My name is Steve Chen, a fellow member of ACCA and course director at APC (www.globalapc.com) teaching ACCA online courses to students from all around the world. This article will explain variable consideration from IFRS 15 Revenue from contracts with customers which is relevant to the ACCA SBR exam.
According to IFRS 15 Revenue from contracts with customers, 5-step model needs to be applied, and my mnemonic for these 5-step model (which is widely copied by many study texts and lecturers) is COPAR (this can be found in my original YouTube video
Step 1 – Contract identification
Step 2 – Performance Obligation
Step 3 – Price
Step 4 – Allocate price to performance obligations
Step 5 – Recognise revenue
This article explains the application of variable consideration (in step 3) of the above 5-step model in the pre-fabricated housing industry.
Let’s see an example in practice (the company name is ‘Tonica plc’)
The reason I named this company as 'Tonica plc' was because I am a fan of 'Gin Tonic' cocktail...
Tonica plc has signed a contract with a house developer in EU to construct several residential houses and the agreed price is $2 million to be delivered in 5 months.
In the contract, it states that if Tonica plc can complete those houses before the deadline (5 months), Tonica plc can be awarded $300,000 extra bonus and if Tonica plc only completes this on time, no bonus is given. However, if Tonica plc delays, the penalty of $500,000 will be applied.
The contract also stated that if those houses achieve the greenhouse certification level (this is a certification offered by the government in that country), Tonica plc can be given an extra bonus of $40,000. Based on past experience, the houses built by Tonica plc have all achieved this certification level because the quality of Tonica plc’s houses is highly reputed in the country.
How would the above transaction price of the contract be recognised?
Analysis from Steve Chen (ACCA APC Course Director at www.globalapc.com):
In the traditional construction industry, outside factors such as weather conditions, market volatility of materials and operating environments, past experience of getting such bonuses for the similar prefabricated house construction contract should also be considered.
However, in the above case, these factors may not affect the business too much because all of the houses are manufactured in the factory which is not affected too much by the weather conditions.
In applying IFRS 15 Revenue from Contracts with Customers:
Fixed Transaction price: $2 million
Variable considerations – Three possibilities:
Before the deadline: a bonus (revenue) of $300,000
On time: 0
Miss the deadline: penalty of $500,000
Therefore, Tonica plc should estimate the probability of those uncertainties at the time when the contract is signed.
After careful analysis, the Finance director of Tonica plc has determined the following possibilities:
Before the deadline, +$300,000 with 60% chance
On time, $0 with 30% chance
Miss the deadline: -$500,000 with 10% chance
Therefore, the contingent consideration is calculated using a weighted average approach: 60% x $300,000 + 0x30% + ($500,000 x10%) = $130,000
Extra bonus of $40,000 when the greenhouse level is achieved. This should be included in the transaction price because, according to the experience, all of the Tonica plc’s houses have achieved this level. It is highly probable that a significant reversal will not occur (it means Tonica plc can get this bonus).
Total transaction price when the contract is signed is:
Consider the following subsequent issue:
When the first four months have passed, the management has revised the probability because they now think the contract can be completed on time. Hence the transaction price could be revised:
Before the deadline, +$300,000 with 90% chance
On time, $0 with 10% chance
Miss the deadline: -$500,000 with 0% chance
The variable consideration is revised as 90%x$300,000+0+0=$270,000
The total new transaction price is therefore: $2m+$270,000+$40,000=$2,310,000. This means that the additional revenue of $140,000 should be recognised ($2,310,000-$2,170,000).
Conceptual Framework Reference:
Many of you may consider the concept of variable consideration really requires lots of judgment, and I agree with you. However, this concept ensures that revenue will not be overstated when it is recognised. Businesses could not recognise higher revenue at the start, but what businesses could do is recognise lower revenue at the start with additional revenue after that.
Therefore, this complies with the ‘prudence’ concept in the conceptual framework according to IASB.
In addition to providing ACCA lectures online, I also wrote articles in ACCA AB magazine. Besides, I am an author of four accounting books. If you are interested in studying ACCA courses with me, please visit my website http://www.globalapc.com for further information, where you can find many of my ACCA demo video lectures.