Step 3 in the new guidance is to “Determine the transaction price.” While this may be simple for many companies, it is difficult for others, especially when their contracts contain elements that could change depending on other interactions between your company and your customer.
Transaction Pricing and Variable Consideration
Under ASC 606, the transaction price is “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.” In other words, it is the amount of the payment a company would expect to receive for the product they deliver.
If your contract contains amounts that could change, it has “variable consideration” elements you need to understand, define, and for which you will need to make estimations.
Some of those elements could be claims, change orders, bulk discounts, price concessions or other incentive or penalty provisions. This article will focus on incentives or other payments you make to the customer, which can make determining a transaction price less simple than it sounds.
Customer Payments and Incentives Under ASC 606
One of the most common elements of variable consideration is payments made to a customer, or, in the jargon of ASC 606, “consideration payable to the customer.” Customer payments can include rebates, discounts or other incentives related to the contract. Payments such as these will generally have the effect of reducing your transaction price, and as a result, lowering the amount of revenue you can recognize.
However, if you are buying “distinct goods or services” from a customer in the ordinary business course that you would buy whether or not you have a contract with them for your goods or services, you will account for that as you would for any other expense.
Customer payments and incentives, or other elements that can affect transaction pricing, may or may not be written into the contract. Suppose your contract does not explicitly include variable consideration. In that case, your consideration may still vary if the customer expects that you will eventually offer some kind of price concession.
Estimating the Amount of Variable Consideration
When estimating variable consideration amounts, select the best method depending on which one you expect to be a better predictor of the correct amount:
- Expected Value Method. If the customer has other contracts with your company, you can use historical payment details. If not, you can create a weighted probability chart to estimate the amount you expect to receive.
- Most Likely Amount Method. From a list of possible options, select the most likely scenario. Again, this could include looking at weighted probability or even more straightforward, like a performance bonus possibility that will either be paid or not paid.
Whichever method you choose, use it consistently throughout the contract. Since the standard is “principle-based,” consider the relevant principles behind making your decision, be consistent in its application and keep accurate records for management review and potential audit trail.
Constraining Estimates of Variable Consideration
Just to make it a little more complicated, you can only include in the transaction price variable consideration that is not likely to be reversed. The guidance talks about “significant reversal” due to uncertainty in determining amounts or whether a variable consideration element will happen.
To determine the likelihood and magnitude of a potential revenue reversal, you need to be aware of several factors and be able to answer questions such as:
- Is the amount of consideration susceptible to market volatility, weather conditions or other factors outside your company’s influence?
- Will you be able to resolve the uncertainty about the amount of consideration within a reasonably short period?
- What experience does your company have with these or similar types of contracts? Can you use that history to make a reasonable estimate?
- Is there a large number or a wide range of consideration amounts that are possible?
These new guidelines around handling customer payments, incentives, and other variable consideration elements are different from prior GAAP, so be sure you are up-to-date on all the nuances of ASC 606 before finalizing any numbers.
Learn more about ASC 606 and how a reliable sales commission tool can help ease the pains of 606 adoption.