Junior Audit Manager at RSM Poland
After a couple of weeks we are coming back in our blog to the analysis of the new standard, i.e. IFRS 15. Just like IFRS 9, it is critical for entities preparing their reports in line with IFRS, because they both must be introduced for the first time in financial reporting as at 31 December 2018. Therefore, it is a good idea to take a closer look at the topic of revenue recognition and discuss it further.
After identification of the contract and performance obligations in the contract, the third step in the five-step model framework of revenue recognition according to IFRS 15 is the measurement of revenue from the concluded sales contract, involving the need to determine the transaction price. In line with IFRS 15, the transaction price is the consideration to which an entity expects to be entitled in exchange for the transfer of promised goods or services to the customer, excluding the amounts collected on behalf of third parties (e.g. value-added tax).
For the purpose of determining the transaction price, it must be assumed that it will be in accordance with the contract terms and conditions, which means that any cases of contract renewal, modification or cancellation are excluded when determining the transaction price. Thus, it is assumed that the goods or services will be transferred to the customer in the course of regular contract performance.
The concept behind determining the transaction price adopted in IFRS 15 is a practical extension of the requirement to measure the revenue at fair value of the consideration received or due. Solutions employed in IFRS 15 produce a transaction price adopted for the purpose of revenue measurement that will not always be consistent with the nominal value of the consideration under the contract. At the same time, revenue recognition in the books will not always be synonymous with the price given directly in the sales invoice.
On the basis of IFRS 15, the consideration for a sales contract becomes an estimated value that needs to be revaluated at the end of each reporting period during the contract term, with potential adjustments entered to reflect the actual revenue from the contract expected by the entity. To estimate the transaction price, the entity has to rely on its earlier experiences and perform reliable forecasting, taking into account both contractual terms and conditions and customary practices of a given industry, so that the recognised revenue reflects the most probable value to be recognised by the entity.
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In order to estimate the transaction price properly, the entity must consider the actual nature of the consideration the entity expects for the transfer of goods or services, which means that the following need to be examined:
- variable consideration,
- constraining estimates of variable consideration,
- existence of a significant financing component in the contract,
- non-cash consideration,
- consideration payable to a customer.
A variable consideration may result directly from the terms and conditions of the contract or non-contractual factors, arising from customary business practices, published policy or specific statements made by the vendor, on the basis of which the customer may reasonably expect the contractual consideration to be reduced. In practice, the consideration is variable due to discounts, rebates, price concessions, allowances, performance bonuses, discounts for early payment, penalties, the right to return the goods, or consideration payable to a customer.
When estimating the transaction price, the entity must take into account all expectations known to the entity on the basis of binding contract and business terms and concerning the actual value of the consideration for transferring the goods or services, in particular those that generate a price concession.
Depending on the nature of the variable consideration for the contract, IFRS 15 provides two methods for estimating the transaction value depending on the nature of the concluded sales transactions: the expected value method and the most likely amount method. We are soon going to discuss both methods in one of the upcoming posts on our blog.
Constraining estimates of variable consideration
For revenue measurement in the case of variable consideration, IFRS 15 introduces a constraint that variable consideration should only be included in the estimated transaction price to the extent that it is highly probable that a significant reversal of recognised revenue will not occur. This constraint requires the entity to consider the following factors when estimating the transaction price:
- the entity has little experience with a specific type of contracts, resulting in the lack of reliable data and forecasts allowing to estimate the amount of variable consideration (e.g. bonus for timely contract performance);
- the range of possible consideration amounts is broad and includes many options (e.g. the contract provides for several price options for predefined sales volume thresholds);
- the uncertainty about the amount of variable consideration is not expected to be resolved for a long period of time;
- the amount of variable consideration is highly susceptible to factors outside the entity’s influence (volatility of the market or the industry, shelf life of goods or weather conditions).
Having considered the above factors, the entity includes in the transaction price only this part of variable consideration in respect of which it is highly probable that the need to adjust a significant part of revenue will not occur.
The entity concluded a contract to supply goods X in the amount of 2,500 items over a period of up to 2 years. Under the contract, there are different prices contingent on exceeding the sales volume thresholds.
1-2,000 items – price PLN 20/ item
2,001- 2,500 items – price PLN 15/ item
If the sale in year one reaches 2,000 items, the entity could take the price of PLN 20/ item as the most probable value, and recognise revenue in the value of PLN 40,000. Under the contract, any further sale entitles the customer to the price of PLN 15/ item, which would require and adjustment of the sale from the previous year by an amount of PLN 10,000. Taking into account the constraining estimates of the price for a predefined sales threshold, the entity should apply the price of 15 PLN/ item when measuring the transaction price for the entire contract.
Recognising the revenue for the contract in year one will require the entity to recognise the following:
- consideration for sale - DT trade receivables PLN 40,000
- revenue in the value of transaction price - CT Revenue PLN 30,000
- liabilities for the surplus of received consideration - CT trade liabilities PLN 10,000
Contracts with the right of return
Contracts of sale with the right of return are contracts in which the entity transfers the control of the product to the customer and grants the customer the right to return the product and to receive a full or partial refund of the consideration. In the case of contracts with the right of return, this right and the entity’s expectations related to this right must be addressed in the measurement of the variable consideration.
To account for the effects of a contract with the right of return or the entity’s expectations that the customer may use this right, the entity must recognise the following:
- revenue for transferred products in the amount of consideration to which the entity expects to be entitled (i.e. after the adjustment for part of the revenue for products that are expected to be returned);
- a refund liability for the part or the total of the received amount or amount due in the future, to which the entity expects not to be entitled because of the return;
- an asset for the right of return in the initial carrying amount of this asset (product, good) less the expected costs of return and the possible impairment;
- adjustment of the cost of sales for the return of the asset.
