Variable Consideration and the Constraint

For contracts that include a variable amount of consideration, entities must estimate the amount of consideration to which it expects to be entitled and use that amount as the transaction price for allocating to different performance obligations.

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

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.

VMware, Inc. (2018 SEC Correspondence): Variable Consideration

“Rebates are variable consideration in accordance with ASC 606-10-32-5 through 32-9 and are accounted for as a reduction to the transaction price on eligible contracts. As rebates are based on eligible sales during the quarter or based on actual achievement to quarterly target sales, actual payout rarely differs from the amounts reserved” (August 2018 letter to the SEC).

Philip Morris International, Inc. (2018 SEC Correspondence): Variable Consideration

“In markets where PMI [Philip Morris International] sells through a third-party distributor or the level of pricing or consumer discounts is dependent on future events (for example the volume of sales to a customer in a particular period) this is variable consideration, as the amount to which PMI is entitled in exchange for transferring the goods is variable” (September 2018 letter to the SEC).

Athenex, Inc. (2019 SEC Correspondence): Variable Consideration

“We considered [the milestone for delivering satisfactory review of data and the milestone for CMC (chemistry, manufacturing, and control) development] to be variable consideration, as the entitlement to the consideration is contingent on the occurrence or nonoccurrence of future events. The Company analyzes whether the milestone is considered probable of being reached and estimates the amount to be included in the transaction price using the ‘most likely amount’ method from ASC 606-10-32-8. We considered the [first] milestone to be variable consideration because the receipt of the consideration is fully dependent on the delivery and satisfactory review of the IP development data […]. We also considered the [second] milestone to be variable consideration because the receipt of the consideration is fully dependent on the delivery and satisfaction of the line extension data” (May 2019 letter to the SEC).

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. 

Expected Value

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.

Example A: Expected Value Method

Entity A enters into a contract to perform a project for Customer B. It enters into similar contracts frequently. When Entity A completes the project by the deadline, it will be entitled to $500 of consideration. Entity A will also be entitled to an additional $50 of compensation for every business day ahead of the deadline it completes the project. For example, if Entity A finishes a week ahead of schedule, it will receive an extra $250 of compensation.

Analysis: Based on its past performance in similar contracts, Entity A estimates a 30 percent likelihood of finishing on the date scheduled, a 50 percent likelihood of finishing a week ahead of schedule, and a 20 percent likelihood of completing the project two weeks ahead of schedule. Using the expected value approach, Entity A calculates the following probability-weighted amounts for each scenario:

Completion TimeConsideration DueProbabilityProbability-weighted Amount
On schedule$50030%$150
One week ahead$75050%$375
Two weeks ahead$1,00020%$200
Expected Value:$725
Summing these probability-weighted amounts, the company would use $725 as the total transaction price. The company would then consider the constraint, as discussed later in this article.

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.

Example B: Most Likely Amount Method

Entity C recently introduced a new service line. One of Entity C’s first contracts for this new service is with Customer D. Customer D agrees to pay $500 if Entity C achieves minimum specifications and $1,000 if Entity C also achieves additional specifications.

Entity C recently introduced a new service line. One of Entity C’s first contracts for this new service is with Customer D. Customer D agrees to pay $500 if Entity C achieves minimum specifications and $1,000 if Entity C also achieves additional specifications.

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:

Arqule, Inc. (2019 SEC Correspondence): Most Likely Amount

Arqule explained how it determines the variable consideration for its drug licensing agreements. “At contract inception the Company evaluates whether milestones are considered probable of being achieved, and to the extent that significant reversal would not occur in future periods, estimates the amount to be included in the transaction price using the most likely amount method. Milestone payments that are subject to the judgments and actions of a third party, such as regulatory approvals, have significant uncertainties and are excluded from the transaction price until those approvals are received. The Company updates its estimates for milestones at each reporting date until the uncertainty is resolved. Lastly, the Company considered ASC 606-10-55-65, which provides that sales-based royalties promised in exchange for a license of intellectual property should be recognized at the later of when the subsequent sale occurs or when the performance obligation is satisfied.”

For the two specific license agreements under discussion, “the Company’s receipt of the development and regulatory milestone consideration was contingent upon future events and was considered variable consideration. At contract inception, the development and regulatory milestones did not meet the recognition criteria in ASC 606-10-32-11 as achieving the milestones was not considered the most likely outcome and were therefore excluded from the transaction price” (June 2019 letter to the SEC).

Philip Morris International, Inc. (2018 SEC Correspondence): Most Likely Amount

“In determining the transaction price, PMI estimates any relevant variable consideration based on the most likely amount PMI expects to be entitled to under the terms of the contract taking into consideration historical experience of discount or rebate redemption where relevant. Based on the evaluation of the factors set out in ASC 606-10-32-12, in the context of the PMI discount and incentive programs, PMI concluded that the potential reversal of any significant variable consideration is not probable and therefore such variable consideration is not constrained” (September 2018 letter to the SEC).

