Step 4 of the revenue model requires entities to allocate the transaction price to the performance obligations. After the standalone selling price has been estimated for each performance obligation in the contract, the transaction price is generally allocated to each performance obligation using the relative standalone selling price method, except for cases involving variable consideration and discounts, and when the residual approach is utilized. The purpose of this article is to illustrate the process of allocating the transaction price through a comprehensive example. The following key accounting issues are addressed in this article:

  • How does variable consideration in a contract impact the transaction price allocated to each performance obligation?
  • When should the guidance on allocating discounts be applied?
  • How do discounts in a contract impact the transaction price allocated to each performance obligation?
  • How is the relative standalone selling price method applied to allocate the transaction price?

The accounting principles involved in this example are discussed at length in the following articles: Standalone Selling Prices, Allocating Discounts, and Allocating Variable Consideration. The “Transaction Summary” section at the end of the article provides a summary of the accounting analysis as well as a solution to the example.


 

Background

Mak’s Farming Equipment (MFE) is a vendor of agricultural machinery as well as a number of separate items that enhance the performance of the machinery (e.g., GPS, harvesting heads).  On January 1, MFE enters into a contract with a customer to sell the following items:

  • a combine harvester
  • harvesting heads for various crops
  • a GPS system for auto guidance and data transfer
  • a cover for the combine
  • a year of nonrenewable post-contract support (maintenance) for the GPS system

The total pre-discount price is $1,230,000. The terms of the contract dictate that the customer make monthly payments of $102,500 to pay off the combine by the end of the year. The standalone selling prices for the items in the contract are as follows:

1

The company regularly offers a $10,000 discount to all customers for purchasing two of the performance-enhancing items together (GPS and harvesting heads). The company also offers a five percent discount on the list price of the combine ($50,000) if the customer pays for half of the list price of the combine ($500,000) in thirty days. For similar transactions, a five percent discount is offered for all equipment purchases over $750,000.

The combine, harvesting heads, and cover are delivered on January 1 and the post-contract support starts on that date. The GPS system is delivered and installed on January 30.  On January 15, the customer makes a $500,000 payment to take advantage of the five percent discount. The remaining $680,000 of the contract is paid in two equal payments of $340,000 on February 28 and March 31. Considering these facts, how should MFE allocate the transaction price?

Accounting Analysis

The transaction price should be allocated to the performance obligations using the relative standalone selling price method. However, when specific criteria are met, variable consideration and discounts are allocated to one or more, but not all of the performance obligations. Also, when an item’s price is highly variable or the item has not previously been sold on a standalone basis, the residual approach may be used. The basic overall objective is that the allocation reflects the expected consideration for each item (performance obligation) in the contract rather than the contract as a whole.

In situations where variable consideration and discounts are present and the residual approach is used, the transaction price should be allocated using the following steps in order: (1) allocate variable consideration to determine the transaction price, (2) allocate discounts, (3) allocate using the residual method, and (4) allocate the remaining transaction price using the relative standalone selling price method. While normal transactions rarely require all four steps, we will consider each step using the hypothetical situation above for illustration purposes.

Variable Consideration

Variable consideration is considered first when allocating the transaction price. The five percent discount offered in the MFE contract is variable because it is contingent on the customer paying half of the combine’s list price, which means the guidance on variable consideration applies to that discount (for more information on variable discounts, see the article Allocating Discounts). To determine if the discount (variable consideration) should be allocated to one or more, but not all of the performance obligations, we consider the two criteria of variable consideration (for more information, see Allocating Variable Consideration):

  • The terms of the variable discount are specifically related to the outcome of satisfying the performance obligation to transfer the machinery.
  • Allocating the variable discount ($50,000) entirely to the machinery correctly represents the amount of consideration that MFE would expect to receive in a separate transaction.

The first criterion is not met since the five percent discount is not specifically related to the performance obligation of the company, which is to transfer the machinery. Rather, the variable discount is related to the performance obligation of the customer, which is to pay for half of the list price within thirty days. Since one of the criteria is not met, the guidance on discounts is taken into consideration to determine if the variable discount may be allocated to one or more, but not all of the performance obligations.

