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Revenue Recognition Serial - Part 4: Step 3 - Determine the Transaction Price

February 4, 2015

The third step in the new revenue recognition guidance represents the half way point within the five step model to determining when, and how much revenue to recognize.

The process of determining the transaction price, which is done for the contract as a whole, will continue to require the thoughtful application of principles that we noted in Steps 1 and 2.

The guidance identifies that the nature, timing and amount of consideration all affect the estimate of the transaction price for a contract. These factors result in the following five considerations when determining the transaction price:

  • Variable consideration
  • Constraining estimates of variable consideration
  • Financing components of a contract
  • Noncash consideration
  • Consideration payable to the customer

As each component is evaluated it is important to remember that the transaction price being determined represents the amount to which the entity expects to be "entitled," said another way, the expected amount that it has rights to under the current transaction. The transaction price by definition would not include consideration for change orders or additional purchases of goods or services.

In its simplest form the transaction price is for cash consideration.

Identifying Variable Consideration

The concept of variable consideration existed in U.S. GAAP prior to the issuance of ASU 2014-09; however, the new guidance will require entities to re-evaluate their existing determinations of what is included in variable consideration, how much revenue to recognize and when recognition of variable consideration is appropriate.

Things to Consider

  • Determining the transaction price requires the election of certain policies and significant use of judgment. Entities will need policies and procedures in place to ensure that the elections and judgments are made consistently for similar transactions.

  • The estimated transaction price will be updated for changes in the estimate at each reporting date.

  • When variable consideration exists in a contract, a constraint must be applied to the amount of the variable consideration included in the transaction price. The application of the constraint requires significant use of judgment and may require extensive documentation.

  • As a result of the constraint on variable consideration, certain types of consideration will often be excluded from the transaction price due to their uncertainties including: asset management fees based on returns, contingent payments based on regulatory or governmental approval, and payments based on future market prices such as long-term commodity supply contracts.

  • The measurement of sales- or usage-based royalties is an exception to the guidance on variable consideration. Royalties of this nature are excluded from the transaction price. We will discuss these royalties in more detail in a future edition addressing the licensing of intellectual property.

  • Under existing U.S. GAAP an entity is able to elect whether sales taxes are presented gross or net when recording revenues. Under the new guidance the transaction price excludes amounts collected on behalf of another party. Therefore, sales taxes collected on behalf of a government must be presented net of revenues within the financial statements once the new standard is adopted.


Assume an entity contracts to sell a piece of equipment for $1,000. There are no explicit or implicit contractual terms that would give rise to variable consideration or other forms of consideration (for example rights of return, extended payment terms and others discussed below).

In this instance the $1,000 amount of consideration to be received from the customer would be the transaction price.

Identifying Variability

Variable consideration may result from explicit contract terms or may exist implicitly within a contract. Implicit variability in the consideration for a contract exists whenever either 1) the customer has a valid expectation that it will receive a price concession or 2) other facts or circumstances indicate that the intention when entering into a contract with a customer was to offer the customer a price concession.

Explicit variable consideration can be identified by the terms of the contract. These include terms that have historically been viewed as variable such as performance bonuses based on meeting certain standards of quality, timing or milestones. Variable consideration under the new guidance may also include contract terms that were previously excluded from the evaluation of variable consideration under existing U.S. GAAP such as rights of return or refunds.

Implicit variable consideration will often be more difficult to identify and evaluate because, by its nature, it represents terms that are not written.

A price concession is an adjustment to a contractual or agreed upon price for a good or service such as a discount, rebate, refund or credit. Existing U.S. GAAP (Topic 605) will often result in a deferral of revenue recognition when an implicit price concession exists because the price of the good or service is not fixed or determinable.

