On May 28, 2014 The Financial Accounting Standards Board (FASB) and The International Accounting Standards Board (IASB) jointly issued ASC 606 – Revenue From Contracts with Customers. This change in recognizing revenue from contracts with customers could have a serious effect on reported revenue in future years. For public companies, the effective date for ASC 606 begins for reporting periods beginning after December 15, 2017. For private companies, the effective date is for reporting periods beginning after December 15, 2018.
“The Core principle of Topic 606 is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration which the entity expects to be entitled in exchange for the goods or services”
There are 5 steps to achieve the core principle stated above:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue when or as the entity satisfies a performance obligation
In this article we will be focusing on step three, determining the transaction price.
The new revenue standard requires an entity to estimate the amount of variable consideration to which it will be entitled, on a single contract basis. This is a significant change in existing Generally Accepted Accounting Principles (GAAP). Existing principles generalized similar contracts and recognized revenue at similar periods throughout those contracts. The new standard hopes to have a clearer guidance on timing of recognition and more accurate revenue reporting.
Some examples of variable considerations are price concessions, rebates, refunds, volume discounts, incentives and credits. One thing to note is that variable considerations can either decrease or increase a contract price. Subsequently, the new revenue standard can either increase or decrease revenue.
To recognize revenue in a contract, an entity must determine the transaction price in a contract. Under ASC 606, any variable considerations in regards to that contract must be included in the transaction price, using a method of estimation.
There are two methods to estimate variable considerations in regards to contracts. The Expected Value Approach and the Most Likely Approach.
The expected value method would be most beneficial to a company that has a large volume of contracts that are all similar in nature. With the large amount of contracts, the company has the ability to more accurately predict the outcomes of the contracts, using a weighted probability.
When a company has fewer possible outcomes, the Most Likely Approach may be the most beneficial form of variable consideration estimation. The Most Likely Approach consists of choosing the best possible outcome as your estimation. With fewer outcomes, the Expected Value method could result in an amount of consideration that is not in the results of the possible outcomes.
Applying these methods of estimation should be applied consistently and should not change throughout a contract’s life. It is management’s responsibility to reassess during each reporting date on what method of estimation they believe will predict the most likely outcome per contract.
There are limitations while applying variable considerations to contracts under ASC 606. Variable considerations should only be included in the transaction price if it is unlikely that such revenue would be reversed. Estimates must be adjusted until they no longer include amounts for which it is probable that a significant reversal will occur. Management has significant responsibility in assessing the likelihood of reversal. Variable consideration should only be included in the transaction price if it is unlikely that such revenue would be reversed.
There are four factors provided in ASC 606 to consider in regards to limiting variable consideration. The factors are:
- The amount of consideration is highly susceptible to factors outside the entity’s influence. Examples include volatility of the market, actions of third parties, environmental factors.
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
- The experience of the company dealing with similar types of contracts are limited, resulting in limited predictability.
- The contract has a broad range of possible outcomes.
Although the FASB intended to simplify revenue recognition through the new accounting pronouncement, the transition will come with many difficulties and unclear revenue recognition situations. If you have any questions or would like to inquire more about Accounting Standard Codification 606 regarding the new revenue recognition standards please feel free to reach out to a Stephano Slack representative to guide you through the process.