understanding variable consideration rec... · –albany, new york –livingston, new jersey •...

MEMBER OF ALLINIAL GLOBAL, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2018 Wolf & Company, P.C.

Understanding Variable

Consideration

May 22, 2018

• Today’s presentation slides can be downloaded at

www.wolfandco.com/webinars/2018.

• The session will last about 45 minutes, and we’ll then

have time for Q & A.

• Our audience will be muted during the session.

• Please send your questions in using the “Questions

Box” located on the webinar’s control panel.

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Before we get started…

http://www.wolfandco.com/webinars/2018

About Wolf & Company, P.C.

• Established in 1911

• Offers Audit, Tax, and Risk Management Services

• Offices located in:

– Boston, Massachusetts

– Springfield, Massachusetts

– Albany, New York

– Livingston, New Jersey

• Over 250 professionals

As a leading regional firm founded in 1911, we provide our clients

with specialized industry expertise and responsive service.

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Introduction

Scott Goodwin, CPAMember of the Firm and Technology Services Team Leader

• E-mail: [email protected]

• Phone: (617) 428-5407

Cecilia Frerotte, CPAAudit Principal and Software Sector Leader


• Phone: (617) 261-8186

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mailto:[email protected]


Agenda

• Types of variable consideration and tips to help identify

variable consideration

• How to estimate variable consideration

• Understanding significant financing components

• Allocating the transaction price

• Wrap-up

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The Five Step Model

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Core Principle

Recognize revenue to depict the transfer of promised goods or

services to customers in an amount that reflects the consideration

to which the entity expects to be entitled in exchange for those

goods or services

Variable Consideration

• Price concessions

• Volume discounts

• Rebates

• Incentives

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If the consideration promised in a contract includes a variable

amount (either explicit or implied), an entity shall estimate the

amount of consideration to which the entity will be entitled in

exchange for transferring the promised goods or services to a

customer.

• Refunds

• Performance bonuses

• Penalties

• Contingencies

• Sales & Usage*


Scenario 1: Variable Consideration or option to purchase additional goods

Case A - A customer purchases a two-year subscription to a SaaS application for

500 users for $1,000,000. The contract states that the customer can add additional

users during the two-year period at a price of $800 per user per year.

Case B – Customer enters into a one-year contract for access to a SaaS

application that allows the customer to process transactions, among other functions.

The customer agrees to pay an annual fee of $250,000 plus overage fees at a rate

of $0.1 per transaction based on the number of transactions processed through the

application during the year that exceed one million

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Scenario 2: Pattern of granting price concessions

Sample Co. licenses CRM software to its customers, typically on a two to five-year

term basis, with coterminous PCS services that are paid annually. Sample Co. is a

relatively small player in the CRM market, and therefore, has an incentive to try to

ensure it keeps its existing customers from moving to one of the larger CRM

providers.

As a result, Sample Co. has developed a practice of frequently providing its

customers a discount on the final year of PCS fees. This discount has ranged from

30% to 50% and is generally expressed to the customer as a reward for their

loyalty.

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Estimating Variable Consideration

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• Variable consideration must be estimated at contract

inception

– This is a big change from the current revenue recognition

rules

• There are two methodologies specified for estimating

variable consideration

– Expected value method

– Most likely amount method

• The choice of which method to apply is not an

election

– You must select the method you expect to better predict the

amount of consideration you will actually be entitled to


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• Expected value method

– Sum of the probability-weighted amounts in a range of

possible amounts

– Appropriate when there are a large number of contracts with

similar characteristics

• Most likely amount method

– The single most likely amount in a range of possible

amounts

– Appropriate when the contract has a limited number of

possible outcomes


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• Estimating variable consideration has a lot of “musts”

– You must select the method expected to best predict that

actual consideration

– You must apply one method consistently throughout the

contract

– You must consider all information reasonably available

– You must identify a reasonable number of consideration

amounts

• In general, use the same type of information that you

would use in a bidding or price setting process


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• Constraints on variable consideration

– Only include variable consideration to the extent it is

probable that a significant reversal of cumulative revenue

will not occur

• This will result in a non-neutral estimate

• When assessing probability of significant reversal,

must consider both the likelihood and the magnitude


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• Factors to consider when estimating the constraint:

– How much of the consideration is highly susceptible to

factors outside your control?

– How much experience do you have with contracts like

these?

– What is the time period until the uncertainty is resolved?

– How likely are you, based on past practice, to offer price

concession or change payment terms?

• Re-assessment of variable consideration

– Estimate of variable consideration needs to be updated each

reporting period


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• Scenario 3 – Estimating variable consideration

Facts:

– Sample Co. enters into software project requiring

significant customization

– Customer requires penalties for delayed “go live”

– Base price of $500,000

– If later than one month, penalty of $100,000

– If later than two months, penalty of $150,000

– If later than that, penalty of $300,000

– If completed early, bonus of $100,000


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• Scenario 3 – Estimating variable consideration

– Consideration of the constraint guidance

– Note – transaction price in this case ($465,000) is not one of

the possible outcomes!

