ASC 606 Revenue Recognition Series: Allocating the Transaction Price (Part V)

The fourth step of the Financial Accounting Standards Board’s (FASB) ASC 606: Revenue from Contracts with Customers (ASC 606) is to allocate the transaction price to the identified performance obligations. This allocation is generally based on the relative standalone selling price of each distinct good or service. By applying this method, the consideration allocated to each distinct good or service represents the amount the entity expects to be entitled to in exchange for that good or service, just like legacy GAAP.

Estimating Standalone Selling Price

First, the entity must determine the standalone selling price of each distinct performance obligation. The easiest way to do this is to determine what the entity sells that performance obligation for when it’s sold separately. If the performance obligation is not sold separately, the entity will have to estimate its standalone selling price, emphasizing observable inputs. This will require significant judgement. Fortunately, the standard recommends three methods for estimation:

1. Adjusted Market Assessment Approach: In the adjusted market assessment approach, the entity determines the amount they believe the market would be willing to pay for the specific good or service. They should consider competitor prices, geographic region, the extent of customization, and other variables. This approach is best applied to determine the standalone selling price for goods or services in well-established markets. A new good or service would not have enough reliable market data to determine the standalone selling price.
2. Expected Cost Plus a Margin Approach: The expected cost plus a margin approach requires the entity to focus their estimate on both internal and external factors. The entity would first estimate its internal costs to produce or provide the good or service, and then add an acceptable margin. The added margin is not meant to be the entity’s desired margin, but rather the margin that the market for the good or service would be willing to pay. This will require adjustment for different markets based on factors like geography and wealth distribution. Overall, this method will work best when the cost to produce or provide the good or service can be estimated with a high degree of accuracy, such as tangible goods or hourly services.
3. Residual Approach: The residual approach allows the entity to estimate the standalone selling value of a performance obligation as the difference between the total contract transaction price and the observable prices of the performance obligations. An entity can only use this method if they sell the exact same good or service to other customers at prices that can vary greatly. They can also use this method if the good or service has not been sold on a standalone basis and the entity does not have an established selling price.

The FASB’s methods are not the only way for an entity to estimate standalone selling price. Since this standard is principles-based, entities have flexibility in estimating the standalone selling price in whichever way they feel accurately depicts the amount they expect to be entitled to for the exchange of related goods or services. This approach is similar to the multiple-element arrangement rules in the current revenue recognition standards; the biggest difference is that ASC 606 eliminates the hierarchy of evidence in making its estimates of standalone selling price.

ASC 606 does not address updating estimated standalone selling prices. Entities should consider the context surrounding their estimates. If information driving estimates changes over time, they should update their estimates accordingly.

Determining the Standalone Selling Price of Customer Options

As noted in step two of the five step process, a material right exists when the contract contains an option for a customer to purchase more goods or services later at a discounted rate. Material rights are separate performance obligations and the entity must allocate a portion of the transaction price to these performance obligations. There is often no standalone selling price for material rights, so the entity will have to use judgement to estimate it. This estimate should reflect the value of the discount offered and be adjusted for the following:

• The discount the customer could have received on the goods and services without exercising the material right.
• The likelihood that the material right will be exercised.

Under typical option-pricing models, users are required to estimate both intrinsic and time value. However, under ASC 606 users are only required to estimate intrinsic value when estimating standalone selling price for material rights.

An example of this method can be illustrated through a contract for the purchase of brake pads. Let’s assume that a customer contracts an entity to buy one million brake pads for $1 per pad, or total consideration of $1,000,000. The customer also has the option to purchase an additional one million brake pads at a 50% discount from the regular rate of $1 per pad. Let’s also assume that the vendor normally uses a volume tiered pricing schedule whereby the first million brake pads are offered at $1 each and the second one and a half million are offered at $0.75 each. The vendor determines that the customer’s option to purchase more brake pads at a discount that is greater than what is normally offered is a material right, and is treated as a separate performance obligation. The vendor would estimate the value of the material right by calculating the marginal discount provided to this customer in excess of the discount that is regularly offered. Accordingly, $25,000 (1,000,000 additional brake pads X $0.25 additional discount offered) of the transaction price would be allocated to the material right performance obligation. The provider multiplies by $0.25 because if they followed the readily available pricing, they would have received the second million brake pads at $0.75, due to the tiered pricing structure. Thus, the option provides an additional benefit of $0.25 per brake pad.

