Revenue Recognition: Allocating Transaction Price

Over the past several months Clayton & McKervey has provided information about the new revenue recognition standard released by the Financial Accounting Standards Board (FASB); (Revenue from Contracts with Customers: Topic 606). The standard replaces the current revenue guidance found in multiple places in the FASB codification, and provides a single comprehensive standard that will apply to nearly all industries and will significantly change how revenue is recognized.

The standard provides a five-step process for recognizing revenue, as follows:

1. Identify the contract with the customer
2. Identify the performance obligations in the contract
3. Determine the transaction price for the contract
4. Allocate the transaction price to each specific performance obligation
5. Recognize the revenue when the entity satisfies each performance obligation

Revenue Recognition: Step 4

After determining the transaction price in Step 3, companies need to allocate that transaction price to the specific performance obligations identified in the contract. The transaction price is allocated to the performance obligations based on its relative standalone selling price.  The standalone selling price for each good or service representing a performance obligation should be determined at the contract inception.

The standalone selling price is defined as the price that an entity would sell the good or service for if they sold it separately to a customer.  The best evidence of that price is if the entity has separate actual sales to customers of a similar good or service. Many times this easily observable selling price is not available, so an entity has to estimate it using observable inputs where possible. Some of these inputs include market conditions, entity-specific factors, and customer information. The methodology to estimate standalone selling price should be applied consistently in like circumstances.

ASC 606 includes specific suitable methods for estimating the standalone selling price of goods and services, including:

a. Adjusted market assessment approach: An entity evaluates the market in which it sells goods or services and estimates the price a customer in that market would be willing to pay for the goods or services. This approach may also include using prices from the entity’s competitors for similar goods or services and adjusting those prices as needed to reflect the entity’s costs and margins.

b. Expected cost plus a margin approach: An entity estimates the expected costs to satisfy a performance obligation and then adds an appropriate margin for that good or service.

c. Residual approach: An entity may estimate the standalone selling price by reference to the total transaction price less the sum of observable standalone selling prices of other goods or services in the contract. This method can only be used if one of the following criteria are met:

• There is a broad range of current selling prices to other customers and no single representative selling price
• The good or service has not previously been sold and there is no established price for the good or service

It is possible that an entity may need to use a combination of methods. Some other considerations in allocating transaction price are allocation of a discount and the allocation of variable consideration.

Allocation of a Discount

A customer may receive a discount for purchasing a bundle of goods or services. When this occurs the sum of the standalone selling prices of the promised goods and services may exceed the promised consideration in a contract (i.e. the bundle is sold at a discount). Because the total transaction price is allocated based on relative standalone selling prices this discounted price only causes complexity when the discount should be allocated to one or more specific performance obligations, but not all. A discount should be allocated entirely to certain performance obligations, but not all, if the following criteria are met:

• The entity regularly sells each distinct good or service on a standalone basis
• The entity regularly sells on a standalone basis a bundle of some of those distinct goods or services at a discount to their standalone selling prices
• The discount attributable to each bundle described in (2) is substantially the same as the discount in the contract and the performance obligations to which the entire discount belongs is readily observable

If there is a discount allocated to some but not all performance obligations in the contract, the allocation should be made before using the residual approach to estimate any standalone selling prices.

Allocation of Variable Consideration

Variable consideration in a contract may be related to the entire contract or to a specific part of the contract. The variable amount of the consideration should be allocated entirely to a performance obligation or to a distinct good or service that forms part of single performance obligation if both of the following criteria are met:

1. The terms of the variable payment relate directly to a performance obligation
2. Allocating the variable consideration entirely to a single performance obligation meets the overall goal to allocate the transaction price in an amount that the entity expects to receive for that individual good or service. In other words, the variable consideration can be allocated entirely to a performance obligation if it doesn’t result in allocating more or less revenue than should be allocated based on standalone selling prices.

Subsequent changes in selling prices should be allocated to the contract in a way that is consistent with the original allocation of the transaction price, except in some unique circumstances where changes relate to one specific performance obligation or there is a contract modification.

One of the important considerations in step 4 of ASC 606 is the concept of observable evidence.  Good documentation of the manner of determining observable evidence for standalone selling prices, allocating discounts and variability will be important. The requirements in Step 4 will require significant judgment and resources to document the conclusions.

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