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.
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.
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.
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. 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.
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:
- 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.
- 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.
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.
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.
Variable consideration – most likely amount
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.