Under the new revenue recognition standard when an entity expects to accept or receive less than the agreed upon price for a good or service it must determine if it is implied that the consideration agreed upon is variable. Implied variability exists when either 1) the customer has a valid expectation that the entity will accept a price concession (this may be due to customary business practices, policies or statements made by an entity), or 2) the entity intended to offer a price concession when it entered into the contract. The results of this evaluation performed in Step 3 may impact the evaluation of whether a contract with a customer exists in Step 1. The potential effects of the evaluation of implied variable consideration results in three potential outcomes:

  • If either of the conditions exists, then the price concession is a form of variable consideration that is evaluated as a component of the transaction price (Step 3).
  • If neither of the conditions are met, then in Step 1 the entity must ignore the potential that it may accept/receive a lesser amount of consideration than agreed upon and evaluate under Step 1 whether it is probable that the transaction price (excluding the potential price concession) will be collected.
    • If it is not probable that the transaction price will be collected, the entity would conclude that the contract is not valid, thus deferring revenue recognition.
    • If despite the potential price concession, the transaction price is still probable of being collected, revenue recognition would be recognized under the five step model and the transaction price would exclude the price concession. Any subsequent reduction in the price paid by the customer as a result of the failure to collect would likely result in a bad debt.

As a result of this guidance, when a contract is entered into and Step 1 is evaluated, an entity must consider credit risks that are known at the inception of the contract to determine if they represent an implied price concession that is included in the transaction price or a risk that the transaction price is not probable of being collected.
A second form of implied price concession can exist for entities that offer extended payment terms. In these situations under existing U.S. GAAP an entity evaluates whether or not the extended payment term results in a price that is not fixed or determinable; thus, for some transactions revenue is deferred.


An entity manufactures and sells tablet computers in the United States. It does not have a history of offering price concessions to its customers.

The entity begins to sell tablet computers in Asia, and as a result of its market research it expects that customers in this new region will request that the contracted price be reduced to match market prices at the time payment is due from the customer. In order to develop this new market the company expects to accept the reduced price.

The entity evaluates the situation and determines that even though it does not have a past history of providing price concessions, it does intend to offer a price concession to its customers located in Asia. Therefore, the entity considers the expected price concession to be variable consideration that will be included in the transaction price.

Under Topic 606 the extended payment terms will need to be evaluated to determine whether it is implied or expected that the entity will not collect all of the amounts due in the same manner as discussed above. In addition, the entity will have to evaluate if the extended terms are a form of financing, which is discussed below.

Estimating Variable Consideration

Once variable consideration has been identified, an estimate of the amount to be included in the transaction price must be made. This estimate will be revised based on changes in assumptions for each period. The estimate can be viewed as two steps, the first is to determine the amount of variable consideration and the second is to apply the constraint on variable consideration.

Determine the Amount of Variable Consideration

In determining the amount of variable consideration an entity must determine the method to estimate the amount of consideration to be received. The two methods are:

  • Expected value
  • Most likely amount

The expected value approach would be most appropriate when there is a range of potential outcomes. As an example, if a right of return exists on the sale of 100 distinct goods, the range of potential outcomes could be anywhere from the return of all 100 goods or the return of none of the goods. In this case it could be appropriate for an entity to develop an estimate of the number that is expected to be returned based on probability using historical results or other evidence available.

The most likely amount would be most appropriate when the amount of variable consideration has two possible outcomes. For instance, an entity is constructing a building and has the potential to receive a $100,000 bonus if the building is completed by June 30. In this circumstance it would be appropriate for the entity to determine whether it is more likely that the project would be completed before June 30 or after June 30 and assign the corresponding value ($100,000 or zero) to the variable consideration.

In either case, after determining the appropriate method it should be used consistently throughout the life of the contract. In addition, after determining the amount of variable consideration, it is critical to apply the constraint.

Other Considerations - Variability

When an entity offers a price concession to a customer, the price concession must be considered in Step 1 to determine if the transaction price for the contract is probable of being collected and in Step 3 to determine the amount of the transaction price. As a result, in some cases an entity will need to evaluate Step 3 in conjunction with its evaluation of Step 1.

The sell-through method under current U.S. GAAP is a function of potential price concessions, which cause the price to not be fixed or determinable. Under the sell-through method an entity recognizes revenue when a good or service is sold to an end user by the entity's distributor, instead of when the entity sold the good or service to the distributor. Entities will likely be required to stop using the sell-through method upon adoption of Topic 606. Instead, they will evaluate the price concession as variable consideration in the contract to the distributor and recognize revenue as control of a good or service is transferred to the distributor.

