IFRS 15 in the Spotlight: Variable consideration

Many businesses have contracts with their customers that set out the consideration receivable that is not just for a fixed amount. The consideration receivable can often include amounts such as:

Awards for early or timely delivery and penalties for late delivery (common in industries such as construction – see example 1 below), or
Volume based rebates or stepped-pricing (common in industries such as retail or manufacturing – see example 2 below).

Under IFRS 15 these amounts are referred to as ‘variable consideration’. Variable consideration can also arise in other situations such as sales with a right of return, or where there is a valid expectation (either based on customary business practice, or the seller’s intention when entering into the contract) that a price concession will be offered later.

It is important to consider the treatment of these elements of revenue when looking at the accounting required under IFRS 15 as this can differ from the previous accounting treatment.

At the start of the contract a seller must estimate the amount of consideration to which it expects to be entitled on the contract. This estimate is updated at each reporting date until no further consideration is receivable. IFRS 15 requires that this estimate of variable consideration is determined using either:

The expected value method – based on probability-weighted amounts, or
The most likely outcome method – appropriate where there are few possible outcomes (for example, an entity either achieves a performance bonus or not).

The most appropriate method should be selected for each contract, and then must be applied consistently throughout the contract term.

Regardless of which method is used, the estimation of the variable consideration amount is constrained to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur. This means that when estimating the variable consideration, IFRS 15 sets a higher hurdle than the previous IFRS standards which may defer the recognition of some revenue.

An exception to the above approach is made in relation to consideration in the form of a sales-based or usage-based royalty for the licence of intellectual property which we will consider in next month’s issue.

Example 1: variable consideration – over-time revenue recognition

A construction company enters into a contract to build a bridge for £10m with an expected completion date of July 2019. The company determines that the over-time revenue recognition criteria of IFRS 15 have been met. The contract contains award / penalty clauses depending on the date of completion as follows:

Date of Completion	Award	Penalty
	£’000	£’000
June 2019 or earlier	200	-
July or August 2019	-	-
September 2019 or later	-	(1,000)

Due to the presence of a £1m penalty clause, the fixed consideration is £9m with any additional revenue being variable consideration.

At the start of the contract, the construction company determines with a high degree of certainty that the bridge will be completed on time and therefore, using the most likely outcome method and applying the constraint, no awards or penalty deductions are included when estimating contract consideration (£10m).

At their reporting date of 31 December 2018 they reassess their variable consideration estimate. At this point, it is most likely that the bridge will be completed in August 2019 but there is a reasonable chance that it will not be completed until September 2019 so they determine that the date by which completion is highly probably is September 2019.

Variable consideration to be recognised is therefore estimated to be constrained to £nil due to the penalty. Previously, the penalty deduction may only have been accounted for when incurred.

If at 31 December 2018 the most likely date of completion is June 2019, with the date by which completion is highly probably being determined as July 2019, then the variable consideration to be recognised would be estimated as £1m giving total consideration of £10m. Previously this may have been £10.2m, including receipt of the award based on the most likely completion date.

Example 2: variable consideration – point in time recognition

A manufacturing company (the ‘supplier’) enters into a contract to sell the product ‘A Biscuit’ to a supermarket chain. The pricing in this contract is such that each pack is sold for £10, with a rebate being offered at the end of the year based upon the total number of packs sold in 12 months. Revenue is recognised for each pack upon delivery of that pack to the supermarket.

Number of packs sold in 12m	Price per pack
	£
1 – 1,000	10
1,001 – 1,500	8
1,501 or more	7

Start of the contract

The variable consideration is the £3 per pack that reflects the difference between the £10 and £7 selling prices.

To determine how much of this variable consideration it can recognise on the sale of the packs to the supermarket chain throughout the year, the supplier must estimate how many packs of A Biscuit it expects to sell. At the start of the contract, based upon normal sale volumes to businesses similar to the supermarket chain it estimates that it will sell 1,200 packs (so consideration of £8 per pack) and it is highly probable that they will not sell more than 1,500 packs. The variable consideration of £3 is therefore constrained to £1 – giving a transaction price per pack of £8.

During the year

Upon sale of each pack of A Biscuit to the supermarket chain during the year, the supplier recognises £8 revenue. The difference of £2 between the invoice amount and revenue recognised is recorded as a contract liability.

At year end

At their reporting date of 31 December 2018 they reassess their variable consideration estimate. At this point, based upon volumes sold to date and the remaining period of the contract, they estimate that they will now sell 2,000 packs to the supermarket chain in total. The variable consideration is now constrained to £nil – giving a transaction price and revenue per pack of £7.

Stepped pricing

The above example shows a reduction in the price of each pack sold in the year. If the pricing were stepped rather than cumulative (ie first 1,000 at £10, the next 500 at £8, and all the rest at £7) the process of estimating variable consideration would still be the same:

During the year: recognise revenue of £9.67 for each pack sold as they estimate sales of 1,200 packs and it is highly probable that they will not sell more than 1,500 packs [(1,000 x £10 + 200 x £8)/1,200]
At year end: recognise revenue of £8.75 for each pack sold as they estimate sales of 2,000 [(1,000 x £10 + 500 x £8 + 500 x £7)/2,000]. This will result in a cumulative adjustment of (£0.92) reduction in revenue for each pack sold to date.

For help and advice on revenue recognition issues please get in touch with your usual BDO contact or Scott Knight.