By: Rob Hamilton
Blog Series: Revenue from Contracts with Customers
Post 4 of 6
It’s time to delve further into the content of ASU 2014 – 09, “Revenue from Contracts with Customers” (Topic 606). We’ll cover Step 3 one of the most difficult of the five steps Determine the Transaction Price. The main goal of this step is to identify the type(s) of consideration promised and to come to a reasonable expectation of the amount that will ultimately be realized as revenue. While this may sound simple, the reality is that there are many factors that must be carefully scrutinized in order to arrive at the end amount.
Per ASU 2014 – 09, the transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties,” and “the consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.” An entity is allowed to assume the goods or services will be transferred in accordance with the existing contract without it being cancelled, renewed, or modified. ASU 2014 – 09 also provides five factors to be evaluated determining the transaction price:
- Variable consideration—Does the contract include a right of return, performance bonus, or are price concessions a normal part of business? If so, such variable consideration should be estimated using either a probability weighted approach, or a single most likely outcome approach. If an entity expects to refund any or all of the consideration to a customer, a refund liability should be recorded. At the end of each reporting period, an entity should reassess its estimate of variable consideration to ensure it properly represents the entities current expectations.
- Constraining estimates of variable consideration—Whether to recognize variable consideration depends on the probability of a significant reversal of the cumulative amount of revenue recognized. Factors to consider include the influence of uncontrollable factors, such as market volatility, weather conditions, and the risk of product or service obsolescence; the length of time until the amount of consideration is resolved; and the number and range of possible contractual outcomes.
- The existence of a significant financing component— Is there a difference between the cash price and the amount of consideration in the contract? If so, interest income or expense must be recognized separately from the contract revenue. The transaction price should be adjusted for the time-value of money, regardless of whether the contract explicitly specifies a financing component. However, as a practical expedient, an entity can avoid this adjustment if the time between the transfer of goods and the time payment is received is one year or less.
- Noncash consideration—Any noncash consideration must be measured at fair value. If the fair value cannot be reasonably estimated, it should be measured using the standalone selling price of the goods or services for which it is being exchanged.
- Consideration payable to a customer—If the contract includes items such as coupons or vouchers which would cause the entity to owe the customer consideration, those items should be accounted for as a reduction of the transaction price. If the consideration is for a distinct good or service, it should be accounted for as a purchase from a supplier.
It is important to remember that the factors above are not necessarily explicit within a contract, so careful analysis must be performed to identify the transaction price. Now that the transaction price has been identified, we can move on to Step 4—Allocating the Transaction Price to Performance Obligations.
Rob Hamilton, CPA is a senior associate with Johnson Lambert LLP and a North Carolina native. He has over two years of experience providing auditing services to insurance companies, employee benefit plans, and not-for-profit organizations. Rob graduated from Virginia Tech with a B.S. in Marketing Management and from N.C. State with a Master of Accounting degree.