The New Revenue Recognition Standard: Step 4 — Allocate the Transaction Price to the Performance Obligations
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. The new standard creates a whole new codification topic (ASC 606) and ushers in a new era of revenue recognition by 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 2014-19 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 three steps in our previous blogs. The fourth step is to allocate the transaction price (determined in Step 3) to the performance obligations.
The transaction price should be allocated to the performance obligations based on relative standalone selling price.
The standalone selling price is the price at which an entity would sell a good or service separately to a customer. The best evidence of standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances, and to similar customers. If there is no directly observable evidence of standalone selling price, then the entity should make its best estimate of standalone selling price by maximizing the use of observable inputs. The method used should be consistently applied in similar circumstances and include all reasonably available information including market conditions, and entity/customer-specific factors.
This is conceptually similar to the fair value measurement principles under current U.S. GAAP contained in ASC 820: Fair Value Measurement, which requires entity’s to maximize observable inputs. However, whereas ASC 820 requires fair value to be determined from a market participant’s point of view, ASC 606 requires standalone selling price to be determined from the entity’s point of view.
Under ASC 606, there is no hierarchy of standalone selling price estimation methods similar to that under current U.S. GAAP contained in ASC 605-25 Multiple-Element Arrangements. However, many of the concepts are similar. First off, the concept of standalone selling price is similar to the concept of vendor specific objective evidence (VSOE). Under current U.S. GAAP, VSOE is the highest measurement method when determining relative selling price, which is the method used to allocate a revenue arrangement’s consideration under ASC 605-25. Though ASC 606 doesn’t provide an estimation hierarchy like ASC 605-25 does, ASC 606 does provide some examples of potential estimation methods including:
- Adjusted market assessment approach – Theoretically, this method estimates standalone selling price by estimating the price that the customer would pay for the good or service in the entity’s market. From a practical perspective this would likely include reference to the price an entity’s competitors charge for similar goods or services adjusted to reflect the entity’s costs and margins. This is very similar to current U.S. GAAP under ASC 605-25 and the concept of third-party evidence of selling price, which is the second highest measurement method when determining relative selling price under current U.S GAAP.
- Expected cost plus a margin approach – As its name implies, under this method the entity estimates standalone selling price by estimating expected cost to satisfy the performance obligations and then adding an appropriate margin. This is somewhat similar to current U.S. GAAP under ASC 605-25’s and the concept of best estimate of selling price, which is the lowest measurement method when determining relative selling price under current U.S GAAP.
- Residual approach – Standalone selling price is estimated by subtracting the sum of all observable standalone selling prices of other goods or services promised from the total transaction price. The residual approach may only be used if one of the following criteria is met:
- There is a broad range of current selling prices to other customers and thus there is no representative standalone selling price.
- The good or service has never been sold, and there is no established price for the good or service.
When determining the allocation price there are several special considerations to evaluate.
Allocation of a Discount
Often, the selling price of a bundle of goods or services will be less than the individual standalone selling prices (i.e. the bundle is sold at a discount). Because the total transaction price is allocated based on relative selling price, this doesn’t create a problem unless the discount should be allocated entirely to one or more specific performance obligations. A discount should be allocated entirely to one more performance obligations if all of the following are met:
- The entity regularly sells each distinct good or service on a standalone basis.
- The entity regularly sells on a standalone basis a bundle(s) of some of those distinct goods or services at a discount to their standalone selling prices.
- The discount attributable to each bundle(s) described in (b) is substantially the same as the discount in the contract being analyzed and the performance obligation(s) to which the entire discount belongs is readily observable.
Any discount allocated entirely to one or more performance obligations should be allocated to those performance obligations before using the residual approach. This makes conceptual sense otherwise the discount would be erroneously allocated to the residual elements.
Allocation of Variable Consideration
Variable consideration should be allocated entirely to a performance obligation (or to a distinct good or service in a series that forms a single performance obligation) if both of the following are met:
- The contractual terms of the variable payments relate specifically to a performance obligation (or to a distinct good or service in a series that forms a single performance obligation), and
- Allocating the variable consideration entirely to the performance obligation (or to a distinct good or service in a series that forms a single performance obligation) is consistent with the overall principle in Step 4 to allocate the transaction price to each performance obligation in an amount that depicts the consideration to which the entity expects to be entitled to for transferring that good or service. In other words, the variable consideration can be allocated entirely to a performance obligation (or to a distinct good or service in a series that forms a single performance obligation) if doing so doesn’t result in allocating more or less revenue than should be allocated based on relative standalone selling price.
Once the entity has completed Step 4 and allocated the transaction price to the performance obligations in the contract, the entity must move onto Step 5: Recognize Revenue, which will be the subject of our next blog.