Step 3 in the new ASC 606 implementation guidance is to “determine the transaction price.” While this may be simple for many companies, it’s more difficult for others—especially those whose contracts contain elements that could change depending on other interactions between the company and their customers.
Every time you change the price of your product or service to negotiate a deal, it affects how you account for revenue. You have to report every rebate, incentive, or customer payment that affects your transaction price.
Transaction pricing and variable consideration
ASC 606 defines the transaction price as “the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.” It’s the payment a company expects to receive for the product they deliver.
If your contract contains payment amounts that could change, it has “variable consideration” elements, and you’ll need to understand, define, and make estimations for them.
Some of those elements could be claims, change orders, bulk discounts, price concessions, or other incentive or penalty provisions. This article will focus on rebates, sales incentives, or other payments made to the customer, which can make determining a transaction price more complicated.
Customer payments, rebates, and sales incentives under ASC 606
Customer payments (or “consideration payable to the customer” per ASC 606) can include rebates, discounts, or other sales incentives related to the contract. These payments will generally reduce your transaction price and lower the amount of revenue you can recognize.
However, if you’re buying “distinct goods or services” from a customer in the course of ordinary business (as you would regardless of having a contract with them for your goods or services), then you account for that purchase as you would for any other expense.
Customer payments, rebates, and sales incentives, or other elements that can affect transaction pricing, may or may not be written into the contract. Even if your contract doesn’t explicitly include variable consideration, 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, you can select one of two methods, depending on which one you expect to provide a more accurate prediction:
- 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: You select the most likely scenario from a list of possible options. This could include looking at weighted probability, but it also includes elements which may or may not happen. For example, a performance bonus either will or won’t be paid.
Consider the relevant principles that go into your decision of which method to use, be consistent in its application, and keep accurate records for management review and potential audits.
Constraining estimates of variable consideration
Within the transaction price, you can only include variable consideration that isn’t likely to be reversed. The ASC 606 guidance discusses “significant reversal” due to uncertainty in determining amounts or regarding whether a variable consideration element will happen.
To determine the likelihood and magnitude of a potential revenue reversal, you need be able to answer questions like:
- Is the amount of consideration susceptible to market volatility, weather conditions, or other factors outside of your company’s control?
- Will you be able to resolve the uncertainty about the amount of consideration within a reasonably short period?
- Does your company have experience with these or similar types of contracts? Can you use that history to make a reasonable estimate?
- Is a large number or wide range of consideration amounts possible?
The ASC 606 guidelines around handling customer payments, incentives, and other variable consideration elements are different from prior GAAP, so be sure you’re up-to-date on all the nuances before finalizing any numbers.
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ASC 606 guidelines are a lot to keep track of, and staying compliant is sometimes easier said than done. Depending on your compensation plan, rebates, sales incentives, and customer payments may affect sales commissions, adding another layer of complexity. But you don’t need to do it all by hand, nor should you rely on a sea of spreadsheets for your calculations.
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