Now that all of the performance obligations (Step 2) of the contract have been separately identified, it’s time to determine a transaction price. Seems easy, right?
ASC 606 defines the transaction price as “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 (for example, some sales taxes).” On the surface this sounds like an easy step for your entity to identify the price you are selling a product for, but in practice we know that not all transaction prices are fixed at the onset of the contract. When calculating the transaction price, an entity needs to consider all of the following:
• Variable consideration
• Constraining estimates of variable consideration
• Existence of significant financing components
• Noncash consideration
• Consideration payable to a customer
Variable consideration can arise in a number of ways; rebates, purchase discounts, available credits, price discounts, incentives, penalties and bonuses.
In determining the impact variable consideration can have on the transaction price, an entity can estimate the amount of variable consideration by using either of the following:
• Expected Value Method – this method is used when there are multiple potential outcomes. In this case, the variable consideration would be equal to the sum of probability-weighted totals from the range of potential outcomes.
• Most Likely/Best Estimate Amount – think of this as the either/or method. This estimate is very useful when there are only two possible outcomes, either the entity meets a desired outcome or it doesn’t.
Since the calculation of the variable consideration includes a significant amount of estimating and uncertainty, the FASB has introduced another new concept, and that is constraint. To apply the concept of constraint to the estimated amount of variable consideration in the contract, an entity has to consider the probability of a significant reversal of revenue during the term of the contract. An entity can include the amount of variable consideration in the transaction price, only to the extent that it is probable that a significant reversal of revenue will not occur. Unfortunately, the FASB does not define the term “significant reversal”, so this again brings into another layer of estimation and subjectivity to the determination of the transaction price. The estimated transaction price, including the assessment of whether the variable consideration is constrained should be performed at each reporting period.
One area the FASB has specifically excluded from the variable consideration analysis is sales-based or usage-based royalties on licenses of IP. There are specific guidelines in ASC 606 for this type of revenue arrangement (ASC 606-10-55-65).
At this point, an entity has determined its transaction price for a specific contract in the normal course of business. However, we know that not all contract negotiations follow a normal process. At times, an entity will give certain concessions to a customer in order to close a deal. ASC 606 identifies the following factors which could impact the overall transaction price: existence of significant financing component; noncash consideration; and consideration payable to a customer. These concessions now need to be analyzed and determination needs to be made as to whether they are material to the contract. If they are material to the contract, the transaction price and/or the timing of the recognition of revenue will need to be reassessed.
Now that the transaction price has been established, it’s on to Step 4 and the process of allocating the transaction price to the performance obligations identified in Step 2.