Revenue from contracts with customers (IFRS 15) - Variable c...

Learning Outcomes

After reading this article, you will be able to explain how variable consideration and significant financing components affect revenue recognition under IFRS 15. You will identify the types of variable consideration, apply methods for estimating amounts, assess the need for constraint, and make required adjustments where payment timing creates a significant financing effect within the transaction price.

ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand how to determine and adjust the transaction price when contracts contain variability or significant financing. Specifically, revision for this article should focus on:

• Determining the transaction price under IFRS 15, including fixed and variable consideration
• Estimating variable consideration using appropriate methods and applying the constraint
• Identifying and accounting for significant financing components in revenue contracts
• Adjusting transaction price for anticipated financing effects
• Allocating the adjusted transaction price to performance obligations

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What are the two main methods permitted under IFRS 15 for estimating variable consideration in a contract?
2. When must an entity adjust the transaction price for a significant financing component? Briefly describe how this affects revenue recognition.
3. True or false? The full amount of variable consideration should always be included in revenue as soon as the contract is signed.
4. A developer sells apartments with a right of return clause and 12-month interest-free financing. Which two IFRS 15 issues are likely to arise?

Introduction

Revenue from most customer contracts is straightforward: the price is fixed and payment is prompt. However, contracts may include rebates, performance bonuses, rights of return, or delayed settlement terms. IFRS 15 requires entities to estimate variable amounts and adjust for the effect of significant financing, so as to present revenue that properly reflects the substance of the transaction.

This article addresses determining the transaction price under IFRS 15 where consideration may vary or when timing of receipts provides a significant financing benefit to either party. Both are critical to accurate revenue recognition and frequently examined on the FR paper.

Key Term: Variable consideration
A component of the contract price that can change because of factors such as discounts, incentives, penalties, or the customer's right to return goods or services.

Key Term: Significant financing component
Where the timing between provision of goods or services and customer payment gives one party a significant economic benefit from financing.

TRANSACTION PRICE: VARIABLE CONSIDERATION

Within IFRS 15, the transaction price is the amount of consideration the entity expects in exchange for transferring goods or services. If the contract provides incentives, rebates, bonuses, or penalties, this pricing is not fixed.

Identification

Variable consideration arises when the payment amount depends on future events—for instance, sales with possible rebates, price concessions, performance bonuses, penalties, or rights of return. Entities must estimate the value they expect to receive.

Estimation Methods

IFRS 15 allows two methods for estimating variable consideration:

1. Expected value method—sum of probability-weighted amounts over a range of possible outcomes (typically used where many contracts have similar characteristics).
2. Most likely amount method—the single most likely amount from the range (used if the outcome is binary, e.g., a bonus is either earned or not).

The selection depends on which method predicts the amount better, given the inherent pattern.

Applying the Constraint

Estimated variable consideration is included in the transaction price only to the extent that it is highly probable that a significant reversal of cumulative revenue will not occur when uncertainties resolve. This is known as the 'variable consideration constraint'.

If significant risk of reversal exists (for example, sales-based royalties for a license where sales are highly uncertain), only the non-variable portion is recognised as revenue until the uncertainty is resolved.

Worked Example 1.1

A company supplies pharmaceuticals to a wholesaler and offers a 2% volume rebate if annual sales exceed $500,000. At quarter-end, cumulative sales suggest the rebate threshold is likely to be met. How should revenue be recognised?

Answer:
The price reduction (2% rebate) is variable consideration. The company estimates expected annual sales (probability-weighted), assesses if it is highly probable a significant reversal will not occur, and recognises revenue net of the 2% rebate—reflecting an amount that will not likely need to be reversed later.

VARIABLE CONSIDERATION: PRACTICAL APPLICATIONS

Variable elements may include:

• Sales returns: Estimate based on historical data, recognised as refund liability and a corresponding asset for the right to recover inventory.
• Volume discounts/rebates: Estimate at contract inception and update at each reporting date.
• Performance bonuses or penalties: Include in revenue only if outcome is sufficiently certain under the constraint.

SIGNIFICANT FINANCING COMPONENTS

A contract includes a significant financing component if its payment terms produce a substantial delay (or advance) between delivery of goods/services and payment, other than for reasons of protecting against default or customer scheduling.

Adjustment is required if payment timing gives a material benefit to either customer (e.g., paying substantially in advance) or the entity (e.g., delayed payment).

Identification Criteria

A significant financing component exists when:

• The time between transfer of goods/services and payment is more than one year (as a practical expedient, IFRS 15 allows not to adjust for financing if the period is less than 12 months).
• The amount to be paid would differ if payment terms were different (e.g., lower price offered for prompt payment).

The purpose of payment timing must be assessed—if timing is set for substantive business reasons other than financing (for example, customer delay in installation), then there may be no significant financing component.

Accounting for Significant Financing

• The entity must adjust the transaction price, recognising revenue at the present value of consideration due at the time goods or services are transferred.
• Interest income or expense is recognised over time, reflecting the effects of financing.

Worked Example 1.2

Fresco Ltd sells machinery for $210,000, with payment due two years after delivery. Market interest rate for the customer is 6%. How much revenue should be recognised at delivery, and how is the remainder treated?

Answer:
The contract contains a significant financing component. At the delivery date, Fresco Ltd recognises revenue at the present value of $210,000 discounted at 6$210,000 × 1/(1.06)^2 ≈ $186,743. The difference ($23,257) is interest income recognised over the two-year period until payment is received.

INTERACTION OF VARIABLE CONSIDERATION AND FINANCING

If a contract contains both variable consideration and significant financing, estimate variable consideration first and then adjust for financing on the estimate. IFRS 15 requires separate assessment for constraint and financing effects.

Exam Warning

Underestimate the risk of revenue reversal, or fail to adjust for a significant financing benefit, and you will misstate both revenue and interest. Carefully analyse payment schedules versus transfer dates. The FR exam often tests such scenarios, especially for long-term contracts and major equipment sales with deferred or advance payments.

Summary

Accurate revenue recognition requires careful estimation of the transaction price under IFRS 15, adjusting for variable elements and for significant financing benefits. Use the appropriate estimation method, apply the constraint to prevent overstatement, and adjust for financing if timing differences exist.

Key Point Checklist

This article has covered the following key knowledge points:

• Define variable consideration and identify when it arises within a contract
• Estimate variable consideration using either the expected value or the most likely amount method, as appropriate
• Apply the constraint to prevent recognition of revenue subject to significant reversal
• Define a significant financing component and the conditions when it applies
• Adjust the transaction price for the time value of money when a significant financing component is present
• Recognise interest income or expense from financing components separately from revenue
• Distinguish between business timing and financing timing in analysing contract terms for revenue

Key Terms and Concepts

• Variable consideration
• Significant financing component