Volume Discounts in ASC 606

Example 1: Volume Discounts For Hierarchical Pricing

Background. Widget Co. sells widgets to a variety of customers, including individual consumers, big-box stores, and boutique knick-knack shops. Widget Co. uses hierarchical pricing, in which the first 500 widgets purchased in a calendar year cost $10 each, the next 500 widgets cost $8 each, and any additional widgets beyond the first 1,000 cost $7.50 each. All customers pay in cash.

One of Widget Co.’s customers, Big Bad Big-Box (or BBBB), purchases large quantities of widgets to get the best prices. Over the past 3 years, they have purchased between 4,000 and 6,000 widgets per year. Based on economic factors and experience with similar customers, Widget Co. estimates that for the current year there is a 20 percent likelihood that BBBB purchases 4000 widgets, a 50 percent likelihood for 5000 widgets, and a 30 percent likelihood for 6000 widgets.

Issue 1A: Using Estimated Purchases to Account for the First Widgets Sold

In January, BBBB purchases 500 widgets for $5,000 and Widget delivers the product. How should Widget Co. account for this transaction?

Analysis of 1A. To calculate the rate at which Widget Co. should recognize revenue from sales to BBBB, Widget Co. must estimate the transaction price. An expected value approach is appropriate, because Widget Co. has many similar contracts. The average sales price is calculated as follows:

Probability*(total price)/number of widgets=Probability-weighted amount

4000 Widgets: 20%*((500*$10)+(500*$8)+(3,000*7.50))/4,000=$1.58

5000 Widgets: 50%*((500*$10)+(500*$8)+(4,000*7.50))/5,000=$3.90

6000 Widgets: 30%*((500*$10)+(500*$8)+(5,000*7.50))/6,000=$2.32

$7.80/widget

Effectively, by calculating the transaction price, management is acknowledging that a portion of revenue for the first 1,000 units is constrained, because the price paid exceeds the overall transaction price. Management should also consider whether any additional portion of revenue is constrained. Because the incremental purchase price for units after the first thousand is $7.50/unit, management determines that a significant reversal is improbable, and no additional constraint is needed. Widget Co. should recognize revenue at the full rate of $7.80 per widget, with an entry for the excess received to a contract liability. The January entry for 500 widgets at $10/unit is as follows:

Issue 1B: Accouting for Later Purchases when Estimated Purchases Holds

Suppose Widget Co.’s estimate is correct and BBBB purchases a total of 4,500 widgets from January through November, with an additional 500 units to be delivered in December (or 5,000 total widgets). What approach should Widget take to account for the delivery of widgets in December?

Analysis of 1B. Because Widget Co.’s estimate of sales volume was correct, no adjustment to the transaction price is necessary, and over the course of the year the entire contract liability will be eliminated. In December, Widget will recognize revenue at the same rate of $7.80 per widget, receive cash of $7.50 per widget (the price for any sales above 1,000 widgets), and relieve the contract liability for the $.30/unit (or $150 total) as follows:

Issue 1C: Accounting for Later Purchases when Estimated Purchases Changes

Suppose in May, one of Widget Co.’s main competitors introduces a new high-end widget, disrupting the Widget Co.’s primary market. Through the first quarter BBBB has purchased 1,500 widgets, and Widget Co. now predicts a 10 percent chance that BBBB will purchase a total of 2,000 widgets during the year, a 75 percent chance it will purchase 3,000 widgets, and a 15 percent chance they will purchase 4,000 widgets. For the quarter ended June 30, Widget Co. sold 500 widgets (of the 1500 sold so far) to BBBB. How much revenue should Widget Co. recognize for the second quarter?

Analysis of 1C. For the first 2,000 widgets, Widget Co. received cash of $16,500 and recognized $15,600 of revenue, with a contract liability for the difference of $900. This change of facts requires Widget to recalculate the per-unit price and allocate the change to performance obligations that have been fulfilled. The new transaction price is calculated as follows:

2,000 Widgets=10%*((500*$10)+(500*$8)+(1,000*7.50)/2000=$.82

3,000 Widgets=75%*((500*$10)+(500*$8)+(2,000*7.50))/3,000=$6.00

4,000 Widgets=15%*((500*$10)+(500*$8)+(3,000*7.50)/4,000=$1.18

$8/Widget

$4,000 of revenue is recognized from the sale of 500 widgets (500 Units*$8/Unit). In addition, $300 is recognized for the widgets sold in the first quarter due to the increase in estimated transaction price from $7.80 to $8 (1,500 units* $.20 price increase). Consequently, the entity recognizes revenue of $4,300 for the quarter. The contract liability is relieved for the difference between the price received and the transaction price. Because the incremental price is $7.50, and the transaction price is $8, the 500 incremental purchases cause the contract liability to be relieved $250 ($.50*500). The transaction price also increased by $.20 per unit for the first 1500 widgets, decreasing the contract liability by $300, causing a total decrease in the contract liability of $550. The change in contract liability will also be the difference between cash received and revenue recognized.