Discounts

In a January 2015 meeting, the Financial Accounting Standards Board’s (FASB) Transition Resource Group (TRG) released a memo entitled “Variable Discounts”. In this memo, the TRG clarified that variable discounts are first subject to the criteria under the variable consideration guidance. If those criteria are not met, the variable discount is then subject to criteria under the discount guidance. Since the variable discount in our example did not meet the variable consideration criteria, we consider the three criteria for allocating discounts (for more information, see Allocating Discounts):

  • All of the goods or services are regularly sold on a stand-alone basis.
  • The company regularly sells the good (combine) at a discount.
  • The normal discount for the good (combine) is substantially the same as the overall discount offered in the contract.

Since the criteria are met, the variable discount is applied entirely to the combine when allocating the transaction price. This will reduce the transaction price allocated to the combine from $1,000,000 to $950,000 as shown in the table in the “Transaction Summary” section.

The second discount offered in the contract for the performance-enhancing items ($10,000) is a fixed discount because it is offered at the outset of the contract, which means that the guidance on allocating discounts applies. To determine if the discount should be applied to one or more, but not all of the performance obligations, we consider the three criteria for allocating discounts (for more information, see Allocating Discounts):

  • All of the goods or services are regularly sold on a stand-alone basis.
  • The company regularly sells the bundle of the performance-enhancing items at a discount.
  • The normal discount of the bundle ($10,000) is substantially the same as the discount offered in the contract ($10,000).

Since the criteria are met, the second discount is applied entirely to the GPS system and harvesting heads using the relative standalone selling price method as follows:

2

As shown in the table, $90,870 of the transaction price would be allocated to the GPS system and $129,130 would be allocated to the harvesting heads.

Residual Approach

The residual approach was not utilized to determine the standalone selling price of any of the items. The residual approach is used only when the entity sells the same good to different customers for a broad range of prices.  An example of the residual approach is available in the articles Standalone Selling Prices and Estimating Standalone Selling Prices.

Relative Standalone Selling Price Method

After accounting for the variable consideration, discounts, and residual approach, the remaining transaction price is allocated to the final performance obligations in the contract using the relative standalone selling price method. In this case, the remaining transaction price of $10,000 is allocated to the cover and post-contract support as follows:

3

As shown in the table, $6,154 of the transaction price would be allocated to the cover and $3,846 would be allocated to the post-contract support. To see how revenue should be recognized in similar situations, see the Revenue Recognition over Time.

Transaction Summary

The transaction price should be allocated to the performance obligations using the relative standalone selling price method. However, since the contract contains variable consideration and fixed discounts, the transaction price is allocated to the performance obligations using these steps in the following order: (1) variable consideration, (2) discounts, and (3) relative standalone selling price method.

Since the criteria for specifically allocating variable consideration are not met, the variable discount is passed through to the guidance on allocating discounts. After meeting the criteria for allocating discounts, the variable discount is allocated entirely to the combine. The criteria for specifically allocating discounts are also met for the fixed discount and it is allocated between the harvesting heads and GPS system according to their standalone selling prices. Since the residual method was not used, the remaining transaction price is allocated between the cover and the post-contract support according to the relative standalone selling price method. A summary of the allocated transaction price is shown in the table below.

4

Comparison to 605

The new revenue standard differs in many ways from ASC 605. This article touches on multiple changes that have been made in different areas of the new standard. The following sections explore these differences by topic.

Variable Consideration

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 (for more information, see Allocating Variable Consideration). In certain situations, these modifications will change the timing and amount of revenue recognized, but the results of this example would be similar under both ASC 605 and 606.

Discounts

Theoretically, under ASC 605 discounts could not be attributed to one or more, but not all of the performance obligations except in the software industry when the residual method was used, and the discount had to be allocated to only the delivered performance obligations. In practice, the guidance was ignored and discounts were generally allocated entirely to the performance obligation to which they pertained. ASC 606 explicitly allows discounts to be allocated to one or more, but not all of the performance obligations and to be attributed to both delivered and undelivered items in the contract regardless of the industry or circumstance.

Conclusion

This article discusses the process of allocating the transaction price to performance obligations in the contract when variable consideration and fixed discounts are present. It provides a comprehensive example of how to allocate variable consideration (variable discounts) and fixed discounts before applying the relative standalone selling price method. The results of the transaction are very similar under ASC 605 and 606, but the guidance in ASC 606 explicitly allows discounts to be allocated to one or more, but not all of the performance obligations regardless of whether those items are delivered or undelivered.


 

References Consulted

Author Kyle Andrus

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