Professor Adams' Lecture Materials

LO6-06: Understand how variable consideration and other aspects of contracts affect the calculation and allocation of transaction price.

Transaction price

Transaction price: the amount the seller expects to be entitled to receive from the customer.
In this learning objective we will cover special issues for step 3 (Determine the transaction price)

Variable consideration

The portion of a transaction price that depends on the outcome of future events.

Real world analogy: Bryce Harper will get paid an extra $500,000 in any season that he wins the National League MVP award.
Business example: the PlayStation Network agrees put a new Electronic Arts game on its service. PlayStation receives $300,000 guaranteed and a $180,000 bonus if the new game is accessed for at least 15,000 hours.

There are two ways to estimate the value of variable consideration

Expected value: define all the possible outcomes. Assign a probability to each outcome happening. Multiply probabilities by value of each associated outcome. Sum the values.
Most likely amount: just what it sounds like. Choose the value of the outcome with the highest probability of happening.

Comprehensive example using both expected value and most likely amount

Revenue reversal

Suppose estimates change and the company no longer anticipates receiving the variable consideration. In that case, previously recognized revenue on variable consideration must be reversed in the current period.

Example of revenue reversal

Indications that a significant reversal will occur

Sellers are limited to recognizing variable consideration to the extent that is probable that a significant revenue reversal will NOT occur in the future. [01] The following are indicators that a significant revenue reversal could occur.

1. There's poor evidence on which to base an estimate.
2. The estimate depends on a lot of factors that are outside of the seller's control.
3. There's a history of the seller changing payment terms on similar contracts.
4. There's a broad range of outcomes that could occur.
5. There's a long delay between now and when the uncertainty will resolve itself.

Right of return

Right of return: customers' right to return merchandise to retailers if they are not satisfied.

1. Not a performance obligation.
2. Sellers report net sales revenue in the income statement, equal to gross sales revenue less actual and estimated returns.

Is the seller a principal or agent?

Would you say the travel website Expedia is a seller? Are they providing flights? Are they providing hotel rooms? Companies like Expedia are called agents.

An agent does not control goods or services, but rather facilitates transfers between sellers and customers.
A principal controls goods or services and is responsible for providing them to the customer.
In the Expedia example, when an airline ticket is sold the airline (e.g., US Airways) is the principal and Expedia is the agent.
Agents only record revenue on commissions earned. Principals record revenue for the good or service provided to the customer.

Time value of money

If the time value of money is significant, a contract is viewed as including delivery and financing components.

Delivery component: Cash price for the good or service.
Financing component: Interest on implicit loan. [02]

Special issues for step 4: Allocate the transaction price to the performance obligations

When goods and services aren't normally sold separately, sellers must ESTIMATE stand-alone selling prices. Examples of approaches to accomplish this:

Adjusted market assessment approach: Look at what similar products - perhaps competitor products - sell for in the market.
Expected cost plus margin approach: Estimate the cost to make the product on a stand alone basis and then add some profit margin.
Residual approach:
- Stand alone selling price = Total price of bundled product - total price of performance obligations with determinable stand alone prices

Example of residual approach

Footnotes

[01] If the uncertainty resolves itself during the contract period, the seller can then begin recognizing the variable consideration at the point in time when the uncertainty resolves itself.[02] Example.

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