STEP 4 Allocating the Transaction Price to Performance Obligations

The amount allocated to each separate performance obligation reflects the consideration to which a vendor expects to be entitled in exchange for transferring the related goods or services to the customer. The starting point for the allocation is to base it on the stand-alone selling prices of each performance obligation.

Allocating the transaction price based on the stand-alone selling price

At contract inception a vendor is required to determine the stand-alone selling price of the good or service underlying each performance obligation and then allocate the transaction price proportionately based on these stand-alone selling prices. The ‘stand-alone selling price’ is the price at which a vendor would sell a good or service separately to a customer. The best evidence of a stand-alone selling price is the observable price of a good or service sold in similar circumstances and to similar customers. Although a contractually stated price or a list price for a good or service may represent the stand-alone selling price, this will not always be the case.

When a stand-alone selling price is not directly observable, it is estimated. The objective is to determine the amount of consideration that the vendor expects to be entitled in return for the good or service. This is achieved by using all available information including market conditions, vendor-specific factors and information about the customer or class of customers. In all cases, the use of observable inputs is required to be maximised to the extent possible.

Approaches that might be used include:

  • Adjusted market assessment: Estimating the price that a customer in the particular market would be prepared to pay, which might include referring to prices charged by the vendor’s competitors for similar goods or services, and adjusting those prices as necessary to reflect the vendor’s costs and margins.
  • Expected cost plus margin: Estimating the expected costs of satisfying a performance obligation and adding an appropriate margin.
  • Residual: Deducting observable stand-alone selling prices that are available for other goods or services to be supplied from the total contract price. However, the use of this approach is restricted to those goods or services for which there is a wide range of selling prices (meaning that these cannot be observed from past transactions or other observable evidence), or in circumstances in which the selling price is uncertain because no selling price has been set for the good or service and it has not previously been sold on a stand-alone basis.

Allocating discounts

A discount exists if the sum of the stand-alone selling prices of the goods or services in the contract exceeds the consideration payable by the customer. A discount is allocated on a proportionate basis to all performance obligations in the contract, unless there is observable evidence that the discount is attributable to only some performance obligations in a contract. This might be the case if a contract is for the supply of three goods, and two of these are frequently sold together at a discount from the total of the two stand-alone selling prices.

Example

A vendor sells three products (A, B and C) to a customer for CU 100. Each product will be transferred to the customer at a different time. Product A is regularly sold separately for CU 50; products B and C are not sold separately, and their estimated stand-alone selling prices are CU 25 and CU 75 respectively.

There is no evidence that suggests the discount of CU 50 relates entirely to one, or a group of two, of the products being sold. Consequently the discount is allocated proportionately to the three products and revenue is recognised as follows:

A            (100 x (50/150))               CU 33

B            (100 x (25/150))               CU 17

C           (100 x (75/150))                CU 50

If a discount is allocated entirely to only some of the performance obligations in the contract, the discount is allocated before considering whether it is appropriate to use the residual approach to estimate the stand-alone selling price of a remaining performance obligation.

Example

Assume the same fact pattern as above, except that products B and C are regularly sold together for consideration of CU 50, the total amount payable by the customer is 90 and product A is regularly sold for amounts between CU 35 and CU 50. Because the vendor has evidence that a discount of CU 50 is regularly applied to products B and C, the selling price attributed to those products is determined first with a residual amount being attributed to product A.

Consequently, revenue will be attributed to each product as follows:

A                                                        CU 40

B                  (50 x (25/100))            CU 12.5

C                  (50 x (75/100))            CU 37.5

However, it should be noted that the residual approach resulted in an amount being attributed to product A that is within the range of prices at which it is regularly sold. If, for example, product A was never sold for less than CU 50, then the residual approach illustrated above would not be appropriate. Instead, the stand-alone selling prices for each separate product would be estimated and the discount allocated on a relative stand-alone selling price basis.

