Dissecting the New Revenue Recognition Guidance: Step 3 of the Five-Step Framework
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as amended, creates a five-step framework for entities to determine when and how much revenue should be recognized. The first article in the ‘Dissecting the New Revenue Recognition Guidance’ series discussed step 1: identifying the contract(s) with a customer. The second article in the series explained step 2: identifying performance obligations in the contract. This article focuses on step 3: determining the transaction price.
Step 3: Determine the Transaction Price
Before delving into step 3, it is important to understand the definition of transaction price. Transaction price, as defined in ASC 606-10-32-2, is 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. Consideration promised in a contract with a customer can include fixed amounts, variable amounts, or both. Said in more simple terms, this step asks entities to estimate what they are ultimately going to be paid for the products and services they provide, net of all potential discounts, rebates, price concession, performance bonuses, and all other potential forms of contract price reductions or increases. Determining the transaction price can be relatively straightforward when the transaction price is the list price for a good or service, but when entities introduce elements of variable consideration or significant financing components, complexities arise. This step includes several provisions that are significantly different from current generally accepted accounting principles in the United States (GAAP), and could potentially require changes in accounting processes, specifically when variable consideration or significant financing components are present.
Variable consideration is most understandably defined as consideration that is contingent on a future event occurring or not occurring. Variable consideration is a common method used by entities to entice customers to purchase incremental goods or services, and also can reflect changes in contractual price based on a customer’s inability to pay the agreed upon price. Alternatively, variable consideration could be an uncertain amount of revenue that an entity will earn in the form of a performance bonus that is contingent on performance or a specific outcome occurring.
The objective of determining the transaction price is to predict the amount of consideration to which the entity will be entitled to, including amounts that are variable. Management should determine the total transaction price, including an estimate of any variable consideration at contract inception, and reassess this estimate at each reporting date. This is a significant change in current accounting practice, as variable consideration is currently accounted for at the point it is earned or realized. Entities will need processes and policies in place to estimate the amount of variable consideration to be received. Refer to the table below for common examples for variable consideration, and whether or not the new revenue guidance will potentially change the accounting for the consideration and require updated accounting policies or practices.
|Point of Sale Discount||No|
|Prompt Payment Discount||Yes|
|Price Protection Clauses||Yes|
Point of sale discounts (discounts which are known when the sale is effected) do not require a change in accounting as the amount of consideration is known when the sale is transacted, and there is no need for estimation. All other forms of variable consideration, which will be earned in the future, require estimation at contract inception.
After an entity has summarized all of the variable consideration in its contracts, it needs to consider how to estimate for variable consideration. The new revenue standard provides two methods to estimate variable consideration, summarized below. It is important to note that electing which method to use is not an accounting policy choice. Companies should chose the method that is the best indicator of the potential future outcome.
- Expected Value Method – The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts.
- Most Likely Amount – The most likely amount is the single most likely amount in a range of possible consideration amounts (the single most likely outcome).
If the achievement of the variable discount is binary, and the customer is either going to receive the discount, rebate, or other form of variable consideration or not, then the ‘most likely amount’ is the preferred method of estimation. If the achievement of a variable discount is possible, but the amount of the variable consideration is dependent on a customer’s behavior (example is a volume discount that increases based on purchasing), then the ‘expected value method’ is the preferred method of estimation. Other factors such as historical knowledge of a customer’s purchasing patterns, how new and therefore unpredictable a discount or rebate program is, and other similar facts should be considered.
The new standard includes a constraint on the amount of variable consideration included in the transaction price as defined in ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration 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. In layman’s terms, the Financial Accounting Standards Board (FASB) is stating that estimates on variable consideration cannot be materially incorrect. As an example, an entity cannot recognize a material amount of revenue related to a potential performance bonus throughout the year, only to reverse all of this revenue when preparing the financial statements. There needs to be a solid fact pattern behind the selected method such that there is not a significant reversal of revenue that would potentially mislead financial statement users. The likelihood of significant reversal is higher in the following situations:
- The amount of variable consideration is highly susceptible to outside 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 types of contracts is limited.
- The contract has a large number and broad range of possible consideration amounts.
- The entity has a history of offering broad price concessions or changing payment terms.
While taking into consideration the “potential for revenue reversal” as defined by the standard, entities need to choose the estimation method that is best suited for them. Refer to the example below of a volume discount using both the expected value method and most likely amount method for further understanding.
