The New Revenue Recognition Standard: Step 3 — Determining the Transaction Price
As mentioned in our previous blog, on May 28th the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers: Topic 606. This creates a whole new codification topic (ASC 606) and ushers in a new era of revenue recognition and replacing hundreds of pages of industry specific guidance with a single comprehensive standard applicable to virtually all industries, and will significantly change how we recognize revenue. ASU 2014-09 isn’t effective for private entities until reporting periods beginning after December 15, 2017, but will be effective for public entities a year earlier.
ASC 606 creates a five-step process for recognizing revenue. We’ve already covered the first two steps in previous blogs. The third step is to determine the transaction price.
Under ASC 606, the transaction price is the amount of consideration the entity expects to be entitled to, in exchange for transferring promised goods or services. For simple fixed price contracts, this will be relatively straightforward. However, for more complex contracts such as those with variable consideration Step 3 can become more difficult.
Consideration is variable anytime it is contingent upon the occurrence or nonoccurrence of a future event. Consideration can vary due to many reasons such as discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, right or return, etc. Variability can be explicitly stated in the contract or implied by customary business practices, published policies, or other facts and circumstances.
One of the biggest changes between current U.S. GAAP and ASC 606 is that variable revenue can be included in the transaction price, and thus allocated (Step 4) to the various performance obligations (Step 2) and recognized (Step 5) as revenue. Under current U.S. GAAP, most variable revenue cannot be recognized until the contingency is resolved.
Under ASC 606, if a contract includes variable consideration, the entity should estimate how much consideration it will receive. There are two acceptable methods for estimating the amount of variable consideration:
a. The expected value method – the sum of the probability weighted amounts for the range of possible contract outcomes; or
b. The mostly likely amount method – the single most likely contract outcome.
The objective is to best predict the amount of consideration the entity will ultimately be entitled. Therefore, the expected value is best used when there are a large number of contracts with similar characteristics or a contract’s outcome has many possible outcomes. The most likely amount is best used when a contract has only two possible outcomes. For example, if a performance bonus is achieved or not. The method of estimating should be consistently applied throughout the contract. That being said, an entity can use a different method for a different contract, just not for the same contract.
Importantly, the amount of variable consideration that can be recognized is constrained. Variable consideration shall be included in the transaction price only to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur.
Some of the factors an entity should consider when determining if a significant reversal of cumulative revenue could occur are:
- The amount of consideration is highly susceptible to factors outside of the entity’s control.
- Resolution of the variable consideration will not occur for a long period of time.
- The entity has limited experience with similar contracts.
- The entity has a history of offering a broad range of price concessions.
- The contract has a broad range of possible outcomes.
In addition to the complexities that variable consideration can introduce when determining the transaction price, there are several other key considerations:
- Refund liabilities.
- The existence of a significant financing component in the contract.
- Consideration payable to a customer.
- Sales-based or usage-based royalty promised in exchange for a license of intellectual property.
Revenue should be offset by a refund liability if the entity expects some refunds will occur and the amount of the estimated liability should be updated each reporting period. If in addition to the right or refund a right of return exists. then an asset should be recognized with an offset to cost of goods sold. For example, assume 10 widgets are sold for $1 each and the cost to produce each widget is $0.50 a widget. Also assume that the entity expects 20 percent will be returned. The entry would be as follows:
Cash/Accounts Receivable $10
Refund Liability $2
Right of Return Asset $1
At the end of each reporting period, the entity should update its return and refund assessments, and adjust the transaction price accordingly which will in turn result in an increase or decrease in revenue recognized. In addition, at the end of each reporting period, the entity should update its measurement of the right of return asset. The measurement should equal the former inventory carrying amount less any expected cost to recover less any expected decreases in the value of returned products.
Under current U.S. GAAP, an entity would not have created a right of return asset but rather would’ve offset revenue with the accrued refund liability (i.e. only the first entry above).
The Existence of a Significant Financing Component in the Contract
The transaction price should be adjusted for the time value of money regardless of whether the contract explicitly specifies a financing component. If the time between the transfer of goods or services and payment is greater than one year then the entity should consider if a financing component exists. All relevant factors should be considered when determining whether a financing component exits. Both of the following are required to be considered:
- Difference between cash selling price and the estimated contract consideration.
- Effect of both:
- The expected length of time between the transfer of goods or services and payment.
- The prevailing interest rates applicable to the parties and the type of transaction.
A contract would not include a financing component if any of the following are present:
- Customer paid in advance and transfer of goods or services is delayed at the customer’s discretion (e.g. bill and hold).
- A substantial amount of consideration is variable, and the variability is dependent upon a future event that is outside of both the entity and customer’s control (e.g. sales-based royalty).
- Difference between contract consideration and cash selling price is due to another reason such as protection against default and the difference is proportional to the reason for that difference.
The interest rate used to compute the financing component should be the hypothetical borrowing rate between the entity and the customer including the credit risk of the borrower and any collateral (including the goods/service transferred as part of the contract). This would likely, but not necessarily, be the rate that discounts the expected contractual payments to the cash selling price.
The financing component should be presented as interest income or expense, but only to the extent that an accounts receivable or liability is recognized. In other words, the interest income/expense should be based on the receivable or contract liability.
Consideration Payable to a Customer
Consideration payable to a customer should be treated as a reduction to the transaction price no differently than a price concession, unless the consideration paid to the customer is in exchange for a distinct good or service, and the consideration payable to the customer does not exceed the fair value of the good or service provided to the seller. If the consideration payable to the customer is above the fair value of the good or service received by the customer, then the excess amount should be treated as a reduction in the transaction price. If the fair value of the good or service transferred by the customer cannot be readily determined, then the entire consideration payable to the customer should be treated as a reduction of the transaction price. Consideration payable to a customer includes both consideration directly payable to the customer or consideration payable to the customer’s clients.
Sales-Based or Usage-Based Royalty Promised in Exchange for a lLicense of Intellectual Property
Revenue for sales-based or usage-based royalty promised in exchange for license of intellectual property should be recognized upon the latter of the following:
- Subsequent sale or usage occurs; or
- The performance obligation which the sales-based or usage passed royalty transaction price was allocated to (in whole or in part) has been satisfied (in whole or in part).
Determining the transaction price is more difficult than it might first appear. Once the entity has completed Step 3 and determined the transaction price then the entity must move onto Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract, which will be the subject of our next blog.