Revenue Recognition - Step 4: Allocate the Transaction Price to the Performance Obligation in the Contract

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:

• Adjusted market assessment approach – The entity will evaluate the market in which it sells goods or services and estimate the price a customer in that market would be willing to pay for those goods or services. This approach may also include referring to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins.
• Expected cost plus a margin approach - The entity will estimate its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service to establish a “price” for the good or service.
• Residual approach – The entity will estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract. However, an entity may only use a residual approach to estimate the standalone selling price of a good or service only if one of the following criteria is met (ASC 606, paragraph 606-10-32-33):

1. The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence).
2. The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain).

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.

Questions? Please contact your Eide Bailly LLP representative today, we can help you through this process. 

Catch up on this series!

Revenue Recognition – Step 1: Identify the Contracts with a Customer

Revenue Recognition – Step 2: Identify the Performance Obligation in the Contract

Revenue Recognition – Step 3: Determine the Transaction Price