Well, if you work in a company that sells some products or services to individuals or general public (not the other businesses), then you probably use some “carrots on the stick” to persuade people to buy.
Here, the question arises:
How can you account for these incentives correctly under IFRS?
I often saw that companies simply recognized the cost of these promotions as their marketing cost in profit or loss.
Yes, this is simple and easy solution, but not the correct one.
In today’s article, we will try to explain the rules guiding us in this area and I will illustrate it on examples.
What do the rules say?
In the past, the guidance was quite confusing and spread over different standards and interpretation.
For example, we had to apply IFRIC 13 Customer Loyalty Programs to accounting for loyalty awards to customers.
For other transactions, there was IAS 18 Revenue, but that standard was quite general and did not offer much guidance. As a result, there was no clear guidance on how to account for future discounts, or coupons.
Luckily, we have new IFRS 15 Revenue from Contracts with Customers now in place and the guidance is quite extensive.
However, there is no general rule on all customer incentives.
Instead, different parts of the standard will apply to different promotion tools and again, it requires careful assessment.
To give you a hint, let me name a few main points that you need to consider:
- Is the incentive provided to your customer right at the inception of the contract (i.e. is it known before purchase)?
Or, did you provide the discount, free goods or something else after the inception, while the contract is in place?
In general, if it’s at the inception, then the customer incentive might be considered separate performance obligation because it’s a material right and you might need to allocate the transaction price to it.
If it’s not provided at the inception, then the customer incentive might be just a bonus to a good client and therefore no allocation of the transaction price to the performance obligation is necessary.
Instead, you might need to recognize a provision under IAS 37 (based on the character of the incentive), adjust the estimate of the transaction price or do something else.
- If you provide volume discounts, do you apply them prospectively for new purchases only?
Or, do you apply them retrospectively? In other words, does the total price for customer’s purchases depend on the total volume of goods purchased during some period?
If you apply discounts only prospectively, for new purchases only, this could be seen as a material right – a customer’s option to get additional goods at discount.
However, if you apply discounts retrospectively, this is a variable consideration in determining the transaction price.
- Do you offer prospective discounts to all customers for big bulk purchases?
Or, did you offer the specific discount to one customer only because of that specific contract?
If the discount is offered in connection with the specific contract while higher prices are charged to other customers, then you might have a material right.
If you offer the discount to all big bulk customers, then it’s not a material right. Instead, you have a variable consideration.
You might have well noted that “material right” shows up quite frequently. But, what is it?
What is a material right?
A material right is some benefit provided to a customer that it would NOT receive without entering into the contract.
For example, you sign a contract for network services for 1 year at CU 50 per month and the contract says that you can get 1 extra month at no cost after the 1st year.
That’s a material right, because you would NOT be able to get 1 month free without signing the network services’ contract first.
Once you identify a material right in the contract with the customer, then you MUST treat it as a separate performance obligation.
Let me tell you that many companies got it wrong – they simply forget to identify a material right, then they don’t allocate any transaction price to it and when that right is exercised, then they don’t book any revenues, just costs.
Wrong, wrong, wrong.
Before I explain this practically on a few examples, I want to show you HOW you can identify the material right.
Is there a material right?
You should answer 2 basic questions to find out whether there is or is NOT a material right:
- Can your customer get an additional good or service WITHOUT entering into another contract?
If yes, then there’s no material right, because the customer can get the goods or services anyway.
If no, then go to question n.2.
- Can the customer buy an additional good or service at the same price as the stand-alone selling price?
If yes, then there is no material right, because the customer can buy the same at the same price anyway.
If no, then yes, there is a material right and you MUST treat it as separate performance obligation.
Let’s see some examples.
Example 1: Additional services at discount
ABC is a provider of network services and to boost its sales, it offers to each customer who signs up for 12-month contract one month of free service after 12- month period of paid services is over. The price of 1-month service is CU 50.
How shall ABC account for this contract under IFRS 15?
It seems that there is a material right in this contract because the customer would not be able to get one month of free service without signing up for 12 months first.
