Revenue Recognition Part Four: Allocate the Transaction Price to the Performance Obligations in the Contract
By Benjamin R. Ripple, CPA, Partner
As everyone prepares to adopt the new revenue recognition standards, which are applicable for years beginning after December 15, 2017 for public companies and the following year for nonpublic companies, we are taking a deeper dive into each of the five steps of the revenue recognition process. Our goal is to make understanding the 700 page original Accounting Standard Update (ASU) and the seven subsequent standard updates a little easier.
If you have properly gotten through the first three steps of revenue recognition, then step four, allocating the transaction price, should be fairly easy. If you only have one performance obligation, then this step is very easy; all of the transaction price goes to that one obligation. The only thing that makes this process difficult if you have multiple performance obligations is if there is no standalone selling price for one of the performance obligations in the contract.
I have gotten this far in the series without actually using numbers in my examples, but it might be the best way to illustrate this step. So, let’s assume the following facts for three examples of allocating transaction price: We have entered into a contract to sell and install a machine, and the transaction comes with a two year warranty. The total price of the contract is $10,000.
For example one, we will assume that Company offers each of these products on a standalone basis and there is no discount on the transaction (the easiest possible scenario for a contract with multiple obligations).
For example two, we will again assume that each are sold standalone, but this time we will be allocating a discount among the three obligations.
Finally, we will assume that the company never sells the piece of machinery without installing it, but they do offer the warranty separately to show estimating the standalone price of those two obligations.
You can see in the first example that the allocated transaction prices are consistent with the standalone price charged by the company. In example 2, the $2,000 discount (the difference between the standalone prices and the transaction price) is allocated by looking at each standalone price as a percentage of the total standalone prices. So, for example, the machine allocated transaction price equals the standalone price of $8,000 as a percentage of the total of the standalone prices of $12,000 (66.7%) times the total transaction price of $10,000. In the third example, I kept it easy by not changing the total standalone price. This transaction would only require the extra step of then allocating the transaction price between installation and machine. To do this, we again use percentage of total, but now we have to estimate what each of the obligations costs. For the machine, you would look at the costs of the parts bought to build it plus labor and overhead to build the machine. For the installation, you would have to estimate the labor and overhead associated with the installation.
One caveat to all of this to consider is you have to make sure you have properly identified the performance obligations. If the transfer of the ownership of the machine does not happen until it is installed, one could argue that the machine and the installation are all one performance obligation in the context of this contract, since you cannot have one without the other. That is why it is important to make sure the first three steps have been closely followed before starting the allocation process. If you went through all of the work in example 3 to allocate the price between the machine and the installation, you would be pretty upset for your accountant to come in and tell you it was unnecessary.
The things to consider as you walk away from this part include thinking about bundle services and products that your Company sells. How will you come up with standalone prices for these items? How much more documentation do you need to pull together to get comfortable with that process? What will an auditor want to see to get comfortable with that allocation?
If you need additional resources on understanding and implementing the standard, you have options. First, please reach out to your accounting service providers early to get on top of the implementation issue before it gets here. Second, FASB has setup the following website to help with transition to the new standard:
FASB/IASB Joint Transition Resource Group for Revenue Recognition
Whatever you do, please do not wait until the audit of the first period under the new standard to try to get this cleaned up. That will lead to a lot of headaches for you, your bankers, your accountants, and all of those people’s significant others that will have to deal with listening to them complain about the new revenue recognition process.
Benjamin R. Ripple Partner, Assurance Practice Leader, CPA
Ben is a partner in BRC’s assurance services. Since starting his career in 2001, Ben has worked with clients ranging from family-owned companies, to multinational corporations, to not-for-profit and governmental entities requiring A-133 audits. Ben’s industry experience includes: Manufacturing and distribution Hospitality, including restaurants and hotels Investment companies Governmental and not-for-profit entities Affordable housing […]