As you know, 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.
The core principle of the standard is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In our previous articles, we looked at Step One and Step Two of the model. At this point, you should be feeling fairly confident about identifying contracts as well as performance obligations within contracts. Our next article in the series focuses on Step Three of the model – determining the transaction price.
ASC 606 defines the transaction price as the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, sales tax). In other words, what am I going to get from the customer? The following items need to be considered when determining the transaction price:
- Variable consideration (including constraints on estimates of variable consideration)
- The existence of a significant financing component in the contract
- Non-cash consideration
- Consideration payable to the customer
The presence of variable consideration is one of the more challenging factors when determining proper revenue recognition. This is due to the need for significant management judgement in formulating estimates. Smaller entities may need help with developing the transaction price when variable consideration is present. Often, variability relating to consideration will be explicitly stated in the contract. However, a contract may also contain implicit variability. For example, a customer may have a valid expectation to a price concession based on an entity’s customary business practices.
If the consideration promised in a contract includes a variable amount, entities will need to estimate the amount of consideration to which they will be entitled. Examples of variable consideration include:
- Discounts, rebates, refunds, and credits;
- Price concessions, incentives, and performance bonuses;
- Penalties; and
- Consideration that is contingent upon 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, depending on which method best predicts the amount of consideration expected to be received:
- Expected value method – the sum of probability weighted amounts in a range of possible outcomes. This method may be appropriate when there are a large number of contracts with similar characteristics.
- Most likely amount method – the single most likely amount in a range of possible outcomes. This method may be appropriate when a contract has only two possible outcomes vs. a wide range of possible outcomes.
The following example from ASC 606 provides further guidance on the use of the above methods when estimating variable consideration:
- An entity enters into a contract to build a customized asset in exchange for promised consideration of $2.5 million. The promised consideration will be reduced or increased depending on the timing of completion of the asset. Specifically, for each day late, the promised consideration is reduced by $10,000. For each day early, the promised consideration is increased by $10,000. In addition, if the asset receives a specific assessment rating, an incentive bonus of $150,000 will be paid.
- The entity uses the expected value method to estimate the variable consideration associated with the daily penalty/incentive because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.
- The entity uses the most likely amount to estimate the variable consideration associated with the incentive bonus because there are only two possible outcomes ($150,000 or $0).
Refunds are a common example of variance consideration. In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons. Consideration for amounts expected to be returned should not be included in the transaction price. To account for a right of return, an entity should recognize all of the following:
- Revenue for the transferred products in the amount that the entity expects to be entitled (therefore, revenue would not be recognized for products expected to be returned)
- A refund liability
- An asset (and adjustment to cost of sales) for the right to recover any products from customers upon settling the refund liability.
As with other variable consideration, the refund liability and corresponding change to the transaction price should be updated at the end of each reporting period for changes in circumstances. Any resulting adjustments should be recognized as either increases or decreases in revenue.
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 to customers ($10,000 total consideration). Cash is received when control of the product is transferred, with a 30 day right of return. The entity’s cost per product is $60.
- Because the contract allows a customer to return products, the consideration received is variable. The entity uses the expected value method to estimate the variable consideration (more than two possible outcomes), and estimates that 97 products will not be returned.
- The entity must also consider whether there are constraining estimates 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 it is probable that a significant reversal in the cumulative amount of revenue recognized ($9,700) will not occur.
- Upon transfer of control of the 100 products, cash is recorded for $10,000, revenue is recognized for $9,700, and a refund liability is recognized for $300. Simultaneously, cost of goods sold is recognized for only the 97 products not expected to be returned in the amount of $5,820 ($60 x 97), and an inventory asset is recognized for the three items expected to be returned into inventory ($60×3).
In the example above, the entity is able to estimate the amount of returns. There could be situations in which, due to the lack of relevant historical or other evidence, an entity is unable to conclude that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. In that situation, an entity may not be able to recognize revenue until the right of return lapses.
Finally, it should be noted that refunds have historically been identified as transactions that could be used to perpetuate fraud and thus could pose additional risk. Refunds estimates will need to be carefully evaluated when determining the ultimate amount of consideration expected to be received.
Constraints on Variable Consideration
Variable consideration should be included in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Factors that could increase the likelihood or the magnitude of a revenue reversal include:
- The amount of the consideration is highly susceptible to factors outside the entity’s control;
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time;
- The entity’s experience with similar contracts is limited;
- The entity’s practices include offering a broad range of price concessions; and
- The contract has a large number and broad range of possible consideration amounts.
Assessing whether it is probable that a significant reversal will not occur will require judgement and evaluation of different possible scenarios. Entities may need third party assistance to help with this assessment.