In previous articles, we have discussed identifying a revenue contract and the performance obligations (promises) the entity commits to in the contract. With this article, we explore the promise the customer makes with respect to the transaction price.
The glossary to ASC 606 provides the following definition:
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.
Of course in many revenue contracts, such as in retail transactions, determining the transaction price is a straightforward exercise. A customer enters a store to buy a pair of shoes with a listed price of $150. The customer pays the listed price and in exchange receives the shoes. Revenue of $150 is recognized.
However, in many other revenue contracts, determining the transaction price is complex because of the element of variable consideration, inherent in the contract. In fact, even the simple shoe purchase described above may be complicated if the customer has the right to return the shoes for a full refund. Below we discuss the complexities related to determining the transaction price.
Many contracts have a degree of variability in the specified transaction price. This variability can arise because of discounts, rebates, refunds, credits, etc. which are either explicitly stated in the contract or implied by the entity’s customary business practices. If this element of variability exists in the contract, the entity must estimate the consideration it expects to receive and use that amount as the basis for recognizing revenue as the goods or services are transferred to the customer.
The standard specifies two methods for determining the variable consideration. These are the expected value method and the most likely amount method. The standard provides the following descriptions:
a) The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.
b) The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).1
Note that these methods are not accounting policy choices, but are to be the best method for recognizing revenues, depending on the facts and circumstances in the contract. The following examples illustrate the concepts:
Expected value method
An entity enters into a contract to sell widgets to a customer, over a two year period of time, up to a maximum of 1,000. The contract specifies that if the customer takes 100, the price will be $10 per item; for purchases from 101-500 items, the price will be $9 per item; any purchases in excess of 500 items will be at $8 per item. Based on the entity's expectations with this particular customer, it would estimate, using a probability weighted approach, how many items it expects to sell to the customer. The entity determines the following:
|Units sold||Price||Probability||Weighted average units|
Based on this expected value (subject to the constraint discussed below) the entity expects to sell 444 items. In that event they would earn $1000 (100*$10) + $3,096 (344*$9) = $4,096 in revenue at an average revenue of $9.23 per unit. The entity would record revenue for the first 100 units as follows:
Then for the next 344 units
An entity must revisit the estimate of variable consideration at each reporting period to determine whether the estimate is still valid, based on the current facts and circumstances. That is, does the entity still believe it will sell 444 units?
If the estimate changes, the entity must account for the change in accordance with ASC 606-10-32-(42-45). For example, assume the entity has been delivering units to the customer and the demand for the units now is expected to exceed the original estimate of 444 and now is estimated to be 600 units. As a result the estimated per-unit price through the run of the contract would now be $1,000 + $3,600 (400*9) + $800 (100*8) = $5,400, for an average sales price of $9.00 ($5,400/600).
Assume that through the date of the change, the entity has sold 350 units and in the period of the change the entity sells an additional 200 units. The entries would be as follows:
|Period(s) prior to the change (sales of 350 units):|
|To record sales of the first 100 units.|
|To record the sales of the second 250 units|
|Period of change (sales of 200 units):||DR||CR|
|To record sales of 100 units at $9 and 50 units at $8; to recognize revenue on 200 at $9 and to reduce the revenue on the previously recognized revenue on the first 350 units by $81 (the difference between 9.23-9.00=.23).|
After this transaction the remaining balance in the contract liability account would be $53, which would be cleared through the final expected sale of 50 units as follows:
|(Difference due to rounding)|
This method of recognizing revenue contrasts with current GAAP, which would not recognize any variability but rather would recognize revenue based on the invoiced amount at the associated discount level. Clearly the accounting complexities are increasing.
Most likely amount method
The most likely amount method would be more likely to be used in situations where there is a binary decision about how much revenue to recognize. As in situations where an entity contracts to deliver a product or service for a fixed price on a particular date; but has the opportunity to earn a bonus if it can deliver the product within a specified time period. In this scenario, the entity considers whether or not it can earn the bonus. If it believes it is probable (subject to the constraint discussed below), it would recognize the higher amount of revenue over the contract period. If not, it would recognize the base price and reconsider its estimate at each reporting period.2
Generally speaking, the concept of variable consideration is only relevant for those contracts where the revenue will be recognized over time rather than at a point in time.
Constraining estimates of variable consideration
While ASC 606 requires entities to estimate how much revenue will be recognized in connection with a contract, the standard also requires entities to consider constraints on such revenue. Entities may only recognize revenue to the extent that it is not probable that there will be significant reversal of such revenue. Entities shall consider not only the likelihood of a reversal but also the potential magnitude. Here, again, probable is defined as it is in other GAAP, which is a probability in excess of 75-80+ percent.
