Step 3 Determining Transaction Price is all about correct revenue accounting in respect of the transaction price for the contract as part of IFRS 15 Revenue from contracts with customers. Step 3 Determining Transaction Price
IFRS 15 The revenue recognition standard provides a single comprehensive standard that applies to nearly all industries and has changed revenue recognition quite significant. Step 3 Determining Transaction Price
IFRS 15 introduced a five step process for recognising revenue, as follows:
- Identify the contract with the customer
- Identify the performance obligations in the contract
- Determine the transaction price for the contract
- Allocate the transaction price to each specific performance obligation
- Recognise the revenue when the entity satisfies each performance obligation
Step 3, determining the transaction price for the contract, describes the promise a customer makes to pay for the performance obligations identified in the contract. IFRS 15 47 defines transaction price as the amount of consideration the entity expects to be entitled to, in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (eg. sales tax).
In some revenue transactions the transaction price is clear. For example, a customer walks into a store and buys a new coat for its normal full price of $200. The customer pays the money to the store and the store gives the customer the coat. The transaction is complete and the store records $200 of revenue. Step 3 Determining Transaction Price
Under the new revenue recognition standard, this straightforward transaction could become complicated if, for instance, the customer can return the coat for a full refund. Complexities like variable consideration, rights of return and other terms inherent in some contracts can make determining the transaction price a little tricky.
Variable consideration is an amount dependent on the occurrence or non-occurrence of a future event. Variable consideration includes discounts, rebates, refunds, price concessions, incentives, performance bonuses, penalties, rights of return and other price modifications. The variability can be explicitly stated in the contract or can be implied through customer business or industry practices or other means. IFRS 15 50 – 54 requires an entity to estimate the impact of the expected variability in the transaction price and allocate it to the performance obligations so it is recognised as revenue. Step 3 Determining Transaction Price
In the standard, variable consideration can be estimated two ways:
- The expected value method which is the sum of the probability weighted amounts in a range of possible outcomes.
- “The most likely amount method” which is the one most likely outcome of the contract. This method is best suited to when there are only two possible outcomes, such as a company finishes ahead of schedule and receives a performance bonus or not.
These two methods are not policy choices with all extended disclosure requirements and restatements but estimation model choices (i.e. change in estimation process). A company is supposed to pick the method which is the best estimate of the variable consideration depending on the facts and circumstances. In general, the concept of variable consideration applies to contracts where the revenue will be recognised over time rather than at a point in time. Step 3 Determining Transaction Price
Constraining estimates of variable consideration
Under IFRS 15 the transaction price includes an estimate of variable consideration only if it is unlikely that there will be a significant reversal of the revenue recognised when the uncertainty related to the variable consideration is resolved. [IFRS 15 56]
In assessing whether it is probable that there will be a significant reversal in revenue recognised, both the likelihood and the magnitude of the revenue reversal are considered. Factors which could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following: Step 3 Determining Transaction Price
- The amount of consideration is highly impacted by factors outside the entity’s influence. Things such as volatility in a market, the judgement or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
- The entity’s experience with similar types of contracts is limited making it difficult to predict the likelihood of reversal.
- The entity typically offers a broad range of price concessions or changes payment terms and conditions of similar contracts in similar circumstances.
- The contract has a large number and broad range of possible consideration amounts. [IFRS 15 57]
Under IFRS 15 55 revenue should be offset by a refund liability if the company expects that refunds will occur. The amount of the refund liability should be estimated, and the estimate adjusted each reporting period. When a right of return exists, in addition to the right to a refund, an asset is recognised with an offset to cost of goods sold for the value of the expected returned goods. This means the entry to record revenue is something like this:
Profit or loss
Right of Return
Right of return asset
Cost of goods sold
The estimates of the refund liability and right of return asset is updated at the end of each period resulting in an increase or decrease in the revenue recognised. A right of return asset is measured at the original inventory carrying amount, less the expected cost to recover the asset, less any anticipated decrease in the value of the asset.
Significant Financing Components
IFRS 15 60 – 65 requires an entity to adjust the transaction price for the time value of money even if the contract does not explicitly call for a financing component. For contracts where the period of time between delivery of the product or services to the customer and the customer payment is less than a year, there is a practical expedient that can be used to eliminate consideration of the time value of money. For all other long term contracts, an entity must consider if there is a financing component. (If customer payments are deferred, the entity recognises interest income; if payments are accelerated, the entity recognises interest expense.) In order to assess in a contract contains a financing component and if it is significant to the contract the analysis should consider if: Step 3 Determining Transaction Price
- There is a difference between the amount of promised consideration and the true cash selling price of the promised goods or services, and Step 3 Determining Transaction Price
- The combined effect of both of: Step 3 Determining Transaction Price
- the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services; and Step 3 Determining Transaction Price
- the prevailing interest rates in the relevant market. Step 3 Determining Transaction Price
- The standard lists certain situations that would not indicate a financing component. These are:
- The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer. Step 3 Determining Transaction Price
- A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or non-occurrence of a future event not substantially within the control of the customer or the entity (eg. if the consideration is a sales-based royalty).
- The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract.
The interest income or interest expense should be presented separately from revenue from contracts with customers in the income statement. Interest income or interest expense is recognised only to the extent that a contract asset (or receivable) or a contract liability is recognised in accounting for a contract with a customer. Step 3 Determining Transaction Price
Non Cash Consideration
Some contracts may include arrangements in which a customer promised consideration in a form other than cash. The estimated fair value of the non-cash consideration at the beginning of the contract should be included in the transaction price. Any variation in the fair value of non-cash consideration after the initial measurement at contract inception does not affect the transaction price. [IFRS 15 66 – 69]
Consideration Payable to a Customer
Consideration payable to a customer includes cash amounts paid, or expected to be paid, to the customer as well as things like credits, coupons or vouchers that can be applied against what is owed to the seller company. Consideration payable to a customer reduces the transaction price and therefore revenue the company recognises in a transaction unless the consideration is in exchange for a distinct good or service and does not exceed the fair value of that good or service. [IFRS 15 70 – 72] Step 3 Determining Transaction Price
After the transaction price for the contract has been determined, then it is time to move to Step 4: Allocate the transaction price to each specific performance obligation.
See also: The IFRS Foundation