In step four of the revenue model, entities are required to allocate the transaction price to the performance obligations in the contract. The transaction price is generally allocated using the relative standalone selling price method and an example of applying this method is available in Standalone Selling Prices. The standard includes two exceptions to the relative standalone selling price method: allocating variable consideration and allocating discounts.
This article explores the process of allocating variable consideration, but an in-depth discussion of the second exception is available in Allocating Discounts. The remainder of this article will discuss when the variable consideration should be allocated to one or more, but not all, performance obligations, how to allocate variable consideration to the transaction price in such situations, and significant changes from Accounting Standards Codification (ASC) 605 to ASC 606.
In many instances, the consideration receivable in a transaction is a variable amount. In these cases, the variable consideration that an entity expects to receive must be estimated (for a comprehensive discussion of the estimation process, see Variable Consideration and the Constraint). Once the variable consideration has been estimated, the entity must determine if it is attributable to:
- All of the performance obligations.
- One or more, but not all, of the performance obligations (e.g., consideration is based on the percentage of sales to customers that use a software license).
- One or more, but not all, distinct goods or services provided in a series of distinct goods or services that make up one performance obligation (e.g., the price for the second year of a two-year cleaning service contract will increase based on the movement of an inflation index).
The variable consideration (and all subsequent changes to that amount) is attributable to one or more, but not all of the performance obligations or distinct services or goods if the following two criteria are met:
- The terms of the variable payment are intentionally connected to the entity’s efforts to satisfy the performance obligation or transfer the good or service (or a specific outcome from satisfying the performance obligation or transferring the good or service).
- Allocating the full variable consideration to the performance obligation or distinct good or service correctly represents the amount of consideration that the entity would expect to receive for transferring the promised goods or services to the customer.
If these two criteria are met, the entity is required to allocate the variable consideration to one or more, but not all, of the performance obligations or distinct goods or services. The following examples provide an illustration of how to allocate variable consideration in the transaction price and are found in ASC 606-10-55-270 through 55-279.
An entity enters into a contract with Customer U for two intellectual property licenses (Licenses X and Y), and each license is considered a separate performance obligation. The standalone selling prices of License X and Y are $800 and $1,000, respectively.
Scenario A- Variable Consideration Assigned to One Performance Obligation
The contract states that the fixed price of License X is $800 and the price of License Y will be 3 percent of Customer U’s future sales of products that use License Y. The entity estimates the variable consideration (sales-based royalty) to be $1,000.
The entity determines whether the variable consideration should be allocated to License Y exclusively by analyzing the two criteria above as follows:
- The terms of the variable payment intentionally connect to an outcome of satisfying the performance obligation to transfer License Y (3 percent of future sales).
- Allocating the variable consideration of $1,000 entirely to License Y correctly represents the amount of consideration that the entity would expect to receive in a separate transaction (the standalone selling price of $1,000).
Since the two criteria are met, the entity is required to allocate all of the variable consideration to License Y. The fixed price of $800 will be recognized as revenue when License X is delivered. The standard provides that sales-based royalties should not be included in the transaction price or recognized as revenue until the subsequent sales have been made. Therefore, the variable consideration of $1,000 will not be recognized at the transfer of License Y, but as Customer U makes subsequent sales of the license.
Scenario B- Variable Consideration Allocated on the Basis of Standalone Selling Price
The contract states that the fixed price of License X is $300 and the price of License Y will be 5 percent of Customer U’s future sales of products that use License Y. The entity estimates the variable consideration (sales-based royalty) to be $1,500.
Again, the entity determines whether the variable consideration should be allocated to License Y exclusively by analyzing the criteria:
- The terms of the variable payment intentionally connect to an outcome of satisfying the performance obligation to transfer License Y (5 percent of future sales).
- Allocating $1,500 entirely to License Y does not represent the consideration the entity would expect to receive because the standalone selling price of $1,000 is significantly lower.
Since the second criterion is not met, the entity is required to allocate the variable consideration to both licenses. License Y is transferred to the customer at contract inception, but License X is transferred three months later. The $300 fixed price is allocated between the two licenses according to the relative standalone selling price method. At the transfer of License Y, $167 of revenue will be recognized and the remaining $133 will be recognized in three months when License X is transferred.
Assuming the royalty due in the first month is $200, the variable consideration is also allocated between the two licenses according to the relative standalone selling price method. The $111 of revenue related to License Y is recognized, but the $89 related to License X will be recognized as a liability until the performance obligation has been satisfied (the license is transferred). After License X has been transferred, the liabilities from the first three months of royalties will be reversed and recognized as revenue. Subsequent sales-based royalties will be recognized as revenue for their full amount since the two performance obligations have been completed. The table below shows a summary of the calculations for the fixed contract price and the royalty from the first month.
Comparison to 605
Under ASC 605, variable consideration was not estimated or allocated to the transaction price. Consideration had to be fixed and determinable to be recognized as revenue or considered as part of the standalone selling price. The concept of applying variable consideration to the transaction price is a significant change in the new standard that has multiple steps.
- First, ASC 606 requires that the entity estimate the portion of variable consideration that is not expected to reverse and include it in the transaction price. A more comprehensive discussion of this topic can be found in Variable Consideration and the Constraint.
- Second, once the variable consideration has been estimated, it is allocated to the performance obligations to which it is attributable, as discussed above.
This new concept of allocating variable consideration to the transaction price will cause revenue to be recognized earlier in certain situation. For example, in scenario B above, $167 of revenue is recognized in the first month with the transfer of License Y. Under ASC 605, the company would have waited for three months for the transfer of License X to occur, at which time it would have recognized $300 of revenue for the fixed and determinable consideration. As illustrated, over half of the revenue would be recognized two months earlier under ASC 606 than under ASC 605.
The new standard will be especially impactful in the software industry. Software companies often have to defer revenue due to concessions offered to customers or other forms of variable consideration. As illustrated above, software companies will be allowed to recognize revenue earlier in certain situations.
After variable consideration has been estimated, an entity must allocate the variable consideration to the performance obligations. The revenue standard provides two criteria to determine if the consideration should be attributed to one or more, but not all of the performance obligations. If both of the criteria are met, the variable consideration must be allocated to those performance obligations alone. This process is a significant change from ASC 605 to ASC 606 and may result in some companies recognizing revenue earlier in certain situations.
- ASC 606-10-32-39 to 32-41; ASC 606-10-55-270 to 55-274; ASC 606-10-55-275 to 55-279.
- EY, Financial reporting developments: “Revenue from Contracts with Customers.” Revised October 2018. Section 6.3 “Allocating variable consideration.”
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 188.8.131.52 “Allocating variable consideration.”
- PWC, “Revenue from contracts with customers.” August 2016. Section 5.5.1 “Allocating variable consideration.”