Allocating the transaction price to performance obligations (IFRS 15)

Fourth step of the five step model introduced by IFRS 15 is allocating the transaction price to performance obligations. If a contract has more than one performance obligations, then an entity is required to allocate the transaction price to each performance obligation on the basis of relative stand-alone selling prices. When a performance obligation is satisfied, revenue is recognized by an amount that has been allocated to that performance obligation on the basis of relative stand-alone selling prices.

What is stand-alone selling price? It is the price at which an entity would sell a promised good or service separately to a customer. At contract inception, an entity should determine the stand-alone selling price of each distinct good or service promised as performance obligation in the contract and allocate the transaction price to each performance obligation in proportion to these stand-alone selling prices.

Example – Allocating the transaction price to performance obligations

XYZ Telecommunications sells wireless internet devices along with various monthly / quarterly internet packages. Stand-alone price of internet device is $50, whereas quarterly internet package with unlimited downloading is sold at $60 per quarter. XYZ Telecommunications has also given its customers an offer to purchase the wireless internet device along with quarterly internet package for a total price of $90. A customer has purchased the internet device with quarterly internet package.

What will be the amount of revenue to be recognized?

Answer

There are two performance obligations involved in the contract:

  1. Sale of internet device
  2. Sale of quarterly / 3 months internet service

Transaction price of $90 is to be allocated between these two performance obligations.

Performance Obligation Stand-alone selling price Proportion of each performance obligation Allocated transaction price
Internet device $50 (50/110) = 45% ($90 x 45%) = $40
Internet services $60 (60/110) = 55% ($90 x 55%) = $50
$110 100% $90

Revenue of $40 is to be recorded at the time of sale of device and internet package. Remaining $50 pertaining to internet services is to be recorded with the passage of time resulting in complete recognition of $50 revenue by the end of 3 months.

Estimating stand-alone selling price

If an entity does not sell a distinct good or service separately, or the stand-alone selling price is not directly observable, the entity shall estimate the stand-alone selling price. Methods to estimate the stand-alone selling price of a good or service include:

  • Adjusted market assessment approach – Referring the market in which an entity sells its good or service to estimate the stand-alone selling price. This may include evaluating the prices of similar goods or services offered by competitors and adjusting those prices in order to reflect the entity’s costs and margins.
  • Expected cost plus margin approach – An entity can estimate stand-alone selling price of a good or service by forecasting the costs and adding an appropriate margin for that good or service.
  • Residual approach – An entity can estimate the stand-alone selling price of a good or service by subtracting the sum of observable stand-alone selling prices of other goods and services promised in a contract from total transaction price. However, this approach should only be used if either the selling price of that good or service is highly variable, or the selling price is uncertain as the entity has not previously sold that good or service separately.

Example – Estimating stand-alone selling price

ABC Company is in a business of selling cars together with an offer to obtain free service of the car for two years. Stand-alone price of car is $8,000 whereas if the customer opts for two years free service as well, the price would be $8,200. Stand-alone price of two years car service in not observable as ABC Company does not provide service of car on a stand-alone basis.

What will be the allocated transaction price of each performance obligation?

Answer

There are two performance obligations involved in the contract:

  1. Sale of car
  2. Two years free service

Transaction price of $8,200 is to be allocated between these two performance obligations. As stand-alone selling price of car service is not observable, ABC Company would need to estimate its stand-alone selling price.

Adjusted market assessment approach

After assessing the market, it was found that similar services were offered by another company for two years against a consideration of $600. Transaction price will be allocated as under:

Performance Obligation Stand-alone selling price Proportion of each performance obligation Allocated transaction price
Sale of car $8,000 (8000/8600) = 93.03% ($8,200 x 93.03%) = $7,629
Free car service $600 (600/8600) = 6.97% ($8,200 x 6.97%) =   $571
$8,600      100%                    $8,200

Expected cost plus margin approach

ABC Company can also use expected cost plus margin approach to estimate the stand-alone price of car service arrangement. ABC Company expects the costs to be incurred on providing free service of car for two years will be $300. ABC Company earns approximately 25% margin on its sales, so by adding the margin and the estimated costs, stand-alone selling price can be estimated.

USD
Expected costs to be incurred on service of car 300
Margin (25% x 300) 75
Expected stand-alone selling price 375

Transaction price of $8,200 will be allocated as under:

Performance Obligation Stand-alone selling price Proportion of each performance obligation Allocated transaction price
Sale of car $8,000 (8000/8600) = 95.52% ($8,200 x 95.52%) = $7,833
Free car service $375 (600/8600) = 4.48% ($8,200 x 4.48%) =   $367
$8,375 100% $8,200

Residual approach

ABC Company can also use residual approach to estimate the stand-alone price of car service arrangement. Using this approach, stand-alone service price of two years car service arrangement would be estimated as follows:

USD
Total transaction price 8,200
Less: Stand-alone selling price of car – 8,000
Expected stand-alone selling price of car service 200

Transaction price of $8,200 will be allocated as under:

Sale of car = $8,000

Car service arrangement = $200

Allocation of discount

It is very common that price of goods and services are slightly lower when purchased as a package compared to purchasing each good and service separately. If a customer purchases a bundle of goods or services and the price of that bundle or package is less than the sum of stand-alone prices of those goods or services, it means that customer is receiving a discount.

But how this discount should be allocated to performance obligations (goods or services in the bundle)? IFRS 15 guides that if there is no evidence or information that this discount is offered on a particular performance obligation (good or service), an entity should allocate the discount proportionately to all performance obligations in the contract. However, an entity should allocated a discount to only one or more, but not all performance obligations if the following criteria is met:

  • The entity regularly sells each good or service in the contract on a stand-alone basis;
  • The entity regularly sells some of those goods or services on a discount, when sold on a stand-alone basis; and
  • Discount offered in the contract is substantially the same as regularly offered when a particular good or service in the contract is sold on stand-alone basis.

Following example will further elaborate how discount should be allocated.

Example – Allocation of discount

An entity enters in a contract with customer to sell a wrist watch, a wall clock and a wall hanging for a price of $50. The stand-alone selling prices are as follows:

Wrist watch $30
Wall clock $20
Wall hanging $10
$60

Allocate the transaction price of $50 to each performance obligation in each of the following scenarios:

  1. There is no other information available
  2. The entity regularly sells wrist watch and wall clock together at a price of $40.

Answer (1)

As it cannot be said that discount of $10 is attributable to any one performance obligation, so it will be allocated to all performance obligations in proportion to their stand-alone selling prices.

Performance Obligation Calculation Allocated transaction price
Wrist watch ($30 / $60) x $50 $25
Wall clock ($20 / $60) x $50 $17
Wall hanging ($10 / $60) x $50 $8
  $50

Answer (2)

As it is evident that discount of $10 is attributable to only wrist watch and wall clock, so it will only be allocated to these two performance obligations and not to wall hanging.

Performance Obligation Calculation Allocated transaction price
Wrist watch ($30 / $50) x $40 $24
Wall clock ($20 / $50) x $40 $16
Wall hanging $10
  $50