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The New Revenue Recognition Model – Step 3: Determining the Transaction Price

Written by Michelle Sanchez, CPA on February 10, 2020

Warren Averett revenue recognition step 1

ASC 606 defines the transaction price as the “amount of consideration due in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (e.g., sales tax).” In other words, what does a company get from the customer? Determining the transaction price depends on these factors:

  • Variable consideration (including constraints on estimates of variable consideration)
  • Significant financing components in the contract
  • Non-cash consideration
  • Consideration payable to the customer

Don’t navigate revenue recognition alone. Connect with a Warren Averett advisor who can help.

Variable Consideration

Determining variable consideration is challenging in revenue recognition due to the substantial management judgement required in formulating estimates. Smaller entities may need help establishing the transaction price when variable consideration is present.

Examples of variable consideration include:

  • Discounts, rebates, refunds and credits;
  • Price concessions, incentives and performance bonuses;
  • Penalties; and
  • Consideration contingent on the occurrence or non-occurrence of a future event.

These estimates should be based on all available information, including historical, current and forecasted information, and should be determined using one of the following methods:

  1. Expected value method – the sum of probability-weighted amounts in a range of possible outcomes. This method is applicable when there are a large number of contracts with similar characteristics.
  2. Most likely amount method – the single most likely amount in a range of possible outcomes. This method applies to contracts with only two possible outcomes.

The following example provides further guidance for estimating variable consideration:

  • An entity enters into a contract to build a customized asset in exchange for $2.5 million. The promised consideration depends on the timing of completion of the asset. Specifically, for each day late (early), the promised consideration is reduced (increased) by $10,000. Also, an incentive of $150,000 will be paid if the delivered asset receives a specific assessment rating.
  • The expected value method is used to estimate the daily penalty/incentive due to the multiple outcomes for variable compensation.
  • The entity uses the most likely amount method to estimate the incentive bonus because there are only two possible outcomes ($150,000 or $0).

Refunds

Refunds are a common form of variable consideration. In some contracts, an entity transfers control with the right to return the product to a customer. Consideration for returns should not be included in the transaction price. To account for returns, an entity should recognize the following:

  1. Revenue for transferred products excluding returns;
  2. A refund liability; and
  3. The right to recover any products from customers upon settling the refund liability.

ASC 606 provides the following example for accounting for a sale with the right of return:

  • An entity enters into contracts to sell 100 products at $100 ($10,000 total consideration). Payment is received when control of the product is transferred to the buyer. The seller’s cost per product is $60, and the buyer receives a 30-day right of return.
  • Because the contract allows the customer to return products, the consideration received is variable. The expected value method estimates the variable consideration (more than two possible outcomes), and 97 products are expected not to be returned.
  • The entity must also consider any external effects on variable consideration. Because they have significant experience in estimating returns, and they will be resolved in a short time frame (30 days), the entity determines that a significant reversal in the cumulative amount of revenue recognized ($9,700) will likely not occur.
  • Upon transfer of the 100 products, cash is recorded for $10,000, revenue of $9,700, and a refund liability of $300. Simultaneously, the cost of goods sold includes only the 97 products not returned in the amount of $5,820 ($60 x 97), and an inventory asset is recognized for the three returned items ($60 × 3).

In the example above, the seller can estimate product returns. However, a seller may be unable to predict the expected number of product returns. In such a case, a seller cannot recognize revenue until the right of return lapses.

Constraints on Variable Consideration

Only when significant changes to revenue are unlikely should the transaction price account for variable consideration. In other words, the following factors should be limited to include variable consideration in the transaction price:

  1. Consideration is highly susceptible to factors outside the entity’s control;
  2. Expected consideration uncertainty occurs for an extended period;
  3. The entity’s experience with similar contracts is limited;
  4. The entity’s practices include offering a broad range of price concessions; and
  5. The contract has a broad range of possible consideration amounts.

Assessing the probability that a significant reversal will not occur requires judgement and evaluation of different possible scenarios. Entities may need third-party assistance to help with this assessment.

Next Steps

Determining the transaction price can be complicated, especially when variable consideration is involved.  The Financial Accounting Standards Board Revenue Transition Group is an excellent resource for understanding the complex issues.  As you work through these issues, don’t do it alone.

Read more about revenue recognition Step 1, Step 2, Step 4 and Step 5.

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