The third step of the revenue recognition method is to determine the transaction price. The transaction price represents the amount of consideration the company expects to be entitled to in exchange for the goods and services it provides to a customer. Fixed consideration should always be included in the transaction price. Variable consideration, on the other hand, should only be included to the extent that the company expects to be entitled to the consideration. This article will define variable consideration, give examples of the two methods to estimate it, and describe how to determine if there is any constraint.
Variable consideration can come in many forms, such as discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, rights of return, and prompt payment discounts. Sales- and usage-based royalties have unique guidance separate from the guidance discussed here. Variable amounts of consideration may be explicitly stated in the contract, but implicit variability also qualifies as variable consideration. For example, if price concessions are typical in a particular industry under similar circumstances, the consideration should be considered variable.
Methods for Estimating Variable Consideration
ASC 606 allows two methods for estimating variable consideration: (1) expected value and (2) most likely amount. A company should choose the method that will provide the best estimate of the amount to which it will be entitled.
The expected value approach is carried out by finding a range of possible consideration amounts, weighting those amounts by their respective probabilities, and then summing the probability-weighted amounts to generate a single number that represents the expected value of consideration to be received from the customer.
The expected value approach works particularly well with the portfolio method of aggregating customer contracts. Even if the company is not using the portfolio method practical expedient, but still has many similar contracts, this approach may be appropriate. If management makes reasonable estimates and applies them to a large number of similar contracts, the aggregate amount of revenue should reflect the sum of all the expected amounts from the individual contracts. The expected value approach also works well in situations where a spectrum of amounts is possible, as shown in Example A above.
Most Likely Amount
When using the most likely amount, the transaction price for the contract is the amount that is most likely to be received. This method works well in situations with only two possible outcomes. If only two real possibilities exist, using an expected value approach would likely result in a transaction price that is significantly different than either of the two possible outcomes. In such cases, the most likely method may be more appropriate because it produces a better estimate of the consideration the company expects to receive. However, this method may be hard to apply when one outcome is not significantly more likely than the other.
Recent comment letters from the Securities and Exchange Commission (SEC) have asked companies to explain their application of the most likely amount method much more often than the expected value method. Here are a few examples:
The Constraint on Variable Consideration
After applying one of the two methods to estimate the variable consideration, entities must overcome one more hurdle. The consideration can only be included in the transaction price “to the extent that it is probable that a significant reversal … will not occur” (606-10-32-11). Probable is defined as “likely to occur” which is a higher standard than “more likely than not.” Making this determination involves significant judgment and must include assessment of both the likelihood and the magnitude of the potential revenue reversal. The process does not have to be separate from the estimation of variable consideration, but all principles of the constraint must be considered.
A significant reversal of revenue could occur when the variable consideration is allocated to a performance obligation that is completely or partially fulfilled by the time the uncertainty is expected to be resolved. If the consideration will be paid or determined before any variable consideration is recognized as revenue, no constraint is needed.
Factors that Increase the Probability of Reversal
Analysis of the constraint is intended to be largely qualitative. ASC 606-10-32-12 lists factors that potentially increase either the probability or magnitude of a revenue reversal (emphasis added):
- The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
- The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
- The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
- The contract has a large number and broad range of possible consideration amounts.
These factors are neither all-inclusive nor determinative. The existence of one, or even multiple, of the above factors does not necessarily create an expectation that a significant amount of revenue will eventually reverse. Additionally, factors beyond those listed, such as the legal and regulatory environment, could impact the likelihood and magnitude of potential reversals.
In their responses to SEC comment letters, companies often use the inverse of these factors as evidence that variable consideration is not constrained. For example, if limited experience with a type of contract makes it more likely that variable consideration should be constrained, then extensive experience may help a company understand whether an amount is likely to reverse and, therefore, whether that amount should be constrained.
Likelihood vs. Magnitude
The standard does not explicitly specify the relative priority entities should give the likelihood and magnitude criteria. Some might interpret the standard to mean that an amount that does not create a significant reversal could meet a lower likelihood threshold than one that was significant. However, the core principle of the standard is to “recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services” (ASC 606-10-05-3). If the company does not expect to be entitled to an amount—of any magnitude—this amount should be excluded from the transaction price before the constraint is even considered (FASB, Question 30). The magnitude criterion plays a bigger role as the size of a potential reversal increases relative to the contract. As the magnitude of the consideration increases, management must have more substantive support for its assertion that a potential reversal is not probable.