Therefore, there are 2 performance obligations in this contract and ABC must allocate the transaction price to both of them:
- Network services
- Material right – 1-month of free service
The next step is to determine the transaction price – in this case, it is 12 x 50 = 600.
Then, ABC needs to allocate this price to both performance obligations based on their relative stand-alone selling prices.
Well, we know the stand-alone selling price of network services – it is CU 50 per month.
What about the stand-alone selling price of material right?
ABC needs to estimate the likelihood that the customer will use the additional free service (or other offered product/service in other cases). Here, let’s say everyone wants one month extra at no cost, so let’s say the probability is 100%.
Therefore, our estimate of stand-alone selling price of the material right is 100% x the discount of CU 50 (remember, the price of 1-month network service) = CU 50.
Let’s do the allocation:
|Performance obligation||Stand-alone selling price||Allocated transaction price|
*Allocated transaction price to network services = 600/650*600 = 554, similar with material right: 50/650*600 = 46
Now, we can recognize the revenue as services are provided. The client’s billing is CU 50 per month, but ABC can recognize only 554/12 as the revenue from network services per month – that is CU 46.
The journal entry is:
Debit Receivables to customers: CU 50
Credit Revenues from network services: CU 46.2 (554/12)
Credit Contract liability: CU 3.8
ABC makes the same entry each month during 12 months if nothing changes.
Then after 12 months, the revenues from network services are 554 (as shown in the above table), but there’s also a contract liability of CU 46 (3.8*12, pardon me for some rounding).
When the customer enjoys its one-month of free service, then ABC will recognize the revenue from that service as
Debit Contract liability: CU 46
Credit Revenues from network services: CU 46
The main point is that instead of recognizing the revenue from 12 month services at 50 per month and then zero for the free month, you need to recognize the revenue from both 12 months of paid service and the material right.
Now, seriously, I bet most people simply don’t care and recognize zero for free services!
Example 2: Loyalty points
DEF, the supermarket chain, issues a loyalty card. For each purchase of CU 100, the customer gets 1 point. The customer can get a discount of CU 1 per 1 point on future purchases.
During the December 20X1, customers collected 80 000 points and based on past statistics, DEF assumes that 90% of customers will use these points for future discounts.
Here, there are also 2 performance obligations:
- Goods sold, and
- Material right – points.
The transaction price is 80 000*100 = 8 000 000, because customers collected 80 000 points for every CU 100.
The stand-alone selling prices of goods is the same as the transaction price – CU 8 000 000.
What about the points?
DEF expects 90%*80 000 points to be redeemed, so their stand-alone selling price is 72 000 (80 000*90%; that is 0,9 per point).
Let’s perform the allocation:
|Performance obligation||Stand-alone selling price||Allocated transaction price|
|Goods||8 000 000||7 928 642|
|Material right||72 000||71 358|
|Total||8 072 000||8 000 000|
So, DEF recognizes the revenue for the goods sold as follows:
Debit Cash: CU 8 000 000
Credit Revenues from goods sold: CU 7 928 642
Credit Contract liability: CU 71 358
And, when the points are redeemed, then DEF can recognize the revenue from the points:
Debit Contract liability: CU 71 358
Credit Revenues from goods sold: CU 71 358
Yes, it can happen that the customers redeem more than 90%. In this case, the revenues are recognized only up to the amount of contract liability and DEF should probably reflect this fact in new estimates for new points.
If customers redeem less than 90%, then the remaining contract liability is recognized in revenues when the points lapse.
Example 3: Buy one, get one free
I have already described it in one of my previous article together with the example, so please check it our here.
Maybe you ask yourself:
Why should we really account for that material right separately? It’s a lot of work and hassle, and everything ends up in revenues anyway.
Well, that’s true, but the timing of revenues is important.
Let’s take example n. 2 from above.
By showing the material right separately, the readers of your financial statements know that at the end of 20X1, you have some liability there – to provide discounts on future purchases resulting from loyalty points.
If you don’t show this separately, then you are effectively hiding your liabilities and overstating your revenues.