By: Michael Hoose, CPA
Blog Series: Revenue from Contracts with Customers
Post 5 of 6
As mentioned in our previous blog, ASC 606 creates a five-step process for recognizing revenue. We’ve already covered the first three steps in our previous blogs. The fourth step is to allocate the transaction price (determined in Step 3) to the performance obligations.
The transaction price should be allocated to the performance obligations based on relative standalone selling price.
The standalone selling price is the price at which an entity would sell a good or service separately to a customer. The best evidence of standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers. If there is no directly observable evidence of standalone selling price the entity should make its best estimate of standalone selling price by maximizing the use of observable inputs. The method used should be consistently applied in similar circumstances and should include all reasonably available information, including market conditions and entity/customer-specific factors.
This is conceptually similar to the fair value measurement principles under current US GAAP contained in ASC 820: Fair Value Measurement which requires entities to maximize observable inputs. However, whereas ASC 820 requires fair value to be determined from a market participant’s point of view, ASC 606 requires standalone selling price to be determined from the entity’s point of view.
Under ASC 606 there is no hierarchy of standalone selling price estimation methods, similar to that under current US GAAP. Though ASC 606 doesn’t provide an estimation hierarchy, it does provide some examples of potential estimation methods including:
- Adjusted market assessment approach
- Expected cost plus a margin approach
- Residual approach
When determining the allocation price there are several special considerations to evaluate.
Allocation of a Discount
Often times the selling price of a bundle of goods or services will be less than the individual standalone selling prices (e.g. the bundle is sold at a discount). Because the total transaction price is allocated based on relative selling price, this doesn’t create a problem unless the discount should be allocated entirely to one or more specific performance obligations. A discount should be allocated entirely to one more performance obligations if all of the following are met:
- The entity regularly sells each distinct good or service on a standalone basis.
- The entity regularly sells on a standalone basis a bundle(s) of some of those distinct goods or services at a discount to their standalone selling prices.
- The discount attributable to each bundle(s) described in (b) is substantially the same as the discount in the contract being analyzed and the performance obligation(s) to which the entire discount belongs is readily observable.
Any discount allocated entirely to one or more performance obligations should be allocated to those performance obligations before using the residual approach. This makes conceptual sense, otherwise the discount would be erroneously allocated to the residual elements.
Allocation of Variable Consideration
Variable consideration should be allocated entirely to a performance obligation (or to a distinct good or service, in a series that forms a single performance obligation) if both of the following are met:
1) The contractual terms of the variable payments relate specifically to a performance obligation (or to a distinct good or service in a series that forms a single performance obligation), and
2) Allocating the variable consideration entirely to the performance obligation (or to a distinct good or service in a series that forms a single performance obligation) is consistent with the overall principle in Step 4 to allocate the transaction price to each performance obligation in an amount that depicts the consideration to which the entity expects to be entitled to for transferring that good or service. In other words, the variable consideration can be allocated entirely to a performance obligation (or to a distinct good or service in a series that forms a single performance obligation), if doing so doesn’t result in allocating more or less revenue than should be allocated based on relative standalone selling price.
Once the entity has completed Step 4 and allocated the transaction price to the performance obligations in the contract, then the entity must move onto Step 5: Recognize Revenue, which will be the subject of our next in-depth blog.
Michael Hoose, CPA, Audit Professional Practices Manager | Cherry Bekaert, LLP
As a licensed Certified Public Accountant, Michael has many years of experience serving a variety of industries. Michael serves as a technical resource for Cherry Bekaert’s Accounting & Auditing (A&A) Professional Practices group and is actively involved in the development of the Firm’s A&A technical papers and internal training. Michael works predominately on SEC filers in the technology and life sciences industries, but has served in variety of others. He received his BS and MS in Accounting from East Carolina University, is a member of the American Institute of Certified Public Accountants (AICPA), and the North Carolina Association of Certified Public Accountants (NCACPA).