Transaction price power and utilities under IFRS 15 – All best read

Determining the transaction price power and utilities

The determination of the transaction price in many power and utilities contracts will be fairly straightforward, particularly where the contract pricing and contract quantities are fixed; however, in practice, reporting entities often enter into contracts that contain index-based pricing, variable volume, or both.

For example, Seller might enter into a requirements contract to sell electricity to Buyer at predetermined prices, but volumes are not known at contract inception. Uncertainty exists with respect to the total consideration to be received by Seller over the term of the contract. Seller might be able to elect a practical expedient to recognise revenue based on the amount invoiced, if it directly corresponds with the value to the customer of Seller’s performance completed to date.

Contracts that contain forms of variable consideration, significant financing components, non-cash consideration and/or consideration payable to a customer are likely to be more complex and will require judgement.

Variable consideration power and utilities

Variable consideration should be estimated using the expected value method or the most likely amount method. This is not a ‘free choice’. An entity needs to consider which method it expects to better predict the amount of consideration to which it will be entitled and apply that method consistently for similar types of contract.

A performance bonus is a form of variable consideration commonly included in service contracts in the power and utilities industry (for example, plant operations and maintenance service arrangements). When determining the transaction price, a reporting entity should estimate the amount of consideration to which it will be entitled in exchange for transferring the promised services to a customer.

Case – Variable consideration: performance bonus

Background

Electric Company (‘ElecCo’) and Rosemary Gas and Electric Company (‘GasCo’) are party to an operations andtransaction price power and utilities maintenance service agreement whereby ElecCo is responsible for all operations and maintenance at GasCo’s generation facility. The contract term is for one year, beginning on 1 January 20X1 and ending on 31 December 20X1.

Under the terms of the agreement, ElecCo receives a fixed fee of $10,000,000 for its services, and it is entitled to a progressive performance bonus of $250,000 if annual operations and maintenance costs, on a per MW basis (‘costs per MW’), are at least 10% lower than the prior year, $500,000 if costs per MW are 12% lower than the prior year, and $1,000,000 if costs per MW are 15% lower than the prior year.

ElecCo’s service agreement with GasCo is similar to its other service agreements, and management believes that its experience enables it to accurately predict the amount to which it will be entitled for its services, including amounts associated with the contractual performance bonuses. ElecCo concludes that the expected value method is most predictive in this case.

How should ElecCo determine the transaction price?

Analysis

The transaction price should include ElecCo’s estimate of the amount of consideration to which it will be entitled for the work performed. Since ElecCo has determined that the expected value approach is more predictive, the transaction price would be calculated as follows:

Probability-weighted consideration

Probability

Amount in $

$11,000,000 (fixed fee plus $1,000,000 performance bonus)

20%

2,200,000

$10,500,000 (fixed fee plus $500,000 performance bonus)

40%

4,200,000

$10,250,000 (fixed fee plus $250,000 performance bonus)

40%

4,100,000

Total probability-weighted consideration

100%

10,500,000

ElecCo assigned probabilities to the scenarios above based on its significant experience with similar contracts. The total transaction price of $10,500,000 is reflective of the probability-weighted estimate. ElecCo will need to update its estimate at each reporting date.

Based on ElecCo’s experience with similar contracts, management concluded that it was highly probable that a significant reversal in the amount of cumulative revenue recognised would not occur if a $500,000 estimate of variable consideration were included in the transaction price; therefore, the variable consideration was not constrained.

However, if ElecCo concluded that it was not highly probable that a significant reversal of cumulative revenue recognised would not occur, ElecCo might have concluded that none (or only a portion) of the variable consideration associated with the progressive performance bonus should be included in the transaction price.

Case – Price protection if competitor subsequently lowers price

Background

A retailer sells a product to customer A for C100 on 1 January, and it agrees to reimburse customer A for the difference between the purchase price and any lower price offered by a certain direct competitor during the three-month period following the sale. The retailer has recent experience with similar promotions of similar products. On a probability-weighted basis, the retailer estimates that it will reimburse the customer C5.

How does the retailer account for the potential refund?

Analysis

The consideration expected to be repaid to the customer is excluded from revenue and recorded as a liability at the time of sale. Management concludes, based on its recent experience that it is highly probable that recognising C95 would not result in significant reversal of cumulative revenue on resolution of the uncertainty. Therefore, the retailer recognises revenue of C95 and a refund liability of C5.

Provisional pricing arrangements power and utilities

Certain commodity contracts are ‘provisionally priced’ on delivery. The transaction price might be variable, or contingent on the outcome of future events, which could include provisional pricing arrangements. Management should understand the sources of variability, which will help to establish an appropriate accounting method.

Case – Variability arises from market price only

On 1 January 20X1, entity A enters into a contract to supply power (electricity) to a customer for delivery on 31 January 20X1. Electricity is supplied, and control transfers, at 31 January 20X1. The consideration is payable at 30 April 20X1, based on the spot electricity price at that date.

There is no other variability associated with the consideration.

Does IFRS 15 or IFRS 9 apply where all variability in the receivable arises from a market price?

Analysis

The IASB discussed this topic at its December 2015 meeting and observed that the variable consideration constraint in IFRS 15 would not apply to variability arising solely from changes in market price. At 31 January 20X1 the entity will recognise a receivable and measure it in accordance with IFRS 9.

The receivable would fail the solely payments of principal and interest (‘SPPI’) test, due to the variability associated with the commodity price. The receivable would be classified as fair value through profit or loss.

