In FASB Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, FASB provides a 5-step framework for determining revenue recognition. In the previous installments to this series, we have discussed the first three steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Leading up to step four, an entity will have identified all the performance obligations and determined the overall transaction price. While it may seem simple on the surface to then apply the overall transaction price to the various performance obligations, in many cases the determination of the value of each performance obligation may be difficult. The most common allocation method is to determine the standalone selling price of each performance obligation. For example, if the purchase of a new car comes with two years of oil changes, the standalone price of the oil changes would be relatively easy to value as this is a service that is separately provided to other customers with a determinable price. However, not all performance obligations are as easy to separate. If the goods or services are not sold separately, there are three pricing strategies, as follows:
An entity may also combine these approaches if the goods or services promised have high variability or uncertainty in their pricing.
Discounts, rebates, and other price concessions included in a contract also need to be included in the allocation of the purchase price. For example, when a customer earns a free night hotel stay with every 10 nights, the hotel would allocate the transaction price over the combined 11 nights. Allocating these items may be difficult when goods or sales a bundled together. Additionally, a discount or rebate may only apply to specified goods, which would further complicate the allocation process.
Catch up on this series!
Revenue Recognition – Step 4: Allocate the Transaction Price to the Performance Obligation in the Contract