Arrangements could include three or more performance obligations with more than one of the obligations having a standalone selling price that is highly variable or uncertain. A residual approach can be used in this situation to allocate a portion of the transaction price to those performance obligations with prices that are highly variable or uncertain, as a group. Management will then need to use another method to estimate the individual standalone selling prices of those obligations. The revenue standard does not provide specific guidance about the technique or method that should be used to make this estimate.
Excerpt from ASC 606-10-32-35
A combination of methods may need to be used to estimate the standalone selling prices of the goods or services promised in the contract if two or more of those goods or services have highly variable or uncertain standalone selling prices. For example, an entity may use a residual approach to estimate the aggregate standalone selling price for those promised goods or services with highly variable or uncertain standalone selling prices and then use another method to estimate the standalone selling prices of the individual goods or services relative to that estimated aggregate standalone selling price determined by the residual approach.
When a residual approach is used, management still needs to compare the results obtained to all reasonably available observable evidence to ensure the method meets the objective of allocating the transaction price based on standalone selling prices. Allocating little or no consideration to a performance obligation suggests the method used might not be appropriate, because a good or service that is distinct is presumed to have value to the purchaser.
Example RR 5-4 and Example RR 5-5 illustrate the use of the residual approach to estimate standalone selling price.
EXAMPLE RR 5-4
Estimating standalone selling price – residual approach
Seller enters into a contract with a customer to sell Products A, B, and C for a total transaction price of $100,000. On a standalone basis, Seller regularly sells Product A for $25,000 and Product B for $45,000. Product C is a new product that has not been sold previously, has no established price, and is not sold by competitors in the market. Products A and B are not regularly sold together at a discounted price. Product C is delivered on March 1, and Products A and B are delivered on April 1.
How should Seller determine the standalone selling price of Product C?
Seller can use the residual approach to estimate the standalone selling price of Product C because Seller has not previously sold or established a price for Product C. Prior to using the residual approach, Seller should assess whether any other observable data exists to estimate the standalone selling price. For example, although Product C is a new product, Seller may be able to estimate a standalone selling price through other methods, such as using expected cost plus a margin.
Seller has observable evidence that Products A and B sell for $25,000 and $45,000, respectively, for a total of $70,000. The residual approach would result in an estimated standalone selling price of $30,000 for Product C ($100,000 total transaction price less $70,000).
EXAMPLE RR 5-5
Estimating standalone selling price – residual approach is not appropriate
SoftwareCo enters into a contract with a customer to license software and provide post-contract customer support (PCS) for a total transaction price of $1.1 million. SoftwareCo regularly sells PCS for $1 million on a standalone basis. SoftwareCo also regularly licenses software on a standalone basis for a price that is highly variable, ranging from $500,000 to $5 million.
Can SoftwareCo use the residual approach to determine the standalone selling price of the software license?
No. Because the seller has observable evidence that PCS sells for $1 million, the residual approach results in a nominal allocation of selling price to the software license. As the software is typically sold separately for $500,000 to $5 million, this is not an estimate that faithfully represents the price of the software license if it was sold separately. As such, the allocation objective of the standard is not met and SoftwareCo should use another method to estimate the standalone selling price of the license.