International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

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  customer finds the same product offered by one of the entity’s competitors for a lower

  price during a specified period of time following the sale.

  Contracts with customers also may contain ‘most favoured nation’ or ‘most favoured

  customer’ clauses under which the entity guarantees that the price of any products sold

  to the customer after contract inception will be the lowest price the entity offers to any

  other customer. How consideration from such contracts would be accounted for under

  IFRS 15 depends on the terms of the clause (i.e. whether the price protection is offered

  prospectively or retrospectively).

  We believe that clauses that require an entity to prospectively provide a customer with

  its best prices on any purchases of products after the execution of a contract have no

  effect on the revenue recognised for goods or services already transferred to the

  customer (i.e. the consideration would not be accounted for as variable consideration).

  However, if an entity is required to retrospectively apply lower prices to previous

  purchases made by a customer (or has a past business practice of doing so even if the

  written contractual terms would only require prospective application), we believe the

  contract includes a form of price protection and the consideration subject to this

  provision would be accounted for as variable consideration, as discussed above. We

  note that these clauses may be present in arrangements with governmental agencies.

  For example, an entity may be required to monitor discounts given to comparable

  customers during the contract period and to refund the difference between what was

  paid by the government and the price granted to comparable commercial customers.

  6.2.1.F

  Early payment (or prompt payment) discounts

  Contracts with customers may include a discount for early payment (or ‘prompt

  payment’ discount) under which the customer can pay less than an invoice’s stated

  amount if the payment is made within a certain period of time. For example, a customer

  might receive a 2% discount if the payment is made within 15 days of receipt (if payment

  is otherwise due within 45 days of receipt). Because the amount of consideration to be

  received by the entity would vary depending on whether the customer takes advantage

  of the discount, the transaction price would be accounted for as variable consideration.

  6.2.2

  Estimating variable consideration

  An entity is required to estimate an amount of variable consideration by using either of

  the following methods, depending on which method the entity expects to better predict

  the amount of consideration to which it will be entitled:

  • The expected value – ‘the expected value is 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.’

  • The most likely amount – ‘the most likely amount is the single most likely amount

  in a range of possible consideration amounts (i.e. the single most likely outcome of

  the contract). The most likely amount may be an appropriate estimate of the

  amount of variable consideration if the contract has only two possible outcomes’

  (e.g. an entity either achieves a performance bonus or does not). [IFRS 15.53].

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  An entity applies one method consistently throughout the contract when estimating the

  effect of an uncertainty on an amount of variable consideration to which the entity will

  be entitled. In addition, an entity is required to consider all the information (historical,

  current and forecast) that is reasonably available to the entity and identify a reasonable

  number of possible consideration amounts. The standard states that the information an

  entity uses to estimate the amount of variable consideration 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. [IFRS 15.54].

  An entity is required to choose between the expected value method and the most likely

  amount method based on which method better predicts the amount of consideration to

  which it will be entitled. That is, the method selected is not meant to be a ‘free choice’.

  Rather, an entity selects the method that is best suited, based on the specific facts and

  circumstances of the contract. [IFRS 15.53].

  An entity applies the selected method consistently to each type of variable

  consideration throughout the contract term and updates the estimated variable

  consideration at the end of each reporting period. Once it selects a method, an entity is

  required to apply that method consistently for similar types of variable consideration in

  similar types of contracts. In the Basis for Conclusions, the Board noted that a contract

  may contain different types of variable consideration. [IFRS 15.BC202]. As such, it may be

  appropriate for an entity to use different methods (i.e. expected value or most likely

  amount) for estimating different types of variable consideration within a single contract.

  Entities determine the expected value of variable consideration using the sum of

  probability-weighted amounts in a range of possible amounts under the contract. To do

  this, an entity identifies the possible outcomes of a contract and the probabilities of

  those outcomes. The Board indicated in the Basis for Conclusions that the expected

  value method may better predict expected consideration when an entity has a large

  number of contracts with similar characteristics. [IFRS 15.BC200]. This method may also

  better predict consideration when an entity has a single contract with a large number of

  possible outcomes. The IASB clarified that an entity preparing an expected value

  calculation is not required to consider all possible outcomes, even if the entity has

  extensive data and can identify many possible outcomes. Instead, the IASB noted in the

  Basis for Conclusions that, in many cases, a limited number of discrete outcomes and

  probabilities can provide a reasonable estimate of the expected value. [IFRS 15.BC201].

