Step 4 Allocate the transaction price

Step 4 Allocate the transaction price to each specific performance obligation is the fourth step in the process required by IFRS 14 Revenue from contracts with customers in order to properly recognise revenue.

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

IFRS 15 introduced a five step process for recognising revenue, as follows:Step 4 Allocate the transaction price

  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

After determining the transaction price in Step 3, companies in step 4 need to allocate that transaction price to the specific performance obligations identified in the contract. The transaction price is allocated to the performance obligations based on its relative standalone selling price. The standalone selling price for each good or service representing a performance obligation should be determined at the contract inception. [IFRS 15 74] Step 4 Allocate the transaction price

The standalone selling price is defined as the price that an entity would sell the good or service for if they sold it separately to a customer. The best evidence of that price is if the entity has separate actual sales to customers of a similar good or service. Many times this easily observable selling price is not available, so an entity has to estimate it using observable inputs where possible. Some of these inputs include market conditions, entity-specific factors, and customer information. The methodology to estimate standalone selling price should be applied consistently in like circumstances. [IFRS 15 76 – 78] Step 4 Allocate the transaction price

Standalone selling price estimation methods

IFRS 15 79 includes specific suitable methods for estimating the standalone selling price of goods and services, including:

  1. Adjusted market assessment approach: An entity evaluates the market in which it sells goods or services and estimates the price a customer in that market would be willing to pay for the goods or services. This approach may also include using prices from the entity’s competitors for similar goods or services and adjusting those prices as needed to reflect the entity’s costs and margins. Step 4 Allocate the transaction price
  2. Expected cost plus a margin approach: An entity estimates the expected costs to satisfy a performance obligation and then adds an appropriate margin for that good or service.
  3. Residual approach: An entity may estimate the standalone selling price by reference to the total transaction price less the sum of observable standalone selling prices of other goods or services in the contract. This method can only be used if one of the following criteria are met: Step 4 Allocate the transaction price
    1. There is a broad range of current selling prices to other customers and no single representative selling price
    2. The good or service has not previously been sold and there is no established price for the good or service [IFRS 15 79]

It is possible that an entity may need to use a combination of methods. Some other considerations in allocating transaction price are allocation of a discount and the allocation of variable consideration. Step 4 Allocate the transaction price

Allocation of a DiscountTrade discounts

[IFRS 15 81] A customer may receive a discount for purchasing a bundle of goods or services. When this occurs the sum of the standalone selling prices of the promised goods and services may exceed the promised consideration in a contract (i.e. the bundle is sold at a discount). Because the total transaction price is allocated based on relative standalone selling prices this discounted price only causes complexity when the discount should be allocated to one or more specific performance obligations, but not all.

[IFRS 15 82] A discount should be allocated entirely to certain performance obligations, but not all, if the following criteria are met:

  1. The entity regularly sells each distinct good or service on a standalone basis Step 4 Allocate the transaction price
  2. The entity regularly sells on a standalone basis a bundle of some of those distinct goods or services at a discount to their standalone selling prices Step 4 Allocate the transaction price
  3. The discount attributable to each bundle described in b) is substantially the same as the discount in the contract and the performance obligations to which the entire discount belongs is readily observable Step 4 Allocate the transaction price

If there is a discount allocated to some but not all performance obligations in the contract, the allocation should be made before using the residual approach to estimate any standalone selling prices. [IFRS 15 83] Step 4 Allocate the transaction price

Allocation of Variable Consideration

Variable consideration in a contract may be related to the entire contract or to a specific part of the contract. The variable amount of the consideration should be allocated entirely to a performance obligation or to a distinct good or service that forms part of single performance obligation if both of the following criteria are met: Step 4 Allocate the transaction price

  1. The terms of the variable payment relate directly to a performance obligation Step 4 Allocate the transaction price
  2. Allocating the variable consideration entirely to a single performance obligation meets the overall goal to allocate the transaction price in an amount that the entity expects to receive for that individual good or service. In other words, the variable consideration can be allocated entirely to a performance obligation if it doesn’t result in allocating more or less revenue than should be allocated based on standalone selling prices. [IFRS 15 85] Step 4 Allocate the transaction price

Subsequent changes in selling prices should be allocated to the contract in a way that is consistent with the original allocation of the transaction price, except in some unique circumstances where changes relate to one specific performance obligation or there is a contract modification. [IFRS 15 87 – 90] Step 4 Allocate the transaction price

One of the important considerations in step 4 of IFRS 15 is the concept of observable evidence. Step 4 Allocate the transaction price

Good documentation of the manner of determining observable evidence for standalone selling prices, allocating discounts and variability will be important. The requirements in Step 4 will require significant judgement and resources to document the conclusions.

