Third step of the five step model introduced by IFRS 15 is determining the transaction price. When performance obligations are satisfied, transaction price is the amount by which an entity should recognize revenue. But what is transaction price? Transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. In determining the transaction price, an entity should consider the terms of the contract and its customary business practices.
Remember! Contract price is not the transaction price. For instance, a business sells a particular item whose invoice price/ contract price is $100 but its customary business practice is to offer a discount of $2 on cash payment. Transaction price will be $98, not $100.
Following factors will affect the entity’s estimate of transaction price:
- variable consideration
- the existence of a significant financing component in the contract
- non-cash consideration
- consideration payable to customer
Consideration promised in a contract may be fixed or variable. Consideration can vary due to discounts, rebates, price concessions, performance bonuses, penalties for late delivery etc. or the consideration may be contingent on happening of a future event. If there is a component of variable consideration in the contract, then the entity would need to estimate the amount of consideration to which the entity will be entitled in exchange of transferring goods or services to the customer.
Variability of consideration may be explicitly stated in the contract, but in addition to the terms of the contract, an entity should evaluate whether there is any implied variability in the consideration. The consideration will be variable if the following circumstances exist:
- the customer has a valid expectation arising from the entity’s customary business practices, published policies or statements that the entity will offer a discount or price concession, or the entity will accept an amount of consideration that is less than the price stated in the contract; or
- other facts and circumstances indicate that entity will offer a price concession to the customer
Methods to estimate variable consideration
The Expected Value: The probability-weighted average amount of all possible consideration amounts is called the expected value. Applying The Expected Value method to estimate variable consideration is appropriate if an entity has a large number of contracts with similar characteristics. The entity can use its historical data to work out probabilities for calculation of the expected value.
The Most Likely Amount: Single most likely amount in a range of possible consideration amounts. Applying The Most Likely Amount method to estimate variable consideration is appropriate if the contract has only two possible outcomes. (Eg. an entity either suffers late delivery penalty or not.)
Constraining estimates of variable consideration
Another concept introduced by IFRS 15 is constraining estimate of variable consideration. An entity should include in the transaction price the amount of variable consideration only to the extent that it is highly probable that “a significant reversal in the amount of cumulative revenue will not occur” when the uncertainty is subsequently resolved.
Reassessment of variable consideration
At the end of each reporting period, an entity should reassess and update the estimated transaction price to reflect changes in the uncertainty associated with the variable consideration. An entity should allocate this change in transaction price to the performance obligations on the same basis on which transaction price was allocated initially.
The existence of a significant financing component in the contract
In determining the transaction price, the entity should consider the time value of money. If there is a significant financing component in the contract, whether explicitly stated in the terms of the contract or not, transaction price should be adjusted for this significant financing component. By doing this, an entity recognizes revenue at an amount that reflects the price of goods or services transferred and the time value of money/ financing component is separately recorded as other income (interest income). As a practical expedient, IFRS 15 has stated that an entity does not need to adjust the transaction price for time value of money if the financing period is one year or less.
ABC Company sells a vehicle to a customer on 1 July 20X7 for a consideration of $2 million. Payment terms agreed were that $1 million will be paid on delivery of machinery and the remaining amount will be paid after two years. What will be the amount of revenue to be recognized? Discount rate is 5%.
On 1 July 20X7, machine is delivered and following amount of revenue should be recognized:
|Amount to be paid on 1 July 20X7||1,000,000|
|Present value of amount payable after 2 years
[1,000,000 / (1.05)2]
Following journal entries will help in understanding the concept:
|I July 20X7|
|Bank / cash||1,000,000||–|
|30 June 20X8|
|Interest income (907,029 x 5%)||–||45,352|
|30 June 20X9|
|Interest income (907,029 + 45,352) x 5%||–||47,619|
|Bank / cash||1,000,000||–|
If consideration promised in a contract with customer is in a form other than cash, an entity shall measure the non-cash consideration at its fair value.
If fair value of non-cash consideration cannot be measured reliably, an entity should measure the consideration with reference to the stand alone prices of goods or services promised in the customer.
Consideration payable to customer
A contract with customer may include consideration payable to customer in the form of cash, credit or other items such as coupons, vouchers etc that the customer can use to adjust the amount owed to the entity. Consideration payable to the customer should be considered by the entity as a reduction in the transaction price.