  Entities determine the most likely amount of variable consideration using the single

  most likely amount in a range of possible consideration amounts. The Board indicated

  in the Basis for Conclusions that the most likely amount method may be the better

  predictor when the entity expects to be entitled to one of two possible amounts.

  [IFRS 15.BC200]. For example, a contract in which an entity is entitled to receive all or none

  of a specified performance bonus, but not a portion of that bonus.

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  The standard requires that when applying either of these methods, an entity considers

  all information (historical, current and forecast) that is reasonably available to the entity.

  Some stakeholders questioned whether an entity would be applying the portfolio

  approach practical expedient in paragraph 4 of IFRS 15 (see 4.3.1 above) when

  considering evidence from other, similar contracts to develop an estimate of variable

  consideration using an expected value method. The TRG members discussed
this

  question and generally agreed that an entity would not be applying the portfolio

  approach practical expedient if it used a portfolio of data from its historical experience

  with similar customers and/or contracts. The TRG members noted that an entity could

  choose to apply the portfolio approach practical expedient, but would not be required

  to do so.68 Use of this practical expedient requires an entity to assert that it does not

  expect the use of the expedient to differ materially from applying the standard to an

  individual contract. The TRG agenda paper noted that using a portfolio of data is not

  equivalent to using the portfolio approach practical expedient, so entities that use the

  expected value method to estimate variable consideration would not be required to

  assert that the outcome from the portfolio is not expected to materially differ from an

  assessment of individual contracts.

  Upon adoption of IFRS 15, many entities will see significant changes in how they

  account for variable consideration on adoption of IFRS 15. This will be an even more

  significant change for entities that previously did not attempt to estimate variable

  consideration under legacy IFRS and simply recognised such amounts when received

  or known with a high degree of certainty (e.g. upon receipt of a report from a customer

  detailing the amount of revenue due to the entity).

  As an example, the standard may change practice for many entities that sell their

  products through distributors or resellers. Before revenue could be recognised,

  paragraph 14 of IAS 18 required that the amount of revenue be measured reliably and

  that it be probable that the economic benefits associated with the transaction will flow

  to the entity. [IAS 18.14]. As a result, when the sales price charged to the distributor or

  reseller was not finalised until the product was sold to the end-customer, entities may

  have waited until the product was sold to the end-customer to recognise revenue.

  Under IFRS 15, waiting until the end-sale has occurred is no longer acceptable if the

  only uncertainty is the variability in the pricing. This is because IFRS 15 requires an

  entity to estimate the variable consideration (i.e. the end-sales price) based on the

  information available, taking into consideration the effect of the constraint on variable

  consideration. However, in some cases, the outcomes under IFRS 15 and legacy IFRS

  may be similar if a significant portion of the estimated revenue is constrained.

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  6.2.2.A Situations

  in which an entity would not have to estimate variable

  consideration at contract inception under IFRS 15

  An entity may not have to estimate variable consideration at the inception of a contract

  in the following situations:

  • Allocation of variable consideration exception – When the terms of a variable

  payment relate to an entity’s efforts to satisfy a specific part of a contract (i.e. one

  or more (but not all) performance obligations or distinct goods or services

  promised in a series) and allocating the consideration to this specific part is

  consistent with the overall allocation objectives of the standard, IFRS 15 requires

  variable consideration to be allocated entirely to that specific part of a contract. As

  a result, variable consideration would not be estimated for the purpose of

  recognising revenue. For example, an entity that provides a series of distinct hotel

  management services and receives a variable fee based on a fixed percentage of

  rental revenue may be able to allocate the percentage of monthly rental revenue

  entirely to the period in which the consideration is earned if the criteria to use this

  allocation exception are met. See 7.3 below for further discussion of the variable

  consideration allocation exception.

  • The ‘right to invoice’ practical expedient – When an entity recognises revenue

  over time, the right to invoice practical expedient allows it to recognise revenue as

  invoiced if the entity’s right to payment is for an amount that corresponds directly

  with the value to the customer of the entity’s performance to date. For example,

  an entity may not be required to estimate the variable consideration for a three-

  year service contract under which it has a right to invoice the customer a fixed

  amount for each hour of service rendered, provided that fixed amount reflects the

  value to the customer. See below 8.2.1.A for further discussion of the right to

  invoice practical expedient.

