This RubinBrown Focus on Revenue Recognition is the sixth 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 4 – Allocating the transaction price
The objective of Step 4 is to allocate the transaction price identified in Step 3 to the performance obligations identified in Step 2. Step 4 is not applicable to contracts with a single performance obligation. The standard calls for the allocation to reflect the amount of consideration that the entity expects to be entitled in exchange for transferring the promised goods and services. Generally, the entire transaction price, including discounts, is allocated to the performance obligations in proportion to their respective standalone selling price. However, in certain circumstances, discounts and variable consideration can be allocated to specific performance obligations.
Standalone selling price is defined as “the price at which an entity would sell a promised good or service separately to a customer.” The most persuasive evidence for standalone selling price is the entity’s sales price for the goods or services when sold separately in similar circumstances to similar customers. If there is no directly observable pricing, an entity will need to estimate its standalone selling prices. In calculating the estimate, market conditions and entity and customer specific information should be considered, while maximizing the use of observable inputs. Estimation methods should be consistent when circumstances are similar. Standalone selling price is determined at contract inception and is not adjusted, even if the underlying assumptions change during the contract. However, if the contract is modified and the modification creates a new contract, the estimates of standalone selling price would be updated at that time.
The standard provides for three acceptable methods to estimate standalone selling price: 1) adjusted market assessment approach; 2) expected cost plus margin approach and 3) the residual approach. The best estimate may require a combination of methods and should ultimately be the amounts that best reflect the allocation objective described above. The adjusted market assessment approach estimates the price that a customer would be willing to pay in a specific market. Inputs to this method would be competitor’s pricing and the entity’s cost and margin expectations. The expected cost plus margin approach estimates the total expect costs to satisfy the performance obligation along with a reasonable estimate of the entity’s expected margins. The residual approach estimates the standalone selling price for a single performance obligation as the total transaction price less the observable standalone selling price of the other performance obligations in the contract. The residual approach is only allowed when the entity has not yet established a price for the goods or service or the entity sells the same goods or services at a wide range of prices.
The requirement to allocate based on standalone selling price includes any options that provide a material right identified in Step 2. If there is no directly observable price for the option, the standalone selling price must be estimated as the incremental discount to be received upon exercise adjusted for the likelihood of exercise. When the option is for discounted contract renewals, the standard allows an entity to treat this as a hypothetical contract for its expected term. This is for purposes of allocation only and any changes in the expected term would need to be considered to ensure proper allocation over the term of the contract.
Overall, these rules will result in similar outcomes as legacy GAAP with one notable exception. The new standard does not require entities to evaluate the evidence used in creating the estimate within the old hierarchy, which in some instances required observable evidence. This provides management with more flexibility in arriving at its estimates in order to meet the allocation objective and may change the timing of revenue recognition.
While allocation based on standalone selling price is the default, the standard provides two exceptions when allocating variable consideration and discounts. In each of these circumstances, an entity must determine if the variable consideration or discounts are related to one or more of the performance obligations in the contract or all of them and calculate the allocation accordingly. In order to allocate variable consideration to anything other than all performance obligations, both of the following criteria must be met:
- The terms of a variable payment relate specifically to the entity's efforts to satisfy the performance obligation to transfer 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 overall allocation objective when considering all of the terms in the contract.
In order to allocate discounts to anything other than all performance obligations, all of the following criteria must be met:
- The entity regularly sells each distinct good or service in the contract on a standalone basis;
- The entity also regularly sells, on a standalone basis, a bundle of some of those distinct goods or services at a discount to their respective standalone selling prices; AND
- The discount attributable to each bundle described in (the first bullet) 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.
In the event that the transaction price changes during the contract, the change should be incorporated into the transaction price on the same basis as at contract inception. The entity should use the guidance related to the allocation of variable consideration described above to determine how to allocate any changes in transaction price between performance obligations. Any changes to the allocation to performance obligations that have already been satisfied will be an adjustment to revenue in the period of the change.
Some contracts contain nonrefundable upfront fees. These fees must be evaluated to determine the nature of the fee and the underlying goods and services, if any. Generally, upfront fees can be categorized in one of two ways: as an advance payment for future goods and services, in which case, the revenue should be allocated to the goods and services (performance obligations) identified in step 2., or as a material right, usually in the form of an option to renew or receive future goods and services at a reduced price.
For many entities, allocating the transaction price will not be significantly different than under legacy GAAP. However, there are notable changes for the kind of evidence needed to support an entity’s estimates of selling prices. In the next installment, we will discuss how to recognize revenue as the performance obligations identified in Step 2 are satisfied.
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Revenue Recognition Resource Center