PDL BioPharma, Inc. (2018 SEC Correspondence): Most Likely Amount

“The revenue reduction we estimate using the most likely method relates to prompt pay discounts. It is appropriate to apply the most likely method to this estimate as the variable consideration has only two possible outcomes and the single most likely outcome is that the discount will be taken. Therefore, the Company has recorded a revenue reduction for the full amount of the discount. To date, actual prompt pay discounts have not differed materially from the Company’s estimates” (August 2018 letter to the SEC).

WABCO Holdings, Inc. (2018 SEC Correspondence): Most Likely Amount

The SEC staff asked WABCO to explain why they felt the most likely method was better than the expected value method for their volume discounts. WABCO explained, “The volume discount offered to the customer is typically binary in nature. That is, either the customer receives the discount or they do not. In certain instances, contracts with customers may provide a limited number of outcomes for volume discounts based on certain qualitative factors.

“In addition, the most likely amount is considered to be the most appropriate method to estimate volume discounts based on the fact that the volume discount offered is specific to the customer, the contract and other factors such as specific strategic initiatives. Each of the customer relationships is managed by a dedicated account team, who is in a position to estimate the sales volume and determine the appropriate volume discount. Therefore, the Company believes that considering that the majority of volume discounts offered to the customer are binary, and thus containing only two possible outcomes, the most likely method would be the more appropriate method for estimating the amount of volume discounts” (May 2018 letter to the SEC).

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):

  1. 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.
  2. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
  3. The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
  4. 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.
  5. 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.

Example C: Variable Consideration Not Constrained

In Example A above (in which Entity A is entitled to increasing bonus amounts the earlier it completes the project), the variable consideration would likely not be constrained. The potential revenue reversal could be up to $225—the estimated transaction price in excess of the fixed consideration of $500. The $225 is 31 percent of the transaction price, which is likely significant in magnitude. 

However, because (1) Entity A enters into these types of contracts frequently, (2) the entity considered this experience in determining the probabilities to use in the expected value calculation, and (3) none of the factors in paragraph 32-12 are present in this example, Entity A concludes that the expected value does not include amounts probable to reverse in the future. The $225 would be reversed only if Entity A fails to complete the project early—an outcome with only a 30 percent likelihood.

Example D: Variable Consideration Constrained

In Example B above (in which Entity C determined a 70 percent likelihood of receiving the higher amount of $1,000), the variable consideration would likely be constrained. The potential revenue reversal could be $500 (50 percent of the transaction price), which is significant in magnitude. Moreover, Customer D is one of Entity C’s first customers for the new service line, indicating that Entity C has limited experience with this type of contract. 

Because of these uncertainties, Entity C would likely conclude that the $500 variable consideration should be constrained. However, Entity C should not default to constraining its variable consideration to $0; rather, it should estimate the amount for which a significant reversal is not likely to occur. Entity C might calculate a range of worst-case scenarios and determine that $100 of variable consideration can be included in the transaction price for this contract.

Emergent BioSolutions, Inc. (2019 SEC Correspondence): Variable Consideration Constraints

“The Company evaluated and concluded no constraint would be necessary on the variable consideration [of cost-plus-fixed-fee development contracts with the United States Government (USG)]. There was low uncertainty about the amount of variable consideration as the consideration reflected a cost build-up for internal and external costs, plus a specified mark-up. The Company has extensive history with performing services for the USG by preparing a cost-based budget to determine the total consideration for its USG contracts.  The Company’s experience with other cost-plus arrangements is that it has historically used all available and approved funding. Based on the current status of the development projects and the expectation that the Company will perform the required development services and collect the consideration in full, the Company concluded it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur and no constraint was necessary on the variable consideration as of September 30, 2018. The Company performs similar analysis on variable consideration and the related constraint (or lack thereof) at each reporting period” (January 2019 letter to the SEC).

Omnicom Group, Inc. (2018 SEC Correspondence): Variable Consideration Constraints

“We can reasonably estimate our commission revenue, including tiered or scaled commissions. However, ASC 606-10-32-12 (a) requires that an assessment be made such that it is probable there will not be a significant reversal of cumulative revenue. The inherent cancellation rights prior to the run date represent a significant constraint on the amount of revenue we will ultimately receive. Our assessment that revenue is subject to a constraint is based on the following: (i) the ability for the client to cancel the media as provided by the contract with the media vendor and/or (ii) the rights of the media provider under the contract to cancel or postpone airing, including preemption, network transmission availability and other contingencies included in the contract” (August 2018 letter to the SEC).

eHealth, Inc. (2019 SEC Correspondence): Variable Consideration Constraints

“Judgments that can be significant in estimating transaction price are related to the constraint. To determine the constraints to be applied to LTV [lifetime value commissions], the Company compares prior calculations of LTV to actual cash received and reviews the reasons for any differences. The Company then applies judgment in assessing whether the difference between historical cash collections and LTV is representative of differences that can be expected in future periods. The Company also analyzes whether circumstances have changed and considers any known or potential modifications to the inputs into LTV and the factors that can impact the amount of cash expected to be collected in future periods such as commission rates, carrier mix, policy duration, changes in laws and regulations, and cancellations of insurance plans offered by health insurance carriers with which the Company has a relationship” (September 2019 letter to the SEC).

