ASC 606 Revenue Recognition Series: Determining the Transaction Price (Part IV)
October 24, 2017
In ASC 606: Revenue from Contracts with Customers (ASC 606), the third step in the conceptual framework is to determine the transaction price of the arrangement. The transaction price is the amount the entity expects to be entitled to in exchange for the goods or services provided, including both fixed and variable amounts.
A big change from the current guidance is that the transaction price is the amount the entity expects to be entitled to. There may be situations where the entity expects to receive less than 100% of the stated amount in the contract. This scenario does not preclude the entity from recognizing revenue on the contract under ASC 606. Significant judgement may become involved to determine the expected amount. Consider a situation where a vendor is entering a new geographic region and gaining a single customer in that region could be pivotal to gaining market traction. The vendor may enter into a contract for a set amount, but only plan to invoice for half of the contracted amount in an effort to build a good relationship with the customer. In this case, the transaction price would not be the amount stated in the contract. Instead it would be 50% of that amount because the vendor only expects to be entitled to 50% of the contracted amount.
The new guidance provides a list of factors that should be considered when determining the transaction price of a contract with a customer. They are as follows:
- Variable consideration
- Constraints on variable consideration
- Significant financing components
- Noncash consideration
- Amounts payable to the customer
While all of these factors are important to consider, variable consideration and any constraints on that variable consideration will have the most impact and be the most difficult to implement, as it will affect companies across all industries.
Variable consideration includes, but is not limited to, refunds, performance bonuses, rebates, incentives, credits, price concessions and penalties. These items are considered variable because the amount of consideration the entity can expect to be entitled to varies depending on a specific event in the future. The occurrence of this specific event is not always in the vendor’s control, so significant judgement is required to estimate variable consideration. For example, if a contract includes a performance bonus where the vendor is entitled to receive additional consideration for completing the project by a certain date, then the performance bonus is considered variable consideration. Additionally, if a customer has the right to return a purchased item, then the consideration received for that item is variable consideration until the customer’s right of return lapses.
While many types of variable consideration, such as a performance bonus or the right of return, are typically explicitly stated in the contract, implicit variable consideration is more difficult to identify. Implicit variable consideration could be in the form of a discount, rebate, refund, or credit that is not explicitly agreed to in the contract. To identify implicit variable consideration, one should consider the customer’s intentions and the vendor’s historical business practices, published policies, or specific statements made by the vendor that indicates it will accept consideration that is less than the stated amount in the contract.
Let’s consider a contract to purchase a car from a dealer. While the signed contract does not state that the customer has one week to return the vehicle for a full refund, the customer is fully aware of this rule because they have seen television commercials where these claims are made. The customer also has friends who have purchased a vehicle from this particular dealer and returned it within one week. In this situation, even though the contract does not explicitly state that a refund will be provided if the vehicle is returned within a week, the facts and circumstances allow the customer to reasonably assume that the refund right exists. As such, the promised consideration for the vehicle is variable until the one week return period has passed.
The guidance prescribes two methods to estimate variable consideration. They are as follows:
Expected value: The expected value approach is a statistical model that is calculated by summing the probability-weighted outcomes in a range of possible outcomes. This method requires the entity to first determine a range of possible amounts of variable consideration it will be entitled to and assign a probability to each. The entity would then sum each of the probability weighted outcomes to arrive at the expected amount of variable consideration. With this approach an entity is not required to consider all possible outcomes, just a limited range of outcomes that are sufficient to provide a reasonable estimate of expected value.
When to use: This method is best to use when there are numerous potential outcomes.
Example: A staffing company offers customer service representatives to its customers for a monthly fee. The staffing company has entered into a contract that includes a performance bonus after the one year term. The performance bonus is determined based on survey responses that come from the staffing company’s clients. The vendor’s performance bonus is determined by the survey responses, based on the following scale: did not meet expectations – $0 bonus; met expectations – $5,000 bonus; or exceeded expectations – $10,000 bonus. This is not the first time the staffing company has entered into a contract that allows for a performance bonus. Based on its history, they know there is a 15% chance that the performance bonus will be $0, a 35% chance that it will be $5,000 and a 50% chance that it will be $10,000. Since there are several potential outcomes, the staffing company elects to use the expected value method to estimate variable consideration. Based on the weighted average, the staffing company determines $6,750 ((15% * $0) + (35% * $5,000) + (50% * $10,000)) as variable consideration in the transaction price. The entity will need to consider applying a constraint to the variable consideration, as we will discuss further later.
Most likely amount: The most likely amount is determined based on the amount that the entity is most likely to be entitled to from a range of potential outcomes. The entity would select the amount that they deem to have the highest probability of occurring.
