IFRS 15 – revenue from contracts with customers (part 5). Allocate the transaction price to the performance obligations

Agnieszka NOSOWSKA
Junior Audit Manager at RSM Poland

In the last post on the new standard of IFRS 15 we discussed determining the transaction price (the third step in the five-step model framework). Today we are going to take a look at the next stage, namely price allocation.

In the case of contracts with customers involving more than one performance obligation, in the fourth step of the model framework for revenue recognition according to IFRS 15, the entity must assign (allocate) the transaction price to each identified performance obligation (identified good/service).

Objective of allocating the transaction price

The objective of allocating the transaction price to each performance obligation (or distinct good or service) is to allocate it in an amount that depicts the amount of consideration that the entity actually expects to be entitled to from the contract in exchange for transferring the promised goods or services (both at the level of specific identified obligations, and the contract as a whole).

General allocation purpose

To allocate the transaction price at contract inception, the entity must determine the stand-alone selling price for each distinct good or service underlying a performance obligation. Then, the transaction price is allocated proportionately to the determined stand-alone selling prices.

Stand-alone selling price

A stand-alone selling price is the price at which the entity sells the promised good or service under separate transactions of sale. A stand-alone selling price may be an observable price or a price that needs to be estimated.

An observable price is the selling price prevailing in similar circumstances and prevailing for a specific class of customers. An example of a stand-alone selling price can be the price of a good/service defined in the contract or the entity’s price list.

If the price is not directly observable, the entity must estimate it with the objection of allocating the transaction price and considering all the information reasonably available, such as:

• market conditions,
• entity-specific factors,
• information about the customer or a class of customers.

When estimating the stand-alone selling price, an entity must take the observable inputs into account and apply the same estimation methods consistently.

IFRS 15 provides for 3 methods of estimating the stand-alone selling price:

1. cost-plus-a-margin approach – the stand-alone selling price is estimated in the amount of the expected costs plus a possible margin;
2. market approach – to  estimate the stand-alone selling price, the entity must evaluate the market in which it operates and estimate a price the customer would be willing to pay, e.g. by referring it to the price offered by the competition and adjusting it to reflect the entity’s characteristics (costs) and capacities (margins);
3. residual value approach – the stand-alone selling price is estimated by reference to the total transaction price less the sum of observable stand-alone selling prices of other goods/services under the contract. This method can be applied only if one of the following conditions is met:
   • the entity sells the same good/service to different customers at the same time in a broad range of amounts, because a single representative stand-alone selling price is not discernible from past transactions (this may apply to e.g. a service whose valuation depends to large extent on the characteristics and capacities);
   • the entity has not yet established a price for a given good/service, and it has not yet been sold on a stand-alone basis, i.e. the selling price is uncertain.

In practice, the above methods can be used individually or in combination to achieve the objective of estimating the transaction price at the level of the amount of consideration the entity actually expects to be entitled to from the contract.

If the entity finds prices to be uncertain or variable in practice, it may be necessary to use a combination of the aforementioned methods of estimating stand-alone selling prices in order to estimate the stand-alone selling price. When using a combination of different methods to estimate stand-alone selling prices, the entity must evaluate whether allocating the transaction price is consistent with the allocation objective.

In practice, we often come across cases in which the consideration for the contract (transaction price) is not always the same as the sum of the stand-alone selling prices of goods or services promised to be transferred under the contract. If this is the case, discounts or bonuses must be taken into account when assigning the transaction price.

The transaction price is lower than the sum of stand-alone selling prices – discount allocation

A discount occurs when the sum of stand-alone selling prices of particular goods and services under the contract is higher than the total consideration for the contract. As a rule of thumb, the discount is proportionately allocated to all performance obligations in the contract, taking the proportion used to allocate the transaction price using stand-alone selling prices of goods or services into account. However, if the entity has observable evidence that the entire amount of discount relates to one and only one of the given goods/services, the discount is allocated to them accordingly, provided that all the following criteria are jointly met:

• the entity regularly sells each distinct good or service or a bundle of goods/services on a stand-alone basis;
• the entity regularly sells a bundle of goods/services at a discount to the stand-alone selling prices of goods/services in each bundle;
• the discount attributable to the bundle is substantially the same as the discount defined in the contract, and an analysis of goods/services in the bundle provides observable evidence of the performance obligation to which the entire discount in the contract belongs.

It should be noted that if the entire discount is attributable only to one or more performance obligations, the discount is accordingly allocated first before using the residual approach to estimate the stand-alone selling price.

Example[1]

An entity enters into a contract to sell goods A, B and C for a total amount of PLN 150. In separate sale transactions , the entity usually sells these goods at the following prices: PLN 70 for A, PLN 40 for B and PLN 90 for C.

The sum of the observable stand-alone selling prices of the goods below is PLN 200. Thus, the consideration for the sales contract involves a discount in the amount of PLN 50. The discount allocation and allocation of the transaction price between all the goods covered by the sales contract are presented in the table below.

