As mentioned in our previous articles, the effective dates of the highly anticipated revenue recognition standard, ASC 606, are quickly approaching. For public entities, the effective date is for fiscal years beginning after December 15, 2017. For everyone else, there is an additional year to get ready, with an effective date of fiscal years beginning after December 15, 2018.
In our previous articles, we covered the first three steps in the five-step revenue recognition model – identifying the contract, identifying performance obligations in the contract and determining the transaction price. We have learned to identify our contracts, pinpointed the various performance obligations and sorted through all the variability to determine the transaction price. This article focuses on step 4 of the model – allocating the transaction price.
Standalone Selling Price
When a contract has more than one performance obligation, the transaction price will need to be allocated to each identified performance obligation based on its relative standalone selling price. The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. The best evidence of the standalone selling price is the observable price of a good or service when the entity sells the good or service separately in similar circumstances and to similar customers. But, what do you do when the standalone selling price is not directly observable? In that case, the standalone selling price will need to be estimated. ASC 606 includes the following methods that may be suitable when estimating the standalone selling price.
- Adjusted market assessment approach – Involves evaluation of the market and estimation of the price that a customer in the market would be willing to pay. This approach may include reference to competitors’ prices for similar goods or services as well as an analysis of overall market conditions.
- Expected cost plus a margin approach – Involves forecasting expected costs to satisfy a performance obligation and then adding an appropriate margin for that good or service.
- Residual Approach – Involves estimating the standalone selling price by referencing the total transaction price less the sum of the other observable standalone selling prices of other goods or services promised in the contract. This method can be used only if one of the following two criteria is met:
- The entity sells the same good or service to various customers for a broad range of prices, therefore, the selling price is highly variable and a representative standalone selling price is not discernible; or
- The entity has not yet established a price for the good or service, and one does not exist from previous similar transactions.
A combination of the above methods may need to be used to estimate the standalone selling prices. Also, management should ensure they are considering all relevant information that is available and maximizing the use of observable inputs, as well as applying estimation methods consistently in similar situations.
One industry that will be significantly impacted by the new guidance is the technology industry. Currently, revenue recognition is often deferred unless there is vendor specific objective evidence (VSOE) to determine the stand alone selling price. The concept of VSOE is eliminated in ASC 606. As stand-alone selling prices can now be determined using various methods, revenue recognition will likely be accelerated under the new standard.
Allocation of Discounts
Discounts exist when the sum of the standalone selling prices exceeds the amount of the promised consideration in the contract. Unless there is observable evidence that the entire discount relates to only one or more, but not all, of the performance obligations in the contract, the discount should be allocated proportionately to all performance obligations in the contract.
The discount should be allocated entirely to one or more, but not all, performance obligations in the contract if all of the following criteria are met:
- There are regular sales, on a standalone basis, of each distinct good or service (or each bundle of distinct goods or services);
- The sales of the bundle of goods or services are regularly priced at a discount; and
- The discount attributable to each regularly sold bundle is substantially the same as the discount in the contract, and an analysis of goods/services in each bundle provides observable evidence of the performance obligation(s) to which the entire discount in the contract belongs.
When the discount is allocated entirely to one or more performance obligations in the contract, the discount should be allocated before the use of the residual approach to estimate the standalone selling price. That way, the discount is not erroneously allocated to any of the residual elements. The following is a brief example from ASC 606 on the allocation of discounts.
- An entity enters into a contract to sell products A, B, and C for $100.
- The entity regularly sells products A, B, and C individually at the following standalone selling prices: A – $40, B – $55 and C – $45 (total of standalone selling prices $140).
- In addition, the entity also regularly sells B and C together for $60.
- The contract includes a discount of $40 overall (total standalone selling price of $140 vs. contract price of $100).
- Because the entity regularly sells B and C together for $60, and A for $40, there is evidence that the entire discount should be allocated to B and C.
- Assuming all products are transferred at separate points in time, the allocation is as follows:
- A – $40 ($40 standalone price);
- B – $33 ($55 standalone/$100 contract x $60 bundled price); and
- C – $27 ($45 standalone/$100 contract x $60 bundled price).
- In this case, the entire discount was allocated to product B and C.
Allocation of Variable Consideration
Variable consideration (including changes in estimates of variable consideration) may be attributable to the entire contract, or to a specific part of the contract. Variable consideration is allocated to specific components of the contract if both the following criteria are met:
- The variable payments relate specifically to the satisfaction of a particular performance obligation. For example, a bonus may be contingent on transferring a promised good or service within a specified period of time (bonus related to a single performance obligation).
- The allocation is consistent with the overall objective of allocating the transaction price to performance obligations, when considering all of the performance obligations and payment terms in the contract. In other words, it should not result in allocating more or less revenue than should be allocated based on relative standalone selling prices.
Changes in the Transaction Price
After contract inception, the transaction price can change for various reasons, including for the resolution of uncertain events or other circumstances that change the amount of consideration to be received. When changes in the transaction price occur, they should be allocated to the performance obligations in the contract on the same basis as at contract inception. If a performance obligation has already been satisfied, additional amounts allocated should be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes. Similar to the guidance for the allocation of variable consideration, changes in the transaction price should be allocated entirely to one or more, but not all, performance obligations only if specific criteria are met. Otherwise, it should be allocated to all of the performance obligations.
One of the key factors in step 4 of the revenue recognition model is the notion of “observable” evidence. Companies will need to document their methodologies and processes for determining observable evidence for standalone selling prices, allocating discounts to only one or more obligation, and allocating variability to only one or more obligation. Again, as with other steps of the model, these processes will require a significant amount of judgement on the part of management, which inherently increases risk. This process may be a burden to smaller entities with limited accounting resources, but will likely pose challenges to larger entities as well. Therefore, now is the time to prepare. If you need help getting started, please reach out to your local Warren Averett advisor for help.