In some cases, an entity may accept a lower price than what was originally stated in the contract. This situation could occur because the entity wants to encourage the customer to keep making purchases, because the entity is trying to gain market share, or because the customer has expressed dissatisfaction with the goods. This lower price is a common form of variable consideration known as a price concession. This article explains how to account for price concessions based on the customer’s expectation and the specific facts and circumstances of the transaction. The article also provides illustrations for different price concession scenarios as well as real-company examples of how this accounting standard has been put into practice.
Price Concessions Scenarios
Whereas other forms of variable consideration may be explicitly stated in the contract, price concessions are frequently implied or assumed. ASC 606-10-32-7 outlines two price concession scenarios that constitute variable consideration: (1) the customer expects a price concession and (2) the facts and circumstances indicate that the entity intends to offer a price concession.
Under the first scenario, the customer could expect that the entity will accept less consideration than the price in the contract because of the entity’s “customary business practices, published policies, or specific statements” (ASC 606-10-32-7a).
If the customer has a valid expectation of a price concession, then the entity should apply the variable consideration guidance and reduce the transaction price to reflect the amount of consideration expected to be received. This concession could be referred to using different names such as discount, rebate, refund, or credit.
Example 1: Customer Expectation
Company X sells 2,000 computers for $500 each to Customer Y, a new customer, for a total transaction price of $1,000,000. Company X has made price concessions in the past. Because of Company X’s customary business practices, Customer Y has an expectation that the entity will offer a price concession. Based on its historical treatment of new customers, Company X determines that it is willing to accept a total transaction price of $700,000 for the 2,000 computers sold to new Customer Y.
Analysis: Because it is likely that Company X will provide a price concession and accept a price lower than $1,000,000, the consideration is variable. Company X expects to be entitled to $700,000, and this amount is not constrained under the variable consideration guidance. Company X, therefore, should adjust the transaction price down to the expected amount of $700,000.
Under the second ASC 606 scenario, the facts and circumstances of the transaction could indicate that the entity intends to offer a price concession. The facts and circumstances must be carefully considered because it is sometimes difficult to differentiate between implicit price concessions and impairment losses. These “facts and circumstances” include the customer’s ability to continue as a going concern, customer cash flow problems, customers entering a new region with a poor local economy, high competition in the market, or the customer’s limited experience. The Financial Accounting Standards Board (FASB) has not developed any detailed guidance for distinguishing between price concessions and impairment losses, but the following examples may be helpful.
Misonix Inc. is a medical production company focusing on ultrasonic instruments and tools. Misonix sold a license to Hunan Xing Hang Rui Kang Bio-technologies Co., Ltd. that would allow Hunan to produce and distribute Misonix’s SonaStar product line in China, Hong Kong, and Macau and pay Misonix through royalty fees. The SEC had questions about the certainty of the price concessions in the royalty contract. Misonix provided an analysis of the factors used to evaluate the price concession (July 2019):
- The ability for Hunan to have a viable revenue stream in order to pay minimum royalties are subject to Hunan building a factory to produce SonaStar, and obtaining Chinese FDA approval to manufacture and distribute the Product.
- The manufacture of the SonaStar product will be the first manufacturing venture by Hunan in the company’s history, adding an additional element of risk to being able to ultimately successfully manufacture and sell the product, and generate cash flow to satisfy royalties due to Misonix.
- Misonix believes that if Hunan defaults under the agreement, that Misonix may not be able to successfully recover stated minimum royalties due to the uncertainty surrounding the legal and regulatory framework in China and Misonix’s limited dealings with China.
- The technology and license on this product that was sold to Hunan may not be as valuable to Misonix due to the ongoing R&D related to new technology.
Based upon these factors, Misonix used the most-likely method of determining variable consideration on the minimum royalties, and determined the value of estimated license revenue and a corresponding contract asset to be $960,000. This makes up about one-sixth of the total estimated price concession of $6,000,000.
Example 2: Implicit Price Concession
Toy Maker Inc. entered into a contract with Plastic Company to buy $300,000 of plastic to make children’s toys. Toy Maker Inc. is in its third year of business and its first two years were cash flow negative. Toy Maker expects to grow, however, and is forecasting positive future cash flows and positive net income by Year 4.
Plastic Company intends to offer Toy Maker a reduction in price in order to keep the supply relationship alive. Plastic Company knows that Toy Maker might not be able to afford the full $300,000 price now, but Plastic Company wants to forge this relationship in order to obtain more business in the coming years. As a result, Plastic Company reduces the transaction price to $100,000. Is this adjustment an implicit price concession or an impairment loss?