If the entity has observable evidence that the discount granted in the contract relates only to one or selected goods, this must be properly accounted for in the process of allocating the transaction price. Assuming that the discount in the example above relates for example to good A in the amount of PLN 20 and to good C in the amount of PLN 30, its allocation and the allocation of the transaction price will be as follows:

Let us modify this example a little bit and assume that goods A and B are often sold in a bundle in practice, and the observable stand-alone selling price of this bundle is PLN 60. Thus, when selling goods A and B in a bundle, the entity offers a discount to the sum of their stand-alone selling prices used when they are being sold on a stand-alone basis in the amount of PLN 110 – PLN 60 = PLN 50, corresponding to the discount granted in the sales contract. In this case, the discount allocation and the allocation of the transaction price will be as follows:

The bonus allocation or variable consideration shall be considered in a similar way. Let us take a look at the examples below.

Example[2]

An entity enters into a contract to sell goods A, B and C for a total amount of PLN 150. In separate sale transactions, the entity usually sells these goods at the following prices: PLN 50 for A, PLN 20 for B and PLN 70 for C.

The sum of the observable stand-alone selling prices of the goods below is PLN 140. Taking the stand-alone selling prices of particular goods into consideration, it is clear that the entity has applied a bonus in the amount of PLN 10 when signing a contract with a consideration at the level of PLN 150. The bonus allocation and the allocation of the transaction price between all the goods covered by the sales contract are presented in the table below.

If the entity has observable evidence that the obtained bonus can be related to a particular promised good/service or a bundle of goods/services, this must be properly accounted for in the process of allocating the transaction price, in line with the same principles as in the case of discount allocation.

A variable consideration can, in turn, be allocated to:

• the contract as a whole;
• one or more, but not all, performance obligations defined in the contract;
• one or more, but not all, distinct goods/services being a part of a single performance obligation.

Example[3]

An entity enters a contract to sell machines forming a production line together with the service of assembly and start-up. A stand-alone price of the production line (machines and equipment) is PLN 1.5 million. The service of assembly and start-up included in the contract was PLN 0.5 million, with the underlying assumption that the entire contract would be performed within a period of 6 months after the date of the contract’s conclusion. At the same time, the sales contract provides for a bonus for faster assembly and start-up in the amount of PLN 0.1 million if the process is shortened to 4 months.

The entity’s experience with such projects and their current capacities indicate that there is a 20% chance that the entity will deliver the project within 4 months.

With standard conditions, the transaction price of the contract is PLN 1.5 million + PLN 0.5 million = PLN 2 million. If the service is performed faster, the transaction price of the contract is PLN 1.5 million + PLN 0.5 million + PLN 0.1 million = PLN 2.1 million. Thus, in the case of this contract, we are dealing with a variable consideration.

When allocating the transaction price, the entity should be guided by the objective of faster delivery, i.e. allocate the amount of consideration the entity expects to be entitled in exchange for transferring the promised goods or services, and  estimate the variable consideration.

Steps of allocating the transaction price

Step 1 – the entity identifies the performance obligations in the contract:

• goods – production line;
• services – assembly and start-up of the production line.

Step 2 – the entity allocates the types of consideration from different performance obligations:

• goods – fixed consideration;
• services – variable consideration, where the variability results from the option of getting an additional consideration for a shorter delivery time of the service of assembly and start-up of the production line.

Step 3 – selection of the method to estimate the variable consideration and estimation of its value:

• the entity should use the expected value method, in which the variable consideration will amount to (20% *PLN 0.6 million) + (80%*PLN 0.5 million) = PLN 0.52 million.

Step 4 – allocation of the transaction price to identified performance obligations, taking the variable consideration into account.

 It should be noted that the transaction price determined by the entity in its part relating to the variable consideration in the amount of PLN 0.52 million is an estimate made by the entity; as a result, the total transaction price determined by the entity as possible to be obtained for the contract in the amount of PLN 2.52 million is different from the values defined in the contract: PLN 2.0 million and PLN 2.1 million. The objective of the standard is thus achieved: to estimate the consideration the entity actually expects for the contract. The entity is obliged to revaluate the assumptions behind estimating the consideration price for each balance sheet date, including the total transaction price for the contract, and to enter relevant revenue adjustments into the books of this period.

Step 5 – allocation of the remaining part of the transaction price (fixed consideration) to different goods.

For the sake of simplicity, the example assumes one price for the delivery of the production line in the amount of PLN 1.5 million (delivery of one complete product).  Depending on the details of the transaction of the production line delivery, its selling price in the contract can be allocated between different elements of the production line according to general rules.

The allocation of the contractual selling price of the production line will then be performed on the basis of the observable or estimated stand-alone selling price of its different elements, with due consideration of any discounts or bonuses.

Changes in transaction price after contract inception

Any changes in the transaction price after contract inception (not resulting from the amendment of the contract terms and conditions) shall be allocated to performance obligations on the same basis as the initial allocation (using the initially determined proportion). The change in the transaction price is accounted for as a revenue adjustment (either positive or negative) in the period in which the transaction price changes.

Clearly, you could ask yourself a question: what is all this for, if we are selling products (services) A, B and C, and the entire sale will be entered to the accounting system as revenue? Well, it does not have to be entered at the same time (1), and – as you can see – owing to an appropriate breakdown of revenue into different elements, the financial statements will not include just the total aggregated amounts, and thus the reporting quality will be better (2). Furthermore, the company management may have a better overview of the margins achieved on a particular product/good or service (3), but this will be further discussed in the upcoming posts.