The standard provides indicators of when a revenue reversal may be probable, as follows:
a. The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.
b. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
c. The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
d. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
e. The contract has a large number and broad range of possible consideration amounts.3
Note that the standard permits an entity to recognize some of the variable consideration when applying the constraint. When the expected value is used, an entity may determine that all of the expected consideration is subject to the constraint; it may also determine that some of the expected consideration should be used as the basis for recognizing the revenue over the contract period. That entity continues to evaluate the probability of significant reversal, as part of its reassessment of variable consideration at each reporting period.
Significant financing component
ASC 606 also brings the concept of a financing component into revenue recognition. For contracts where the entity expects to deliver the goods or services in a time period of less than one year, entities may elect a practical expedient to disregard the consideration of the time value of money. But for all other longer term contracts, an entity must consider whether the contract has a financing component and, if so, recognize interest income (when customer payments are deferred) or interest expense (when customer payments are accelerated).
The standard provides the following indicators of a financing component:
a) The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services
b) The combined effect of both of the following:
a. The expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services
b. The prevailing interest rates in the relevant market4
The standard provides for certain situations which would not indicate a financing component, as follows:
a) The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.
b) A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity (for example, if the consideration is a sales-based royalty).
c) The difference between the promised consideration and the cash selling price of the good or service (as described in paragraph 606-10-32-16) arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract.
The following examples, derived from the standard, illustrate the concept:
An entity sells a product to a customer for $121,000 that is payable 24 months from the delivery date. The customer obtains control of the product upon delivery. The cash selling price for the product is $100,000. As such the entity determines there is a significant financing component. The entity determines there is an implicit discount rate of 10% in the contract. Here the entity must determine if the implicit interest rate is comparable to the rate in a separate financing arrangement and concludes that it is.
Upon delivery, the entity would record the following:
Thereafter, the entity would periodically accrete the interest income to end with a receivable balance of $121,000, when the payment is due.
To illustrate the accounting for advance payments, consider this example:
An entity enters into a contact to deliver a machine, for $50,000, in two years when control of the asset will pass to the customer. The entity offers the following: payment of $50,000 when the machine is delivered or payment of $40,000 upon signing of the contract. Here the implied interest rate in the contract is 11.8%. However, the entity knows that its implicit borrowing rate is actually 6%. That rate will be used to calculate interest expense.
The entity records the following upon signing of the contract:
Over the two year period of the contract, the entity recognized interest expense:
Then upon delivery of the product the entity recognizes revenue:
An entity will determine the discount rate at inception based on then prevailing rates for separate financing transactions. Once determined, the entity does not adjust the rate for changes in interest rates.
Goods are often sold with an explicit or implied right of return. In those situations, an entity must determine whether goods will be returned and reduce revenue accordingly. With sales of many similar products, it may be useful to use a portfolio approach5. As noted in this example:
An entity sells consumer products and has a reliable history of the returns it can expect from those sales. During its seasonal busy time, the entity sells 10,000 units at a price of $100 and a cost of $80. The units may be returned within 30 days for a full refund. The returned units can be resold. Based on experience, the entity expects that 5% of the units will be returned for a refund.
The entity uses the portfolio approach and records the following entries:
|Cost of goods sold||$40,000|
The returned inventory amount should be reduced if the entity is expected to incur any additional handling costs.
Some contracts may contain provisions for non-cash consideration to be paid by the customer, including equity consideration. In these cases, the entity shall estimate the consideration at its fair value. Recently the FASB issued ASU 2016-12, which provided narrow scope improvements to ASC 606. In that ASU, the FASB clarified that the fair value of non-cash consideration should be measured at contract inception; and that variable consideration does not include any variability related to the fair value of non-cash consideration.
Consideration payable to a customer
Consideration expected to be paid to the customer reduces the transaction price. This can be in the form of cash, credits or other items, such as coupons or vouchers for future purchases. In situations where the entity is uncertain as to whether the customer will make use of such consideration, the entity must estimate an amount and record a liability based on the estimate. The estimate will need to be reassessed at each reporting period.
If the consideration payable to the customer is in exchange for distinct goods or services where the entity obtains control upon transfer, then the entity will account for such consideration in the manner which it accounts for purchases from other suppliers. However, if the consideration paid is in excess of the fair value of the distinct goods or services, the entity will account for that difference as a reduction of the transaction price.
Determining the transaction price of a contract can be quite complex, depending on the nature of an entity’s business and revenue streams. These assessments historically have not been required under current revenue recognition models. In particular the concept of variable consideration could result in accelerating revenue. Applying the concepts will result in many more judgments by management and as such will require robust internal controls over financial reporting in order to provide a consistent and reliable process, when applying the judgments.
For more information on revenue recognition, or learn how Baker Tilly’s specialists can help, contact our team.
1 ASC 606-10-32-8
2 See last month’s article for an example related to performance obligations which also includes this type of variable consideration.
3 ASC 606-10-32-12
4 ASC 606-10-32-16
5 The portfolio approach, refers to grouping similar types of contracts for accounting analysis. This approach is permitted as long as the resulting measurement is not materially different from analyzing each contract individually.