Transaction

Outcome # Price Probability Weighting

1 $500,000 50% $250,000

2 $400,000 20% $80,000

3 $350,000 10% $35,000

4 $200,000 5% $10,000

5 $600,000 15% $90,000

100% 465,000$


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• Scenario 4 – Impact of service level agreements

Facts:

– Sample Co. enters into standard SaaS arrangement with

Customer for three years

– Customer pays monthly fees of $1,000

– SaaS contract contains a service level provision

• 99% uptime commitment

– In month where service level is not met, 10% penalty on

that month’s fee ($100)


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• Scenario 4a – Impact of service level agreements

Facts:

– Sample Co. has significant experience with contracts like

this

– Rarely grants service level credits based on history

Analysis:

– Most likely amount method will best predict consideration

to which Sample Co. will be entitled

– Sample Co. expects to be entitled to 100% of contract price

– Constraint consideration – granting of service level credits

is so rare, even if it was required to do so, would not result

in a “significant revenue reversal”


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• Scenario 4b – Impact of service level agreements

Facts:

– Sample Co. operating for only a short time

– Limited experience with these types of contracts

Analysis:

– Cannot conclude it is probable it will not grant credits

– Must estimate credits to be granted

• Expected value method probably most appropriate

– Would still need to consider the constraint rules

– Would need to re-evaluate this estimate each reporting

period

Significant financing components

• The transaction price will be adjusted for the time value of

money if the timing of payments provide either party with a

significant benefit.

• Two factors in considering significance (at contract level)

1) Difference between the amount of promised consideration and the

cash selling price

2) Combined effect of:

A. Expected length of time between transfer of goods or

services and when the customer pays

B. Prevailing interest rates in the relevant market

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Scenario 5:

An arrangement where the customer pays the entity a fixed

amount up-front and the customer draws down against that

prepaid amount (e.g. issues purchase orders to acquire

various software licenses and related services) at its discretion

over the term of the arrangement.

Scenario 6:

A software license transferred to the customer at contract

inception that the customer will embed in its products and the

consideration for the software license is a sales-based royalty.

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Scenario 7:

SaaS Company signs a three-year, non-cancellable

agreement with Customer to provide SaaS. Customer may

elect to either pay:

a. $200 per month (total payment is $6,000); or

b. $5,000 at the beginning of the contract term, with no

additional monthly payments.

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Allocating the transaction price

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• Quick recap before we dive into Step 4 – allocate the

transaction price to the performance obligations

• Objective of the allocation process:

To allocate the transaction price to each performance

obligation in an amount that depicts the amount of

consideration to which the entity expects to be entitled in

exchange for transferring the promised goods or services to

the customer

• Step 4 topics to be covered:

– Standalone selling price. What is it? How is it estimated?

– How is variable consideration handled in Step 4?

– How are changes in the transaction price handled in Step 4?


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• What is standalone selling price?

– the price at which an entity would sell a promised good or

service separately to a customer

– Best estimate is the price you actually sell it at when it is sold

separately (observable price)

– When there is no directly observable price, need to estimate

• How do you estimate standalone selling price?

– Three methodologies are outlined

– You may consider these but you are not limited to these


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• How do you estimate standalone selling price?

– Adjusted market assessment

– Expected cost plus a margin

– Residual approach

– May need to consider more than one approach


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• Scenario 8 – Allocating the transaction price

Facts:

– Sample Co. sells one year SaaS and implementation

services

– SaaS and implementation services are only performance

obligations

Performance Contract

Obligation Price

One-year SaaS 225,000$

Implementation services 30,000

255,000$


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Facts:

– Sample Co. has established sufficient history to establish a

narrow range of observable prices for both SaaS and

implementation services

– Sample Co. has elected a policy of using the mid-point of

the narrow range of observable standalone selling prices

when the contract price falls outside the range

Performance Range of Standalone

Obligation Selling Prices

One-year SaaS $230,000 - $255,000

Implementation services $22,500 - $25,000


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Analysis:

– Contract prices for both performance obligations fall

outside the narrow range of observable standalone selling

prices

– Allocation of transaction price would be as follows:

Performance Contract Standalone Selling Price Price

Obligation Price Selling Price Ratio Allocation

One-year SaaS 225,000$ 242,500$ 91% 232,254$

Implementation services 30,000 23,750 9% 22,746

255,000$ 266,250$ 100% 255,000$


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Lessons:

– If you can establish a narrow range of observable prices,

you can use contract price

– How to handle contract prices outside the narrow range is

a policy election that should be applied consistently


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• Allocating variable consideration

– Variable consideration may be attributable to the entire

contract or only to specified parts of the contract

• Could be attributable to one or more performance obligations

• Could be attributable to one or more distinct good or service in a series

of distinct goods or services that form a single performance obligation

– In order to allocate variable consideration to a specific

performance obligation, must meet specific criteria

• Variable payment relates directly to the efforts to satisfy the

performance obligation

• Meet the overall objective of the allocation process (see slide 23)


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• Changes in the transaction price

– When would this occur?

– Changes in the transaction price are allocated to the

performance obligations on the same basis as was done at

contract inception

• You do not undertake a reallocation process

– If you allocate some to a satisfied performance obligation

then that amount is recognized immediately

– Contract modifications and related changes in transaction

price are treated a little differently

Questions?

Scott Goodwin, CPA

Member of the Firm and Technology Services Team Leader


• Phone: (617) 428-5407

Cecilia Frerotte, CPAAudit Principal and Software Sector Leader


• Phone: (617) 261-8186

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Upcoming webinars

This is the second in a 4-part series on ASC 606

Join us on Tuesday, June 5th at 10am for Part 3:

Costs to Acquire and Costs to Fulfill



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