Case – Variability arises from physical attributes only

On 1 January 20X1, entity B enters into a contract to sell wet gas (that is, natural gas containing natural gas liquids transaction price power and utilities(‘NGLs’)) to a customer for delivery on 31 January 20X1. The pricing will be based on the dry gas and NGL content of the gas. The quantity of dry gas and NGLs will not be known until further measurement and assessment by the purchaser at the delivery point. Gas is supplied, and control transfers, at 31 January 20X1.

The consideration is payable at 30 April 20X1. Prices for the dry gas and NGLs are fixed in the contract. The consideration is derived from these fixed prices, based on the final amount of NGLs determined after the further processing and assessment. No adjustments are made for changes in market prices.

Does IFRS 15 or IFRS 9 apply where all variability in the receivable arises from physical attributes?

Analysis

The IASB discussed this topic at its December 2015 meeting and suggested that IFRS 15 applies, and the contract is subject to the variable consideration guidance in paragraphs 56 to 58 of IFRS 15. This is because the entity’s right to consideration is contingent on the physical attributes of the product delivered, as confirmed by the customer.

There is no embedded derivative to be separated at delivery under paragraph 4.3.1 of IFRS 9. This is because the underlying is a non-financial variable specific to a party to the contract (being the physical attributes of the commodity delivered).

Case – Variability arises from both market price and physical attributes

Entity C enters into a contract to sell wet gas (that is, natural gas containing NGLs) to a customer on 1 January 20X1. Wet gas is delivered, and control transfers, at 31 January 20X1. The quantity of dry gas and NGLs will not be known until further processing and assessment by the purchaser at the delivery point.

The consideration is payable at 30 April 20X1, based on the spot gas price per unit at that date. The price is also subject to adjustment for the final quantity of gas determined after the further processing and assessment.

Does IFRS 15 or IFRS 9 apply where variability in the receivable arises from both market price and physical attributes, and the two kinds of variability are not readily separable?

Analysis

The variability would be considered on a combined basis in accordance with paragraph 4.3.2 of IFRS 9. The IASB discussion at their December 2015 meeting suggests that the entity should apply IFRS 9 to the variability.

Variable consideration within the scope of IFRS 15 is subject to a constraint. The objective of the constraint is that an transaction price power and utilitiesentity should recognise revenue as performance obligations are satisfied, to the extent that it is ‘highly probable’ that a significant revenue reversal will not occur in future periods. Such a reversal would occur if there is a significant downward adjustment of the cumulative amount of revenue recognised for that performance obligation.

This might be particularly relevant where the final quality of product being delivered will not be known until assessment at its destination. This is more likely to be variable consideration if the price is conditional solely on the quality of the product.

Judgement will be required to determine if there is an amount that is variable consideration and, if so, whether it is subject to a significant reversal. IFRS 15 has a list of factors that could increase the likelihood or magnitude of a revenue reversal.

Judgement is required to identify the point at which the variable consideration becomes unconditional and is then considered a financial asset within the scope of IFRS 9.

Management’s estimate of the transaction price will be reassessed in each reporting period.

Power and utilities entities would be required to continue to separate provisional pricing features that represent embedded derivatives, and to recognise and measure them in accordance with financial instrument guidance.

Retrospective price adjustment power and utilities

A volume incentive is a form of variable consideration commonly included in supply contracts in the power and utilities industry (for example, power supply arrangements). In these arrangements, the price per unit will be adjusted retroactively once the customer reaches a certain sales volume.

When determining the transaction price, reporting entities should estimate the amount of consideration to which it will be entitled in exchange for transferring the promised services to a customer. Reporting entities should consider their experience (or other evidence) with similar types of contract and whether this experience has predictive value.

Retroactive adjustments to the transaction price, allocated to satisfied performance obligations, are recognised as revenue immediately on a cumulative catch-up basis. [IFRS 15 para 88]. A change in the amount allocated to a performance obligation that is satisfied over time is also adjusted on a cumulative catch-up basis. This will result in less revenue or more revenue in the period of change for the satisfied portion of the performance obligation.

Case – Volume discount incentive

Background

Power Sale Co (‘Seller’) and Electric Buy Co (‘Buyer’) are parties to an existing arrangement for the purchase and sale of electricity. The contract price is $50/MWh. The price will be retrospectively reduced to $48/MWh if Buyer consumes more than 90,000 MWh in a calendar year.

Seller estimates that the total sales volume for the year will be 82,000 MWh, based on its prior experience with, and forecast sales to, Buyer. Seller considers that it is highly probable that there would be no significant reversals based on this assessed volume.

In the first quarter ended 31 March, Buyer consumes 19,000 MWh, which fell within the range of Seller’s expectations. Buyer recognised revenue of $950,000.

In May, Buyer starts an unanticipated new project that increases Buyer’s needs for power. In the second quarter ended 30 June, Buyer consumes 25,000 MWh.

In light of the new project, Seller revises its sales forecast and now estimates that Buyer will exceed the 90,000 MWh threshold. As a result, Buyer will need to retroactively adjust the selling price to $48/MWh.

How does Seller account for this change in estimate?

Analysis

Seller should update its calculation of the transaction price to reflect the change in estimate. The updated transaction price is $48/MWh, based on the new estimate of total sales volume.

Consequently, Seller recognises revenue of $1,162,000 for the quarter ended 30 June, calculated as follows:

$48 * 25,000 MWh consumed in 2Q

1,200,000

Less: $2 * 19,000 MWh consumed in 1Q

-38,000

1,162,000

The cumulative catch-up adjustment reflects the amount of revenue that Seller would have recognised if, at contract inception, it had had the information that is now available. Seller will continue to update its estimate of the total sales volume at each reporting date until the uncertainty is resolved.

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