Step 3 of the revenue recognition model requires a company to determine the transaction price of a contract. At times, a company may accept a price lower than is stated in the contract because the customer has experienced dissatisfaction with goods or services, the company is trying to gain market share, or the company is trying to build a relationship with the customer in expectation of future business. This practice of accepting a price lower than the stated transaction price is called a price concession and is a common form of variable consideration. The purpose of this article is to explain how to identify a price concession, estimate the transaction price, and determine when to recognize revenue.
Blueberry, Inc. (Blueberry) is in the business of creating video game console add-ons to enhance the user’s gaming experience. Blueberry has been in business for fifteen years and has developed significant market recognition for its creative and high-quality console add-ons.
To sell products to its customers, Blueberry uses multiple distribution channels, including direct sales at local stores and through its website. To reach more customers, Blueberry contracts Dyno-matic Distributors, LLC (Dyno) to sell console add-ons to non-local customers and retailers. Because each console add-on that Blueberry sells is unique, Blueberry creates a new contract with Dyno for each new console add-on. Each contract contains a price protection agreement1 clause, indicating that Blueberry will offer a price concession to Dyno if the end customers are no longer buying the product for more than the contract price per product. Historically, Blueberry has consistently offered price concessions to Dyno.
On December 15, 20X7, Blueberry entered into a contract with Dyno to receive $20 million for the sale of 500,000 of its newly developed virtual reality headsets ($40 per headset). The contract extends for the later of December 31, 20X8, or until all headsets are sold. At the inception of the contract, Blueberry needs to determine the transaction price of the contract.
Though the total contract is for $20 million, the transaction price will likely be less than $20 million because Blueberry expects to offer Dyno price concessions. Blueberry needs to (a) identify the price concession, (b) estimate the transaction price, and (c) determine when to recognize revenue.
Identifying a Price Concession
The potential for a price concession may be explicitly detailed within a contract, or it may be indicated or implied by an entity’s expected behavior. According to Accounting Standards Codification (ASC) 606-10-32-7, a transaction contains a price concession when “it is expected that the entity will offer a price concession” or “other facts and circumstances indicate that the entity’s intention, when entering into the contract with the customer, is to offer a price concession to the customer.”
Blueberry explicitly includes a price concession within the contract with Dyno by including the price protection agreement. Were this provision not included, the contract still contains an implicit price concession because Blueberry has a history of offering price concessions to Dyno in other contracts. Because the contract contains a price concession, Blueberry must reduce the transaction price at the inception of the contract by the amount of the expected price concession (ASC 606-10-32-5). We see a clear price concession in our case study, but price concessions may not always be so easily identified. In certain circumstances, management teams may need to carefully consider the facts to distinguish price concessions from collectability issues. For more information on the judgement required in differentiating a price concession from a collectability issue, see our article Collectibility of Consideration.
Estimating the Amount of Revenue to Recognize
At inception of the contract, Blueberry needs to determine the transaction price by evaluating the contract price less any expected price concessions. Blueberry may estimate the total transaction price by using the “expected value” or “the most likely amount” method (ASC 606-10-32-8). For more help determining which method to use, please see our article Variable Consideration and the Constraint.
To determine the total transaction price, Blueberry first calculates a range of possible transaction prices and then assigns a probability to each transaction price. Based on previous contracts with Dyno, Blueberry expects the following at the inception of the contract:
Because Blueberry has a history of price concessions to draw from and because the situation has more than two possible outcomes (ASC 606-10-32-8), Blueberry uses the expected value method to calculate the transaction price. The expected value is a sum of probability-weighted amounts in a range of possible transaction prices. Using the sum of the probability-weighted amounts, Blueberry determines that it should recognize $18.85 million in revenue2.
Using the guidance from ASC 606-10-32-11 through ASC 606-10-32-13, Blueberry should review its contract with Dyno for any indications that its price concession estimate is too low, which would cause a significant revenue reversal as the uncertainty is resolved (i.e., the price concessions are actually granted). After considering the factors in ASC 606-10-32-12, Blueberry determines that its historical data and current market information support its revenue estimate and that a significant reversal will not occur as the uncertainty is resolved.
Determining the Timing of Revenue Recognition
Revenue is recognized as the performance obligation is satisfied. In this case study, the obligation is satisfied as Blueberry transfers the VR headsets to Dyno. In recognizing revenue, Blueberry should allocate the transaction price of $18.85 million evenly across the 500,000 VR headsets and recognize revenue as the headsets are transferred to Dyno.
As the contract is carried out, Blueberry’s actual transaction price will likely differ from the estimated transaction price. Blueberry’s transaction price will change as the company determines the actual amount of price concessions it will grant. At the end of each reporting period, Blueberry must update its estimated transaction price based on any changes to the amount of expected consideration (ASC 606-10-32-14).
In early February 20X8 (2 months into the contract), Blueberry quickly realized that the VR headsets were a huge hit in the gaming industry, and Blueberry shipped the remainder of the 500,000 headsets to Dyno by the end of April 20X8. Because the headsets were so successful, Blueberry did not expect that Dyno would request any price concessions for the headsets on March 31, 20X8. Accordingly, Blueberry increased its expected transaction price to $20 million on March 31, 20X8. As expected, Blueberry did not grant any price concessions as the remaining units were shipped, and Blueberry recognized a total of $20 million in revenue for the contract.
Comparison to 605
Under ASC 605, a company could only recognize revenue that was fixed and determinable. In industries where companies used distribution channels to sell their products, most companies concluded that revenue was not fixed and determinable until the products were sold to the end customer because the amount of price concessions that would be granted over the course of the contract could not be determined. Thus, companies would often default to a sell-through method of revenue recognition.
Under ASC 606, a company can no longer default to a sell-through method if the only uncertainty is variability in pricing (i.e., the revenue is not fixed and determinable). As described above, a price concession leads to variable consideration treatment, which requires a company to estimate how much revenue to recognize at inception of the contract. This estimate is constrained by the amount of revenue the company expects not to be able to recognize as uncertainty surrounding the variability is resolved.
While this article focuses primarily on price concessions offered in distribution networks, the accounting principles apply to companies that offer price concessions in any form, including price concessions intended to build relationships with an unhappy customer or to expand a company’s market presence. At the inception of the contract, your company should estimate the transaction price of the contract, which includes estimating price and other forms of variable consideration. Because this estimate happens at the inception of the contract, companies may not be able to default to a sell-through method of revenue recognition.
- ASC 606-10-32-7 to 32-8, 32-11 to 32-13
- PwC, “Revenue from contracts with customers.” August 2016. Section 188.8.131.52.
- KPMG, “Revenue for software and SAAS.” December 2017. “Software and SAAS Industry Overview.”
- BDO, “Revenue from Contracts with Customers – Manufacturing Industry.” January 2018.