Accounting: The Language of Business - Vol. 2 (Intermediate: Part 122)

Some of the first accountants were employed around 300 BC in Iran, where tokens and bookkeeping scripts were discovered. Around the first millennium the Phoenicians invented an alphabetic system for bookkeeping, while the ancient Egyptians may have even assigned someone the role of comptroller.

 

Revenue Recognition (Part I)

by

Charles Lamson

Step 4: Allocate the Transaction Price to the Performance Obligations (continued from Part 121)

Recall from Exhibit 8.1 from Part 114 and reintroduced below, the five steps in revenue recognition. In this post, we discuss Step 4.

The next step in the revenue recognition process is allocating the transaction price determined in Step 3 (Parts 118, 119, 120, and 121) to the performance obligations determined in Step 2 (Part 117). If the determination from Step 2 is that there is only one performance obligation, then Step 4 is not required.

 

Standalone Selling Price

To allocate the transaction price, the entity first determines the standalone selling price of the goods or services related to each performance obligation. Then, if the sum of the standalone selling prices is higher than the transaction price, the seller typically allocates the discount to separate performance obligations on the basis of the relative standalone selling prices.

The standalone selling price of each performance obligation is the price the seller would charge for the same goods or services if it sold them on a standalone basis to similar customers under similar circumstances. Companies can often determine the standalone selling price using this method because they typically sell their goods or services on a standalone basis.

However, in practice the seller sometimes does not sell the same goods or services separately. In this case, the seller must estimate the standalone selling price. The authoritative literature does not stipulate an exact method but states that the company should use a method that maximizes the use of observable inputs. Whatever method the entity chooses for estimating the standalone selling price, it should use the same method consistently in similar circumstances.

Standalone Selling Price Estimation Methods

Although the authoritative literature does not specify a particular method, it does provide three suggestions suitable to determine a standalone selling price specific to a good or service: the adjusted market assessment approach, the expected-cost-plus-a-margin approach, and the residual approach. 

1. The adjusted market assessment approach focuses on the amount that the seller believes that customers are willing to pay for the good or service by evaluating the market. This approach might include using prices from the seller's competitors and adjusting those prices as necessary.

2. The expected-cost-plus-a-margin approach focuses on internal factors by forecasting the costs associated with providing the goods or services and adding an appropriate profit margin.

3. The residual approach allows an entity to estimate one or more, but not all, of the standalone selling prices and then allocate the remainder of the transaction price, or the residual amount, to the goods or services for which it does not have a standalone selling price estimate. 

Specifically, when using the residual approach, the entity estimates the residual standalone selling price by subtracting the standalone selling prices of the goods or services that underlie the other performance obligations from the total transaction price.

Once the entity has estimated all of the standalone selling prices, it allocates any discount (that is, any amount by which the sum of the standalone selling prices is higher than the transaction price) to separate performance obligations on the basis of relative standalone selling prices. In other words, the entity allocates the transaction price to each separate performance obligation based on the proportion of the standalone selling price of each performance obligation to the sum of the standalone selling prices of all of the performance obligations in the contract. Example 8.13 illustrates the three approaches. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 387-389*

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