Current practice requires that the offering of extended payment terms when selling a software license results in the deferral of revenue recognition because the price is thought to not be fixed or determinable. Upon adoption of the new guidance this rule no longer applies and software vendors will be able to evaluate the extended payment terms under the guidance of variable consideration and/or financing components. As a result, software vendors may be able to recognize revenue sooner under the new guidance.

The estimation of variable consideration and the application of the constraint on variable consideration may be applied in a single process as long as the result is consistent with the guidance in Topic 606.

Constraint on Variable Consideration

When Topic 606 was originally discussed by the Boards the intent was to establish a neutral revenue recognition standard in which revenue recognition would mirror economic reality without bias towards recognizing revenue too quickly or deferring revenue too conservatively. As feedback from stakeholders was received, the Boards determined there was a need to reduce the potential for manipulation or inconsistency of earnings through variable consideration. As a result, a constraint was created that introduces a bias towards deferring revenue recognition. This deferral is specifically for those situations where there is uncertainty in the amount of consideration an entity would receive, the effect of which is limited to the portion of consideration that is subject to the uncertainty, i.e. the variable consideration.

When variable consideration is identified in the transaction price of a contract it is restrained such that the amount of variable consideration is only included up to the amount that is probable of not being significantly reversed when the uncertainty causing the variability is resolved.

When evaluating the constraint an entity considers both the likelihood of reversal (probability) and the magnitude of the reversal relative to the entire transaction price of the contract (significance).


An attorney enters into a contract to represent a client in a court case where the client is pursuing $10,000,000 in claims. The contract calls for the attorney to receive $100,000 minimum payment plus 10% of any payments to be received by the client as a result of winning the court case or reaching a settlement. The attorney estimates, using expected value computed through a probability weighted method, that the expected amount of settlement for the case is $2,500,000; therefore he/she estimates the variable consideration to be $250,000.

In applying the constraint the attorney considers whether it is probable (70-80% chance) that the variable consideration, or a portion thereof, would not be reversed. Since receiving any variable consideration is subject to a favorable court ruling or a 3rd party's agreement to settle, the attorney concludes that it is not probable that a significant reversal of the entire $250,000 of variable consideration will not occur (i.e. there is a 20-30% chance the variable consideration will be zero). Since the transaction price, including estimated variable consideration is $350,000 and the potential reversal is $250,000, the reversal is considered significant in magnitude. Therefore, the constraint is applied and the transaction price (amount of revenue recognized) is limited to $100,000 until the uncertainty is resolved.

In order to assist in interpreting the likelihood and magnitude of a potential reversal of variable consideration the FASB provided five factors that could increase the likelihood and magnitude. These factors include:

  • The amount of consideration is highly susceptible to factors outside the entity's influence, such as market volatility, judgment and actions of third parties (governments, courts, customers, etc), weather conditions, or a high risk of obsolescence.
  • The uncertainty about the amount of consideration will not be resolved for a long period of time.
  • Experience or other evidence about the outcome of the variable consideration with similar types of contracts is limited, or that experience and evidence has limited predicative value.
  • The contract has a large number and broad range of possible consideration amounts.

Unlike in some other areas of the standard, these factors are not criteria. They may or may not apply to a specific contract or there may be additional factors not listed here that may be important to the evaluation. In addition, since they are not criteria, the presence of one or more of the factors does not automatically mean that variable consideration should be constrained. When evaluating the factors judgment must be carefully applied and documented about the likelihood and magnitude of the potential reversal.

Other Considerations - Rights of Return

Rights of return are accounted for in a similar manner to today's guidance, but may require a new evaluation and some changes to systems, processes and reporting. Under the new guidance a right of return or refund results in the contract price being variable, and as a result of the constraint on revenue recognition, the estimated amount of return/refund reduces the transaction price. A few key considerations include:

  • The estimated transaction price will be limited by the constraint so that it is net of the price of those products expected to be returned or refunded.
  • The price of those products expected to be returned/refunded (i.e. the expected amount of returns) is recognized as a refund liability.
  • The value of products that are expected to be returned is recorded as a return asset, and is measured as the lower of 1) the cost basis of the product when it was in inventory (historical cost basis) less the costs expected to be incurred to recover the product, or 2) the expected fair value of the product when returned. The estimate of the return asset reduces cost of goods sold.
  • The return asset is required to be recorded separately from inventory and may not be netted against the refund liability.
  • Changes in the estimates of the refund liability and return asset are adjusted through current period earnings each reporting period.