More substantive support may also be necessary if a company determines that variable consideration in a contract falls near the range considered to be probable. The standard does not provide percentage thresholds to determine what is considered probable or significant; the following is merely an example. If a contract includes variable consideration that is not significant to the rest of the contract, and that variable consideration is between 70 and 75 percent likely not to reverse, a company might conclude that a year of experience with similar contracts is adequate to support the conclusion that such an amount need not be constrained. On the other hand, if that variable consideration accounted for 25 percent of the total contract consideration, the company would likely need more extensive experience with similar contracts to support the inclusion of that amount.
Additional Issues Related to Variable Consideration
Several additional issues are relevant to the variable consideration discussion. Here are a few of those issues:
Should the constraint on variable consideration be applied at the contract level or performance obligation level?
Contract level. In its 2020 Q&A, the Financial Accounting Standards Board (FASB) addressed whether the magnitude of a potential reversal should be assessed at the level of the performance obligation or at the level of the contract. While the standard does not specifically address this issue, the Basis for Conclusions paragraph 234 clearly states that the unit of account for determining the transaction price in a contract is the contract (ASU 2014-09). As the constraint is primarily a transaction price issue, the FASB agreed that the contract should be seen as the unit of account for the constraint as well (FASB, Question 30). In other words, when considering the magnitude of a potential reversal of variable consideration, the assessment should be based on the total consideration of the whole contract, not just on amounts specific to the variable consideration or to the specific performance obligation.
Can the most likely amount and expected value approaches be used in the same contract?
While the two approaches should not be applied simultaneously to the same source of variable consideration within a contract (or aggregate group of similar contracts), they may be applied separately to different sources of variable consideration within the same contract (BC202). For example, if a contract includes both a bonus for early completion of a project (which scales with the number of days ahead of schedule) and a quality bonus if a project exceeds certain specifications, a company may use the expected value approach for the early completion bonus and the most likely approach for the quality bonus.
Is consideration variable if the price per unit is fixed but the units are variable?
In its 2020 Q&A, the FASB addresses the issue of whether variable consideration is present if a contract includes an undefined quantity of outputs, but the price is fixed (FASB, Question 41). For example, assume a transaction processor charges $0.001 per processed transaction but does not have a fixed quantity of transactions that must be processed. The staff cited the following statement from ASC 606-10-32-6: “The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event.” With this in mind, the staff concluded that the transaction price would be variable if the nature of the promise is to perform an unknown quantity of tasks throughout the contract period and the consideration is contingent on the quantity completed.
How did the FASB decide on the constraint?
In the Basis for Conclusions of Accounting Standards Update (ASU) 2014-09, the FASB indicates that the constraint was strongly influenced by the large number of respondents to Exposure Drafts who indicated that the most useful revenue figure would be one that would not reverse in a future period. The FASB noted that the constraint introduces a definite downward bias into revenue numbers. However, it felt this treatment was appropriate in trying to avoid significant reversals of revenue, making the revenue numbers more useful (BC206-BC207). However, while the FASB and respondents did not wish to include revenue likely to reverse, not including variable consideration in transactions prices could seriously understate revenues, which would still lead to reporting less relevant and useful data. This interplay led to the constraint.
Specifying a level of confidence (i.e., use of the language “probable” [US Generally Accepted Accounting Principles (GAAP)] and “highly probable” [International Financial Reporting Standards (IFRS)]) also received significant attention from the FASB. While the staff initially considered not specifying a level of confidence at all, preparers and auditors indicated that constraining estimates would be very difficult and would result in a great deal of diversity in practice if no guidance were given on the necessary level of confidence. Thus, the criterion of meeting a level of confidence is intended to facilitate preparation and reduce diversity in practice. The specific level of confidence to be used was also discussed, and the FASB decided to use wording already present and defined in other standards for clarity.
Estimating variable consideration requires significant judgment by preparers and auditors. ASC 606 requires companies to include variable consideration in the transaction price of each contract only to the extent that it is not probable that a significant reversal of revenue will occur for that amount. Companies are required to determine both the likelihood and the magnitude of potential reversals to correctly determine what amounts should be constrained. The constraint requires the most judgment when variable amounts are near the “probable” threshold.
- ASC 606-10-32-2 to 32-13
- ASU 2014-09: “Revenue from Contracts with Customers.” BC206-BC207, BC218, 234.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” January 2020. Section 5.2.
- FASB, “Revenue Recognition Implementation Q&As.” January 2020. Question 30, Question 41.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” December 2019. Section 5.3.
- PWC, “Revenue from contracts with customers.” August 2019. Section 4.3.