When an entity estimates variable consideration under step 3 of Accounting Standards Codification (ASC) 606, the entity is required to evaluate how much of that consideration should be included in the transaction price. ASC 606-10-32-11 requires that an entity only include variable amounts in the transaction price to the extent that it is probable that they will not cause a significant reversal of cumulative revenue. Subsequent paragraphs clarify that an entity must consider the likelihood and magnitude of potential future revenue reversals. This article specifically addresses the magnitude aspect of the constraint and the interaction between the likelihood and magnitude criteria.
When an entity estimates variable consideration, it must estimate the consideration it expects to be entitled to and the amount of consideration that is constrained. This may be done in a single process that incorporates both principles, or as two separate steps. If a two-step approach is used, an entity first estimates the variable consideration to which it expects to be entitled, and then assesses the constraint based on the probability and magnitude of a future revenue reversal. Imagine a transaction where an entity could be entitled to $70, $80, $90, or $100 for its performance. Further assume the entity determines that the following probabilities apply:
The standard allows two approaches when estimating variable consideration. The entity can either use the expected value ($86, from the table above), or the most likely amount, which is the amount with the highest individual probability (in this case, $90). It is unclear from the guidance how an entity would apply the most-likely approach to a situation where none of the outcomes is significantly more likely than the others (i.e. 45% compared to 40%). For more details about these approaches, see Allocating Variable Consideration. After estimating variable consideration, an entity must apply the constraint.
In order to include variable consideration in the transaction price, that consideration must meet the “probable” threshold. The standard defines “probable” as a higher standard than “more likely than not” (which is defined as greater than 50%). In the example above, the probability of recognizing at least $90 is only 60%, which may not be great enough to meet the probable threshold. However, the probability of recognizing at least $80 is 90%, which clearly meets the threshold. Additionally, the entity should consider the magnitude of potential reversals. At the $90 level, there is a 30% likelihood of a $20 reversal and a 10% likelihood of a $20 reversal. The entity will consider various factors (discussed later in this article) to consider whether reversals of these magnitudes would be considered significant. Because both the probability and magnitude aspects of the constraint suggest a portion of the $90 price is constrained, the estimate of variable consideration should be constrained to $80.
In evaluating the magnitude of potential future revenue reversals, an entity should consider ASC 606-10-32-12, which lists the following examples of factors that could increase the likelihood or magnitude of a reversal.
- 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.
Entities should evaluate these factors when accounting for contracts with variable consideration. Additionally, factors beyond those listed, such as the legal and regulatory environment, could impact the likelihood and magnitude of potential reversals. Generally, an entity applies the constraint after the amount of consideration has been estimated. However, an entity may consider the factors that would increase the likelihood or magnitude of a reversal in conjunction with estimating variable consideration. If an entity can show that it has already considered both the probability and magnitude of potential revenue reversals, there is no need for that entity to include a separate step in its process to consider the constraint. In effect, the constraint has been automatically applied in estimating variable consideration. For a comparison, see Basis for Conclusion (BC) 215.
Diversity in Thought
Applying the likelihood criterion of the constraint involves judgment, but will likely be fairly straightforward in practice. Entities may establish policies for what qualifies as probable, and contracts that are near that threshold would be subject to both auditor and preparer scrutiny. Significantly more judgment will be required in applying the magnitude criterion of the constraint.
Three issues specific to the constraint will be discussed here:
- Issue 1: Should the constraint be evaluated at the performance obligation or contract level?
- Issue 2: How do the magnitude and likelihood aspects of the constraint interact?
- Issue 3: What does the magnitude of future reversals mean, and how should it be applied to the constraint?
Issue 1- Should the constraint be evaluated at the performance obligation or contract level?
At their January 2015 meeting, the Transition Resource Group (TRG) 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 states clearly in BC 234 that the unit of account for determining the transaction price in a contract is the contract. As the constraint is primarily a transaction price issue, the TRG agreed that the contract should be seen as the unit of account for the constraint as well. In other words, when considering the magnitude of a potential reversal of variable consideration, that assessment should be made based on the total consideration of the whole contract, not just on amounts specific to the variable consideration or to the specific performance obligation.
Issue 2- How do the magnitude and likelihood aspects of the constraint interact?
