If you have been following Steps 1 (Identify the Contract with the Customer) through 3 (Determining a Transaction Price), of the revenue recognition update as eagerly as I have, then I am sure that you keenly await the discussion on Step 4 about the allocation of the transaction price to the performance obligations in a contract. The wait is over as we explore Step 4 in this blog post. A couple key concepts that we need to understand in this process: the allocation objective and standalone selling price.
The basic premise of the allocation objective is for the transaction price to be allocated to each performance obligation in the contract such that it represents the consideration an entity would be entitled to in exchange for transfer of the goods or services. This involves determining the standalone selling price of the distinct goods or services and allocating the transaction price on a relative stand-alone basis to each underlying performance obligation.
Standalone price is best explained and best evidenced as the observable price of a similar good or service when sold separately in similar circumstances. The absence of an observable price requires an estimate of the standalone price and in doing so, sound judgment must be applied and all relevant factors ought to be considered, such as market and entity-specific conditions, type of customer, reliability of estimated data, etc. and the use of observable inputs should be maximized in arriving at this estimate. Some of the acceptable methods for estimating standalone price under ASC 606-10-32-34 are:
- Adjusted market assessment approach: which is based on the price of a similar commodity or service sold in the market, possibly by a competitor, and as adjusted by the reporting entity’s costs and margins;
- Expected cost plus a margin approach: which uses a forecast of the entity’s expected costs with an appropriate margin for the commodity or service;
- Residual approach: as the name suggests, the residual price of a commodity is what remains of the transaction price after backing out the observable standalone prices of other goods and services within the contract. The use of the residual method is considered permissible if the selling price of the commodity is either highly variable or uncertain.
While ASC 606 does not stipulate a hierarchy or preference of evidence for standalone price, it is important to assess the appropriateness of the estimates and the validity of the assumptions made in arriving at the estimate of standalone price; simply defaulting to the residual approach does not meet the prescribed criteria.
Now that we’ve understood the key concepts, let’s discuss how to address discounts or variable consideration in the allocation of the transaction price. Often times, such discounts or variable consideration only apply to some but not all performance obligations within the contract and understanding how to allocate them to some performance obligations rather than to all is an important undertaking.
Unless an entity can demonstrate through observable evidence that the discount relates to only one or more, but not all performance obligations within a contract, the discount should be proportionately allocated to all performance obligations in the contract. Under ASC 606-10-32-37, the observable evidence criteria is met if all of the following conditions are fulfilled:
- The entity is in the practice of selling each distinct good or service in the contract on a standalone basis;
- The entity also regularly sells on a standalone basis, a bundle or bundles of these distinct goods or services at a discount;
- The discount attributable to each bundle of goods as explained in (ii) above is substantially the same as the discount in the contract and observable evidence supports the entity’s claim that such discount applies to a specific performance obligation or performance obligations.
Another important nuance to bear in mind is that if a discount is allocated entirely to one or more performance obligations in the contract, the entity shall allocate the discount before using the residual approach to estimate the standalone selling price of a good or service.
Variable consideration, as explained here, Step 3: Determine a Transaction Price, can be allocated to a specific performance obligation provided both of the following criteria are met:
- The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service), and
- Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective.1
Changes in the transaction price can occur for a variety of reasons such as the resolution of uncertain events or other events that alter the consideration an entity is entitled to receive. Any subsequent changes in the transaction price should be allocated on the same basis as at contract inception for the most part. Changes resulting from a contract modification require a deeper understanding, as explained here, Step 1: Identify the Contract with the Customer. However, for a change in the transaction price that occurs after a contract modification, an entity shall allocate the change to the unsatisfied performance obligations in the modified contract, unless the modification was accounted for as a termination of the existing contract and the creation of a new contract or the change relates to variable consideration promised
And with this, we arrive at the doorstep of Step 5 Recognizing Revenue when (or as) the entity satisfies a performance obligation. Stay tuned for the finale.