Other Forms of Consideration

Significant Financing Component

An entity may create a financing explicitly or implicitly when entering into a revenue contract. Financing components can be in one of two forms: 1) the entity finances the customer - the customer pays consideration after the good or service is transferred (paid in arrears) or 2) the customer finances the entity - the customer pays for a good or service in advance. In either case, under Topic 606 an election can be made by the entity to apply a practical expedient to not adjust consideration for the financing component if the date the customer pays for the good or service is one year or less from the date that the good or service is transferred to the customer.
For those transactions that do not meet the requirements of the practical expedient, or for an entity that elects not to apply the practical expedient, an analysis must be done to determine if a revenue contract contains a significant financing component. The objective of this analysis is to recognize revenue at the amount the customer would have paid for the goods or services had the customer paid on the date that control was transferred. The evaluation is done at the contract level and not at either a combined level for all contracts or at the level of individual performance obligations within a contract.

A financing does not exist when any of the three conditions are met:

  1. The transfer of the good or service is at the discretion of the customer and the customer paid for the goods or services in advance.
  2. The consideration promised in the contract has a substantial amount of variable consideration of which the amount or timing varies based on a future event not substantially in the control of the customer. For example a sales-based royalty.
  3. The difference between the promised consideration and the cash selling price is not due to a financing component because it is proportionally attributable to other reasons. For instance, if the payment is to protect one of the parties from potential incomplete or inadequate performance by the other party.

In addition to evaluating the three conditions above, a potential financing component must be assessed to determine if it is significant. The evaluation of whether a financing component is significant includes both of the following considerations as compared to the total amount of consideration in the contract:

  • The amount of the difference for the contract as a whole between the promised consideration and the cash selling price of the goods.
  • The combined effect of the expected length of time between the payment from the customer and the transfer of the goods or services and the prevailing interest rates in the relevant market.

In the January 26 meeting of the Transition Resource Group (TRG) the Staff discussed three different interpretation of how to recognize the financing element into revenue when it exists in a contract in the scope of Topic 606. We anticipate the TRG will have further discussion on how to implement this guidance in their future meetings and that these discussions will shape how the standard is implemented in practice.

Noncash Consideration

An entity may receive consideration from customers that is not in the form of cash. Noncash consideration under current U.S. GAAP is evaluated by first determining the fair value of the good or service transferred by the entity to the customer, and secondly by the value of the noncash consideration received if it is more clearly evident. The new guidance reverses this order of evaluation and therefore may lead entities to change their processes and controls.

Noncash consideration can come in many forms, examples include advertising barter transactions, and customer provided equipment, labor or goods. In all cases under the new guidance, if the entity obtains control of the good or service from the customer the noncash consideration is included in the transaction price. The amount attributed to the noncash consideration is estimated based on the fair value of the noncash consideration received, or if fair value cannot be reasonably estimated, by referencing the fair value of the good or service transferred to the customer by the entity.

In some instances the fair value of noncash consideration may vary. When this variation occurs because of the form of noncash consideration it is not considered variable consideration. For example, if an entity is to receive 100 shares of stock in exchange for a good, the fair value of the stock may change over time as a result of the form of consideration. The fair value of this form of noncash consideration would be estimated along with the transaction price in Step 3 and not evaluated as variable consideration. Therefore the changes in fair value would not be re-evaluated under Step 3 at the end of each reporting period. It is important to note that the accounting for the noncash consideration to be received will need to comply with other applicable areas of U.S. GAAP. In some instances changes in fair value may result in impairment of the contract asset or receivable recorded that needs to be considered at each reporting date or may result in gains or losses to be recognized.

If noncash consideration varies as a result of there being uncertainty about whether it will be received, the amount or timing of the receipt of noncash consideration would be considered variable consideration. For example if an entity was to receive 100 shares if all of the goods are received by the customer within 1 month, 80 shares if within six weeks or no shares if later than six weeks, the estimate of the number of shares to be received based on the performance within the contract would be variable consideration. If at the end of the first reporting period the entity estimated it would receive 80 shares because it was most likely they would deliver the goods in six weeks and at the end of the next reporting period the estimate was revised to zero shares, the change in quantity, but not the value of the shares, would be reflected as an adjustment to variable consideration through revenues and the related receivables or contract assets.

