The third step of the revenue standard addresses the determination of the transaction price in a contract arrangement. Topic 606 defines the 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."
The consideration promised in a contract arrangement may include fixed amounts, variable amounts, or both. Determining the transaction price can be simple when evaluating fixed amounts. For example, a customer agrees to pay ABC Company $2,500 in cash in exchange for specified goods; the consideration under the contract is not variable.
However, complexities can arise when contracts include variable consideration, noncash consideration, and consideration payable to a customer, among other circumstances. For example, a customer agrees to pay ABC Company $2,000 in cash in exchange for specified goods and an additional $500 in cash if delivered before a certain date; the additional $500 of consideration is variable. The following sections of this article will further discuss these complexities.
The revenue standard requires a company to estimate the amount of variable consideration at the inception of a contract arrangement, and that estimate is to be included in the transaction price. Examples of variable consideration include discounts, incentives, rebates, penalties, refunds, contingencies, credits, price concessions, performance bonuses, etc.
A company can use either of the following methods for estimating variable consideration – (i.) the expected value method or (ii.) the most likely amount. The expected value method is the sum of probability-weighted amounts in a range of possible consideration amounts; this method may be appropriate in circumstances when variable consideration has to be estimated for multiple outcomes or when there is a large number of contracts that involve variable consideration. The most likely amount method is the single most likely amount in a range of possible consideration amounts, that is, the single most likely outcome of the contract; this method may be appropriate in circumstances when the number of outcomes is limited (for example, two possible outcomes).
Exhibit 1 – Estimating variable consideration with multiple outcomes:
ABC Company enters into a contract with XYZ Inc. to build an asset for $100,000 with a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance bonus decreases by 10% per week for every week beyond the agreed-upon completion date. The contract terms are consistent with contracts ABC Company has previously performed, which management believes such experience is predictive for this contract. Therefore, ABC Company concludes that the expected value method is the most reliable method in this circumstance to determine the transaction price.
ABC Company estimates that there is a 50% probability that the contract will be completed by the agreed-upon completion date, a 35% probability that it will be completed one week late, and a 15% probability that it will be completed two weeks late. Based on the expected value method, using a probability-weighted estimate, the total transaction price is $146,750.
Exhibit 2 – Estimating variable consideration with two outcomes:
|$150,000 (fixed fee plus full performance bonus) x 50%
|$145,000 (fixed fee plus 90% of performance bonus) x 35%
|$140,000 (fixed fee plus 80% of performance bonus) x 15%
|Total probability-weighted consideration
ABC Company enters into a contract with XYZ Inc. to build an asset for $100,000 with a performance bonus of $50,000 that will be paid based on if the asset has been built by a specified date. ABC Company will not receive any of the performance bonus if the asset is not completed by the specified date. Thus, the contract only has two possible outcomes.
Based on ABC Company’s experience, it is 95% likely that the contract will be completed by the specified date. ABC Company concludes that the most likely amount method is the most reliable method in this circumstance to determine the transaction price since only two possible outcomes are available. Using the most likely amount method, the total transaction price is $150,000.
Topic 606 further states that a company should only recognize variable consideration “…to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved”. Accordingly, the revenue standard includes a constraint on the amount of variable consideration included in the transaction price. The assessment of whether variable consideration is constrained should include two elements – (i.) the likelihood of a reversal and (ii.) the potential magnitude of a reversal. The following factors could indicate constrain on variable consideration – (i.) an uncertainty will not be resolved for a long time, (ii.) available evidence is limited and/or not predictive, (iii.) a broad range of discounts or price concessions is generally offered, (iv.) the range of estimates of the transaction price is broad, and (v.) the amount of consideration is heavily dependent on factors the entity cannot control (i.e., market volatility, third-party actions, weather conditions, risk of obsolescence). Ultimately, the concept of constraint forces the need for management to develop solid estimates regarding variable consideration with a high degree of confidence.
Any noncash consideration received from a customer must also be included when determining the transaction price. An entity should measure noncash consideration at fair value. The measurement date for noncash consideration should be contract inception. In some cases, management might not be able to reliably determine the fair value of noncash consideration. If an entity cannot reasonably estimate the fair value of noncash consideration, such consideration should be measured by referencing the standalone selling price of the goods and services promised to the customer in exchange for the consideration.
In addition, if a customer contributes goods or services to facilitate an entity’s fulfillment of a contract, the entity should assess whether it obtains control of those contributed goods or services. If it does, the entity should account for the contributed goods or services as noncash consideration received from the customer.
Exhibit 3 – Contributed goods as noncash consideration:
ABC Company enters into a contract to build a corporate headquarters for XYZ Inc., a customer that manufactures windows. XYZ Inc. contributes the window materials that ABC Company will use when constructing the building. ABC Company concludes that it gets control of the windows because it can both direct their use and obtain substantially all of their remaining benefits. Therefore, the contributed windows are noncash consideration that should be included in the transaction price at fair value.
Consideration Payable to a Customer
Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to a customer. The consideration payable can be cash in the form of rebates or could be a credit or some other form of incentive that reduces amounts owed to the entity by a customer. An entity should account for consideration payable to a customer as a reduction of the transaction price, and therefore, of revenue. The entity should recognize the reduction of revenue as it recognizes revenue for the transfer of the related goods or services to the customer.
However, if a payment to a customer is for a distinct good or service that the customer transfers to the entity, than the entity should account for the purchase of the good or service in the same way that it accounts for purchases from other suppliers.
Exhibit 4 – Consideration payable to customers (no distinct good or service received):
ABC Company sells bottled water to XYZ Inc., a grocer. ABC Company also pays XYZ Inc. a fee to ensure that its products receive prominent placement on store shelves (i.e., a slotting fee). The fee is negotiated as part of the contract for sale of the bottled water.
ABC Company does not receive a good or service that is distinct in exchange for the payment to XYZ Inc. Therefore, ABC Company should reduce the transaction price for the sale of the bottled water by the amount of the slotting fees paid to XYZ Inc.
Exhibit 5 – Consideration payable to customers (payment for a distinct service):
ABC Company sells bottled water to XYZ Inc., a grocer. ABC Company’s contract also includes an advertising arrangement that requires ABC Company to pay $15,000 toward a specific advertising promotion that XYZ Inc. will provide. XYZ Inc. will provide the advertising on billboards and in other local advertisements. ABC Company could have engaged a third party to provide similar advertising services for a similar cost.
The advertising cost paid to XYZ Inc. is distinct because ABC Company could have engaged a different third party to provide similar advertising services. Accordingly, ABC Company should account for the payment to XYZ Inc. consistent with other purchases of advertising services.
What’s next? Every entity’s implementation of Topic 606 will be unique, and could present different sets of complexities depending on facts and circumstances. It is important to begin considering the impact Topic 606 will have on your entity.