In this case, the estimation of the transaction price is going to involve an adjustment of the expected contractual consideration for the right of return, resulting either directly from this contract or the customary practices in the industry. Therefore, any adjustment of the estimated transaction price requires the entity to have reliable data on the expected returns at the level of the contract, the group of customers or the type of goods.
Existence of a significant financing component in the contract
A contract is considered to include a significant financing component if the timing of contractual payments agreed in the contract provides the customer or the entity with a significant benefit of financing the transfer of goods or services. A significant financing component may be stated explicitly in the contract or implied by the payment terms agreed by the parties to the contract.
If a significant financing component exists in the contract, the promised amount of consideration must be adjusted for the effects of the time value of money, and this adjustment will determine the transaction price for the contract. The objective of adjusting the promised amount of consideration for the effects of the significant financing component is to recognise the revenue in the amount reflecting the cash selling price, i.e. the price the customer would have paid for these goods or services at the time when they were being transferred.
The financing component can be skipped in the measurement of the transaction price if it is not significant. When evaluating whether the financing component is significant, you need to consider a combined effect of the following circumstances:
- the difference between the amount of consideration and the cash selling price,
- the expected length of time between the transfer of goods and the payment for these goods,
- the prevailing interest rate in the relevant market.
Once a significant financing component is identified, its effects must be presented as interest revenue or interest expense separately from the revenue from contracts with customers (the contract is recognised at the level of the estimated transaction price). In the case of deferred consideration (including payment in instalments), the interest revenue for a significant financing component is recognised. For the deferred consideration, the transaction price shall be measured at the level of the present value of future contractual payments. The interest expense shall be recognised for upfront payments and shall be accounted for as an increased liability in order to measure the value of the revenue as at the date when its recognition criteria are met (delivery of promised goods or services).
It should be emphasised that the obligation to identify and recognise a significant financing component shall not apply to sale transactions in which the time between the entity transferring the goods or services and the customer paying for it is one year or less.
Let us note the types of transactions that do not include the significant financing component:
- the consideration is variable, but neither the customer nor the entity have any impact on the level of amounts and payment times (the consideration is contingent upon meeting a predefined condition, e.g. achieving a certain turnover);
- there is no difference between the cash selling price and the amount of consideration under the contract, but the reasons are other than financing (e.g. amounts retained to secure proper contract performance);
- there is a prepayment, but the timing of transfer of goods or services is at the customer’s discretion (e.g. gift cards).
If the contract provides for consideration in a form other than cash, determining the transaction price requires the entity to measure this type of consideration (part of consideration) at fair value, provided that the entity is able to perform a reliable measurement of this value. The fair value of the non-cash consideration depends on the form of this consideration and may take different values, e.g.:
- consideration in the form of other goods or services transferred in exchange for the supply of goods or services sold by the entity: the prevailing selling price of these goods or services on the market;
- consideration in the form of quoted equity instruments: the market price of these instruments;
- consideration in the form of advisory granted by the purchasing entity to the selling entity: the selling price of the advisory service of a relevant type used by the purchasing entity or the market price in a given industry.
If the fair value of non-cash consideration cannot be estimated, the consideration shall be measured by reference to the stand-alone selling price of goods or services promised to the customer in exchange for the non-cash consideration.
The delivery of goods or services by the entity to fulfil the contract shall constitute non-cash consideration for this contract provided that the entity obtains control of the transferred assets.
Consideration payable to a customer
In the business practice, there are contracts that involve a consideration the vendor pays to the purchaser or is expected to pay. The consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer. The existence of the consideration payable to a customer may be stated explicitly in the contract or implied by the entity’s customary business practices. Examples of this type of consideration include the following:
- returns of a price difference of a given good or service identified by the customer;
- payments to the customer for introducing modifications that allow purchasing specific goods or services from the vendor in the future (modernisation at the purchaser’s premises in order to use goods from a specific supplier in production);
- discounts and rebates payable for reaching a predefined turnover of the vendor’s goods.
The presence of such payments in the contract (they do not constitute a payment for a distinct good or service) requires an adjustment (reduction) of the transaction price. The transaction price shall be adjusted for the consideration payable to the customer when the later of either of the following events occurs:
- the entity recognises the revenue for the transfer of the related goods or services to the customer;
- the entity pays or promises to pay the consideration, even if the payment is conditional on a future event.
Once consideration payable to the customer is identified, it should be determined whether it is not actually a payment for a distinct good or service.
Summing up, in accordance with IFRS 15, revenue measurement is performed at the level of the transaction price determined by the entity as an estimate reflecting the amount of actual consideration the entity expects for the entire contract. The estimated transaction price includes both the time value of consideration and any adjustments of the consideration resulting from constraining estimates, price concessions and the entity’s liabilities towards the customer (acceptance of the return, payment of the consideration).
The estimated nature of the transaction price means it must be revaluated at each balance sheet date on the basis of the entity’s best knowledge concerning the actually expected consideration for the contract. Any probable reductions of the consideration identified for a given balance sheet date require an appropriate adjustment of the revenue in this reporting period.
At the same time, the standard requires the constraining estimates of the consideration for the contract to be measured, thus limiting the possibility of overestimating the revenue that would cause its adjustment in the following periods. Applying a properly measured transaction price and revaluating it at each balance sheet date allow to measure revenue from the sales contracts in the most reliable value of the expected consideration.
And how should this consideration be allocated to different obligations? We are going to discuss it soon in our blog.
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*Compiled on the basis of training materials of the Education Centre of the Polish Chamber of Statutory Auditors – New model framework for revenue recognition according to IFRS 15 “Revenue from contracts with customers”.