Variable consideration in transaction price and 4 best examples

Variable consideration in transaction price

IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here. Variable consideration in transaction price

This section is part of step 3 determining the transaction price. Instead of the amount of consideration specified in a contract being fixed, the amount receivable by a vendor may be variable. In other cases, the consideration may be a combination of fixed and variable amounts.

Variable consideration can arise for a wide range of reasons, including discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items. The principle is that if there is any potential variation in the amount that a vendor will receive in return for its performance, then the related provisions in IFRS 15 will apply.

Customer credit risk

However, the transaction price is not adjusted for the effects of a customer’s credit risk. In some cases, such as when a discount is offered between the date of supply of goods or services and the payment date, it may be difficult to determine whether a vendor has offered a price concession, or has chosen to accept the risk of the customer defaulting on the contractually agreed amount of consideration. In the development of IFRS 15, it was noted that this judgment already exists in application of current IFRSs and it was decided not to include detailed requirements in IFRS 15 for making the distinction between a price concession and impairment losses. Variable consideration in transaction price

Variable consideration in transaction priceVariable consideration

As with the identification of contractual terms themselves, it is necessary to look more widely than the contract between a vendor and its customer. Variability in the amount of consideration receivable may arise if the customer has a valid expectation arising from a vendor’s customary business practices, published policies or specific statements that the vendor will accept an amount of consideration that is less than the price stated in the contract. Variable consideration in transaction price

In addition, it is necessary to consider whether there are any other facts and circumstances that suggest that the vendor has the intention of offering a price concession to its customer. For example, a manufacturer of retail goods might expect to offer a retailer a discount (or additional discount) from that specified in a contract for goods, in order to enable the retailer to sell the goods to its own customers at a discount and therefore to increase sales volumes. Variable consideration in transaction price

Example – Variable consideration – over-time revenue recognition

A construction company enters into a contract to build a bridge for €10m with an expected completion date of July 2019. The company determines that the over-time revenue recognition criteria of IFRS 15 have been met. The contract contains award / penalty clauses depending on the date of completion as follows:

Date of completion (amount in CU000) Award Penalty
June 2019 or earlier 200
July or August 2019 – i.e. on time
September 2019 or later 1,000

Due to the presence of a €1m penalty clause, the fixed consideration is €9m with any additional revenue being variable consideration.

At the start of the contract, the construction company determines with a high degree of certainty that the bridge will be completed on time and therefore, using the most likely outcome method and applying the constraint, no awards or penalty deductions are included when estimating contract consideration (€10m).

At their reporting date of 31 December 2018 they reassess their variable consideration estimate. At this point, it is most likely that the bridge will be completed in August 2019 but there is a reasonable chance that it will not be completed until September 2019 so they determine that the date by which completion is highly probably is September 2019.

Variable consideration to be recognised is therefore estimated to be constrained to € nil due to the penalty. Previously, the penalty deduction may only have been accounted for when incurred.

If at 31 December 2018 the most likely date of completion is June 2019, with the date by which completion is highly probably being determined as July 2019, then the variable consideration to be recognised would be estimated as €1m giving total consideration of €10m. Previously this may have been €10.2m, including receipt of the award based point in time recognitionon the most likely completion date.

Example – variable consideration – point in time recognition

A manufacturing company (the ‘supplier’) enters into a contract to sell the product ‘A Biscuit’ to a supermarket chain. The pricing in this contract is such that each pack is sold for £10, with a rebate being offered at the end of the year based upon the total number of packs sold in 12 months. Revenue is recognised for each pack upon delivery of that pack to the supermarket (‘point in time‘).

Number of packs delivered/sold in 2019
1 – 1,000 10/pack
1,001 – 1,500 8/pack
> 1,501 7/pack

Start of the contract

The variable consideration is the €3 per pack that reflects the difference between the €10 and €7 selling prices.

To determine how much of this variable consideration it can recognise on the sale of the packs to the supermarket chain throughout the year, the supplier must estimate how many packs of A Biscuit it expects to sell. At the start of the contract, based upon normal sale volumes to businesses similar to the supermarket chain it estimates that it will sell 1,200 packs (so consideration of €8 per pack) and it is highly probable that they will not sell more than 1,500 packs. The variable consideration of €3 is therefore constrained to €1 – giving a transaction price per pack of €8.

During the year

Upon sale of each pack of A Biscuit to the supermarket chain during the year, the supplier recognises €8 revenue. The difference of €2 between the invoice amount and revenue recognised is recorded as a contract liability.

At year end

At their reporting date of 31 December 2018 they reassess their variable consideration estimate. At this point, based upon volumes sold to date and the remaining period of the contract, they estimate that they will now sell 2,000 packs to the supermarket chain in total. The variable consideration is now constrained to €nil – giving a transaction price and revenue per pack of €7.

Stepped pricing

The above example shows a reduction in the price of each pack sold in the year. If the pricing were stepped rather than cumulative (ie first 1,000 at €10, the next 500 at €8, and all the rest at €7) the process of estimating variable consideration would still be the same:

  • During the year: recognise revenue of €9.67 for each pack sold as they estimate sales of 1,200 packs and it is highly probable that they will not sell more than 1,500 packs [(1,000 x €10 + 200 x €8)/1,200]
  • At year end: recognise revenue of €8.75 for each pack sold as they estimate sales of 2,000 [(1,000 x €10 + 500 x €8 + 500 x €7)/2,000]. This will result in a cumulative adjustment of (€0.92) reduction in revenue for each pack sold to date.

Estimating the variable consideration

When the consideration promised in a contract with a customer includes a variable amount, a vendor estimates the amount of consideration to which it is entitled to in exchange for the transfer of the promised goods or services. There are two possible methods which can be used, which are required to be applied consistently throughout the term of each contract: Variable consideration in transaction price

  • Expected value method: The sum of probability weighted amounts in a range of possible outcomes. This may be an appropriate approach if the vendor has a large number of contracts which have similar characteristics. Variable consideration in transaction price
  • Most likely amount: The most likely outcome from the contract. This may be an appropriate approach if a contract has two possible outcomes, such as a performance bonus which will or will not be received. Variable consideration in transaction price

The approach which is chosen is not intended to be a free choice, with the approach chosen for each contract being the one which is expected to provide a better prediction of the amount of consideration to which a vendor expects to be entitled.

Example – Variable consideration – expected value method

On 1 January 20X4, a vendor enters into a contract with a customer to build an item of specialised equipment, for delivery on 31 March 20X4. The amount of consideration specified in the contract is CU 2 million, but that amount will be increased or decreased by CU 10,000 for each day that the actual delivery date is either before or after 31 March 20X4.

In determining the transaction price, the vendor considers the approach that will better predict the amount of consideration that it will ultimately be entitled to, and determines that the expected value method is the appropriate approach. This is because there is a range of possible outcomes.

Example – Variable consideration – most likely amountVariable consideration in transaction price

A vendor enters into a contract with a customer to construct a building for CU 1 million. The terms of the contract include a penalty of CU 100,000 if the building has not been completed by a specified date.

In determining the transaction price, the vendor considers the approach that will better predict the amount of consideration that it will ultimately be entitled to, and determines that the most likely amount method is the appropriate approach. This is because there are only two possible outcomes; either the penalty will be applied or it will not.

The estimated amount of variable consideration is updated at each reporting date to reflect the position at that date, and any changes in circumstances since the last reporting date.

Also read: IFRS 15 in the spotlight variable consideration

Variable consideration in transaction price

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