Example 2: Not A Volume Discount – Fixed Price For Separate High-Volume Purchases

Background. Gizmo Biz, Inc. allows customers to order gizmos in quantities of 500, 1,000, or 5,000 units. Each customer order is independent of any prior order from that customer. Gizmo provides a discount based on the volume ordered, with orders of 500, 1,000, and 5,000 priced at $15, $14, and $12 per gizmo, respectively. BBBB regularly purchases 22,000 gizmos in a year from Gizmo Biz (typically 4 orders of 5,000 and 2 orders of 1,000).

Issue 2A. What transaction price should Gizmo Biz use to recognize revenue for BBBB’s purchases?

Analysis of 2A. There is no variable or contingent element in these contracts. Although there is a reduced selling price for high-volume purchases, the price is fixed. As such, this is not a “volume discount” in the sense used in this article. The 5-step approach should be used as with any other transaction, with a transaction price of $12/unit for any 5,000 unit order and $14/unit for the 1,000 unit orders.

Example 3: Volume Discount With Retrospective Refund And Constraint

Background. Lee’s T-Rex shop sells full-size plaster T-Rex molds to various museums and dinosaur collectors. To encourage sales, they provide volume discounts with retrospective refunds. To receive volume discounts, all sales must take place within a two-year period. The pricing schedule is provided below. Customers must pay a higher price for lower volume purchases until the next threshold is met. When a customer reaches the next level of sales they will receive a refund for all cumulative purchases equal to the difference between what they initially paid and the new price threshold.

Despite this policy, most sales are still for one to five plaster molds. A prospective customer that owns many dinosaur museums, The American Institute of Tyrannosaurus Plaster Accumulators (or AITPA), has approached Lee’s T-Rex shop to make a very large purchase of plaster molds. Lee’s T-Rex shop rarely has transactions of this scale. The retrospective discount schedule for the shop is shown below, along with its estimates of the likely amount of AITPA purchases.

Issue 3A: Determining the Most Appropriate Method for Estimating Variable Consideration

Which approach to estimating variable consideration (expected value or most likely amount) is preferable? Which approach would be appropriate supposing that Lee’s T-Rex shop has many similar transactions?

Analysis of 3A. The proper approach depends on which method the entity believes will better predict the amount of consideration to which it will be entitled. ASC 606-10-32-8 states that the expected value approach is likely appropriate when there are many similar contracts, whereas the most-likely approach is preferable if there are only two possible outcomes. Although there are more than two possible outcomes, three outcomes still represents a relatively small number of discrete possible outcomes. Because there are few similar contracts, the most-likely approach is appropriate. However, if there were thousands of similar transactions then the expected value approach would be applied. Regardless of the method, the entity would also need to consider the constraint.

Issue 3B: Determining the Constraint

Is there a constraint on the recognition of revenue? Does this vary depending on which approach is used to estimate variable consideration?

Analysis of 3B. Revenue should be recognized to the extent it is probable (of a high likelihood) that a significant reversal will not occur. An entity should consider the likelihood and magnitude of a potential reversal. If Lee’s T-Rex shop decides to use the most-likely amount, then a transaction price of $6,000/unit would be used; however, there remains a 40 percent chance the contract will ultimately lead to a price of $5,000 per unit. This is only slightly less than the 45 percent likelihood of the $6,000/unit price, and would be of significant magnitude due to the relative size of the transaction. Additional factors that provide evidence that revenue recognition should be constrained include (1) the company has limited experience with similar contracts, (2) the uncertainty will not be resolved for a relatively long period of time (two years), and (3) the amount of consideration is susceptible to factors outside the influence of Lee’s T-Rex Shop. If the facts of the case warranted using the estimated value approach, then the estimated transaction price would be $5,638. Although the magnitude of a subsequent reversal would be smaller, the factors mentioned previously would still provide strong evidence that the transaction price should be constrained to the minimum purchase price. Regardless of the approach used, the amount of revenue that is not probable to be subject to a significant reversal (and therefore the constraint) should be the same. Consequently, revenue should be recognized at the minimum selling price of $5000 in either case.