ASC 606 provides an alternative approach to estimating the standalone selling price of a material right. This alternative only applies when the goods and services included in the option are both similar, or the same as the goods and services already included in the contract and  provided to the customer under the same terms as the original contract.

Assuming these two criteria are met, entities may use the following approach: the total consideration expected to be received, including expected consideration from the customer’s exercise of options, would be allocated to the total goods and services expected to be provided, including the goods and services from options that the customer is expected to exercise. The amount allocated to the goods and services already under contract is subtracted from the total amount of consideration received, under the assumption the options are exercised according to management’s estimate. The excess is the value attributed to the option.

This can be illustrated using the same scenario as the example above. In addition to the assumptions from above, let’s assume that based on historical experience, the vendor expects the customer to purchase 750,000 additional brake pads under the option, bringing the expected total brake pads sold to 1,750,000. This would bring the total hypothetical consideration to $1,375,000 (1,000,000 original brake pads X $1 + 750,000 additional brake pads X $0.50). If this consideration is allocated to all brake pads expected to be purchased, the per unit standalone selling price is $0.786 ($1,375,000 total hypothetical consideration / 1,750,000 brake pads). Of the total hypothetical consideration, $786,000 would be allocated to the original brake pads under contract (1,000,000 units X $o.786) and thus the remaining hypothetical transaction consideration of $214,000 ($1,375,000 total hypothetical consideration – $786,000 allocated to the non-optional units) would be allocated to the material right performance obligation.

Allocating the Transaction Price

Once the entity has obtained standalone selling prices, they can then allocate the transaction price based on the relative selling price of each performance obligation. This is consistent with the current multiple element arrangement guidance for revenue recognition, illustrated below:

Let’s assume a contract with a customer has four performance obligations. The standalone selling price for each performance obligation has been determined as follows:

Performance obligation one:       $100,000

Performance obligation two:        $75,000

Performance obligation three:     $35,000

Performance obligation four:       $15,000

Sum:                                            $225,000

The contract has a transaction price of $150,000. The entity would allocate the transaction price to each performance obligation as follows:

Performance obligation one allocation = (100,000/225,000) X 150,000 = $66,667

Performance obligation two allocation = (75,000/225,000) X 150,000 = $50,000

Performance obligation three allocation = (35,000/225,000) X 150,000 = $23,333

Performance obligation four allocation = (15,000/225,000) X 150,000 = $10,000

Other Considerations

There are a few exceptions to the rule in which an entity would not be required allocate the relative selling prices proportionally.

The first exception relates to the allocation of variable consideration. Under this exception entities may allocate variable consideration to a specific performance obligation instead of calculating the proportional amount to be allocated to all performance obligations. Similarly, variable consideration may be allocated to a specific series of distinct goods or services. This is allowable under the standard only if both of the following criteria are met:

• The terms of the variable consideration relate to the entity’s efforts to satisfy that performance obligation.
• The allocation of variable consideration to the specific performance obligation depicts the consideration that the entity expects to be entitled to in exchange for delivering that specific good or service.

The FASB permitted this exception to the rule because the proportional method might not result in an accurate depiction of the amount of consideration the vendor is entitled to from the customer for each performance obligation.

A similar exception can be made when allocating discounts that do not pertain to all performance obligations in the contract. Entities often sell a bundle of goods or services to a customer at a transaction price that is less than the sum of all the individual selling prices. Using the relative selling price allocation methodology, this discount would be allocated proportionately to all performance obligations. However, this may not represent the economic reality if the discount is related to a specific performance obligation(s) in the contract. This exception to the rule ensures the discount is allocated only to the performance obligation it relates to.

The exception can be applied if the entity has observable evidence that the discount does not relate to all performance obligations in a contract. Three criteria must be met to justify this treatment:

• The entity regularly sells each of the goods or services in the contract by themselves.
• The entity regularly sells a bundle of some of the goods and services in the contract at a discount to the standalone selling prices.
• The discount in the contract is substantially the same discount as noted in point 2.

For example, a customer contracts an entity to provide three auto parts for $150. The auto parts have standalone selling prices as follows:

Part A – $70

Part B – $60

Part C – $50

Additionally, the company regularly sells part A and part B together for $100. Because of this, the entity has observable evidence that the $30 discount in the contract price relates entirely to part A and part B, and thus will allocate the transaction price accordingly.

The FASB provided these exceptions to better illustrate the underlying economics of transactions and to keep allocation consistent with the guiding principle that allocation should reflect the consideration the entity is entitled to for transfer of a specific good or service.

Read Part I, Part II, Part III, and Part IV of the blog series.

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