The guidance on certain aspects of noncash consideration may be interpreted in different ways and may change as practice develops. For instance, in its January 26 meeting the TRG discussed three different interpretations on what the measurement date for noncash consideration should be. These include the inception of the contract, the date the performance obligation is satisfied, or the date the asset arising from noncash consideration is recognized.

Other Considerations - Noncash Considerations

An entity may enter into a contract to sell a product or service which includes the customer providing equipment, goods or services to the entity in order to aid fulfillment of the customer's order. When control over the fulfillment of goods or services are transferred from the customer to the entity they are considered noncash consideration. This is true even when the good or service is incorporated into the product sold by the entity to the customer.

The Consideration Paid or Payable to Customers

In some revenue transactions an entity pays consideration to a customer or a customer's customer. This payment may come in many forms including:

  • Cooperative advertising arrangements
  • Coupons and rebates to an indirect customer (for example a manufacturers coupon on a grocery product)
  • Price protection
  • Slotting fees
  • Purchase of a good or service

For these types, and similar consideration paid by the entity to the customer, the entity must determine if the payment in whole, or in part, is for a distinct good or service.

If the payment is determined to be for a distinct good or service received from the customer by the entity, the accounting would be the same as for any other purchase made by the entity. However, if the payment is not for a distinct good or service, for example, a rebate to an end user, the payment reduces the transaction price. The reduction is recognized at the later of 1) the recognition of the revenue for the transfer of the related good or service to the customer or 2) when the entity pays or promises to pay the consideration to the customer. In some cases a portion of the payment to the customer may be determined to be for the distinct good or service received and a portion to be a reduction in the transaction price (i.e. the amount of revenue to be realized).

While seemingly straight forward to apply, this guidance is one area in Topic 606 where significant judgment must be applied and the application may change as practice develops. Potential issues include:

  • Whether a contract to sell a good or service to a customer and a separate contract to purchase a good or service from the customer should be combined.
  • How to account for a transaction when the consideration paid to a customer reduces the transaction price below zero.
  • How to determine when historical business practices create an implied promise to pay consideration (such as an expectation that a manufacturers coupon will be issued).
  • Whether the guidance applies to transaction in which an entities customers receive an incentive from an agent of the entity.

Update Corner

The Transition Resource Group met on January 26 and discussed several question about the revenue recognition standard that had been submitted. The following matters were discussed which may result in additional clarification or guidance on the revenue recognition standard as the Boards decide whether action is needed:

  • Effective date: the Staff indicated that they expect to submit the results of their outreach on delaying the effective date in an early second quarter FASB Board meeting in order for the Board to decide if a delay will be provided.
  • Sales taxes: the need for a practical expedient is being evaluated to eliminate the need to evaluate if sales taxes are collected on behalf of another party.
  • Transition: the Staff is researching whether a practical expedient should be provided to limit the requirement to evaluate contract modifications that occurred prior to adoption for long term contracts.
  • Shipping activities: the staff is researching various interpretations of how shipping activities should be viewed under the new standard and how those interpretations affect the timing of revenue recognition and the identification of performance obligations to determine if a practical expedient or additional guidance should be provided.
  • Based on the results of the meeting, the Boards will also consider if further guidance is necessary on:
    • Collectability (Step 1)
    • Noncash consideration (Step 3)
    • Consideration payable to a customer (Step 3)

Final Thoughts

Evaluating the transaction price is a step in the new revenue recognition model that requires significant judgment and could lead to diversity in practice amongst economically similar entities and transactions. It will be important to continually review decisions in applying this guidance as practice develops and the standard is implemented. The impact of this step may affect accounting and information systems, procedures and internal controls. As a result, consideration of these changes will be necessary well in advance of implementing the new guidance in order to have time to plan for these impacts, and consider potential changes in the contracts and selling methods used by an entity.

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 or 858.795.2029, Mark at or 816.945.5614, and Brad at 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 4: Allocate the transaction price to the performance obligations in the contract.

Previous Editions

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