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Revenue Recognition Serial Part 5: Step 4 - Allocating the Transaction Price

Feb. 1, 2016

Step 4 of the new five-step revenue recognition standard requires the allocation of the transaction price to each performance obligation in a contract with a customer. Entities reach this point by first identifying the contract with a customer, identifying the performance obligations in the contract and determining the transaction price.

The transaction price determined in Step 3 reflects the consideration the entity expects to receive once it meets the performance obligations in the contract. Allocating the transaction price is done based on the standalone selling price of the performance obligations in the contract, but it also requires an evaluation of variable consideration or discounts that may be specifically linked to one or more performance obligations.

The overall objective when performing Step 4 of the model is to arrive at an allocation that represents the amount of consideration the entity expects to be entitled to for the transfer of the promised good or service. Said another way, the objective is to arrive at an allocation that is generally representative of the economics of the transaction. As with other areas of the new revenue recognition standard, determining the standalone selling price requires the use of judgment and may require management to make significant estimates.

Things to Consider

  • The allocation of the transaction price under Topic 606 has similarities to existing accounting standards, but unlike the existing standards, the new guidance is based on overall principles rather than a specific hierarchy.

  • The allocation concept in the new guidance is based on the relative standalone selling price of goods and services in a contract. Exceptions to the relative standalone selling price method are required to be applied when discounts or variable consideration meet certain criteria and therefore are allocated to a specific good or service.

  • The new guidance eliminates the concepts of Vendor Specific Objective Evidence (VSOE), Third Party Evidence (TPE) and Best Estimate of Selling Price (BESP). The techniques used to determine these amounts may still be useful under Topic 606 to determine the standalone selling price of performance obligations in a contract.

  • Proper allocation of the transaction price based on the relative standalone selling price method may require new controls and procedures in order to evaluate and monitor the judgments and estimates required by the new standard.

Standalone Selling Price

In its simplest form, a contract with a customer promises the transfer of a single good or service, and there is no need to allocate the transaction price. In such a simple contract, Step 3 and Step 4 are completed concurrently. Many entities, however, have contracts with customers that promise multiple goods or services. When the goods and services are not transferred at the same time, allocating the transaction price in Step 4 becomes a significant part of the process of recognizing revenue.

The basic principle in Step 4 is that the transaction price—that is, the revenue that will be recognized—should be allocated between the performance obligations in the contract based on the relative price for which they would be sold if they were sold separately, i.e. the standalone selling price.

As an example, assume that an entity is a distributor of computer equipment. The entity enters into a contract with a customer to sell a server, a color printer and a one-year maintenance contract for $5,000, which is the transaction price. Management of the entity determines each of the goods and the service is a separate performance obligation and estimates the standalone selling price for each performance obligation. The combined standalone selling price of the three performance obligations is $6,000. On the relative standalone selling price basis, the transaction price is allocated as follows:

Performance Obligation

Standalone Selling Price

Allocated Transaction Price

Server

$3,000

$2,500
(($3,000 / $6,000) * $5,000)

Printer

$1,200

$1,000
(($1,200 / $6,000) * $5,000)

Maintenance

$1,800

$1,500
(($1,800 / $6,000) * $5,000)

Total

$6,000

$5,000

The new guidance requires a determination of the standalone selling price for the goods and services to be transferred, but it does not require the use of a specific method to make the estimate. Instead the standard calls for determining the standalone selling price by using the technique, or combination of techniques, that maximizes the amount of observable inputs.

Approaches for Estimating the Standalone Sale Price

Entities are not wholly on their own for coming up with a method to estimate standalone selling price. Topic 606 provides three examples of techniques that may be used to establish standalone selling price: adjusted market assessment, expected cost plus a margin, and/or residual approach.

Although the use of one of these three methods is not required, it is expected that one of these approaches, or a combination of them, will be used in most situations.

Adjusted Market Approach

The adjusted market approach encompasses both internal and external evidence of the market price of a good. Under existing U.S. generally accepted accounting principles (GAAP), both VSOE and TPE would be methods that could be acceptable under the umbrella of an adjusted market approach for the determination of standalone selling price. Entities that currently rely on those methods may experience little or no change in their estimates of standalone selling price.

When developing a standalone selling price using the adjusted market approach, an entity may use multiple factors including current pricing by the entity, competitor pricing for similar goods and services, market trends in pricing or other market-based inputs. In addition, the development of the estimated standalone selling price would consider whether the conditions in the geographic market of the customer, market share or other market characteristics of the customer or entity would adjust the observed market price.

