Determining the Transaction Price - Step 3

Transaction Price
Amount of consideration that company expects to receive from a customer.

(Amount of money that is expected to receive from the customer.

The amount is often easily determined in a contract as the customer agrees to pay a fixed amount.
Accounting for the amount to be received will be very easy.

However, there are a number of cases where the amount has to be estimated and the exact
amount is not necessary to be calculated. In this case, the estimation would only be done if there
is enough information to determine the price.

The factors involved in estimating the price include:

Issues involved:

1. Variable consideration

2. Time value of money

3. Noncash consideration

4. Consideration paid or payable to the customer

Variable consideration

1. Price is dependent on future events.

- It might include discounts, rebates, credits, performance bonuses or royalties.

The exact amount of revenue is not known but an estimation can be done instead.

To estimate the revenue to recognize:

a) Expected value - (when to use and how to use it?)

b) Most likely amount - (when to use and how to use it?)

A) Expected Value
Probability-weighted amount in a range of possible consideration amounts.

Probability weighted calculation

When is this appropriate?

1. if the company has a large number of contracts with similar characteristics (they have lot of
experience with large numbers of contracts which makes it easier to determine the expected
value)
2. can be based on a limited number of discrete outcomes and probabilities. (There is a limited
amount of probabilities or the probability is closely fixed)
B) Most Likely Amount
The single most likely amount in a range of possible consideration outcomes.

For example: 60%, 30%, 5%, 5%

Amongst all the percentage, 60% has the highest probability of occurring.

When is this appropriate?

If the contract has only two possible outcomes.
Example: 60% or 40% (60% has the most probable outcome)

Example:
Facts: Peabody Construction Company enters into a contract with a customer to build a
warehouse for $100,000, with a performance bonus of $50,000 that will be paid based on the
timing of completion. The amount of the performance bonus decreases by 10% per week for
every week beyond the agreed-upon completion date. The contract requirements are similar to
contracts that Peabody has performed previously, and management believes that such
experience is predictive for this contract. Management estimates that there is a 60%
probability that the contract will be completed by the agreed-upon completion date, a 30%
probability that it will be completed 1 week late, and only a 10% probability that it will be
completed 2 weeks late.

The company can receive 150000 as revenue from the customer. However, there is a chance that
their 50000 performance bonus can decrease by 10% per week after the completion date. In
other words, their revenue can decrease if they are late.

They also have performed with the similar requirements from previous contracts which indicates
that the company has experience and they can estimate an expected value.

Expected Value (Probability-weighted method)

Agreed completion date: 60% completed

1 week late: remaining 30% will be completed

2 weeks late: last 10% will finally be completed

Completion date: 150 000 x 60% = 90000 (will be received

1 week late: 100000 + (50000 x .90) <- as they will lose 10%. = 145 000

145 000 x 30% = 43 000

2 weeks late: 100000 + (50000 x .80) <- they will lose 20% at this point = 1400000

140 000 x 10% = 14 000

90 000 + 43 500 + 14 000 = 147 500 (Expected value to be received)

This was concluded by using the Probability-weighted method as the most predictive approach.

Most likely outcome

If the company believes they will meet the deadline and receive the 50000 bonus, the transaction
price will be: 150000

150000 has the highest probability of 60% while assuming there are two probabilities and the
other is lower than 60%. Example: 40% will be incomplete but 60% probability will be completed.

A company can only use variable consideration if they are assured that they will receive the
estimated amount. In other words, they can only use this method if they have enough experience
with similar contracts to create a close estimation the expected value or the most likely amount
they can receive.

If they do not have experience, this type of revenue recognition will be constrained.

Time Value of Money

Timing of the payment to the company sometimes does not match the timing of the transfer of
goods or services to the customer. In most cases payment is made after the product is provided
or service is performed.

When contract (sales transaction) involves a significant financing component.

When we sell something and we’re financing it, the transaction will involve a revenue and
financing component and we’ll have to differentiate them.

The cash received will have two components

Cash:

1. Revenue from sales (revenue)

2. Interest revenue (financing component)

• Interest accrued on consideration to be paid over time

• Fair value determined either by measuring the consideration received or by discounting the
payment using an imputed interest rate.

• Company reports as interest expense or interest revenue. (financing component?)

Example:
Facts: On July 1, 2015, SEK Company sold goods to Silva Company for R$900,000 in exchange
for a 4-year, zero-interest-bearing note with a face amount of R$1,416,163. The goods have a
cost on SEK’s books of R$590,000.

Questions: (a) How much revenue should SEK Company record on July 1, 2015? (b) How much
revenue should it report related to this transaction on December 31, 2015?

the difference between 900000 and 1416163 will show the interest component of the sale, as it is
a “zero-interest bearing note”

Although the actual sale is 900000, Silva company must pay 1,416,163 after 4 years.

Entry of sale: (revenue component)

Notes Receivable 900000

Sales 900000

Cost of Goods 590000

Inventory 590000

By December 31 an adjusting entry must be made to recognize a portion of the interest revenue.

SEK company will earn interest of 12%

to find it in excel:

Rate = (Nper, PMT, PV, FV,)

Rate = (4,,-900000, 1416163) => result: 12%

Adjusting Entry: (financing component)

December 31, 2015

Interest revenue: 900,000 x 12% x 1/2 = 54,000

Notes Receivable 54000

Interest Revenue 54000

Companies are not required to reflect the time value of money if the time period for payment is
less than a year, instead it will be recorded at face value.

NON CASH CONSIDERATION

It will be recorded at Fair Market Value.

These are goods, services or other non cash consideration.

1. Companies may receive contributions (gifts and donations

2. Customers may contribute goods or services such as equipment or labor for the goods or
services performed by the company.

The company will recognize these contributions on the basis of the fair value when it was
received.

CONSIDERATION PAID OR PAYABLE TO CUSTOMERS

1. may include discounts, volume rebates, coupons, free products or services.

2. These elements reduce the consideration received and the revenue to be recognized. (offering
discounts or coupons will reduce the revenue received.

Example:
Volume Discount