Although it’s been several years since entities have adopted ASC 606, Revenue from Contracts with Customers, challenges continue to arise in the application of the standard. We’ve explored some of the common challenges and themes that companies face as they apply the five-step model to their new and existing revenue arrangements.

Challenge #1 – Assessing Whether a Promise is Distinct and Separately Identifiable

Revenue recognition may only occur upon the completion of promises which meet the definition of a “performance obligation”, which replaces the notion of a deliverable or element of a contract under legacy guidance. Specifically, entities must first assess which promises meet the definition of a performance obligation by considering if such promises are “capable of being distinct” and “distinct within the context of the contract”.

The task of properly identifying performance obligations can be particularly challenging when contracts involve bundled offerings or long-term agreements with multiple deliverables. As such, it is important to understand what a company promises to a customer and what a customer expects to receive as a final product and/or service, as well as how the entity markets the goods and/or services. Companies need to collaborate with their legal and sales teams to ensure they have a complete understanding of the goods and/or services being promised in order to properly identify performance obligations, which is essential in order to properly allocate revenue to different performance obligations.

Challenge #2 – Calculating the Standalone Selling Price When a Wide Range of Selling Prices Exist

Once the performance obligation(s) and transaction price(s) are identified, companies need to allocate the total transaction price to each distinct performance obligation. The allocation must be completed based on each standalone selling price (“SSP”), which represents the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers when that information is available. If not available, a company is required to estimate the price using other techniques that maximize the use of observable inputs (even if the company never sells the promised good or service separately, which is common as many performance obligations are never sold on a standalone basis).

In selecting the appropriate methodology and inputs to estimate the SSP, entities should consider all available data points such as historical costs to produce or manufacture goods and services, pricing lists, profit margins earned, contractually stated prices, and third-party pricing. Entities should additionally assess the impact of market conditions such as competition, product trends and overall demand for comparable products. Finally, entities should ensure entity-specific factors are accounted for such as the demographics of targeted customers and the pricing strategy and objectives of executive-level personnel.

Challenge #3 – Assessing Material Rights

ASC 606 introduced the concept of “material rights”, which requires significant judgment on the part of management. A material right is a customer option to purchase additional goods or services at a discount that is incremental to the range of discounts given for those goods and services to that class of customer in a specific market. If such a right exists in the contract, then it should be accounted for as a separate performance obligation.

Judgment is required in determining whether options contain a material right. An entity should assess qualitative factors, such as whether the rights accumulate, and quantitative factors, such as the value of the benefit. Additionally, an entity should consider the class of customer, the geographic region of the customer, and the market in which the goods and services are sold to customers. Entities may also find that understanding the customers’ perspective on the incentive and discounts may provide clarity over whether a material right exists.

Challenge #4 – Estimating and Constraining Variable Consideration   

An issue often present in the life sciences industry is the concept of variable consideration, including the potential reduction in the amount of transaction price to which a company will be entitled in exchange for goods or services to a customer. Potential reductions to transaction price may include concessions, discounts, rebates, refunds, credits, incentives, bonuses, and royalties. ASC 606 requires entities to estimate variable consideration in its determination of transaction price to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Thus, the determination of the amount of variable consideration requires significant judgment as entities must consider qualitative factors (the likelihood of a change in estimate) as well as quantitative factors (the magnitude of the potential reversal). If the reversal of revenue is probable and expected to be significant, the variable consideration must be “constrained” (reduces total transaction price).

Entities have observed challenges in applying and assessing the factors to consider under ASC 606 and often utilize an “all or nothing” mentality when calculating the constraint. For example, if faced with minimal historical data with similar contracts, entities may default to a 100% constraint of variable consideration without considering alternative factors such as market comparables and/or a range of potential outcomes. Entities should ensure all factors are considered when determining the amount of variable consideration to recognize. An extended period until the uncertainty is resolved is exceptionally challenging for entities as numerous variable factors over the time period may impact the future outcome. To address these challenges, entities should implement a process to perform an ongoing assessment as uncertainty is resolved on a contract-by-contract basis.

Challenge #5 – Operational and Procedural Challenges When Dealing with Revenue Data

With the application of ASC 606 to new and existing revenue contracts, entities have quickly observed that proper controls and maintenance of revenue data is essential. Primarily, the availability of accurate and complete data is key in developing and updating estimates such as the standalone selling price of identified performance obligations and the amount, if any, of variable consideration to be estimated at a contract’s inception challenges many entities. For example, a company utilizing the expected value method will require accurate historical data to estimate the probability of various outcomes and/or the output associated with each outcome.

Beyond the availability of data, efficient storage and maintenance of such information is also necessary to allow for timely and accurate reporting of revenue recognition. Entities utilizing manual spreadsheets may find increased effort and greater potential for human error when calculating period-end accruals and preparing disaggregated revenue disclosures. Entities utilizing systems should consider IT limitations and ensure information controls exist for correct reporting and calculations. Upon the initial revenue of contracts under the revenue standard, entities should thus always contemplate the availability of pertinent data, as well as the process for ongoing management and storage of information necessary to account for contracts under ASC 606.

Count On WM to See You Through

Ensuring revenue is recognized in accordance with ASC 606 is not a simple exercise. Significant judgements and estimates must be considered in addition to the ongoing compliance with required financial statement disclosures. On an ongoing basis, companies must evaluate these judgments and estimates. Questions continue to arise as companies enter into new or modified revenue arrangements. WilliamsMarston regularly engages with companies, auditors, and regulators as it relates to the application of the five-step revenue model within ASC 606 and has a proven track record of successfully navigating through these issues.