The adjusted market approach is expected to be most commonly applied when there is a past history of sales of the good or service or a similar good or service in the market place. Use of another approach may be appropriate in instances where a new product is being developed and launched to market for a first time or the good or service that makes up a performance obligation is not historically sold separately.

Expected Cost Plus a Margin Approach

Development of Internal Controls

  • Entities will need to develop control systems in order to estimate the standalone selling price of goods and services. Under the new revenue recognition model, each contract is evaluated separately or a portfolio of contracts is grouped together for evaluation.

  • In practice, it is likely that many entities will determine a standalone selling price for goods and services they sell once and update the pricing for use in all contracts on a periodic basis, such as quarterly or annually. Controls will need to consider whether the standalone selling price needs to be evaluated for each contract or if it can be established for a good or service on a periodic basis.

  • Consideration should also be given to whether the standalone selling price for a good or service should be set globally for all sales, or if there are customer layers, such as customer types, distributions channels, geographic regions or other relevant groupings that may have different standalone prices for a particular good or service.

Unlike the adjusted market-based approach, which focuses on observable market factors, the expected cost plus a margin approach is oriented towards factors specific to the entity. The first component of this approach is to estimate the cost basis of the good or service being sold, which may consider projected costs, cost savings based on the size of an order, expecting increases in cost as a result of customization and other relevant information.

Determining the appropriate margin to apply is the second component of this method. The margin used is the expected margin that the entity expects the market to be willing to pay, not the margin the entity hopes to receive. As such, it is generally not appropriate to rely on price lists on their own to determine margins. Estimates of margin may be impacted by internal factors, such as the cost structure, profit objectives and pricing practice of the entity, as well as characteristics specific to the contract, such as the nature of the customer, its geographic region, distribution channel or market share.

In some instances, the estimate that maximizes observable inputs may be a combination of the expected cost plus a margin approach and the adjusted market approach. For example, the determination of the margin to apply to the expected costs may be based on market information about margins achieved by competitors or similar products sold by the entity.

Residual Approach

Entities can sometimes estimate the price of a good or service by subtracting from the overall transaction price those items that have standalone selling prices that were determined based on one of the other approaches. The residual approach may only be used when one of the following criteria is met:

  • The seller sells the same good or service to different customers using a wide range of prices; or
  • The entity has not yet established a price point for the good or service because it has not sold the good or service on a standalone basis.

Options

  • An entity may include an option in a contract, such as the ability to renew a service at a discounted price. When the option is a separate performance obligation, it is necessary to allocate a portion of the transaction price to the option based on the standalone selling price. If the standalone selling price of the option is not observable, an estimate may be made based on the amount of discount the customer would receive and the likelihood that the option would be exercised.

  • A practical expedient exists for options that are 1) similar to the original good or service and 2) part of an original contract. Generally, options to renew a service will qualify for the practical expedient. Under the practical expedient, an entity assumes the option will be exercised and includes optional goods or services and the consideration to be received for them in the estimated transaction price. Therefore, under the expedient, the entity performs the allocation based on the relative standalone selling price by including the goods and services in the original contract plus the optional goods or services.

The residual approach may be used in combination with another approach as a way to determine the standalone selling price for multiple goods or services. For instance, assume an entity sells four products, each of which is a performance obligation (product A, B, C and D). The entity is able to determine the selling price of products A and B using the adjusted market approach but is unable to determine the selling price of products C and D. Therefore, it computes the residual price of products C and D by subtracting the standalone selling price of A and B from the transaction price. Once the combined price of products C and D are determined, the entity would determine a best estimate of the allocation between products C and D using another method.

Due to the limitations on the use of the residual approach and its inability to maximize the observable inputs used in determining the standalone selling price, the residual approach is less likely to be used than the other approaches.

Allocation of a Discount

While in general the allocation of the transaction price is done by the relative standalone selling price as determined by one of the approaches mentioned above, the allocation can also be affected by discounts. In the new guidance, unlike existing U.S. GAAP, when a discount is related to one or more goods or services within a contract and certain criteria are met, the discount is allocated to those specific goods and services rather than ratably amongst all the goods and services. The following criteria must be met for a discount to be allocated to some but not all of the performance obligations in a contract:

  1. The entity regularly sells the goods or services (or bundles of goods or services )on a standalone basis;
  2. The entity regularly sells on a standalone basis a bundle of some of those goods or services at a discount; and
  3. The discount described in 2 is substantially the same as the discount in the contract, and an analysis of the goods or services in each bundle provides evidence of the performance obligation to which the discount in the contract belongs.

