This RubinBrown Focus on Revenue Recognition is the fifth in a series of articles on the new accounting guidance for revenue recognition. In this series, we will explore different aspects of the new standard. Please contact a member of your RubinBrown team for more information and ways that we may be able to help you.
The core principle of the new standard is to recognize revenue from customers in a way that reflects the entity’s transfer of promised goods and services at an amount that represents the consideration that the entity expects to receive in exchange for those goods and services. The new revenue recognition model uses five steps to achieve this principle:
- Identify the contract with the customer.
- Identify the performance obligations within the contract.
- Determine the overall transaction price of the contract.
- Allocate the transaction price between the identified performance obligations.
- Recognize revenue as performance obligations are satisfied.
Step 3 – Determining the transaction price
The new standard defines 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). The consideration may include fixed amounts, variable amounts or both.” The transaction price can also include a financing component, non-cash compensation and consideration payable to customers. The transaction price does not include any estimates of the future exercise of options included in the contract as the entity is not entitled to consideration until the customer exercises that option.
In the context of the new standard, variability results from uncertainty surrounding future events that impact the amount of consideration to be paid under the contract. Variable consideration can come in a variety of forms including discounts, refunds, incentives and other kinds of price concessions. Variability can also result from uncertainty related to consideration that is contingent upon the occurrence or non-occurrence of future events like a customer’s exercise of a right to return or a bonus or penalty tied to performance. These can either be explicit in the contract or result from a customer’s valid expectations because of customary business practice or an oral or side agreement.
Variable consideration is estimated at contract inception using one of two allowed methods. The expected value method is the probability-weighted estimate of a range of possible amounts. The most likely amount method is the single most likely amount within a range of possibilities. This method is generally most appropriate when the contingency has only two possible outcomes. This estimate is reevaluated at each reporting period, using the method consistently over the term of the contract. The entity should use all reasonably available information to create and reevaluate the estimate. We would expect that this information would be consistent with that used by management when bidding on contracts and setting prices.
The new standard places a constraint on these estimates. Variable consideration can be included in the transaction price only to the extent that it is not probable that a significant reversal of cumulative revenue will be required when the uncertainty is resolved. In other words, variable consideration is limited to the amount that management determines is probable of being realized through the end of the contract. This determination must be reassessed at each reporting period.
Under the new standard, the right of return in certain contracts is subject to the guidance on variable consideration. The transaction price is limited by the amount of consideration the entity will not be entitled to as a result of customer returns. We expect that the method used to estimate this amount will not change, but may be impacted by the application of the constraint. Similar to legacy GAAP, at the time of the initial sale, revenue is reduced and a liability is recorded for the expected refund. The new standard also requires the entity to record an asset and corresponding reduction of cost of sales for the right to receive the returned product. Like all variable consideration, these estimates are to be reevaluated at each reporting period and the asset is subject to impairment review.
A significant financing component exists when the timing of the payments provides a significant benefit to either the entity or the customer. The financing arrangement can be either implicit or explicit in the agreement. There are two key factors in determining if a financing component exists. The first is the difference between the promised consideration and the cash selling price and the second is the combined effect of the term and prevailing interest rates.
Upfront deposits and retainage allowed for in the contract are generally not considered a financing component as they are generally protective in nature as opposed to financing. The standard also includes a practical expedient that allows the entity to disregard the impact of a significant financing component if, at contract inception, the expected time between payment and the transfer of goods and services is one year or less.
Non-cash consideration should be measured at fair value. If fair value is not readily determinable, it can be estimated indirectly by the stand alone selling price of the related goods and services. Consideration paid to customers, like rebates, co-op advertising, slotting fees, etc., is generally consistent with legacy GAAP. However, when the customer provides goods or services to the entity, the new standard of “distinct” may result in a different conclusion that the legacy standard of “identifiable benefit” when determining whether these transactions represent something other than a reduction of revenue. Similarly, the timing of the recognition of the reduction of revenue may change under the new standard.
For many entities, determining the transaction price will not be significantly different than under legacy GAAP. However, there are notable changes for certain contracts, specifically those with variable consideration and consideration paid to customers. In the next installment, we will discuss how to allocate the transaction price to the performance obligations identified in step 2.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.
Revenue Recognition Resource Center