Another issue arises in determining how the magnitude and likelihood determinations interact. Some might interpret the standard to mean that the magnitude and probability determinations should be considered equal – in other words, an amount that does not create a significant reversal could meet a lower likelihood threshold than the probable threshold set by the standard. However, it is important to remember that 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). It is inconsistent with the core principle to include any amount in the transaction price, regardless of magnitude, if the entity does not expect to be entitled to that amount. Therefore, we conclude that the probability determination should have a higher priority than the magnitude of a potential reversal.
As explained above, for a variable amount to be included in the transaction price, it must be probable that such an amount will not cause a significant reversal of revenue. Probable is a higher standard than “more likely than not”, which is defined as greater than a 50% likelihood. Authoritative guidance does not give any further clarifications, so determining what percentage of likelihood meets the probable threshold will require professional judgment.
Based on non-authoritative examples, it seems that many practitioners are comfortable constraining amounts that are 60% likely to not reverse, and similarly comfortable recognizing revenue for amounts that are 80% likely to not reverse. Determining the treatment for amounts that fall into this range of 60% to 80% likely to not reverse will require significant judgment. Entities that frequently deal with contracts that include variable amounts might be tempted to make a policy election that sets a bright line somewhere in this range, and include variable amounts that are above that line, while constraining those that are below the bright line. While this approach is appealing because of its simplicity, entities that do so must also be aware that such bright line tests create opportunities for manipulation of estimates of the probability. At a minimum, some kind of controls would need to be in place to ensure that appropriate scrutiny exists for estimates of the likelihood of reversals of variable consideration.
Scrutinizing the magnitude of a potential reversal (in addition to considering the probability) will take a higher priority when the cumulative probability of a given amount being realized is within this 60-80% range. As the size of a potential reversal increases relative to the contract, it becomes more important that management have substantive support for its assertion that a potential reversal is not probable.
If an entity determines that variable consideration in a contract falls near the range considered to be probable, the entity should carefully consider whether any of the factors found in ASC 606-10-32-12 (quoted above) exist for the contract or the entity. As an example, if a contract includes variable consideration that is not significant to the rest of the contract, and that variable consideration is between 70-75% likely to not reverse, an entity 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% of the total contract consideration, the entity would likely need more extensive experience with similar contracts to support inclusion of that amount. In such a situation, the entity might seek further positive or negative evidence about whether such an amount would reverse. If the entity cannot provide additional support for such an estimate, it may be required to constrain at least part of that variable consideration.
Comparison to 605
Under ASC 605, entities are required to only include the amount of consideration that is fixed or determinable in the price of an arrangement. Variable amounts are only allowed to be recognized at the point they become fixed and determinable, or when they are paid. The new standard requires entities to estimate the amount of variable consideration to which they expect to be entitled, and then to constrain that estimate to only include amounts that are not probable to cause a significant reversal. While the constraint will introduce a limit on the amount of revenue recognized, companies that frequently enter into contracts with variable consideration will likely be required to recognize revenue sooner.
Applying the new variable consideration model will be a subjective process, requiring significant judgment from preparers and auditors. ASC 606 will require companies to include variable consideration in the transaction price of each contract, to the extent that it is not probable that a significant reversal of revenue will occur for that amount. Companies will be required to determine both the likelihood and the magnitude of potential future reversals in order to correctly determine what amounts should be constrained. The constraint will require the most judgment when variable amounts are near the probability threshold. It is our opinion that it is within this range that the magnitude of potential reversals will become most relevant. This is an area that requires significant judgment and may cause diversity in practice.
- ASC 606-10-32-11 to 32-12.
- ASU 2014-09: “Basis for Conclusions.” BC 215, 234.
- Deloitte, Revenue from Contracts with Customers: “Roadmap to Applying ASU 2014-09.” February 2015. Section 1.1.3 “Constraining Estimates of Variable Consideration.”
- EY, Financial reporting developments: “Revenue From Contracts With Customers.” Revised August 2017. Section 5.1.3 “Constraining estimates of variable consideration.”
- FASB & IASB, TRG Memo 14: “Variable Consideration.” 26 January 2015.
- KPMG, Issues In Depth: “Revenue from Contracts with Customers.” May 2016. Section 220.127.116.11 “Determine the amount for which it is probable that a significant reversal will not occur (‘the constraint’).”
- PWC, “Revenue from Contracts with Customers.” August 2016. Section 4.3.2 “Constraint on variable consideration.”