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. Estimates introduce a degree of uncertainty into the amount of revenue that a vendor expects to receive. In order to avoid overly optimistic estimates being included in the calculation (and related revenue recognised), followed by a subsequent downward adjustment to actual amounts receivable (together with a reversal of previously recognised revenue), a constraint on the amount of variable revenue that can be recognised has been introduced.
The effect of the constraint (or restriction) is that the estimated transaction price can only include an amount of variable consideration if it is highly probable that there will not be a subsequent significant reversal in the amount of revenue recognised at the point at which uncertainty over the amount of variable consideration is resolved. As noted above, the position may change at each reporting date as more information becomes available and there is greater certainty about the expected amount of consideration.
The use of judgment and consideration of all facts and circumstances is required when assessing the potential for such a reversal and, includes the likelihood of a change in the estimate of variable consideration and the amount of the possible revenue reversal. Factors that indicate a significant revenue reversal may result from including an estimate of variable consideration in the transaction price include:
- The consideration is highly susceptible to factors outside the vendor’s influence, including:
- Volatility in a market Constraining estimates of variable consideration
- The judgement or actions of third parties (e.g. when the amount of variable consideration varies based on the customer’s subsequent sales of a good or service)
- Weather conditions Constraining estimates of variable consideration
- A high risk of obsolescence of the promised good or service. Constraining estimates of variable consideration
- Where uncertainty regarding the amount of variable consideration is not expected to be resolved for a long period of time
- The vendor’s experience (or other evidence) with similar types of contracts is limited or it has limited predictive value
- The vendor has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances
- The contract has a large number and broad range of possible variable consideration amounts.
In addition, there are specific requirements for revenue relating to sales- or usage-based royalties that are receivable in return for a licence of intellectual property. In those cases, revenue is recognised when (or as) the later of the following events takes place:
- The subsequent sale or usage occurs, Constraining estimates of variable consideration
- The performance obligation to which some or all of the sale- or usage-based royalty has been allocated has been satisfied (in whole or in part).
The requirement to assess variable consideration in this way might lead to a change in the timing of revenue recognition for some transactions.