Allocation of variable consideration

Variable consideration may be attributable either to the entire contract, or to specific part(s) of the contract, such as:

  • One or more, but not all, performance obligations. For example, a bonus may be contingent on the vendor transferring a good or service within a specified period of time,

  • One or more, but not all, of the distinct goods or services of a single performance obligation. This would apply if, for example, the consideration promised for the second year of a two-year maintenance service will increase based on movements in a consumer price index.

A variable amount of consideration (and subsequent changes to that amount) is allocated entirely to a performance obligation (or a distinct good or service that forms part of a single performance obligation to transfer a series of distinct goods or services that are substantially the same) if both:

  • The terms of a variable payment relate specifically to the vendor’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service), and

  • The allocation of the variable amount in its entirety to a performance obligation or distinct good or service is consistent with the objective that the selling price is allocated to each performance obligation in order to reflect the consideration to which the vendor expects to be entitled in exchange for the good or service.

Example

A vendor enters into a contract with a customer for two licences of intellectual property (licences A and B). It is determined that each licence represents a separate performance obligation, which is satisfied at a point in time (the transfer of each of the licences to the customer). The stand-alone selling prices of the licences are CU 1,200 (licence A) and CU 1,500 (licence B).

Scenario A

The prices included in the contract are as follows:

  • Licence A: a fixed amount of CU 1,200, payable 30 days from the transfer of the licence to the customer,

  • Licence B: a royalty payment of 5% of the selling price of the customer’s future sales of products that use licence B.

The vendor estimates that the amount of sales-based royalties that it will receive in respect of licence B will be approximately CU 1,500.

The vendor then determines the allocation of the transaction price to each of the two licences. It is concluded that the allocation should be as follows:

  • Licence A: CU 1,200,

  • Licence B: the variable royalty payment.

This allocation is made because both of the following conditions apply:

The variable payment relates solely to the transfer of licence B (the subsequent royalty payments); and

The fixed amount of licence A, and the estimated amount of sales-based royalties for licence B, are equivalent to their stand-alone selling prices.

Although revenue will be recognised for licence A on its transfer to the customer, no revenue will be recognised when licence B is transferred to the customer. Instead, revenue attributable to licence B will be recognised when the subsequent sales of the customer’s products that use licence B take place (see Sales-based or usage-based royalties).

In contrast, the allocation of variable consideration is different if the prices included in a contract do not reflect stand-alone selling prices.

A vendor enters into a contract with a customer for two licences of intellectual property (licences A and B). It is determined that each licence represents a separate performance obligation, which is satisfied at a point in time (the transfer of each of the licences to the customer). The stand-alone selling prices of the licences are CU 1,200 (licence A) and CU 1,500 (licence B).

Scenario B

The prices included in the contract are changed to:

  • Licence A: a fixed amount of CU 450,

  • Licence B: a royalty payment of 7.5% of the selling price of the customer’s future sales of products that use licence B.

The vendor estimates that the amount of sales-based royalties that it will receive in respect of licence B will be approximately CU 2,250. In this case, although the variable payments relate solely to the transfer of licence B (the subsequent royalty payments), allocating the variable consideration only to licence B would be inappropriate. This is because allocating CU 450 to licence A and CU 2,250 to licence B would not reflect a reasonable allocation based on the stand-alone selling prices of those two licences.

Instead, the fixed amount receivable in respect of licence A is allocated to the two licences on the basis of their stand-alone selling prices. This allocation is calculated as:

–– Licence A: (1,200 / 2,700) x CU 450 CU 200,

–– Licence B: (1,500 / 2,700) x CU 450 CU 250.

As the sales by the customer of products that use licence B occur, the royalty income will be allocated to licences A and B on a relative stand-alone selling price basis. Because the royalty income will only be recognised when the related product sales take place, recognition of the royalty income allocated to each of the two licences will be deferred to future periods.

Although the royalty income relates solely to the transfer of licence B, the allocation of the fixed selling price of licence A and the estimate of sales-based royalties to be generated by licence B is disproportionate in comparison with the stand-alone selling prices of the two licences.

This means that, in effect, some of the income to be generated by licence B in fact relates to the sale of licence A.

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