ASC 606-10-32: Determining the Transaction Price

Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, provides the guidance for revenue recognition under U.S. GAAP. The standard uses a five-step model for customer contracts, with the core principle being to recognize revenue for the amount of consideration an entity expects to receive for its goods or services.

This article focuses on the third step of this model: determining the transaction price. The requirements for this step, detailed in ASC 606-10-32, establish the total amount of consideration that will be recognized as revenue.

Determining the Transaction Price

The transaction price is the amount of consideration an entity expects to be entitled to for transferring goods or services, excluding funds collected for third parties like sales taxes. A company must consider the contract terms and its business practices to determine this price. While some contracts have a simple, fixed price, many arrangements are more complex.

Consideration can include fixed amounts, variable amounts, or both. For example, if a customer pays a fixed $500 for a product, the transaction price is $500. However, the stated price is not always the final transaction price, as several factors can affect the amount a company expects to receive.

Four issues can complicate the calculation. The first is variable consideration, where the amount depends on future events like bonuses or rebates. The second is a significant financing component, which addresses the time value of money. The third is noncash consideration, where a customer pays with items other than cash. The final factor is consideration payable to a customer, such as credits or fees a company pays to its customer.

Accounting for Variable Consideration

Variable consideration is any amount that can change based on future events, such as discounts, rebates, performance bonuses, or refunds. Since the final amount is unknown at the contract’s start, companies must estimate the consideration they expect to receive based on all reasonably available information.

The guidance provides two estimation methods, and a company must choose the one that better predicts the final amount, applying it consistently. The first is the “expected value” method, which calculates the sum of probability-weighted amounts from a range of possible outcomes. This approach is suitable when a company has many similar contracts and can use historical data. For instance, if a company has a 60% chance of earning a $10,000 bonus and a 40% chance of a $5,000 bonus, the expected value is $8,000.

The second method is the “most likely amount,” which uses the single most likely amount from a range of possible outcomes. It is more appropriate when a contract has only two possible outcomes, such as achieving a performance bonus or not. For example, if a company will receive a $100,000 bonus for completing a project on time and is highly likely to do so, it would use $100,000 as its estimate.

After estimating, a company faces a limitation known as the “constraint.” A company can only include the estimated variable amount in the transaction price if it is “probable” that a significant reversal of cumulative revenue will not occur later. “Probable” is a high threshold, meaning likely to occur. This assessment requires considering both the likelihood and magnitude of a potential revenue reversal.

Factors increasing the risk of a revenue reversal include a long period before resolution, limited experience with similar contracts, or susceptibility to factors outside the company’s control. If these are present, some or all of the estimated variable consideration may be excluded from the transaction price until the uncertainty is resolved. This constraint prevents overstating revenue early in a contract.

The Existence of a Significant Financing Component

If the timing of payments provides either the customer or the entity a significant financing benefit, the transaction price must be adjusted for the time value of money. The goal is to recognize revenue at an amount reflecting the cash price at the time of transfer. A significant financing component can be explicit in the contract or implied by the payment terms.

To identify a significant financing component, a company considers the difference between the promised consideration and the cash selling price, and the length of time between transfer and payment. For example, if a customer pays two years after a service is delivered, a financing component likely exists. Likewise, if a customer pays a large fee a year before services are rendered, the entity may be receiving a financing benefit.

When a significant financing component exists, the transaction price is adjusted using a discount rate that reflects a separate financing transaction between the parties at the contract’s start. The rate must consider the credit characteristics of the party receiving financing and any collateral. The effect of the financing is recognized as interest income or expense, separate from revenue.

A practical expedient is available. An entity is not required to adjust for a significant financing component if the period between transfer and payment is one year or less. This allows companies to disregard the time value of money for most short-term contracts. A company using this expedient must apply it consistently to similar contracts and disclose its use.

Noncash Consideration

A customer may promise consideration in a form other than cash, such as goods, land, equipment, or equity instruments like stock. When this occurs, the transaction price must include the value of these noncash items.

Noncash consideration is measured at its fair value at contract inception, the date the contract meets the criteria in ASC 606-10-25. The transaction price is fixed based on this initial fair value. Subsequent changes in the fair value of the noncash item, such as a stock price change, do not affect the transaction price.

Determining fair value is straightforward for items like publicly traded stock. If the fair value of the noncash consideration cannot be reasonably estimated, an entity should measure it indirectly. This is done by referencing the standalone selling price of the goods or services promised in the exchange.

Consideration Payable to a Customer

Payments made to customers, such as cash, credits, slotting fees, or volume rebates, are known as consideration payable to a customer. These payments are treated as a reduction of the transaction price, and therefore revenue, because they are effectively a discount or refund.

The accounting treatment depends on whether the payment is for a distinct good or service transferred from the customer. A good or service is distinct if the entity can benefit from it on its own and it is separately identifiable. If the company receives a distinct good or service, the payment is accounted for as a purchase from a supplier, resulting in an expense or asset.

For example, if a retailer provides verifiable promotional services for a manufacturer, the payment may be a marketing expense. However, if the payment is not for a distinct good or service, it must be recorded as a reduction of the transaction price. This is often the case with slotting fees paid to a retailer to secure shelf space.

If a payment for a distinct good or service exceeds its fair value, the excess amount is treated as a reduction of the transaction price. If an entity cannot reasonably estimate the fair value of the good or service received, the entire payment is accounted for as a reduction of the transaction price.