Accounting: The Language of Business - Vol. 2 (Intermediate: Part 119)

Whenever you find yourself on the side of the majority, it is time to pause and reflect.

Mark Twain

Revenue Recognition (Part F)

by

Charles Lamson

Step 3: Determine the Transaction Price (continued from Part 118)

Recall from Exhibit 8.1 from Part 114 and reintroduced below, the five steps in revenue recognition. In this post, we continue our discussion of Step 3.

 

Also recall from part 118 that the transaction price is the amount that an entity will ultimately recognize as revenue. Measuring the transaction price can be quite simple in some cases. For example, assume a customer shopping at a retail store selects and pays $100 cash for a new dress. The transaction price is $100. However, with complex transactions, determining the transaction price is involved. Sellers consider the effects of a number of different factors when determining the transaction price, including:

1. Variable consideration and constraining estimates of variable consideration

2. Any significant financing component in the contract

3. Noncash consideration

4. Consideration payable to a customer

Variable Consideration and Constraining Estimates of Variable Consideration

Variable consideration is when the payment received for providing a good or service is not a fixed amount. The amount of consideration may vary from a fixed amount due to price concessions, performance bonuses or penalties, discounts, refunds, rebates, and incentives. Elements of variable consideration may be stated explicitly or implicitly in the contract. For example, a discount for early payment typically offered by a seller is considered an element of variable consideration, even though it may not be specified explicitly in the contract.

If variable consideration is included in the contract, then the entity must estimate the consideration that it expects to receive using one of two acceptable approaches: the expected-value approach (discussed in Part 118) or the most-likely-amount approach (discussed below). The entity should use the approach that provides the best estimate of the amount of consideration it will receive.

Most-Likely-Amount-Approach. The most-likely-amount approach uses the single most likely amount in a range of possible consideration amounts as the estimate. This approach is best suited when there are only two possible outcomes. Example 8.7 illustrates estimating variable consideration under the most likely amount approach.

Constraining Estimates of Variable Consideration. Entities must also assess the contract to determine if there are any constraints to variable consideration. For the entity to include variable consideration in the estimated transaction price (and thus the amount of revenue recognized), It has to conclude that it is probable that a significant revenue reversal will not occur in future periods. “Probable” is generally interpreted as 70 to 75%. This assessment requires the use of a cumulative probability level to determine if the definition of probable (likely to occur) is met. Example 8.8 provides a case with a constraining estimate of variable consideration. 

Variable Consideration and Constraining Estimates of Variable Consideration: International Financial Reporting Standards (IFRS). In estimating the constraint on variable consideration, Generally Accepted Accounting Principles (GAAP or U.S. GAAP) uses the term “probable,” whereas IFRS uses the term “highly probable.” The definition of “probable” under U.S. GAAP and “highly probable” under IFRS are essentially the same. 

*GORDON, RAESY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 382-384*

end