When to use: This method is best applied when there are only two potential outcomes. It would also be used if there were numerous potential outcomes and one of those outcomes is clearly the most likely.
Example: An appliance seller offers a rebate if the customer completes specific paperwork within 30 days of the purchase. Historically, the appliance seller receives the paperwork, thus pays the rebate, for 85% of washer and dryer sales. The appliance seller enters into a contract to sell a washer and dryer to a customer for $1,000 with a $100 potential rebate. In this instance, there are only two potential outcomes, the rebate is paid or the rebate is not paid, and there is a clear outcome that is more likely to occur and the entity would elect to use the most likely amount. The transaction price is $900 ($1,000 contract price minus $100 in variable consideration).
Management must select the method that most accurately predicts the amount of variable consideration the entity is entitled to receive. Once a method is selected, it should be used consistently by the entity for that type of variable consideration.
Constraints on Variable Consideration
Before including the estimate of variable consideration in the transaction price, entities should evaluate whether that estimate needs to be constrained. This means that the transaction price, which includes the fixed and variable components, cannot be greater than the total amount of consideration that the entity expects to be entitled to. Management must limit the variable consideration so that it is not likely that there will be a significant reversal of cumulative revenue recognized at a later date. This principle seeks to ensure that companies are conservative in their estimates of variable consideration, as the area requires significant judgement.
To apply this constraint principle, management should consider the following factors:
- The portion of contract consideration that is subject to the occurrence of events that is outside the control of the entity.
- The duration of time before uncertainties will be resolved.
- Results of similar contracts in the past.
- Historical trends of offering price concessions on similar contracts.
- The number of potential variable consideration outcomes.
The above factors should be considered in determining how susceptible the cumulative revenue recognized for variable consideration might be to a significant reversal; however, this list is not all-inclusive and there are certainly other factors that should be considered. These qualitative factors require significant judgement and should be considered in conjunction with the likelihood and magnitude of the potential revenue reversal. This analysis will require significant judgement.
Let’s consider the example from earlier where the staffing company could receive a performance bonus of $0, $5,000, or $10,000. Based on the expected value method, management estimated the variable consideration related to the bonus was $6,750. This estimate was based on historical trends the staffing company has experienced; however, let’s assume that due to turnover, the staffing company has recently hired new employees to staff customer service positions. Without any history related to these employees, the staffing company may consider constraining the variable consideration to $5,000 assuming they’ll receive an average rating of ‘meets expectations,’ or even to $0 assuming an average rating of ‘below expectations,’ based on the lack of historical results with this new group of employees. The transaction price for the contract would only include the amount of variable consideration that is within the constraint.
Variable consideration estimates must be updated for each reporting date. This requires management to re-evaluate the facts and circumstances around the estimate, including assumptions about any constraints and updates the variable consideration portion of the transaction price.
Significant Financing Components
Significant financing components are when a customer prepays or pays any debts for promised goods or services. The financing component is accounted for separately from the transaction price because it represents a benefit of delayed payment or early receipt of payment to the customer or vendor. The contract consideration should be adjusted for the time value of money so that it equals the amount of consideration that would have been transferred if the goods or services were received at the same time. To do this, the company should use an interest rate that is similar to what would be charged for during similar financing situations.
If a vendor believes before the start of the contract that the period between the date the good or service will be transferred, and the date that consideration will be received is one year or less, they are exempt from this consideration.
Noncash consideration should be included in the overall transaction price. The value of the noncash consideration is calculated based on the fair value of the noncash consideration received. If the vendor cannot determine this, then the entity can estimate its value with the standalone selling price of the good or service being transferred in exchange for the noncash consideration. When applying a constraint on the variable noncash consideration, an entity should not constrain for variability due to the nature of the noncash consideration. For example, if the noncash consideration is a stock or bond, its fair value will likely change over time due to its nature; this type of expected future variability is not constrained for when calculating the transaction price.
Amounts Payable to the Customer
The final consideration noted in determining the transaction price is for consideration that a vendor owes its customer. This entices the customer to purchase or continue purchasing goods and services from the user.
If the consideration owed to the customer is for a distinct good or service that is provided by the customer, the vendor should account for it as a payable outside the scope of the contract. If the consideration owed is not related to a distinct good or service, then the vendor should reduce the transaction price by the amount owed to the customer. A rebate is an amount owed to a customer that is not in exchange for any distinct goods or services. As such, a rebate is accounted for as a reduction to the transaction price. Conversely, reward points given to a customer with a purchase, giving them the opportunity to purchase goods or services at a significant discount in the future, would be accounted for outside of the scope of the contract since it will be used at a later time.
Make sure to read Part I, Part II, and Part III of the blog series.
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