On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued their final standard on revenue from contracts with customers. The standard, issued as ASU 2014-09 by the FASB and as IFRS 15 by the IASB, outlines guidance for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance.
The goals of the revenue recognition project are to clarify and converge the revenue recognition principles under U.S. GAAP and IFRS and develop guidance that would streamline and remove inconsistencies in revenue recognition; improve comparability; provide a more robust framework for addressing revenue issues; and increase the usefulness of the financial statement disclosures.
Previous articles have covered steps one and two above. In determining the transaction price, it is necessary to evaluate whether it is probable that the entity will collect substantially all of the consideration to which it is entitled under the contract. In fact, contract consideration can be considered variable even if the price in the contract is fixed. This is because many entities offer customers a price concession after the initial contract—resulting in the seller receiving less consideration than it is entitled to in the contract.
Entities may find themselves using significant judgement in determining whether they have provided an implicit price concession or if the collection of the contract price will be reduced due to the customer’s credit risk. Certain entities may be willing to accept less than the contract amount in exchange for goods or services due to the customers’ ability to pay. Note that credit risk should be evaluated separately from price concessions and would impact bad debt expense rather than revenue.
An entity may accept a lower price than the amount stated in the contract to develop or enhance a customer relationship or because the incremental cost of providing the service to the customer is not significant and the consideration it expects to collect provides a sufficient margin. A seller may also accept payment for less than the stated contract to encourage the customer to pay for previous purchases and continue making future purchases. Price concessions are also sometimes provided when a customer has experienced some level of dissatisfaction with the good or service (other than items covered by warranty).
An entity sells 1,000 products to a customer for promised consideration of $1 million. This is the entity’s first sale to a customer in a new region, which is experiencing significant economic difficulty. Thus, the entity expects that it will not be able to collect from the customer the full amount of the promised consideration. Despite the possibility of not collecting the full amount, the entity expects the region’s economy to recover over the next two to three years and determines that a relationship with the customer could help it to forge relationships with other potential customers in the region.
When assessing whether it is probable that the entity will collect the consideration to which it will be entitled in exchange for the services that will be transferred to the customer, its customary business practices as well as other facts and circumstances indicate the entity’s intention, when entering into the contract with the customer, is to offer a price concession to the customer. As a result, the entity determines that it expects to provide a price concession and accept a lower amount of consideration from the customer.
Accordingly, the entity concludes that the transaction price is not $1 million and, therefore, the promised consideration is variable. The entity estimates the variable consideration and determines that it expects to be entitled to $400,000.
When evaluating the customer’s intention and ability to pay the consideration, the entity would base its assessment on the variable consideration determined of $400,000 rather than the stated contract purchase price.