Something else -   Identify the contract with the customer - Engineering & Construction industry

Example discount allocations

An entity agrees to sell three products (A, B and C) to a customer for $100. The entity regularly sells product A, so a directly observable price is available. However, for products B and C, the entity does not have directly observable selling prices and, therefore, must estimate them. For product B, the entity uses the adjusted market assessment approach as they are aware of other entities that sell a similar product. For product C, the entity was unable to observe any similar products and thus uses an estimated cost plus margin approach to estimate the selling price. The analysis yielded the following: Step 4 Allocate the transaction price Step 4 Allocate the transaction price

Product Price Source Step 4 Allocate the transaction price
Product A $50 Directly observable selling price Step 4 Allocate the transaction price
Product B $25 Adjusted market assessment approach Step 4 Allocate the transaction price
Product C $75 Cost plus margin approach Step 4 Allocate the transaction price
Total $150 Step 4 Allocate the transaction price Step 4 Allocate the transaction price

The entity initially allocates the consideration as follows:

  • Relative percentage

In the example, the customer receives a discount of $50 from the standalone selling prices for purchasing the bundle. This discount is allocated proportionately as follows:

Product Calculation Step 4 Allocate the transaction price
Standalone selling price
Product A $50  / $150 = 33.33% X $100 = Step 4 Allocate the transaction price $33
Product B $25 / $150 = 16.67% X $100 = Step 4 Allocate the transaction price $17
Product C $75 / $150 = 50.00% X $100 = Step 4 Allocate the transaction price $50
Total Step 4 Allocate the transaction price $100
  • Allocation to some performance obligations

An entity enters into a contract to sell three products for $100. As it shows from the  table below, the contract has a discount of $40. But the entity sells products B and C together for $60 and product A for $40. So in this situation, the discount of $40 would be applied to products B and C, but not product A. The relative standalone selling prices would be used to allocate the consideration:

Something else -   Transfer of control for distinct licences
Product Standalone selling prices Calculation Step 4 Allocate the transaction price
Allocated prices
Product A $40 N/A Step 4 Allocate the transaction price $40
Product B $55 $55 / ($55 + $45) = 55% X $40 = $22 discount, $55 – $22 = $33
Product C $45 $45 / ($55 + $45) = 55% X $40 = $18 discount, $45 – $18 = $27
Total $140 Step 4 Allocate the transaction price $100

Depending on the complexity of the contract and the number and types of performance obligations, an entity may need to go through several steps to completely allocate the consideration. However, as noted above, typically any discounts will be allocated based on the relative standalone selling prices. Step 4 Allocate the transaction price

  • The residual approach

Using the residual approach is not a free choice, as it can only be used when the conditions noted above are present. The following example illustrates when use of the residual approach is appropriate: Step 4 Allocate the transaction price

An entity enters into a contract to sell products A, B, C as in the above example, but also agrees to supply product D. The total consideration is $130. The standalone selling price is sold to several customers, but at a wide range of prices, $15-$45. The entity determines that, because of this variability, it meets one of the conditions in the standard for using the rUSDesidual approach (see above or [IFRS 15 79]). Step 4 Allocate the transaction price

Before applying the residual approach, it must apply any discounts to other performance obligations as required in the standard. Because of the observable evidence for products A, B and C, the entity determines that $100 of the selling price should be allocated to those items (as per above in Allocation to some performance obligations). So the allocated prices are Product A $40, Product B $33 and Product C $27, total $100 (as per above table). This therefore leaves $30 of the consideration as the allocated price for product D, which is in the range of selling prices that the entity has used for product D alone. Step 4 Allocate the transaction price Step 4 Allocate the transaction price

Note in the last example, if the selling price were $105, this would result in an allocation of only $5 to product D, which is not a price within the observable range of the entity’s sales. Therefore, the entity would need to use another method to determine the standalone selling price for product D and properly allocate the consideration.

