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Contract vs. Portfolio Method in ASC 606

Specific criteria must be met for the portfolio method to be used as the practical expedient under ASC 606.

Published:
Mar 11, 2016
Updated:

Accounting Standards Codification (ASC) 606 allows for an entity to account for multiple contracts as a portfolio (commonly known as the portfolio method), instead of accounting for them on a contract by contract basis (commonly known as the contract method).

It should be noted that entities are not required to use the portfolio method. The portfolio method is a practical expedient that the Financial Accounting Standards Board (FASB) authorized to prevent companies from spending an unreasonable amount of time and money applying ASC 606 to their contracts (or performance obligations). Entities should analyze the cost and benefits of applying the portfolio method. If the costs of applying the portfolio method exceed the benefits, then the entity may want to invest in a system that would account for customer contracts on an individual basis (and vice versa).

Criteria to Use the Portfolio Method

Firms may elect to account for multiple contracts as a portfolio if certain criteria are met. ASC 606-10-10-4 states that the following criteria must be met in order to use the portfolio method:

  • Contracts or performance obligations must have similar characteristics
  • The entity reasonably expects that the effects on the financial statements from applying the portfolio method are not materially different than applying ASC 606 to the individual contracts
  • The entity must use estimates and assumptions that reflect the size and composition of the portfolio

The new guidance does not explicitly outline to what extent contracts or performance obligations should be similar in order to meet the first criterion above. Entities should focus primarily on those characteristics that have the largest impact on the amount of revenue recognized and the timing of revenue recognition under ASC 606. For instance, entities could evaluate the similarity of contracts based on contract deliverables, contract duration, terms and conditions, amount and form of consideration, characteristics of the customers, and timing of transfer of goods or services (i.e. over time or at a point in time). These objective criteria applied to the facts and circumstances of each case will help entities determine whether contracts are sufficiently “similar” to warrant use of the portfolio approach.

The FASB has expressed that the entity need not quantitatively evaluate whether using the portfolio approach will produce an outcome that is materially different from that of applying the guidance on an individual contract basis. The entity should, however, demonstrate in a reasonable manner why it expects the two approaches will not differ materially. The entity can perform data analytics using information related to the portfolio, sensitivity analysis to determine a range of potential differences between the two approaches, or a qualitative assessment of disaggregating and aggregating the portfolio. The entity typically should use some form of objective and identifiable information to show that the financial statements will not differ materially using the portfolio approach.

The FASB has stated that the contract method should be used to determine if a financing component exists in a customer contract. This specification is to reduce the burden for entities, enabling them to assess the financing component on one contract and apply that component to the portfolio. If the entity finds that the financing component is significant, the transaction price should be adjusted for the financing component. See Significant Financing Component for more information.

Example A: Using Portfolio Method To Estimate Sales Returns

Company A enters into 100 contracts with customers. Each contract includes the sale of 1 blender for $100 (100 total products × $100 = $10,000 total consideration). Cash is received when control of the blender transfers. The entity’s customary business practice is to allow a customer to return any unused blenders within 30 days and receive a full refund. The entity’s cost of each blender is $60.

Using the expected value method, the entity estimates that 97 blenders will not be returned. The entity has significant experience in estimating returns for these blenders for this customer class. In addition, the uncertainty will be resolved within 30 days (due to the 30-day return policy). Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $9,700) will not occur over the return period. See the chart below for a summarization of the details.

Number of Contracts 100
Number of Blenders Sold on Each Contract 1
Price per Blender $100
Total Consideration of Portfolio $10,000
Cost per Blender $60
Return Policy for Unused Blender 30 days
Blenders Expected to Not Be Returned 97
Revenue Not Expected to Be Reversed $9,700

Because the contract deliverables are the same and because the terms and conditions of the contracts are the same, the entity can reasonably expect that the effects on the financial statements would not differ materially from applying the guidance to the individual contracts. The contract allows a customer to return the products, so the consideration received from the customer is variable. Therefore, the entity recognizes and records the following journal entries for the portfolio of contracts:

Cash $10,000 ($100 x 100 products transferred)
Revenue $9,700 ($100 x 97 products not expected to be returned)
Refund liability $300 ($100 refund x 3 products expected to be returned)
Cost of sales $5,820 ($60 x 97 products not expected to be returned)
Inventory $6,000 ($60 x 100 products)
Asset $180 ($60 x 3 products for its right to recover products from customers on settling the refund liability)

Example B: Widely Varying Contracts – Portfolio Method Not Applicable

Company B is a cable TV provider. Company B provides multiple combinations of products to its customers, and all customers agree to a one-year contract for Company B’s services. The products and services that Company B offers are as follows:

  • Basic cable box–Company B provides free of charge (standalone selling price of $300)
  • Deluxe cable box that can record shows–Company B charges $250 (standalone selling price of $550)
  • Basic cable stations–Company B charges $50/month (same as standalone selling price)
  • Deluxe cable stations–Company B charges $70/month (same as standalone selling price)

The following table shows the possible combinations of these products and services offered by Company B.

Contract Type Product Combination Total Transaction Price Revenue on Cable Box* Revenue on Cable Stations*
Contract A Basic Cable Box & Basic Cable Stations $600 $200 (33%) $400 (67%)
Contract B Basic Cable Box & Deluxe Cable Stations $840 $221 (26%) $619 (74%)
Contract C Deluxe Cable Box & Basic Cable Stations $850 $407 (48%) $443 (52%)
Contract D Deluxe Cable Box & Deluxe Cable Stations $1,019 $431 (40%) $659 (60%)

In this example, the amount of revenue allocated to the sale of the cable box is calculated by comparing the standalone cost of the cable box to the total standalone cost of the transaction (relative standalone selling price basis).

Contract A: (300/(300 + 600)) * 600 = 200

Contract B: (300/(300 + 840)) * 840 = 221

Contract C: 550/(550 + 600)) * 850 = 407

Contract D: (550/(550 + 840)) * 1090 = 431

As illustrated in the table above, each product combination has a different effect on the financial statements. It is difficult to determine whether the entity can “reasonably expect” that the portfolio approach will not differ materially from the contract approach. The percentage of consideration applied to the cable box ranges from 26 percent to 48 percent. This range may be too wide to conclude that the characteristics are similar. If the range is too wide, then the entity should segregate the contracts to some degree.

The entity might instead determine that there are two portfolios—one for the basic cable box and one for the deluxe cable box. In order to make this determination the entity would need to perform additional analyses to conclude that the accounting consequences of having two portfolios rather than four portfolios do not differ materially.

Conclusion

ASC 606 allows an entity to account for contracts and performance obligations as a portfolio. The portfolio method is a practical expedient that can be used to recognize revenue when contracts have similar characteristics and when the entity reasonably expects that using the portfolio method will not be materially different than using the contract method. The entity must also use estimates and assumptions that reflect the size and composition of the portfolio. Professional judgment must be used to determine which contracts are sufficiently similar to be accounted for as a portfolio in accordance with the new standard.

Resources Consulted

Footnotes