Discounts

A discount occurs when the cumulative price for a bundle of goods or services is less than the sum of the individual standalone selling prices for each good or service. The discount is allocated across all of the goods or services based on the relative standalone selling price of each good or service except when the discount meets certain conditions and is therefore attributable to a single good or service or a bundle of goods or services. In most cases, the exception will only be applicable to a group of two or more goods or services.

If the criteria above are not met, then the discount is applied proportionally to all performance obligations provided by the contract based on the relative standalone selling price.

Discounts that meet these criteria will be allocated to the appropriate performance obligations. Any remaining amount of discount from the collective standalone selling price is allocated using the residual approach to the remaining goods or services in the contract.

For example, assume the same distributor of computer equipment and contract with a customer from above. If management determined that based on previous history they can sell the server and printer together at discounted price of $3,850 ($350 discount), then the allocation of the purchase price would be as follows:

Performance Obligation

Standalone Selling Price

Allocated Transaction Price

Server

$3,000

$2,750
(($3,000 / $4,200) * $3,850)

Printer

$1,200

$1,100
(($1,200 / $4,200) * $3,850)

Subtotal for the discounted bundle

$4,200

 

Maintenance

$1,800

$1,150
($5,000 - $3,850)

Total

$6,000

$5,000

Allocation of Variable Consideration

Another exception to the relative selling price method of allocating the transaction price is variable consideration. Similar to discounts, if certain conditions are met variable consideration must be allocated to a single performance obligation, group of performance obligations or to a distinct good or service that is part of a single performance obligation. The allocation of variable consideration to specific performance obligations or a distinct good and service occurs when both of the following are met:

  • The terms of the variable payment relate specifically to the efforts to satisfy the performance obligation or transfer of the distinct good or service; and
  • The allocation of the variable consideration to the performance obligation or distinct good or service is representative of the amount of consideration the entity is expected to be entitled to in exchange for the good or service.

In some instances, a portion of variable consideration is related to a specific performance obligation, and the remainder is related to the other performance obligations in the contract. The variable consideration in that circumstance is allocated among the remaining performance obligations using the relative selling price method. Likewise, if none of the variable consideration is specifically allocable, then the entire amount is allocated among the performance obligations using the relative selling price method.

For example, assume a construction contractor enters into a contract with a customer to construct two buildings that are separate performance obligations. The contracted price is for $4,000,000, but the contractor is entitled to a $250,000 bonus if the first building is completed in less than six months. The contractor determines the transaction price is $4,250,000 because it anticipates achieving the bonus. The contractor estimates that the standalone selling price for the first building is $2,750,000, and the standalone selling price of the second building is $1,500,000. Based on an analysis of the contract, the contractor determines that the variable payment relates specifically to the first building, and by allocating the variable consideration to the first building, it can achieve an allocation that is representative of the amount of consideration it expects to receive. Therefore, the contractor allocates $2,500,000 of the fixed consideration and all of the $250,000 variable consideration to the first building. The second building is allocated the remaining $1,500,000 of the fixed consideration and none of the variable consideration.

Changes to the Allocation

Changes in the standalone selling prices of individual goods or services are not adjusted once determined at contract inception. However, changes to the total transaction price, determined in Step 3, may occur after the contract is underway. When this occurs, entities should apply the expected changes to the transaction price for their performance obligations using the same method they would have used at contract inception to allocate the transaction price. Entities will recognize the amounts incurred to satisfy performance obligations as revenue (or reduction of revenue) in the period in which the transaction price changes.

Final Thoughts and Things to Consider

Allocating the change in transaction price will require entities to develop and maintain a comprehensive approach to determining the amount of consideration they expect to receive from their goods or services. Discounts, variable consideration and changes in transaction price should be carefully monitored, as these instances will require a thorough evaluation of the facts and circumstances involved. Entities should be starting the evaluation of their processes and policies now to be prepared for when the new standard takes effect.

For More Information

If you have any specific questions, comments or concerns, please share them with James Comito, Mark Winiarski or Brad Hale of MHM's Professional Standards Group or your MHM service professional. You can reach James at jcomito@cbiz.com or 858.795.2029, Mark at mwiniarski@cbiz.com or 816.945.5614, and Brad at bhale@cbiz.com or 727.572.1400.


» Up Next

In the next edition of our Revenue Recognition Serial we will discuss the considerations and factors that go into the evaluation of Step 5: Allocate the transaction price to the performance obligations in the contract.

Previous Editions

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