Identifying variable consideration, or: in the penalty box!

Here’s an issue discussed a while ago by IFRIC:

  • The Committee received a request about an airline’s obligation to compensate customers for delayed or cancelled flights. In the fact pattern described in the request:
  • a)   legislation gives a flight passenger (customer) the right to be compensated by the flight provider (entity) for delays and cancellations subject to specified conditions in the legislation. The legislation stipulates the amount of compensation, which is unrelated to the amount the customer pays for a flight.
  • b)   the legislation creates enforceable rights and obligations, and forms part of the terms of a contract between the entity and a customer.
  • c)   applying IFRS 15 to a contract with a customer, the entity identifies as a performance obligation its promise to transfer a flight service to the customer.

The request asked whether the entity accounts for its obligation to compensate customers either: (a) as variable consideration applying paragraphs 50–59 of IFRS 15; or (b) applying IAS 37 Provisions, Contingent Liabilities and Contingent Assets, separately from its performance obligation to transfer a flight service to the customer.

IFRS 15 addresses the situation where a law requires an entity to pay compensation if its products cause harm or damage, specifying that this doesn’t in itself give rise to a performance obligation, and falls within the scope of IAS 37. On the other hand, it also specifies that when an amount of consideration varies due to “penalties,” it falls within the scope of variable consideration. The line between “paying compensation for harm or damage” and incurring a “penalty” is evidently a fine one. In this case, IFRIC took the view that any compensation for delays or cancellations relates directly to the entity’s performance obligation (regardless that it may be specified by legislation rather than by contract) and so falls within the concept of variable consideration. The Committee concluded that IFRS 15 provides an adequate basis as it stands for analyzing this, and therefore decided not to add the matter to its agenda. Among other things it cites illustrative example 20 to the standard, in which an entity enters with a contract with a customer to build an asset, with the terms of the contract setting a penalty if construction isn’t completed within three months of a specified date: in this case the penalty gives rise to a variable consideration amount.

The International Air Transport Association submitted a comment on the initial tentative agenda decision, arguing in disagreement that payments made to compensate passengers for delays and cancellations:

  • are consistently referred to as compensation and not a penalty in the legislation, Montreal Convention and contract for carriage; (2) are insurable losses commonly included in most travel insurance indicating that these are losses and not a penalty; (3) vary based upon the loss of time incurred by the customer suggesting that the payment is to compensate for a loss of time; and (4) have no relationship to the price paid by the customer and therefore do not represent an adjustment to the price of the service to be provided.

For example, to flesh out the third point, “the passenger on a significantly delayed or cancelled flight incurs the loss of time and opportunity, and may incur other loss related to booked cars, hotels, tours, etc.” If an airline compensates the passenger for such losses, then IATA sees this as compensation for harm or damage rather than as a penalty. From a plain language kind of perspective, I expect many might see their general point. But the IASB staff paper comments:

  • The compensation payable to flight customers may increase in increments whereas the penalty in Illustrative Example 20 is a fixed amount—however, we think fixed versus increasing does not change the nature of the payments. In our view, it is nature of the payment that is relevant to the assessment—i.e. whether the payment relates to the transfer of the promised good or service in the contract and, thus, is part of the consideration to which the entity is entitled in exchange for transferring that good or service. The label attached to a payment (eg ‘compensation’), how the amount of the payment is determined (eg whether related or unrelated to the ticket price) and whether the payment is fixed or variable do not affect the assessment of whether the payment represents variable consideration.

Still, one can see what the Accounting Standards Committee of Germany was getting at in the following:

  • .. .we would have appreciated a more holistic discussion that included variations of the fact pattern submitted or modified circumstances in order to better distinguish between situations where something is indeed a reduction of the selling price per IFRS 15 or separate obligations provided for under IAS 37. Without this, the tentative decision is not as helpful as it could be, as it does not illustrate potential legal or contractual rights and obligations that could distinguish between (a) compensations “still” being a variable consideration of the very same performance obligation and (b) those being a separate obligation, thus in the scope of IAS 37…

IFRIC let that pass, on the basis that further research and analysis would be necessary to identify and address all the possible fact patterns. Which may indicate that further challenging fact patterns are still lurking out there…

The opinions expressed are solely those of the author.

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