Give It Your Best Estimate

In this blog on the revenue recognition standard I want to cover how you determine the allocation of revenue across performance obligations. As I mentioned in previous blogs performance obligation is the new term for deliverable and it includes items that previously were not considered standalone deliverables. Once you determine your performance obligations and total compensation due from the customer (known as Total Transaction Price or TTP), you have to allocate that TTP over the performance obligations.

As a reminder, today we allocate the total compensation over the deliverables using a relative standalone selling prices for each deliverable. If you are getting paid $80 for two deliverables each with a standalone selling price of $50 then you allocate $40 of revenue to each deliverable ($50/($50+$50)*$80). The allocation process under the new standard is the same but the difference comes in how you determine standalone selling price (SSP). Today we have a strict hierarchy we must follow:

  1. If Vendor Specific Objective Evidence (VSOE) – or what you sell the product for on a standalone basis – is available we must use that to determine the standalone selling price
  2. If VSOE is not available then we look at Third Party Evidence (TPE) – or what someone else sells the product for on a standalone basis
  3. If VSOE or TPE does not exist then we use our best estimate of the selling price

The new revenue standard does not include the above strict hierarchy for determining standalone selling price. It does say the best evidence is an observable price when the entity sells the good or service separately, but then it goes on to add “in similar circumstance and to similar customers.” If I have been selling a product in California and launch a new operation in Texas I can probably reasonable argue that the sales price in California is not in a similar circumstance to a similar customer so I do not need to use it to determine the standalone selling price in Texas. The same might also be said for selling a single cellphone to a customer versus a multiple line plan because it can be argued a multi-line customer is not “similar” to a single-line customer.

The new standard goes on to say that if a standalone selling price is not directly observable you need to estimate the SSP by “considering:”

  • Market conditions (I take this to mean TPE)
  • Entity-specific factors (I don’t think this is VSOE, but your guess is as good as mine)
  • Information about the customer

It goes on list ways to estimate a standalone selling price including bringing back the residual approach as a last resort which was eliminated from GAAP a few years back.

When a deliverable today equals a performance obligation tomorrow, I think many companies will initially default to the standalone selling price they already use today. As new products and services are developed and new performance obligations are added that don’t exist as deliverables today, I predict you will see a decline in the use of VSOE.


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