Dissecting the New Revenue Recognition Guidance: Step 4 of the Five-Step Framework

Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as amended, creates a five-step framework for entities to determine when and how much revenue should be recognized. The first article in the ‘Dissecting the New Revenue Recognition Guidance’ series discussed step 1: identifying the contract(s) with a customer. The second article in the series explained step 2: identifying performance obligations in the contract. The third article discussed step 3: determining the transaction price. This article focuses on step 4: allocating the transaction price to the performance obligations in the contract.

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract

The overall objective of step 4 is to allocate an amount to each performance obligation (distinct good or service) that represents consideration to which an entity expects to be entitled for transferring control of the underlying good or service. This step should be a focal point for entities that have performance obligations that are bundled together within the same contract. Said in simpler terms, this relates to any entity performing or providing two or more services or products and invoicing the customer for the combined output, as opposed to each individual service or product. Step 4 will result in a significant change in process for allocating the transaction price between multiple performance obligations as compared to the existing revenue guidance for entities that need to estimate standalone selling prices. While there are similarities between the old and new revenue standards, there may be differences that result in a different amount being allocated to a unit of account for revenue recognition purposes, and different timing of revenue recognition.

Allocating Transaction Price

Before delving into the requirements of the new standard, it’s important to understand the specific requirements of the current revenue standard. Under the current standard, entities that sell bundled products and services will use standalone selling prices for each product and service when determining how much of the transaction price should be allocated to each deliverable (defined as a performance obligation under ASC 606). This concept does not change in the new guidance. Most often entities look to see if that specific product or service is sold standalone (by itself), and would use that standalone sale value in determining how much of the combined value to allocate to each deliverable.

Example

A technology company is selling a laptop with an operating system included for $3,500. The laptop is typically sold by itself for $3,000, while the operating system is sold by itself for $1,000. The company should allocate 25 percent ($1,000 / $4,000), or $875, of the total transaction to the operating system, and 75 percent ($3,000 / $4,000), or $2,625, of the total transaction to the laptop. It is important to note that this allocation exercise does not change in the new guidance for entities that bundle their products and services, but also sell these products and services standalone.

Existing Guidance and Changes

Where the new revenue guidance changes from the existing guidance is when entities do not sell certain products or services standalone, and are required to estimate standalone selling price. The existing guidance required entities to consider a relative selling price hierarchy when estimating standalone selling prices. Accounting departments utilized a three-level hierarchy, first considering “vendor-specific objective evidence,” followed by “third-party evidence,” and finally “best estimated selling price.” This guidance was complex and entailed significant efforts to aggregate data to come up with an estimated selling price. For example, vendor-specific objective evidence required that a certain percentage of product or service sales fall within a somewhat narrow pricing range in order for it to be used as the estimated selling price. Technology companies that bundled services certainly could commiserate on the pain and complexity that the standard required. The good news with the new guidance is that this hierarchical structure is now removed, and entities no longer have to follow the model. The new guidance allows entities to more easily allocate the transaction price to each performance obligation for consideration, which the entity expects to be entitled to in exchange for transferring the promised goods or services to the customer.

Under the new guidance, entities are encouraged, but not required, to use one of the following methods when estimating standalone selling price:

1. Adjusted market assessment
2. Expected cost plus a margin
3. Residual approach (in limited circumstances)

The above mentioned methods are those that will likely be commonly used, however, they are not intended to be a prohibitive list of acceptable methods. In practicality, the new standard provides entities the ability to more broadly interpret data to estimate standalone selling price.

The adjusted market assessment approach considers the market in which the good or service is sold and what a customer would be willing to pay. This involves a significant amount of judgment and requires entities to think through the product or service’s position in the market, expected profit margin, distribution channel, and cost structure.

The expected cost plus a margin approach is the most user-friendly approach and entails aggregating the direct and indirect costs required to provide that product or service as well as what margins are achieved on similar products made by the entity or other competitors.

The residual approach involves deducting from the total transaction price the sum of the estimated standalone selling prices of other goods and services in the contract to estimate a standalone selling price for remaining goods or services. Entities should only use this approach if a broad range of pricing for a product or service is used or a price for a good or service has not yet been established.

Example

A software company enters into an arrangement to provide a license and implementation services to a customer. The license and implementation services are each distinct and therefore accounted for as separate performance obligations, but neither is sold as a standalone item. The best approach for determining the standalone selling price of the license will depend on the rights associated with the license, the stage of the development of the technology, and the nature of the license itself. An entity that does not sell comparable licenses should consider factors including projected cash flows from the licenses to help estimate a standalone selling price of the license, especially if the license is already being sold. An expected cost plus a margin approach is more applicable for licenses in the infancy stages in which comparable sales data does not exist. For the implementation services, an expected cost plus a margin approach would be more applicable for estimating the standalone value considering the payroll costs needed to perform the implementation services.

Specific Concerns Related to Allocating Transaction Price

The standard addresses the following items related to allocating transaction price, which may ease the process of determining how to allocate transaction price to certain performance obligations.

Can there be a range of standalone selling prices for products or services underlying a performance obligation?

Yes, the customer class and geographic region in which the entity sells a product could result in a range or separate standalone prices.

Should discounts be allocated to separate performance obligations?

Yes, discounts and variable consideration should be allocated to performance obligations consistent with the allocation for the separate performance obligations, unless there are facts and circumstances that would indicate otherwise.

Do Your Contracts Include Bundled Performance Obligations?

The implications of step 4 may impact how an entity has historically recognized revenue, and could result in accelerated or delayed revenue recognition for specific performance obligations.

Entities in the technology and manufacturing industries, as well as those in other industries that frequently market and sell products together, should begin assessing now the changes that the new standard will bring.

Entities should also review the changes that this step will bring in conjunction with step 2, identifying performance obligations. This step will be significantly more time consuming for entities that have multiple performance obligations that are bundled together, and it is paramount that entities have vetted changes in allocation in advance of when the new revenue standard becomes effective. Finally, entities should communicate potential changes to parties of interest (third-party lenders, shareholders, members of management, and board members) in advance of the effective date of the new guidance.