Some issues around the third step in the IASB’s new framework for recognizing revenue
As we summarized here, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2017 (NB this was subsequently amended to January 1, 2018). The new standard is built around a five-step framework, and we discussed the first and second of these steps here and here. In this article we’ll take a brief look at some of the issues attaching to the third step – to determine the transaction price.
The transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes).” As with most aspects of the standard, determining this amount will often be straightforward – in a standard retail sale, for instance, there’s usually no doubt about the price attaching to the transaction. However, in many circumstances, IFRS 15 will require entities to think more specifically about the amount of consideration they expect to receive under a contract, and often to adopt a more systematic approach to anticipating and recording the effects of any factors that might change that amount.
In particular, IFRS 15 contains new requirements for identifying and measuring variable consideration – amounts of consideration that can vary due to the effect of discounts, rebates, refunds, returns, penalties, or other items. These factors may be specifically identified in the contract, or may arise when the customer has a valid expectation arising from an entity’s customary business practices, published policies or specific statements that it will offer a price concession. Before an entity can recognize any revenue on a contract, the standard requires estimating the amount of consideration to which it will be entitled, taking all of this into account, in exchange for transferring the promised goods or services to a customer.
The entity makes the estimate by using either of the following methods, depending on which method it expects to better predict the amount of consideration to which it’ll be entitled:
- (a) The expected value— the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.
- (b) The most likely amount—the single most likely amount in a range of possible consideration amounts (i.e. the single most likely outcome of the contract). This may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or doesn’t).
The entity applies one method consistently through the life of a contract (although it may apply different methods for different contracts), considering all the historical, current and forecast information available to it. The standard notes that the information used for this purpose “would typically be similar to the information that the entity’s management uses during the bid-and-proposal process and in establishing prices for promised goods or services”.
The entity recognizes a refund liability if it receives consideration from a customer and expects to refund some or all of that consideration to the customer. It updates the refund liability (and corresponding change in the transaction price) at the end of each reporting period for changes in circumstances.
In some cases, the variability attached to an element of consideration may be so great that the standard precludes the entity from recognizing any revenue. An entity doesn’t include any amount of variable consideration in the transaction price unless “it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.” This might apply for instance when the entity only has limited experience with a particular product, or where the range of concessions that might be offered to customers is unusually wide or unpredictable. The entity updates its assessment of these matters at the end of each reporting period, along with updating other aspects of its assessment of variable consideration.
Entities reporting under IFRS are presumably already accustomed to reducing the amount of revenue they recognize from their transactions to reflect an estimate for price concessions or similar matters, but current standards don’t address how to implement this. Consequently, for some entities (such as those engaging in a high volume of transactions, subject to multiple ways in which the amount ultimately received from a customer might vary), this aspect of IFRS 15 might require establishing significant systems and procedures, and an ongoing challenge in assessing the adequacy of estimation processes.
Among other things, the new standard also requires adjusting the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract contains a significant financing component (either explicitly or implicitly). This requirement is similar but not identical to a current requirement in IAS 18. However, the standard specifies as a practical expedient that an entity needn’t adjust the promised amount of consideration for the effects of a significant financing component if it expects, at contract inception, that the period between when it transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less. So that’s something…
The opinions expressed are solely those of the author