Authored by: Phil Santarelli, CPA, Partner Emeritus
So far in this series, we have addressed three of the five elements of revenue recognition. The first was to determine whether we had a contract in scope for revenue recognition; next we identified the promises we made to the customer for delivery of goods or services; and then we determined the transaction price, including variable consideration. In this article, we discuss how to allocate the transaction price to the performance obligations in the contract.
The objective of ASC 606 in allocating the transaction price is that the entity will recognize revenue for each performance obligation in the amount the entity expects to receive in exchange for the promised goods or services. To do so, the entity should allocate the transaction price to the promises based on the relative standalone selling price of the separate goods or services. This is defined in the Glossary as follows:
Standalone selling price
The price at which an entity would sell a promised good or service separately to a customer.
An entity will determine the standalone selling price for each of the performance obligations at the inception of the contract and will not adjust the initial allocation for future changes in any selling prices. The entity should maximize the use of observable inputs when estimating the selling price. The standard describes three suitable methods for determining the standalone selling price, but does not require their use if a more suitable method is available with more observable inputs.
The suggested methods are:
- Adjusted market assessment approach—An entity could evaluate the market in which it sells goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. That approach also might include referring to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins.
- Expected cost plus a margin approach—An entity could forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service.
- Residual approach—An entity may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract. However, an entity may use a residual approach to estimate, in accordance with paragraph 606-10-32-33, the standalone selling price of a good or service only if one of the following criteria is met:
- The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence).
- The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain).1
Depending upon the nature of the performance obligations, an entity may need to use a combination of methods if certain performance obligations have highly variable or uncertain standalone selling prices.
Once the selling prices have been determined, the entity will apply the relative values to the total contract consideration and estimate the amount of the transaction price to be recognized as each promise is fulfilled.
Example: Allocating consideration
An entity agrees to sell three products (A, B and C) to a customer for $100. The entity regularly sells product A, so a directly observable price is available. However, for products B and C, the entity does not have directly observable selling prices and, therefore, must estimate them. For product B, the entity uses the adjusted market assessment approach as they are aware of other entities that sell a similar product. For product C, the entity was unable to observe any similar products and thus uses an estimated cost plus margin approach to estimate the selling price. The analysis yielded the following:
|Product A||$50||Directly observable selling price|
|Product B||25||Adjusted market assessment approach|
|Product C||75||Cost plus margin approach|
The entity initially allocates the consideration as follows:
|Relative percentage||Allocated consideration|
|Product A||50/150 = 33.33%||$33.33|
|Product B||25/150 = 16.67%||$16.67|
|Product B||75/150 = 50.0%||$50.00|
In the example, the customer received a discount of $50 from the standalone selling prices for purchasing the bundle. This discount was allocated proportionately.2
Allocating a discount
Typically, an entity will allocate a discount based on relative selling prices as noted in the above example, but the standard does provide guidance for allocating discounts to some, but not all performance obligations if certain conditions are met, as follows:
- The entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a standalone basis.
- The entity also regularly sells on a standalone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the standalone selling prices of the goods or services in each bundle.
- The discount attributable to each bundle of goods or services described in (b) is substantially the same as the discount in the contract, and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs.3
If an entity determines that it should allocate a discount to one or more, but not all of the performance obligations, it must do so before applying the residual approach.
Example: Allocating a discount to fewer than all performance obligations
An entity enters into a contract to sell three products for $100. The standalone selling prices are as follows:
The contract therefore has a discount of $40. But the entity sells products B and C together for $60 and product A for $40. So in this situation, the discount of $40 would be applied to products B and C, but not product A. The relative standalone selling prices would be used to allocate the consideration:
|Product B||55/100 = 55%||$33|
|Product C||45/100 = 45%||27|
Depending on the complexity of the contract and the number and types of performance obligations, an entity may need to go through several steps to completely allocate the consideration. However, as noted above, typically any discounts will be allocated based on the relative standalone selling prices.
The residual approach
Using the residual approach is not a free choice, as it can only be used when the conditions noted above are present. The following example illustrates when use of the residual approach is appropriate:
An entity enters into a contract to sell products A, B, C as in the above example, but also agrees to supply product D. The total consideration is $130. The standalone selling price is sold to several customers, but at a wide range of prices, $15-$45. The entity determines that, because of this variability, it meets one of the conditions in the standard for using the residual approach.
Before applying the residual approach, it must apply any discounts to other performance obligations as required in the standard. Because of the observable evidence for products A, B and C, it determines that $100 of the selling price should be allocated to those items. This therefore leaves $30 of the consideration to allocate to product D, which is in the range of selling prices that the entity has used for product D alone.
|Product A||$40||Directly observable|
|Products B and C||60||Directly observable with discount|
|Product D||30||Residual approach|
Note in the example, if the selling price were $105, this would result in an allocation of only $5 to product D, which is not a price within the observable range of the entity’s sales. Therefore, the entity would need to use another method to determine the standalone selling price for product D and properly allocate the consideration.
