Allocating Variable Consideration in ASC 606

However, this method may be hard to apply when one outcome is not significantly more likely than the other. Variable consideration is included in the contract amount based on a probability analysis that a significant revenue reversal will not occur in a subsequent period. ASC 606 requires companies to estimate variable consideration in determining the transaction price, subject to restrictions on estimating variable consideration. In another instance, a software company may offer post-delivery support that is contingent on customer satisfaction.

Example 2 – Optional Purchases

These payments are typically tied to specific outcomes, such as the successful completion of a clinical trial phase or regulatory approval. The uncertainty of these events means that revenue from milestone payments is recognized only when it becomes sufficiently certain that the milestones will be achieved. On the other hand, an auditor would emphasize the need for robust documentation and justification for any estimates made, ensuring that the company’s approach complies with the relevant accounting standards and that the rationale behind the estimates is transparent and defensible. From the standpoint of an auditor, assessing the reasonableness variable consideration of management’s estimates of variable consideration is paramount.

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). Variable consideration often appears in contracts across various industries, influencing the final price companies receive. These elements include performance bonuses, volume discounts, and refund provisions, all of which can adjust the total transaction price based on future outcomes or customer behavior. For example, if a company offers a sales rebate, auditors will review past historical data, current market trends, and the company’s sales forecasts to evaluate the accuracy of the rebate estimation.

Start by identifying all the components in a contract that could lead to variable consideration, such as potential refunds, performance bonuses, or price concessions. Once identified, choose the right estimation method, whether it’s the Expected Value Method or the Most Likely Amount Method, depending on the complexity and predictability of the contract. After calculating the estimate, companies should determine if a constraint is necessary, especially if external factors like market conditions or customer behavior introduce uncertainty. Additionally, the application of constraints helps companies avoid significant reversals in cumulative revenue during the reporting period.Accurately managing variable consideration requires ongoing analysis throughout the period covered by the contract.

• As new information emerges, adjustments may be necessary to reflect changes in potential payment terms, a broad range of price concessions, or other factors that influence the total contract price.
• 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.
• This estimated transaction price is then allocated to one or more of the performance obligations in the contract, and revenue is recognized as these obligations are satisfied.
• When a contract contains an unknown quantity of outputs, determining whether the uncertainty arises from variable consideration or from optional purchases can be challenging.
• The $300 fixed price is allocated between the two licenses according to the relative standalone selling price method.
• It is important to consider the treatment of these elements of revenue when looking at the accounting required under IFRS 15 as this can differ from the previous accounting treatment.
• An option to purchase additional goods or services is only a performance obligation if it gives the customer a material right that would not otherwise be available without entering into a contract.

Introducing Uncertainty

Entities must disclose the methods, inputs, and assumptions used to estimate variable consideration, as well as any subsequent changes to those estimates. This transparency allows stakeholders to understand the potential impact on future financial statements. Examples include a sales-based royalty for intellectual property, a performance bonus for early project completion, or a range of price concessions based on volume purchases. This method works well for more straightforward contracts where there are fewer possible outcomes or one dominates. To ensure that variable consideration is recognized appropriately, companies must consider the probability of occurrence, measurement, and timeliness of the expected revenue. By following these guidelines, SaaS companies can maintain transparent and compliant revenue recognition practices.

Revenue Impacting Contract Terms: Variable Consideration

If at 31 December 2018 the most likely date of completion is June 2019, with the date by which completion is highly probably being determined as July 2019, then the variable consideration to be recognised would be estimated as £1m giving total consideration of £10m. Previously this may have been £10.2m, including receipt of the award based on the most likely completion date. 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. To date, actual prompt pay discounts have not differed materially from the Company’s estimates” (August 2018 letter to the SEC). Summing these probability-weighted amounts, the company would use $725 as the total transaction price. The probability of a significant revenue reversal not occurring in a subsequent period is a matter of judgment regarding the restraints, but generally, in our opinion, the confidence level should be 75% or better.

3.3.2 Prompt payment discounts

This method is ideal when different results have varying chances of happening, offering a balanced estimate of the total variable consideration. The expected value approach is based on the sum of probability-weighted amounts in a range of multiple expected consideration possibilities. These estimates should be revised at the end of each reporting period and any changes to the transaction price as a result of the change in estimate should be made in the reporting period. With the new revenue recognition standards upon us and adoption for public entities right around the corner, we’re finding that two aspects are tripping our clients and prospects up more than any other – variable consideration and the time value of money. The TRG admits that, in some cases, the distinction between variable consideration and an optional purchase makes little difference in the timing and measurement of revenue.

For example, a company might offer a volume discount to a customer based on the number of units purchased over a year. If the customer has historically purchased 100 units but is expected to purchase 150 units this year due to market growth, the auditor must evaluate whether the increased estimate is reasonable and supported by evidence. If there are changes in the estimated variable consideration after the initial recognition, the company must adjust its revenue. This could happen if, for example, a construction company faces delays and realizes it is less likely to receive a timely completion bonus.

• The transaction price includes such variable considerations, whether explicitly stated in the contract or implicitly stated.
• Both variable consideration and optional purchases require an entity to disclose the transaction price allocated to any outstanding performance obligations at the end of a reporting period, subject to the short-term contract and right-to-invoice practical expedients (see Disclosures).
• In the complex landscape of revenue recognition, the inclusion of variable consideration stands as a pivotal aspect that demands careful attention.
• Thus, the criterion of meeting a level of confidence is intended to facilitate preparation and reduce diversity in practice.
• Although Hospital is not obligated to purchase from Biotech, it is highly likely to do so because no other supplier exists.
• This means that when a contract includes variable consideration—payments that can vary based on the occurrence of future events—companies must estimate the amount of consideration to which they will be entitled.
• The recognition of this revenue is contingent upon the firm’s ability to meet the early completion deadline, and thus, cannot be recognized until it is likely that the deadline will be met.

The difference of £2 between the invoice amount and revenue recognised is recorded as a contract liability. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory. Variable consideration specifics range widely, and the scenarios discussed here are not all-inclusive. Each entity must assess the particular facts and circumstances as needed for their organization and come to a conclusion that makes the most sense. We have a wide range of construction services that we offer, and we’re always happy to help you with any questions that you might have.

Subsequent sales-based royalties will be recognized as revenue for their full amount since the two performance obligations have been completed. The table below shows a summary of the calculations for the fixed contract price and the royalty from the first month. “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.