Example allocation variable consideration

If a contract calls for variable consideration, the entity shall allocate the variable consideration it has determined can be recognized, subject to the constraint. This can result in situations where the variable consideration can be allocated to all of the performance obligations based on relative standalone selling prices, or if the variable consideration only relates to a specific performance obligation, such as a bonus for completing one or more promises before a certain date, it is allocated only to the relevant performance obligation.

An entity sells a customer two licenses, X and Y. The entity determines that these are distinct performance obligations. The standalone selling prices are $800 for X and $1,000 for Y. The contract provides a fixed price of $800 for X and for Y the selling price is a royalty of 3 percent of future sales related to the use of license Y. The entity estimates that the variable consideration associated with license Y will be $1,000. Step 4 Allocate the transaction price

The entity considers the requirements above. The variable payment is related solely to Y, so criterion (a see Allocation of Variable Consideration above or[IFRS 15 85]) has been met. It assesses criterion (b see Allocation of Variable Consideration above or[IFRS 15 85]) and determines that this has been met, because the expected royalty payment approximates the standalone selling prices of X and Y. Therefore, none of the fixed consideration will be allocated to license Y. Step 4 Allocate the transaction price

The entity recognizes $800 of revenue when license X is transferred to the customer. It recognizes no revenue when license Y is delivered, rather as the customer generates sales, it recognizes revenue at the 3 percent royalty rate. Step 4 Allocate the transaction price

In a variation of the preceding example, assume the standalone selling prices of licenses X and Y are the same, but that the contract states a fixed amount of $300 for license X and a 5 percent royalty for license Y, which the entity estimates will be $1,500. In this case, even though the variable component is attributable entirely to license Y, it would be inappropriate to allocate all of the variable consideration to license Y. Step 4 Allocate the transaction price

This is because the amount allocated to licenses X and Y would not reflect a reasonable allocation based upon their standalone selling prices. Consequently, the entity first allocates the $300 amount to licenses X and Y based on standalone selling prices, then allocates its estimate of variable consideration of $1,500 on the same basis. However, this revenue cannot be recognized until the sales actually occur or the performance obligation is satisfied. Step 4 Allocate the transaction price

License Y is transferred immediately and license X is transferred three months later. The entity recognizes revenue as follows:

Something else -   Transaction price allocation

At delivery of license Y Step 4 Allocate the transaction price

Based upon a fixed price of $300 for license X (see above in bold). Step 4 Allocate the transaction price

Estimated variable consideration License Y  $1,000 / $1,800 ($1,000 standalone price License Y  +  $800 standalone price License X) = 55.6% , $300 X 55.6% = $167

Three months later Step 4 Allocate the transaction price

License X $300 -/- $167 = 133 Step 4 Allocate the transaction price

Assume that in the month after delivery of license Y (but before delivery of license X), the sales royalty is $200. The entity would then record the following revenue entry:

Accounts receivable Step 4 Allocate the transaction price Step 4 Allocate the transaction price $200
Revenue license Y (55.6% of $200) Step 4 Allocate the transaction price Step 4 Allocate the transaction price $111
Contract liability related to X ($200 – $111) Step 4 Allocate the transaction price Step 4 Allocate the transaction price $89

In the same ratio as above, the entity recognizes 55.6 percent of the revenue as related to license Y. It also records a contract liability for the balance of 44.4 percent as license X has not been delivered yet. It will continue to record the contract liability until delivery of license X. Thereafter, it will recognize revenue in the same ratios for both licenses as the royalties are earned

After the transaction price to each specific performance obligation has been properly allocated, then it is time to move to Step 5: Recognise the revenue when the entity satisfies each performance obligation. Step 4 Allocate the transaction price

General model of measurement of insurance contracts

Step 4 Allocate the transaction price

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Something else -   Implied price concession or Impairment loss

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