Revance Therapeutics, Inc. (2018 SEC Correspondence): Variable Consideration Constraints

In a collaboration agreement, Revance gave Mylan an exclusive, worldwide license to Revance’s IP for a biosimilar (a medical product similar to another that is already approved) to the product BOTOX. Revance has certain obligations to continue development of the product to a certain point, and Mylan has the option to end or continue the agreement at a certain point. The SEC asked for details of Revance’s judgments in determining the consideration to be included in the transaction price from these milestones. Revance explained:

“In determining whether the consideration associated with the individual milestones should be included in the transaction price, as there can be only two outcomes with respect to each milestone, we applied the most likely amount method. We further incorporated into our estimates the impact of the constraint.

“It is important to note that in a collaboration like the one with Mylan, payment of milestones is synonymous with continuing the development activities and continuation of the agreement itself. […] Accordingly, there is an inherent link between the amount of the consideration the Company is entitled to, and the volume of services it will be ultimately required to perform.

“To determine the transaction price, including the impact of the constraint, we developed a recognition model that incorporates the expected progress of the collaboration and when the events underlying various milestones are expected to occur. We use this model to determine how much revenue is recognized in each period based on the measure of progress we concluded is most appropriate, which is the value of internal labor and third-party services used during the initial and development phases. We also use this model to determine the impact of the constraint.

“The transaction price includes the nonrefundable upfront fee, cost-sharing payments, as well as certain milestones due prior to the successful completion of the Phase 3 clinical trials (specifically, the FDA Advisory Milestone and [confidential milestones]). In the application of the measure of progress, the inclusion of the cost-sharing payments and certain milestones in the transaction price as described above, at no point results in a scenario where the revenue recognized exceeds the cash received to date. Therefore, it is not probable that a significant reversal of cumulative revenue recognized would occur, regardless of whether Mylan exercises the option and whether the collaboration progresses as expected.

“The remaining milestones were not included, as these could result in a significant reversal of revenue” (October 2018 letter to the SEC).

The SEC staff asked for additional explanation, asking how no scenario exists “where the revenue recognized exceeds the cash received to date.” Revance offered the following responses:

“There is no scenario under this concluded total transaction price in which a significant (or any) reversal of revenue is possible when the uncertainties associated with the milestones are subsequently resolved. This is further illustrated outlining the following three different situations described below:

  • If Mylan decides not to exercise option to continue (i.e. not pay the Continuation Decision milestone) – As of the expected date for the Continuation Decision, the Company would not yet have recognized the entire upfront payment of $25 million as revenue, so if Mylan decided not to continue, the Company would recognize the remaining portion of the upfront payment as revenue and there is no reversal of the cumulative revenue recognized.
  • If Mylan pays the Continuation Decision milestones, but the [confidential 1] milestone event thereafter does not take place – If Mylan decided to exercise the option to continue, it would trigger a Continuation Decision milestone payment … . As of the [confidential 1] milestone event, the Company would not yet have recognized the entire payments received to date as revenue, so if the [confidential 1] milestone event does not take place and the agreement is dissolved, the Company would recognize the remaining portion of the contract liability as revenue and there is no reversal of the cumulative revenue recognized.
  • If Mylan decides to continue through [confidential 2] – Mylan would have paid the $25 million upfront payment and $40 million of milestones and most of the estimated net cost-sharing payments to-date. At no point during the [confidential 2] would the Company have recognized the entire payments received to date as revenue. Therefore, if the trial stopped and the agreement is dissolved, the Company would recognize the remaining portion of the contract liability as revenue and there is no reversal of cumulative revenue recognized.

“Based on our assessment we have appropriately estimated the total transaction price and there is no possibility of a significant reversal of cumulative revenue associated with any variable consideration included in the total transaction price.

“Any alternative scenario with a higher transaction price (e.g., by including the next milestone) would result in scenarios where the cumulative revenue recognized would be higher than cumulative cash received at points in time, during which a reversal of cumulative revenue would occur if the next milestone event beyond the point of constraint does not trigger (i.e. the uncertainty is not favorably resolved)” (November 2018 letter to the SEC).

Cross Country Healthcare, Inc. (2018 SEC Correspondence): Variable Consideration Constraints

In some of Cross Country’s contracts, it agrees to fill a certain percentage of open positions for its clients, known as fill rate guarantees. The SEC staff questioned whether Cross Country treated these guarantees as variable consideration. The company explained:

“Fill rate guarantees specify a penalty to be paid by the Company in the event that certain fill rate percentages are not achieved with a customer. These types of guarantees are limited to and only included in certain of our larger Managed Services Program (MSP) contracts. In instances where our MSP contracts contain these fill rate guarantees, we generally have been able to meet the required fill rate percentages, and, as a result, the penalties are rarely triggered.

“Pursuant to ASC 606-10-32-5 and ASC 606-10-32-6, we identified the fill rate guarantees as performance-based penalties that result in variable consideration, however, adjustments to the transaction price have not been made because it was probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved” (September 2018 letter to the SEC).

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.

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Author Brett Riley

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