IFRS 15: Variable Consideration & Revenue Cut-Off
IFRS 15 ‘Revenue from Contracts with Customers’, establishes a comprehensive framework for recognising revenue in a manner that reflects the transfer of goods or services to a customer. A key objective of the standard is to improve consistency and comparability of revenue recognition practices across different industries and jurisdictions.
Two areas which require significant judgement under IFRS 15 are variable consideration and revenue cut-off, both of which can materially impact the timing and amount of revenue recognised.
What is a variable consideration?
IFRS 15 defines a variable consideration as the portion of the transaction price that is contingent on uncertain future events such as discounts, penalties, rebates, refunds and credits. An entity shall estimate a variable consideration by using one of the following methods;
- Expected value: the sum of probability weighted amounts in a range of possible consideration amounts. This is typically used when an entity has a large number of contracts with similar characteristics.
- The most likely amount: the most likely amount in a range of possible consideration amounts. This is typically used when the amount of variable consideration in the contract has only two possible outcomes.
The chosen method must be applied consistently, using historical, current, and forecasted information to substantiate the value of variable consideration.
How is the variable consideration allocated to the performance obligations in a revenue contract?
The objective is to allocate the transaction price to each performance obligation in an amount that depicts the consideration to which the entity expects to be entitled in exchange for transferred goods or services to the customer. This allocation is generally made based on the proportion of the stand-alone selling price; being the price of the distinct good/service when sold separately.
Where the variable consideration does not relate to all performance obligations, it is wholly allocated to those specific performance obligations and not to the whole contract. This is done in the following instances.
- The variable payment relates specifically to that performance obligation, and
- The allocation must depict the consideration the entity expects for transferring each good/service.
Constraining estimates of variable consideration
An entity shall include in the transaction price an amount of variable consideration only to the extent that it is highly probable that a significant reversal will not occur. In assessing this probability; an entity shall consider both the likelihood and magnitude of the revenue reversal. Factors that could increase the probability of reversal include the following;
- High susceptibility to external factors,
- Uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
- Limited historical evidence and entity experience,
- Broad price concessions
- Wide ranges of possible consideration amounts.
Estimates must be updated at each reporting date to reflect current circumstances.
Revenue cut off
IFRS 15 stipulates that revenue must be recognised in the period when control of goods or services is passed on to the customer and the performance obligations are satisfied.
This is satisfied either:
a. At a point in time: whereby the customer obtains control of the asset at one specific point, they obtain legal title to the asset, along with the significant risks and rewards tied to the asset ownership, and the entity has a right to receive payment.
b. Over time: Meaning that performance obligations are satisfied over time. This is the case when one of the below three criteria are met:
1. The customer receives benefits provided as the entity performs;
2. The entity's performance creates or enhances an asset controlled by the customer as this is created or enhanced;
3.The asset created has no alternative use to the entity, and the entity has a right to payment for performance to date.
Cut-off issues typically arise when an invoice is raised (or payment received) before satisfaction of a performance obligation or vice versa, meaning that performance obligations are satisfied but the invoice has not yet been raised (or paid). This leads to a situation whereby an adjustment is required to record revenue in the appropriate period.
4. When it comes to performance obligations satisfied at a point in time, the entity needs to assess for any promises satisfied, for which there is no revenue recognised, in which instance a contract asset (accrued income) is to be created for the revenue in relation to that period; or promises are not satisfied, but revenue has already been recorded, in which case a contract liability (deferred income) is to be created to shift revenue to a future period.
The key to avoiding cut-off issues in the case of revenue recognised over time, is to recognise revenue by measuring progress towards complete satisfaction for each reporting period. Progress can be measured by using either an input or an output method.
Input method - based on effort or resources consumed (costs, labour hours, machine time); ideal when outputs are difficult to measure directly and inputs better reflect progress.
Output method - based on value delivered to the customer (surveys, appraisals of completed work); ideal when results can be directly measured.
This computed progress value is considered to be the revenue figure relating to the relevant period. Any differences between the progress value and invoices/payments from customers are accounted for as a contract asset or contract liability to show an accurate value of revenue.
The progress is then re-measured at each reporting period and revenue is recorded in proportion to the satisfaction of performance obligations.
There are certain other scenarios which could create revenue cut-off issue, such as;
- Bill and hold arrangements whereby revenue is recognised before physical delivery of the product, however, there is sufficient evidence that the reason for the arrangement is substantive, the product can be identified separately as belonging to the customer, the product is ready for physical transfer and the entity is not able to use the product or transfer it elsewhere.
- Consignment arrangements where goods have been transferred however, revenue is not recognised until control has been transferred to the end customer.
In conclusion, a robust understanding of variable consideration, combined with sound revenue cut‑off practices, enhances the quality, reliability, and comparability of financial reporting, supporting the overarching objective of IFRS 15 to provide useful information to users of financial statements.
