One of the most significant changes included in the new revenue recognition standard, Accounting Standards Codification (ASC) 606 Revenue from contracts with customers, is the treatment of variable consideration. Unlike the treatment required under ASC 605 Revenue Recognition, when a contract includes a variable amount of consideration, the entity 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. In cases where there is uncertainty around the variable consideration amount, a constraint on that consideration must also be considered.
To recognize revenue in contracts with customers, an entity must determine the transaction price according to the guidance contained in ASC 606-10-32-2 through 32-27 (note that this article focuses on the guidance contained in paragraphs 32-2 through 32-13). In determining the transaction price for a performance obligation, an entity should use the amount of consideration “to which [they] expect to be entitled in exchange for transferring promised goods or services to a customer.”
Fixed consideration should be included in the transaction price. Variable amounts, on the other hand, should only be included to the extent that the entity expects to be entitled to the consideration. Variable amounts of consideration may be explicitly stated in the contract, but do not necessarily need to be explicit to qualify as variable consideration. As an example, if the practices of an industry or of the entity make it likely that the entity will offer a price concession, consideration should be considered variable.
ASC 606 Revenue from contracts with customers states that discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, and other similar items could result in variable consideration in a contract. Other sources of variable consideration might include volume discounts, rights of return, refunds, prompt payment discounts, and most sources of contingent revenue under ASC 605.
When estimating variable consideration, an entity can either:
- Follow the expected value approach, or
- Use the most likely amount.
Expected Value Approach. The expected value approach is carried out by finding a range of possible consideration amounts, weighting these amounts by their respective probabilities, then summing these probability-weighted amounts to generate a single number that represents the expected value of consideration to be received from the customer.
Entity A enters into a contract to perform a project for Customer B. When Entity A completes the project by the deadline, they 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. If Entity A finishes a week ahead of schedule, it will receive an extra $250 of compensation and so on.
Analysis. Entity A assesses the likelihood of receiving a bonus for timely completion, and determines that it is only 30% likely that it will finish on time, 50% likely that it will finish a week ahead of schedule, and 20% likely that it will complete the project two weeks ahead of schedule. Using the expected value approach, Entity A creates the following table:
The company should then consider the constraint, as discussed below.
The expected value approach works particularly well with the portfolio method of aggregating customer contracts. 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 of the expected amounts of the individual contracts. The expected value approach also works well in situations where there is a spectrum of amounts possible, as in the example above where there is a bonus for each day prior to a deadline that an entity completes a performance obligation (or a penalty for each day late).
Most Likely Amount. Estimating variable consideration by using the most likely amount is easy to understand: for each contract, whichever amount in the range of possible amounts is most likely to be received will be used as the transaction price. While ASC 606 Revenue from contracts with customers allows the most likely amount approach for any contract where it most accurately predicts the actual consideration to which an entity is entitled, the standard also points out that this method works well in situations where there are only two possible outcomes. In these cases, because there are only two real possibilities, using an expected value approach would result in an estimate of revenue that is impossible. However, the expected value approach could still be useful or relevant for companies using the portfolio approach.
Entity A enters into a contract with Customer B to provide a service. Customer B agrees to pay $500 if Entity A achieves minimum specifications, and $1,000 if Entity A also achieves additional specifications. (For simplicity, assume there is no need to constrain revenue).
Analysis. In this case, because there are two possible outcomes, Entity A decides to use the most likely amount. Entity A determines that it has a 30% chance of exceeding the minimum specifications (without meeting the additional specifications), and a 70% chance of exceeding the additional specifications as well. Entity A uses $1,000 as the transaction price for this contract.
While these 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. For example, if a contract included both a bonus for early completion of a project, which scaled with the number of days ahead of schedule, and a quality bonus if a project exceeds certain specifications, an entity might choose to use the expected value approach for the early completion bonus, and the best estimate approach for the quality bonus, within the same contract.
After estimating possible amounts of variable consideration to be received, these estimates must be adjusted until they no longer include amounts for which it is probable that a significant reversal will occur. This area involves significant judgment and must include assessment of both likelihood of reversal as well as the magnitude of the reversal when compared to the total transaction price.
When describing this constraint, the standard requires that variable consideration only be included in the transaction price to the extent that it is “probable that a significant reversal…will not occur.” Probable is defined in the standard as “The future event or events are likely to occur.” In other words, variable consideration should only be included in the transaction price if it is unlikely that such revenue would reverse as the inherent uncertainty is resolved and performance obligations are fulfilled.
The magnitude of a reversal must be considered in addition to the probability of a reversal. The basis for conclusions, paragraph BC218, explains that an entity might find that there is too much uncertainty to include the total amount of variable consideration in the transaction price for a contract or performance obligation. However, this entity may still include some portion of that variable consideration, given that the amount they include is not probable to cause a significant reversal in cumulative revenue recognized.
ASC 606-10-32-12 provides the following list of factors that may lead to an increase in either the probability of revenue reversing, or the magnitude of that 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.
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 revenue will eventually reverse.
