Understanding Variable Consideration. May 22, 2018 MEMBER OF ALLINIAL GLOBAL, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS

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1 Understanding Variable Consideration May 22, 2018 MEMBER OF ALLINIAL GLOBAL, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS 2018 Wolf & Company, P.C.

2 Before we get started Today s presentation slides can be downloaded at 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. 2

3 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. 3

4 Introduction Scott Goodwin, CPA Member of the Firm and Technology Services Team Leader Phone: (617) Cecilia Frerotte, CPA Audit Principal and Software Sector Leader Phone: (617)

5 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 5

6 The Five Step Model 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 6

7 Variable Consideration 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. Price concessions Volume discounts Rebates Incentives Refunds Performance bonuses Penalties Contingencies Sales & Usage* 7

8 Variable Consideration 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 8

9 Variable Consideration 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. 9

10 Estimating Variable Consideration 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 10

11 Estimating Variable Consideration 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 11

12 Estimating Variable Consideration 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 12

13 Estimating Variable Consideration 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 13

14 Estimating Variable Consideration 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 14

15 Estimating Variable Consideration 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 15

16 Estimating Variable Consideration Scenario 3 Estimating variable consideration 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, % $ 465,000 Consideration of the constraint guidance Note transaction price in this case ($465,000) is not one of the possible outcomes! 16

17 Estimating Variable Consideration 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) 17

18 Estimating Variable Consideration 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 18

19 Estimating Variable Consideration 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 19

20 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 20

21 Significant financing components 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. 21

22 Significant financing components 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. 22

23 Allocating the transaction price 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? 23

24 Allocating the transaction price 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 24

25 Allocating the transaction price 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 25

26 Allocating the transaction price 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 Obligation Contract Price One-year SaaS $ 225,000 Implementation services 30,000 $ 255,000 26

27 Allocating the transaction price Scenario 8 Allocating the transaction price 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 Obligation Range of Standalone Selling Prices One-year SaaS $230,000 - $255,000 Implementation services $22,500 - $25,000 27

28 Allocating the transaction price Scenario 8 Allocating the transaction price 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, % $ 255,000 28

29 Allocating the transaction price Scenario 8 Allocating the transaction price 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 29

30 Allocating the transaction price 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) 30

31 Allocating the transaction price 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 31

32 Questions? Scott Goodwin, CPA Member of the Firm and Technology Services Team Leader Phone: (617) Cecilia Frerotte, CPA Audit Principal and Software Sector Leader Phone: (617) Upcoming webinars This is the second in a 4-part series on ASC 606 Join us on Tuesday, June 5 th at 10am for Part 3: Costs to Acquire and Costs to Fulfill 32