  • Sales-based and usage-based royalties on licences of intellectual property

  recognition constraint – The standard provides explicit application guidance for

  recognising consideration from sales-based and usage-based royalties provided in

  exchange for licences of intellectual property. The standard states that an entity

  recognises sales-based and usage-based royalties as revenue at the later of when:

  (1) the subsequent sales or usage occurs; or (2) the performance obligation to which

  some, or all, of the sales-based or usage-based royalty has been allocated has been

  satisfied (or partially satisfied).

  In many cases, using this application guidance results in the same pattern of

  revenue recognition as fully constraining the estimate of variable consideration

  associated with the future royalty stream. However, in cases where an entity is

  required to allocate sales-based or usage-based royalties to separate performance

  obligations in a contract, it may need to include expected royalties in its estimate

  of the stand-alone selling price of one or more of the performance obligations.

  See 9.5 for further discussion about sales-based and usage-based royalties related

  to licences of intellectual property.

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  6.2.3

  Constraining estimates of variable consideration

  Before it can include any amount of variable consideration in the transaction price, an

  entity must consider whether the amount of variable consideration is required to be

  constrained. The Board explained in the Basis for Conclusions that it created this

  constraint on variable consideration to address concerns raised by many constituents

  that the standard could otherwise require recognition of revenue before there was

  sufficient certainty that the amounts recognised would faithfully depict the

  consideration to which an entity expects to be entitled in exchange for the goods or

  services transferred to a customer. [IFRS 15.BC203].

  The IASB explained in the Basis for Conclusions that it did not intend to eliminate the

  use of estimates from the revenue recognition standard. Instead, it wanted to make sure

  the estimates are robust and result in useful information. [IFRS 15.BC204]. Following this

  objective, the Board concluded that it was appropriate to include estimates of variable

  consideration in revenue only when an entity has a ‘high degree of confidence’ that

  revenue will not be reversed in a subsequent reporting period. Therefore, the constraint

  is aimed at preventing the over-recognition of revenue (i.e. the standard focuses on

  potential significant reversals of revenue). The standard requires an entity to include in

  the transaction price some or all of an amount of variable consideration estimated only
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  to the extent that it is highly probable that a significant reversal in the amount of

  cumulative revenue recognised will not occur when the uncertainty associated with the

  variable consideration is subsequently resolved. [IFRS 15.56].

  In making this assessment, an entity is required to consider both the likelihood and the

  magnitude of the revenue reversal. The standard includes factors that could increase

  the likelihood or the magnitude of a revenue reversal. These include, but are not limited

  to, any of the following: [IFRS 15.57]

  ‘(a) the amount of consideration is highly susceptible to factors outside the entity’s

  influence. Those factors may include 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.

  (b) the uncertainty about the amount of consideration is not expected to be resolved

  for a long period of time.

  (c) the entity’s experience (or other evidence) with similar types of contracts is limited,

  or that experience (or other evidence) has limited predictive value.

  (d) the entity has a practice of either offering a broad range of price concessions or

  changing the payment terms and conditions of similar contracts in similar

  circumstances.

  (e) the contract has a large number and broad range of possible consideration amounts.’

  The standard does have an exception ‘for consideration in the form of a sales or usage-

  based royalty that is promised in exchange for a licence of intellectual property.’

  [IFRS 15.58].

  To include variable consideration in the estimated transaction price, the entity has to

  conclude that it is ‘highly probable’ that a significant revenue reversal will not occur in future

  periods once the uncertainty related to the variable consideration is resolved. For the

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  purpose of this analysis, the meaning of the term ‘highly probable’ is consistent with the

  existing definition in IFRS 5 – Non-current Assets Held for Sale and Discontinued

  Operations, i.e. ‘significantly more likely than probable’. [IFRS 5 Appendix A]. For US GAAP

  preparers, ASC 606 uses the term ‘probable’ as the confidence threshold for applying the

  constraint, rather than ‘highly probable’, which is defined as ‘the future event or events are