Diversity in Thought
Variable consideration is a broad topic that will likely introduce diversity in practice that will differ across industries; exhaustively listing all of the potential diversity in application across all industries is beyond the scope of this article. However, a few general sources of diversity of thought have been noted in publications and discussions thus far, as detailed below. The discussion of these issues will be divided into two sections: diversity around variable consideration, and diversity in applying the constraint.
Diversity surrounding Variable Consideration. Some have argued that the expected value approach may not be representative of contracts where a small number of discrete amounts are possible, as an expected value will likely be an amount that is not possible under the terms of the contract. This is a valid concern, and in situations where this is the case, the most likely amount may provide a better prediction of the amount to be received, instead of the expected value approach. However, if an entity enters into a number of contracts with similar terms, and the entity determines that these contracts may be aggregated into a portfolio of contracts with those terms, then the expected value approach could still be used at the aggregate level, and might even be more appropriate. See the following examples:
Entity A enters into a contract with a customer to provide implementation services for fixed consideration of $2,500,000. This is a unique contract, and the terms were negotiated with this customer. The contract includes a quality bonus, where Entity A is entitled to a performance bonus of $500,000 if the new system meets certain performance metrics. Entity A determines that it is 60% likely that it will meet the performance metrics.
Analysis. Because this is a unique contract that includes an all-or-nothing bonus, the most likely amount approach will be a better prediction of the actual consideration to which Entity A will be entitled. Entity A should use $3,000,000 ($500,000+$2,500,000) for the transaction price. Entity A would then need to consider the constraint.
Assume the same facts as in Example C, except that Entity A is in the business of implementing this specific system in a variety of clients. Assume further that the terms of this contract are standard terms that Entity A offers its customers, typically with little negotiation.
Analysis. In this case, because the contract is on standard terms, it would likely be appropriate to aggregate all of these contracts into a portfolio for the purposes of revenue recognition. In this case, even though the individual contracts only have two possible outcomes (full bonus or no bonus), the expected value approach would provide a better prediction of the amount to which Entity A will be entitled on the whole. Entity A should use $2,800,000 ($500,000 * 60% = $300,000 bonus; $300,000 + $2,500,000 = $2,800,000 total transaction price) for the transaction price of each contract. Entity A would then need to consider the constraint.
Diversity around the Constraint. In the Basis for Conclusions (BC), the Boards indicate 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, as such a figure would be most predictive of future revenues. The Boards noted that the constraint introduces a definite downward bias into revenue numbers. However, they felt that this was appropriate in trying to avoid significant reversals of revenue, as indicated by respondents (see, for example, BC 206-207). However, while the Boards and respondents did not wish to include amounts that were likely to reverse, not including variable consideration in transactions prices could seriously understate revenues, leading to less relevant and useful data being reported.
Specifying a level of confidence (i.e., the use of the language “probable” [US Generally Accepted Accounting Principles] and “highly probable” [International Financial Reporting Standards]) also received significant attention from the Boards. While they initially considered not specifying a level of confidence at all, during redeliberations, 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 Boards decided to use wording already present and defined in other standards for clarity.
Some firms have taken the position in their publications that even when an amount of consideration is highly susceptible to factors outside the entity’s influence (ASC 606-10-32-12), predictive information might enable the entity to determine that variable consideration is not constrained. This seems consistent with the indicator discussed in factor c (ASC 606-10-32-12). If limited experience or experience with little predictive value with a type of contract makes it more likely that variable consideration should be constrained, then extensive experience or experience that has high predictive value may help an entity understand whether an amount is likely to reverse, and therefore whether that amount should be constrained.
Comparison to 605
The recognition of variable consideration is a significant change from prior accounting standards. In the past, entities were required to determine whether the amount of consideration was fixed or determinable, and only recognize the fixed or determinable portion. Under the new standard, the recognition of variable revenue is limited to the amount that is not expected to reverse, instead of being precluded entirely. This will likely lead to earlier revenue recognition for many entities.
In particular, this and other changes will accelerate revenue recognition in tech and software companies that were previously under ASC 985-605, Software Revenue Recognition. Under this guidance, these companies frequently had difficulty asserting that revenue was fixed or determinable when they offered concessions to their customers, as estimating the amount of a concession was restricted. Under ASC 606, however, these companies are allowed to estimate the amount of concessions that will be offered, particularly when they have a narrow range of concessions in similar transactions. Broad concessions may still make it difficult to estimate the magnitude of the potential revenue reversals, however.
As noted previously, the treatment of variable consideration is a significant departure from current U.S. GAAP, as well as requiring significant professional judgment. Companies with contracts that include variable consideration should begin analyzing those contracts to determine how ASC 606 will affect the timing of recognition; generally, we expect that this will lead to accelerated revenue recognition for contracts with variable consideration. Applying these principles may lead to significant diversity in practice, and this has been identified as an area where there is potential for ongoing discussion by the FASB/IASB Joint Transition Resource Group.
- ASC 606-10-32-2 to 32-13; ASC 985-605.
- ASU 2014-09: “Basis for Conclusions.” BC 206-207, 218.
- EY, Financial reporting developments: “Revenue from Contracts with Customers.” Revised October 2018. Section 5.1 “Variable Consideration.”
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 5.3.1 “Variable consideration and the constraint.”
- PWC, “Revenue from contracts with customers.” August 2016. Section 4.3, Variable consideration.