Analysis: This adjustment is an implicit price concession. Plastic Company is offering this price concession for the purpose of forming and keeping alive a customer relationship. Positive forecasts for Toy Maker give Plastic Company confidence that Toy Maker will enter into future contracts with Plastic Company. Although Toy Maker’s operations are currently cash flow negative, Plastic Company offers the reduction in price because the facts and circumstances of the transaction lead them to believe that Toy Maker will be a profitable company in the future. Consequently, Plastic Company should account for the price reduction as a price concession rather than as an impairment loss.
GTT Communications, a telecom and internet service provider, entered correspondence with the SEC about the treatment of variable consideration in its contracts. In this conversation, GTT offered analysis on its consideration of price concessions.
In certain instances a customer may seek to renegotiate its contract with the Company when or if they incur usage-based fees. The modified contracts provide for new distinct services that are offered at the then current standalone selling price. These modifications would therefore be treated as a termination of the existing contract and the creation of a new contract, in which case revenue would be adjusted prospectively for the terms of the new contract. These modifications would not be considered a concession by the Company. The Company has no history of issuing price concessions or entering into other arrangements that would change the payment terms of its usage-based contracts. Therefore, the Company has concluded that this criteria does not exist. (April 2020)
Because the company recognizes a new contract each time it renegotiates fees with its customers, GTT does not recognize price concessions. Instead, GTT creates a new contract with terms that meet the needs of its customer.
Example 3: Impairment Loss
Furniture Company enters into a contract with Lumber Company to buy $300,000 of wood to make specialty cabinets. Furniture Company is experiencing economic difficulties and has some cash flow problems. Because of the heightened competition in the local furniture industry, Furniture Company is struggling to stay survive.
Based on the credit risk of Furniture Company, Lumber Company determines that it might only receive $250,000 from Furniture Company. This revised determination is made after contract inception. Lumber Company is willing to accept this credit risk because Lumber Company would have sufficient margin on the sale of wood to cover the risk of loss. Lumber Company has not offered price concessions to furniture companies in the past. Is this adjustment an implicit price concession or an impairment loss?
Analysis: This adjustment in price is an impairment loss. In this situation, Lumber Company has analyzed the credit risks of Furniture Company and is collecting the highest amount of consideration that it can from Furniture Company. Lumber Company does not expect Furniture Company to continue as a going concern for much longer. Lumber Company would not normally offer such a concession, but because of the unique facts and circumstances of this situation it must reduce the transaction price and account for the reduction as an impairment loss.
As an entity considers the possibility of an impairment loss, it must also consider the probability of collecting the consideration. If it is not probable that the entity will collect the consideration to which it is entitled, the transaction does not meet the criteria for a contract with a customer found in ASC 606-10-25-1. For instance, in example #2, if Plastic Company determined that it was not probable that the entity would collect the reduced price of $100,000 from Toy Maker Inc., a contract would not exist and Plastic Company could not account for the transaction as a sale under ASC 606. (For more information on differentiating between a price concession and an uncollectible amount, see Collectibility.)
Hanger Inc. is a prosthetics and physical health company founded about 150 years ago. The company entered correspondence with the SEC to deliver more information on how the company disclosed and accounted for its price concessions. Hanger explained to the SEC how it accounts for price concessions and why it deems them important enough to disclose (January 2020).
Implicit price concessions reflect variable consideration and represent the difference between contractual amounts billed and amounts we expect to collect based on our settlements experience pertaining to similar claims. We follow the guidance set forth in ASC 606-10-32-5 through ASC 606-10-32-9 which requires that we estimate these concessions in the determination of transaction price. We apply the expected value method to estimate these concessions and the resulting amounts are recorded as a reduction to gross charges with a corresponding reduction to billed accounts receivable. Given that our estimates of implicit price concessions pertaining to a current period relate to the amount we expect that we will not ultimately realize upon settlement in a future period, an accumulated balance arises which reflects the aggregate portion of our billed accounts receivable that we do not expect to ultimately realize.
With respect to the Staff’s question regarding our reasons for providing this additional disclosure, given that the accumulated balances of implicit price concessions reflect a significant estimate, we believe that disclosure of the amounts of these balances provides meaningful insight to investors regarding the composition of accounts receivable, in that changes in the estimated balances of billings which the Company expects it will not realize can be distinguished from the gross billings themselves. While the literature does not address this disclosure, given the magnitude of the accumulated balance (which amounted to 33% of billed accounts receivable within the Patient Care segment at December 31, 2018), we believe that disclosure of these amounts is meaningful and not prohibited.
Entities must determine whether they intend to offer a price concession or whether the customer has a valid expectation of a price concession. Entities must also consider special facts and circumstances such as customer cash flow problems, economic difficulty, or high competition in the marketplace to evaluate the likelihood of a price concession. If an entity determines that there is an explicit or implicit price concession, then the consideration is variable, and the entity must reduce the transaction price to the amount to which it expects to be entitled. If the entity determines that it is not probable that it will collect the consideration, under ASC 606 it cannot account for that portion of the transaction price as part of the sales revenue.