Accounting for revenue – allocating the transaction price

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 three of these steps here, here and here. In this article we’ll take a brief look at some of the issues attaching to the fourth step – to allocate the transaction price.

An entity’s objective when allocating the transaction price is to allocate that price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which it expects to be entitled in exchange for transferring the promised goods or services to the customer. It does this on a on a relative stand-alone selling price basis – determining the stand-alone selling price, at the time of incepting the contract, of the distinct good or service underlying each performance obligation in the contract and allocating the transaction price in proportion to those stand-alone selling prices.

The stand-alone selling price is the price at which an entity would sell a promised good or service separately to a customer. IFRS 15 states: “The best evidence of a stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers. A contractually stated price or a list price for a good or service may be (but shall not be presumed to be) the stand-alone selling price of that good or service.” If a stand-alone selling price isn’t directly observable, the entity estimates it in the way that achieves the standard’s allocation objective, considering all information (including market conditions, entity-specific factors and information about the customer or class of customer) reasonably available to it. IFRS 15 requires maximizing the use of observable inputs and applying estimation methods consistently in similar circumstances.

As with many aspects of the new standard, this may cause some differences from existing practices. Canadian entities that sell goods and/or services on a “bundled” basis are accustomed to allocating consideration between different elements in the contract, but IFRS currently contains little specific guidance on how to accomplish this. For example, IAS 18 currently states only that when a product’s selling price includes an identifiable amount for subsequent servicing, that amount is deferred and recognized as revenue over the period during which the service is performed; it defines the amount deferred as “that which will cover the expected costs of the services under the agreement, together with a reasonable profit on those services.” IFRS 15 continues to support an “expected cost plus a margin approach,” stating that “an entity could forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service”, but the result of this calculation will now have to be assessed against a clearer overriding objective.

Some issuers have supplemented the current broad concept by continuing to refer to the more detailed concepts existing under old Canadian GAAP and US GAAP – for example of “vendor-specific objective evidence” of fair value; however, at the very least, such entities will need to re-examine their current methods to ensure they generate results consistent with the objectives of IFRS 15, and provide adequate evidence for how this is accomplished.

The standard allows an entity to estimate the observable stand-alone selling price for a particular performance obligation on a residual basis (that is, based on what’s left of the transaction price after computing the amounts to be assigned to other goods and services), but only when the selling price is highly variable because a representative stand-alone selling price isn’t discernible from past transactions (that is, the evidence shows the item is sold in practice for a broad range of amounts), or when the entity hasn’t yet established a price for that good or service and the good or service hasn’t previously been sold on a stand-alone basis (i.e. the selling price is inherently uncertain). Otherwise, a residual basis isn’t acceptable under the standard.

As we discussed here, the transaction consideration may include an amount that’s variable (based on returns, rebates, performance bonuses or other matters). By its nature, the variable amount may relate only to one part of the contract (for example, a bonus triggered by delivering a particular item to the customer by a particular date) or else to the contract as a whole. An entity allocates the variable amount to a particular performance obligation or distinct good or service if the terms of that variable payment relate specifically to its efforts to satisfy that obligation or transfer that item, and if allocating the entire variable amount of consideration in that way is consistent with the overall allocation objective when considering all of the performance obligations and payment terms in the contract (that is, the entity must step back and consider the overall appropriateness of the allocation), Otherwise, it allocates the variable amount between the elements of the contract using the same overall principles set out above.

The opinions expressed are solely those of the author

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