Step 4 of the new five-step revenue recognition standard requires the allocation of the transaction price to each performance obligation in a contract with a customer. Entities reach this point by first identifying the contract with a customer, identifying the performance obligations in the contract and determining the transaction price.
The transaction price determined in Step 3 reflects the consideration the entity expects to receive once it meets the performance obligations in the contract. Allocating the transaction price is done based on the standalone selling price of the performance obligations in the contract, but it also requires an evaluation of variable consideration or discounts that may be specifically linked to one or more performance obligations.
The overall objective when performing Step 4 of the model is to arrive at an allocation that represents the amount of consideration the entity expects to be entitled to for the transfer of the promised good or service. Said another way, the objective is to arrive at an allocation that is generally representative of the economics of the transaction. As with other areas of the new revenue recognition standard, determining the standalone selling price requires the use of judgment and may require management to make significant estimates.
Things to Consider
- The allocation of the transaction price under Topic 606 has similarities to existing accounting standards, but unlike the existing standards, the new guidance is based on overall principles rather than a specific hierarchy.
- The allocation concept in the new guidance is based on the relative standalone selling price of goods and services in a contract. Exceptions to the relative standalone selling price method are required to be applied when discounts or variable consideration meet certain criteria and therefore are allocated to a specific good or service.
- The new guidance eliminates the concepts of Vendor Specific Objective Evidence (VSOE), Third Party Evidence (TPE) and Best Estimate of Selling Price (BESP). The techniques used to determine these amounts may still be useful under Topic 606 to determine the standalone selling price of performance obligations in a contract.
- Proper allocation of the transaction price based on the relative standalone selling price method may require new controls and procedures in order to evaluate and monitor the judgments and estimates required by the new standard.
Standalone Selling Price
In its simplest form, a contract with a customer promises the transfer of a single good or service, and there is no need to allocate the transaction price. In such a simple contract, Step 3 and Step 4 are completed concurrently. Many entities, however, have contracts with customers that promise multiple goods or services. When the goods and services are not transferred at the same time, allocating the transaction price in Step 4 becomes a significant part of the process of recognizing revenue.
The basic principle in Step 4 is that the transaction price—that is, the revenue that will be recognized—should be allocated between the performance obligations in the contract based on the relative price for which they would be sold if they were sold separately, i.e. the standalone selling price.
The new guidance requires a determination of the standalone selling price for the goods and services to be transferred, but it does not require the use of a specific method to make the estimate. Instead the standard calls for determining the standalone selling price by using the technique, or combination of techniques, that maximizes the amount of observable inputs.
Approaches for Estimating the Standalone Sale Price
Entities are not wholly on their own for coming up with a method to estimate standalone selling price. Topic 606 provides three examples of techniques that may be used to establish standalone selling price: adjusted market assessment, expected cost plus a margin, and/or residual approach.
Although the use of one of these three methods is not required, it is expected that one of these approaches, or a combination of them, will be used in most situations.
To view an example of the allocation process, learn more about each of the approaches for estimating standalone sale price, as well as information on the allocation of a discount, the allocation of variable consideration, changes to the allocation, and final thoughts and things to consider, please click on Revenue Recognition Step 4 - Allocating the Transaction Price to read the full article. If you have any questions, please contact us here.
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Dave is a Managing Director and Leader of CBIZ Tofias’ Accounting Advisory Practice. He can be reached at 617-761-0508 or at DLewin@cbiztofias.com.
