Are you ready for the new revenue recognition standard? Do you know how transitioning from ASC 605 / SAB 104 to ASC 606, Revenue from Contracts with Customers, will affect your organization? If not, you’re in luck! In our new series of blog posts, we walk through the new five-step model, step-by-step, to get you prepared!

ASC Topic 606 prescribes a new five-step model for entities to follow when recognizing revenue. These five steps are:

1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfied the performance obligations.

In this post, we will focus on step 3: Determine the transaction price, including the potential changes to existing guidance.

The essence of step 3 is to determine the amount the entity expects to receive for satisfying the performance obligations in revenue contracts with customers. The transaction price may include fixed amounts set forth in the contract, variable amounts or both. It might also include adjustments for significant financing arrangements (i.e., time value of money) or the fair value of non-cash consideration.

Variable consideration is very broadly defined and can be explicitly or implicitly set forth in the contract. Variability can take many forms and different contract features impact it, such as discounts, rebates, customer incentives, refunds, credits, performance bonuses, penalties, contingencies and price concessions.

To estimate variable consideration, entities will use one of two methods and apply the method consistently throughout the term of the contract:

1. Expected value: the sum of an entity’s probability-weighted estimates.
2. Most likely amount: the amount with the highest likelihood of occurrence in a range of possibilities.

When estimating variable consideration, entities should only include amounts they are likely to realize (sometimes referred to as the revenue constraint) and, therefore, not subject to significant revenue reversal. In making this determination, entities will need to consider factors that might increase the chances of revenue reversal such as:

• The consideration is heavily impacted by factors outside an entity’s control (such as market volatility, regulatory changes, weather conditions and technological obsolescence).
• The consideration uncertainty will not be resolved for a long period of time.
• The entity has limited experience with similar contracts.
• The entity has a history of offering price concessions or other changes in contract terms with similar contracts.
• The contract has a large number and broad range of possible consideration amounts.

So how do the above principles work in practice? Let’s take a look at an example.

Practical Example

Dempsy Outsourcing provides call-center ordering services for Airmall magazine. Dempsy receives an annual fee of $100,000 for providing such services and is also eligible to receive a performance bonus up to $50,000, if average customer wait times are below certain thresholds at the end of the year. Using historical results as well as current expectations, Dempsy estimates the chances of achieving the different performance bonuses are as follows:

Question 1: When recognizing revenue during the period that they perform services under existing guidance, would Dempsy include the performance bonus?

Question 2: Would the answer change under new guidance (ASC 606)?

Answer to the first question: Existing Guidance (ASC 605 / SAB 104)

No. Dempsy would only include the annual fee of $100,000 when recognizing revenue during the period (possibly on a straight-line basis throughout the year). The performance bonus would be recognized at the end of the year, if at all, when the amount becomes known.

Under ASC 605 / SAB 104, entities only consider amounts for revenue recognition when they are fixed and determinable. Prior to the end of the year, this would just include the annual fee of $100,000. The performance bonus would be recognized once the contingency is resolved (i.e., once the average customer wait times for the year are determined at the end of the year).

Answer to the second question: New Guidance (ASC 606)

Yes. Assuming the estimates in the above table are reasonable, Dempsy would recognize both the annual fee and the performance bonus during the period, making any adjustments in the estimate of the performance bonus prospectively. To determine the amount of performance bonus to include in transaction price, Dempsy would apply one of the two methods discussed above:

Method 1: Expected value approach = $20,000

• Using probability weighting, the performance bonus would be initially estimated at $29,000 ((50,000 x 5%) + (40,000 x 20%) + (30,000 x 45%) + (20,000 x 20%) + (10,000 x 10%)).
• When considering the revenue constraint, receiving $29,000 is not possible as it is not one of the five bonus levels. Therefore, Dempsy would be limited to including $20,000 in the estimated transaction price until it became probable that the next bonus level (i.e., $30,000) would be achieved.

Method 2: Most likely amount approach = $20,000 or $30,000

• The most likely performance bonus is $30,000 (45% chance of receipt).
• The impact of the revenue constraint depends on Dempsy’s determination of “probable.” There is a 70% chance of receiving at least $30,000 and a 90% chance of receiving at least $20,000.

Under ASC 606, different judgments and estimates will need to be considered when estimating the transaction price, including the method used to estimate variable consideration. The new standard does not explicitly call for one method over the other and, instead, requires entities to use the method that will better predict the amount of consideration to which the entity will be entitled.

Final Thoughts

Step 3 in ASC 606 presents a variety of challenges to entities when implementing the new standard. Specifically for variable consideration, entities may need to begin to estimate these amounts upfront, whereas under current practice, contingent features may lead them to not recognize this revenue until the contingency is resolved. Additionally, the estimation of the transaction price will involve judgment in the method chosen (expected value versus most likely amount), as well as the key inputs and assumptions based on historical and forecasted results and expectations, respectively. These changes will impact entities’ systems, processes and controls and will be key considerations as we move toward the effective date of the new standard.