1.6 Step 3: Determine the Transaction Price (Chapter 6 of the Roadmap)

Step 3 requires an entity to determine the transaction price for the contract, which is the amount of consideration to which the entity expects to be entitled in exchange for the promised goods or services in the contract. The transaction price can be a fixed amount or, as stated in ASC 606-10-32-6, can vary because of “discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items.” An entity must consider the following when determining the transaction price:

• Variable consideration (see Section 6.3) — When the transaction price includes a variable amount, an entity is generally required to estimate the variable consideration by using either an “expected value” (probability-weighted) approach or a “most likely amount” approach, whichever is more predictive of the amount to which the entity will be entitled (subject to the “constraint” discussed below). However, estimation may not be required in all circumstances. For example, variable consideration may not require estimation if it could be allocated entirely to a distinct good or service when certain criteria are met (see Section 1.7).
• Significant financing components (see Section 6.4) — Adjustments for the time value of money are required if the contract includes a “significant financing component” (as defined by the guidance).
• Noncash consideration (see Section 6.5) — To the extent that a contract includes noncash consideration, an entity is required to measure that consideration at fair value at contract inception.
• Consideration payable to a customer (see Section 6.6) — The revenue standard requires consideration payable to the customer to be reflected as an adjustment to the transaction price unless the consideration is payment for a distinct good or service (as defined by the standard).

Under ASC 606-10-32-11, some or all of an estimate of variable consideration is only included in the transaction price to the “extent that it is probable[5] that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved” (this concept is commonly referred to as the “constraint”). The guidance requires entities to perform a qualitative assessment that takes into account both the likelihood and the magnitude of a potential revenue reversal and provides factors that could indicate that an estimate of variable consideration is subject to significant reversal (e.g., susceptibility to factors outside the entity’s influence, a long period before uncertainty is resolved, limited experience with similar types of contracts, practices of providing concessions, or a broad range of possible consideration amounts). This estimate would be updated in each reporting period to reflect changes in facts and circumstances. In addition, the constraint does not apply to sales- or usage-based royalties derived from the licensing of intellectual property (IP); rather, consideration from such royalties is only recognized as revenue at the later of when the performance obligation is satisfied or when the uncertainty is resolved (e.g., when subsequent sales or usage occurs). See Section 12.7 for further discussion of the sales- or usage-based royalty exception for licenses of IP.

Entities will need to exercise significant judgment when determining the amount of variable consideration to include in the transaction price. Consequently, they could find it challenging to consistently apply the standard’s requirements throughout their organizations.