Learning Outcomes
After reading this article, you should be able to explain and apply the IFRS 15 requirements on variable consideration and significant financing components within revenue contracts. You will understand how to estimate variable amounts, determine if a significant financing component exists, and present these correctly in financial statements. You will also be able to identify common pitfalls in exam scenarios relating to these concepts.
ACCA Strategic Business Reporting (SBR) Syllabus
For ACCA Strategic Business Reporting (SBR), you are required to understand the principles and application of IFRS 15 as it relates to variable consideration and financing components. This article covers:
- The recognition and measurement of variable consideration under IFRS 15
- The identification and accounting for significant financing components
- When to include variable amounts in the transaction price
- Adjusting the transaction price for the time value of money
- Appropriate disclosure requirements relating to these issues
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.
- When can variable consideration be included in the transaction price under IFRS 15?
- A customer is promised a cash rebate if they purchase over 1,000 units in a year. Is this variable consideration? How is it recognised?
- What factors determine whether a contract with deferred payment contains a significant financing component?
- How is revenue recognised if a customer pays significantly in advance for goods to be delivered after two years?
Introduction
IFRS 15, Revenue from Contracts with Customers, requires entities to account for revenue based on a five-step model. Within this model, determining the correct transaction price is critical. This often involves assessing both variable consideration (where the amount an entity expects to receive may change depending on future outcomes) and determining whether there is a significant financing component (where the timing of payments provides a benefit to one party over the other). Mistakes in these areas lead to frequent errors in both practice and exams.
Understanding when and how to estimate variable consideration, and how to adjust for the time value of money when a contract includes a financing arrangement, is essential for producing financial statements that faithfully present the revenue-generating activities of an entity.
Key Term: Variable Consideration
The portion of the transaction price in a contract that can change due to discounts, rebates, refunds, credits, price concessions, incentives, penalties, or similar arrangements.
Variable Consideration
Contracts may promise consideration that is contingent on the outcome of future events. Variable consideration includes sales-based royalties, performance bonuses, penalties, price discounts, rebates, and claims.
Under IFRS 15, the transaction price should include an estimate of any variable consideration, but this estimate can only be included if it is highly probable that a significant reversal of cumulative revenue will not occur when the uncertainty is resolved.
Estimating variable consideration requires significant judgement. Entities must select from one of two approaches:
- The expected value method (weighted average of possible outcomes),
- The most likely amount method (single most likely outcome).
Key Term: Most Likely Amount
The single most likely amount in a range of possible outcomes, used when there are two or more possible outcomes.Key Term: Expected Value
The sum of probability-weighted amounts in a range of possible outcomes.Key Term: Constraint
The limitation imposed by IFRS 15 that an entity should only include variable consideration in the transaction price to the extent that it is highly probable a significant revenue reversal will not occur.
Worked Example 1.1
A company provides a service with a fixed fee of $50,000 and a $10,000 bonus if project completion meets a specified deadline. Past experience suggests there is a 60% probability the bonus will be earned and a 40% probability it will not.
Answer:
Using the expected value method: ($10,000 × 60%) + ($0 × 40%) = $6,000. The initial transaction price is $56,000 ($50,000 + $6,000). The $6,000 may only be included if it is highly probable that a significant reversal of the bonus will not occur. Consider historical evidence and any known factors that could affect the outcome.
Exam Warning
In the exam, do not include variable consideration in the transaction price unless you have justified why a significant revenue reversal is unlikely. If there is limited relevant experience, variable amounts should be excluded until the outcome is known.
Sales with a Right of Return or Refund
When customers are permitted to return goods or receive refunds, consideration is variable. Entities must estimate expected returns based on experience and apply the constraint.
Entity should recognise revenue only for the amount expected to be entitled to (i.e., net of expected returns) and a refund liability for expected refunds.
Worked Example 1.2
A retailer sells 200 items for $100 each. Based on experience, it expects 5% of items to be returned.
Answer:
Expected sales (net) = 200 × 95% × $100 = $19,000. Recognise a refund liability for 10 items ($1,000) and an asset for the right to recover products from customers (measured at the entity’s original cost for those units). Adjust revenue and cost of sales accordingly.
Significant Financing Components
A contract has a significant financing component if the timing of payments agreed by the parties either provides the customer or the entity with a significant benefit of financing the transfer of goods or services.
Indicators of a significant financing component include a large difference between the promised consideration and the cash selling price, and a substantial period between transfer of goods/services and payment.
When such a component is present, the transaction price must be adjusted to reflect the time value of money, using the rate that would be charged in a separate financing transaction with the customer.
Key Term: Significant Financing Component
An element of a contract where payment timing provides a significant financing benefit to either the customer or the entity, requiring discounting of consideration to present value.
Worked Example 1.3
An entity transfers equipment to a customer and will receive $1,100,000 two years later. The cash price of the equipment is $1,000,000. Market interest rate is 5%.
Answer:
Present value of payment = $1,100,000 / (1.05)^2 = $997,732. Recognise revenue at $997,732 at delivery. The difference ($102,268) is recognised as interest income over two years.
Revision Tip
Review whether long payment terms or upfront payment suggest a financing component. Do not overlook advance deposits for goods/services delivered after more than a year.
Exclusions from the Financing Component
A significant financing component does not exist when:
- The customer pays in advance, and the timing of transfer is at the customer’s discretion.
- The difference between the promised consideration and the cash selling price arises for reasons other than financing (e.g., variable consideration, customer non-performance).
- Payment terms are less than one year (the entity may use the practical expedient to ignore discounting).
Disclosures
Entities must disclose significant judgements related to variable consideration and significant financing components, including methods used, inputs and assumptions, and the effect on the timing and amount of revenue recognised.
Summary
Variable consideration and significant financing components affect both the measurement and timing of revenue recognition. IFRS 15 requires estimated variable amounts to be included in revenue only when it is highly probable that a significant reversal will not occur. In cases of significant timing differences between delivery and payment, the transaction price must be adjusted for the time value of money. Correct application and clear disclosure of these principles are essential for transparent and reliable financial reporting.
Key Point Checklist
This article has covered the following key knowledge points:
- Define variable consideration and the associated constraint under IFRS 15
- Apply estimation methods (expected value and most likely amount) for variable amounts
- Recognise refund liabilities and related assets for right of return cases
- Identify the presence of a significant financing component in a contract
- Adjust the transaction price for the time value of money
- List situations where discounting for financing is not required
Key Terms and Concepts
- Variable Consideration
- Most Likely Amount
- Expected Value
- Constraint
- Significant Financing Component