting fees, in practice, an entity determines whether the payments are for an identifiable benefit that is separable from the supply contract, and therefore recognized as an expense; or whether they are a reduction in price, and therefore recognized as a reduction of revenue.

Under IFRS 15, an entity determines whether slotting fees are:

• paid in exchange for a distinct good or service that the customer transfers to the entity, and therefore recognized as an expense by the entity; or
• sales incentives granted by the entity, and therefore recognized as a reduction from the transaction price by the entity.

IFRS 15 does not contain an example, and is silent on its application to slotting fees. As a consequence, an entity will need to carefully consider the guidance above with respect to its particular circumstances to conclude whether these payments are for a distinct good or service or should be treated as a reduction of the transaction price.

For many of these arrangements, this will require significant judgment and an entity will need appropriate internal controls and documentation to support its judgment.

Scope of consideration payable to a customer is wider than payments made under the contract

Payments made to a customer that are not specified in the contract may still represent consideration payable to a customer. An entity will need to develop a process for evaluating whether any other payments made to a customer are consideration payable that requires further evaluation under the standard.

The determination of how broadly payments within a distribution chain should be evaluated requires judgment. However, an entity need not always identify and assess all amounts ever paid to a customer to determine if they represent consideration payable to a customer.

Consideration payable may include payments made outside a direct distribution chain

Consideration payable to a customer includes amounts paid to a customer’s customer – i.e. amounts paid to end customers in a direct distribution chain. However, in some cases an entity may conclude that it is appropriate to apply the guidance more broadly – i.e. to amounts paid outside the direct distribution chain. [IFRS 15.70, BC92, BC255]

For example, Marketing Company M may market and incentivize the purchase of Merchant P’s products by providing coupons to Merchant P’s Buyer B. When Buyer B purchases from Merchant P as a result of Marketing Company M’s actions, Marketing Company M earns revenue from Merchant P. Buyer B is not purchasing Marketing Company M’s services and is not within a direct distribution chain.

Service fee based on number of units sold by Merchant P

Depending on the facts and circumstances, Marketing Company M may conclude that both Merchant P and Buyer B are its customers, or it may conclude that only Merchant P is its customer. As a consequence, judgment will be needed to evaluate a specific fact pattern to determine whether a payment to a party outside a direct distribution chain is treated as consideration payable to a customer and therefore as a reduction of revenue.

Amounts payable to a customer may be either variable consideration or consideration payable to a customer

IFRS 15 states that consideration payable to a customer includes amounts that an entity pays, or expects to pay, to a customer or to other parties that purchase the entity’s goods or services from the customer. The guidance on consideration payable to a customer states that it is recognized at the later of when the entity recognizes revenue or when the entity pays or promises to pay the consideration. However, because consideration payable to a customer can be included in the transaction price, it can also be a form of variable consideration.

Variable consideration is estimated and included in the transaction price at contract inception, and remeasured at each subsequent financial reporting date. This is different from the guidance on when to recognize consideration payable to a customer.

This discrepancy puts pressure on the determination, at contract inception, of whether the entity intends to provide an incentive or the customer has a reasonable expectation that an incentive will be provided.

This evaluation includes an assessment of the entity’s past practice and other activities that could give rise to an expectation at contract inception that the transaction price includes a variable component. The consideration payable to a customer guidance is used only when an entity has not promised a payment to the customer at contract inception, either implicitly (including through its customary business practice) or explicitly.

After the transaction price for the contract has been determined, then it is time to move to Step 4: Allocate the transaction price to each specific performance obligation.

Step 3 Determining Transaction Price

Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price

Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price

Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price Step 3 Determining Transaction Price