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. However, the standard includes two exceptions: allocating discounts and allocating variable consideration. This article explores the process of allocating variable consideration.
Deciding Whether the Exception Applies
In many instances, the expected consideration in a transaction is a variable amount, such as when an entity will get a bonus if it finishes the project ahead of schedule. In these instances, the variable consideration that an entity expects to receive must be estimated. Once the variable consideration has been estimated, the entity must determine if the consideration is attributable to:
- All of the performance obligations
- One or more, but not all, of the performance obligations (e.g., the consideration is based on the percentage of sales to customers that use a software license when the license is only one portion of the contract).
- 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) (see ASC 606-10-32-39).
The variable consideration is allocated to one or more, but not all, of the performance obligations or distinct goods or services if the following two criteria are met:
- The terms of the variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the good or service (or to a specific outcome from satisfying the performance obligation or transferring the good or service).
- Allocating the variable amount of consideration entirely to the performance obligation or distinct good or service represents the amount of consideration that the entity would expect to receive for transferring the promised goods or services to the customer (see ASC 606-10-32-40).
If these two criteria are met, the entity is required to allocate the variable consideration to the related performance obligations or distinct goods or services. The following examples illustrate how to allocate variable consideration in the transaction price (see ASC 606-10-55-270 to 55-279).
Example: Allocating Variable Consideration to the Transaction Price
An entity enters into a contract with Customer U for two intellectual property licenses (Licenses X and Y). 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 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.
The entity determines the variable consideration should be allocated to both licenses 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.
|License||Standalone Selling Price||Contract Fixed Price||Contract Royalty|
|License X||$800||(1,000/1,800) * 300 = $167||(1,000/1,800) * 2 = $111|
|License Y||$1,000||(800/1,800) * 300 = $133||(800/1,800) * 200 = $89|
R1 RCM indicated an interesting benefit from the variable consideration allocation exception. It stated that using the exception has made it easier to estimate variable consideration. Its customer contracts are typically three to ten years in length and expected consideration towards the end of the contract is harder to predict. However, because the company’s contracts satisfy the two criteria in ASC 606-10-32-40, R1 RCM can focus on the consideration to be received for the next piece of the obligation. The company is able to estimate the transaction price over these shorter time durations, limiting the significant judgments needed to be made to estimate the uncertainty associated with incentive fees. (June 2018 letter to the SEC)
After variable consideration has been estimated, an entity must allocate the variable consideration to the performance obligations. Usually, the consideration will be allocated to all performance obligations using the relative standalone selling price method. However, the 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 the related performance obligations.
- ASC 606-10-32-39 to 32-41, 55-270 to 55-274, 55-275 to 55-279
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” October 2018. Section 6.3.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 184.108.40.206.
- PWC, “Revenue from contracts with customers.” August 2016. Section 5.5.1.