Example – Most Likely Amount
On Jan. 1, 2019, Company ABC enters into a one-year contract with a customer to deliver widgets. The contract states that the customer will receive a $1,000 discount upon purchasing 1,001 widgets.
Volume is determined based on sales during the fiscal year, and Company ABC estimates that total sales volume for the year will be 1,800 widgets, based on experience with this customer. Company ABC should record the $1,000 discount against revenue ratably as the customer is likely to achieve the required sales metrics.
Example – Expected Value
On Jan. 1, 2019, Company ABC enters into a one-year contract with a customer to deliver widgets. The contract states that the price per widget will be adjusted retrospectively once the customer reaches certain sales volumes defined as follows:
|$15||0 – 1,000 widgets|
|$10||1,001 – 2,000 widgets|
|$5||2,001 widgets and above|
Volume is determined based on sales during the fiscal year, and Company ABC estimates that there is a 25 percent chance that the Company achieves between 1,001 – 2,000 widgets sales, and a 75 percent chance that the customer buys 2,001 widgets or greater. Using this method, Company ABC determines a sales price of $6.25 (($10 x .25) + ($5 x .75)). Revenue is therefore recognized at a selling price of $6.25, and Company ABC will recognize a liability for cash received in excess of the transaction price until facts and circumstances indicate a more likely achieved volume discount.
Estimates of variable consideration are subject to change as facts and circumstances evolve, and as such accounting departments should revise estimates of variable consideration at each determined reporting date throughout the contract period.
Significant Financing Components
Topic 606 introduces a new concept called significant financing components. Entities need to adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by parties provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. The objective is for entities to recognize revenue at a price that reflects the price that a customer would have paid for the products or services if the customer had paid when the entity transferred the goods or services to the customer. As a result, interest income or interest expense resulting from a significant financing component should be accounted for separately from revenue from contracts with customers. FASB has allowed for a practical expedient that permits entities to ignore the time value of money in a contract if the difference between when payment and performance occurs is a year or less. An entity cannot use the practical expedient to disregard the effects of a financing in the first 12 months of a longer-term arrangement that includes a significant financing component. Consider the example below to illustrate the concept of a significant financing component.
Example – Significant Financing Component
Company ABC enters into an arrangement with a customer for financing of a home entertainment system purchase. Company ABC is running a promotion that offers all customers two percent financing. The two percent contractual interest rate is significantly lower than the six percent interest rate that would otherwise be available to the customer. Company ABC determines that there is a significant financing component present in the contract. As a result, Company ABC should use a six percent discount rate to determine the transaction price. It would not be correct to use two percent, as this represents a marketing incentive and does not reflect the credit characteristics of the customer. Interest expense would be recorded as a result of this significant financing component.
The purpose of the significant financing component is to account for the time value of money, and to allow financial statement users the ability to review the quantified impact of such contracts.
Specific Concerns Related to Determining Transaction Price
The standard addresses the following items related to allocating transaction price which may ease the process of determining how to determine transaction price for certain performance obligations.
Can I use a different method of estimation for different discount or rebate programs?
Yes, the facts and circumstances of each incentive program can be different. Entities should consider what method reflects the most likely, accurate reflection of the end result. Entities should consider past customer results, and other influencing factors that may help determine the most accurate estimate of variable consideration.
If I have a significant amount of variable consideration, what should I do to prepare for the change in accounting literature?
Variable consideration is something that entities will have to think about how their processes and procedures will need to change. For the most part, variable consideration does not span over periods greater than a year, and as a result, this should be a regular (albeit new) financial reporting exercise for entities. Entities should think through how they are going to process this new accounting change. It’s possible, although unlikely, that certain entities will need to consider system changes or upgrades if this presents a large enough change. In addition, although this part of the standard may not have an impact today, accounting departments should be in conversations with the applicable sales and marketing personnel so they are both on the same page with regards to the financial implications of the standard.
The implications of step 3 will impact how entities have historically accounted for variable consideration and financing components, and could result in significant change in processes. All entities should review the changes that this step will bring. This step will be significantly more time consuming for entities that have material variable consideration. Variable consideration is common in many industries, including technology, manufacturing, construction, and service. It is paramount that entities have vetted changes in advance of the implementation date for the new revenue standard. Entities should communicate potential changes to parties of interest (third-party lenders, stockholders, members of management, and board members) in advance of implementation. Accounting, sales, and marketing departments should also be aware of these changes.
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