Allocation of variable consideration
If a contract calls for variable consideration, the entity shall allocate the variable consideration it has determined can be recognized, subject to the constraint.6 This can result in situations where the variable consideration can be allocated to all of the performance obligations based on relative standalone selling prices, or if the variable consideration only relates to a specific performance obligation, such as a bonus for completing one or more promises before a certain date, it is allocated only to the relevant performance obligation.
These allocations to specific performance obligations must meet both of the following criteria:
- 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).
- Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective in paragraph 606-10-32-28 when considering all of the performance obligations and payment terms in the contract.7
Any remaining transaction price will be allocated to other performance obligations in accordance with the methods noted above.
Example of a special allocation
An entity sells a customer two licenses, X and Y. The entity determines that these are distinct performance obligations. The standalone selling prices are $800 for X and $1,000 for Y. The contract provides a fixed price of $800 for X and for Y the selling price is a royalty of 3 percent of future sales related to the use of license Y. The entity estimates that the variable consideration associated with license Y will be $1,000.
The entity considers the requirements above. The variable payment is related solely to Y, so criterion (a) has been met. It assesses criterion (b) and determines that this has been met, because the expected royalty payment approximates the standalone selling prices of X and Y. Therefore, none of the fixed consideration will be allocated to license Y.8
The entity recognizes $800 of revenue when license X is transferred to the customer. It recognizes no revenue when license Y is delivered, rather as the customer generates sales, it recognizes revenue at the 3 percent royalty rate.
In a variation of the preceding example, assume the standalone selling prices of licenses X and Y are the same, but that the contract states a fixed amount of $300 for license X and a 5 percent royalty for license Y, which the entity estimates will be $1,500. In this case, even though the variable component is attributable entirely to license Y, it would be inappropriate to allocate all of the variable consideration to license Y. This is because the amount allocated to licenses X and Y would not reflect a reasonable allocation based upon their standalone selling prices. Consequently, the entity first allocates the $300 amount to licenses X and Y based on standalone selling prices, then allocates its estimate of variable consideration of $1,500 on the same basis. However, this revenue cannot be recognized until the sales actually occur or the performance obligation is satisfied.
License Y is transferred immediately and license X is transferred three months later. The entity recognizes revenue as follows:
|At delivery of license Y||Bases upon fixed price of $300|
|License Y||1000/1800 = 55.6%||$167|
|Three months later|
|License X||800/1800 = 44.4%||$133|
Assume that in the month after delivery of license Y (but before delivery of license X), the sales royalty is $200. The entity would then record the following revenue entry:
|Revenue license Y||$111|
|Contract liability related to X||$89|
In the same ratio as above, the entity recognizes 55.6 percent of the revenue as related to license Y. It also records a contract liability for the balance of 44.4 percent as license X has not been delivered yet. It will continue to record the contract liability until delivery of license X. Thereafter, it will recognize revenue in the same ratios for both licenses as the royalties are earned.9
Changes in transaction prices
Resolution of uncertainties
If the transaction price changes because an uncertainty has been resolved such as one related to variable consideration, the entity will allocate those changes to the performance obligations based on the original allocation without regard to any changes in standalone selling prices which may have occurred. The entity will also allocate the change entirely to one or more performance obligations following the guidance noted above for doing so at contract inception.
If the change in transaction price is the result of a contract modification,10 an entity will apply the following guidance in whichever of the following ways is applicable:
- An entity shall allocate the change in the transaction price to the performance obligations identified in the contract before the modification if, and to the extent that, the change in the transaction price is attributable to an amount of variable consideration promised before the modification and the modification is accounted for in accordance with paragraph 606-10-25-13(a).
- In all other cases in which the modification was not accounted for as a separate contract in accordance with paragraph 606-10-25-12, an entity shall allocate the change in the transaction price to the performance obligations in the modified contract (that is, the performance obligations that were unsatisfied or partially unsatisfied immediately after the modification).11
As discussed above, allocating the transaction price can be a relatively straightforward exercise, when standalone selling prices are easily obtained. However, when variations in transaction price, including discounts or variable consideration, are related to other than all of the performance obligations the complexities increase as do the number of judgments.
When applying this element in complex environments attention to adequate documentation of the related processes for evaluating the elements, making and documenting the related judgments and estimates, and adequately applying internal control over financial reporting will be challenging. Beginning the evaluation process cannot happen too soon.
For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, please contact our team.
1 ASC 606-10-32-34
2 Derived from ASC 606-10-55-(256-258)
3 ASC 606-10-32-37
4 ASC 606-10-55-(261-264)
5 ASC 606-10-55-(265-268)
6 As discussed in the previous article, recognition of variable consideration is limited to the amount that is probable not to result in a significant revenue reversal.
7 ASC 606-10-32-40
8 Derived from ASC 606-10-55-(271-274)
9 Derived from ASC 606-10-55-(275-279)
10 Discussed in a previous article on identifying a contract
11 ASC 606-10-32-45