Many contracts require companies to fulfill multiple performance obligations. Step four in the five-step revenue recognition process requires that entities allocate the transaction price to each performance obligation in proportion to its standalone selling price (SSP). The standalone selling price is the price at which the entity would sell a promised good or service individually to a customer.
ASC 606 Revenue from Contracts with Customers (ASC 606) requires companies to estimate the SSP if the selling price is not readily observable. The remainder of this paper will describe how to estimate standalone selling price and present examples of estimating and allocating the transaction price.
Methods of Assigning Standalone Selling Price
The best evidence of standalone selling price is the price that the entity charges for the good or service in a separate transaction with a customer. However, sometimes goods or services are sold exclusively as a package combined with other goods or services rather than on an individual basis (e.g., nonrenewable customer support). For example, Apple recognizes as a separate performance obligation “the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device.” In these cases, the standalone selling price must be estimated. The revenue standard does not prohibit any method for estimating the standalone selling price as long as the estimation results in an accurate representation of what price would be charged in a separate transaction. However, the standard does include the following three examples of suitable estimation methods:
- Adjusted market assessment approach. This approach considers the market in which the goods or services are sold and estimates the price that a customer of that market would be willing to pay. This method is suitable in situations where a competitor offers similar goods or services that can be used as a basis for the analysis. Activision Blizzard Inc., an American video game company, uses this approach when pricing their new games. This method is described in the company’s 10-K; information pulled from market data, pricing strategies for other products and competitors, and the design of both the online and offline version of games is considered.
- Expected cost plus margin approach. Expected cost plus margin considers the forecasted costs of fulfilling the performance obligation and adds margin at the amount the market would be willing to pay. This method may be most suitable in situations where (1) the demand for the good or service is unknown and information on the demand for similar goods or services from competitors is not available and/or (2) the direct fulfillment costs are clearly identifiable. Lockheed Martin uses this method when allocating revenue to their rockets in bundled service packages. These packages are part of non-U.S. Government contracts that include multiple performance obligations which deliver customized solutions unique to each customer.
- Residual approach. This approach allows an entity that has observable standalone selling prices for one or more of the performance obligations to allocate the remaining transaction price to the goods or services that do not have observable standalone selling prices. The sum of the observable standalone selling prices is deducted from the total transaction price to find the residual estimated standalone selling price for the goods or services that do not have observable standalone selling prices. The residual approach can only be used if (1) the entity sells the same good or service to multiple customers for a wide variety of prices (highly variable) or (2) the entity has not established a price for that good or service and the good or service has not been sold previously on a standalone basis. The residual approach is intentionally limited to ensure that companies first attempt to utilize another acceptable method to reach a reasonable estimation. National Instruments Corporation, an automation testing and equipment company, uses this method to determine the prices of some of their software in enterprise (large company) agreements. The company first applies other approaches to each standalone selling price within its contract, then applies the remaining percentage to the maintenance fees. Finally, the company reevaluates if that approach has produced a realistic SSP for that section of the license (June 2019).
Regardless of the approach used, the standalone selling price must be determined at the outset of the contract and should not be updated to reflect changes between contract inception and performance completion, with the exception of contract modifications (for more information see Contract Modifications). Management should consider all information and maximize observable inputs in determining which approach to use. For example, although an entity may not sell an item on a standalone basis or have a price for that item, it should first consider any available information from competitors to make an estimate before relying on the residual approach.
The actual price charged to customers is rarely represented by a point estimate but may fall within a range of numbers over time. One method of determining standalone selling price for observable prices is to analyze the entire population of standalone sales (or stratified sections of that population) to find a narrow range of prices where a substantial majority of standalone sales occur. Judgment will be involved in deciding which point in the range to use for the practical purpose of allocating consideration. Once a point in the range has been chosen, generally that point should be consistently applied to all similar transactions.
The following example illustrates how to estimate the standalone selling price using each of the three approaches described above.
Combination of Methods
A combination of methods may be used to determine the standalone selling price for each performance obligation that does not have an observable standalone selling price. ASC 606-10-32-35 states that in some situations, the residual approach may be used to determine the aggregate standalone selling price of two or more goods or services with highly variable or uncertain standalone selling prices. Once the aggregate residual amount is determined for those goods or services in total, other estimation methods (adjusted market assessment, cost plus, etc.) may be employed to determine the standalone selling price of those goods or services on an individual level.
ASC 606 outlines three methods of recognizing the standalone selling price of a product: adjusted market assessment, expected cost plus margin, and residual approach. The method chosen should be constantly reevaluated when there are discounts and packages offered, and a company can use a variety of these methods to identify which is most accurate. By evaluating and possibly combining the methods, companies can identify the best allocation of product prices.
- ASC 606-10-32-31 to 32-35
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” January 2020. Section 6.1.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 188.8.131.52, 184.108.40.206.
- PWC, “Revenue from contracts with customers.” March 2020. Section 5.2, 5.3.
- Apple’s 2019 Form 10-K Page 25
- Activision Blizzard Inc.’s 2019 Form 10-K Page 56
- Lockheed Martin’s 2019 Form 10-K Page 47