The Dreadful - ASC 606 Variable Consideration
For most companies with long-term contracts, the sale is not a static number nicely sitting in the P/L. Contracts with customers typically contain so many variabilities that successes are never guaranteed. Just name a few: liquidated damage, services level or other performance level agreement penalties or bonuses, pass or fail acceptance, rebates, pricing adjustment, payment and various forms of other discounts, tiered pricing, and return rights. Estimating, accounting for, and forecasting those variabilities accurately and completely in sales contracts, with limited resources in Project or Product Deliveries, FP&A, and Accounting, is one of the hardest challenges in managing a company’s cash flow, revenue recognition, and forecast. After all, it is variable.
First of all, although the majority of variabilities in a sale contract can be considered variable consideration under ASC 606, it is not necessarily so (e.g., right of return). This article will focus on the Variable Consideration under ASC 606 only since it represents most of the variabilities in a revenue contract.
We will start with a simple scenario. For a $500 million revenue contract, if we face two future variable consideration events estimated at the contract inception: the first one has the 50% likelihood of obtaining a performance bonus of $50M, and the second one has the same 50% likelihood of giving $50M rebates to the customer, how much we should record the contract price initially?
The correct answer aligns with the conservatism accountants typically embrace: on the one hand, because it is not yet probable to record the performance bonus, the bonus amount should not be recorded. But, on the other hand, because it is not probable for us to collect the entire $500M due to the potential rebate, we deduct the rebate amount from the contract price at the contract inception.
In other words, we record the reduction but not the increase when both are not probable. This is due to the unique intended bias inserted in ASC 606, especially ASC 606-10-32-11:
32-11 An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 606-10-32-8 only to the extent that it is 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.
To summarize the intended bias for variable consideration in ASC 606: we need to make a biased estimate for variable consideration that focuses on possible future downward revenue adjustments (such as revenue reversals) rather than on upward revenue adjustments (such as favorable adjustments).
With this being said, there is no way for the simple example above to illustrate all the complexities around variable consideration. Below I summarized some relatively common but rather complex variable consideration or variability scenarios for your interests:
Performance guarantee (e.g., when a contract contains an SLA) under ASC 460 vs. ASC 606 (as variable consideration)
Contracts could have performance guarantees with customers to stipulate service coverage and availability (e.g., SLA).
Note ASC 606 specifically excludes from its scope contracts with customers for guarantees (other than product or service warranties) that are within the scope of ASC 460. ASC 606-10-15-4 also includes guidance on how to separate and initially measure a contract that is partially within the scope of ASC 606 and partially within the scope of other topics.
As a result, we must consider the scope of ASC 460 first to determine whether a transaction falls within the scope of ASC 460, ASC 606, or partially between them. ASC 460-10-15-7(i) states that a guarantee or indemnification of an entity’s future performance is not within the scope of ASC 460.
Accordingly, because of the ASC 460-10-15-7(i) scope exception, contracts that guarantee a future performance do not contain a guarantee within the scope of ASC 460, and we should account for the contract under ASC 606. As a result, any penalties and remedies related to a revenue contract SLA shall be considered variable considerations.
Estimate the variable consideration when noncash goods and/or services are provided to a customer
When noncash goods and/or services are considered variable consideration(s) in a contract, we need to estimate the fair value of such non-cash goods and/or services.
If a variable consideration represents a non-cash consideration, the fair value should be consistently measured on the date when the variable consideration is first identified.
Please note that noncash goods and/or services are not automatically considered as variable consideration(s). At first, we need to determine whether the non-cash goods and/or services represent a contract modification to an existing contract.
Factors outside seller’s influence
If determined that a contract contains a variable consideration, sellers should strive to estimate the amount of variable consideration to the best of their abilities, including considering factors that may be out of sellers’ influence, such as market indexes.
Sellers may price contracts based on factors outside sellers’ influence, such as CPI, etc. Nonetheless, sellers should constrain revenue to the extent to which sellers anticipate a future revenue reversal is not probable.
Also, note that factors outside sellers’ influence may indicate a contract modification instead of a variable consideration or indicative of a transaction outside of ASC 606. For example, if a seller goes beyond its legal responsibilities to provide customers additional goods and services in the event of a natural disaster, it may not be necessarily included in the scope of ASC 606.
Optional purchases vs. variable consideration
Variable consideration can exist in both the present contract and also in options offered to a customer. Accordingly, ASC 606 TRG has concluded that ASC 606 does not require an entity to estimate the transaction price of future contracts into which it will enter with a customer when such future contracts are not included as material rights of an existing contract.
In other words, unless an option is a material right, such options would not factor into the accounting of the present contract. Uncertainty is considered variable consideration when a seller has enforceable rights and obligations under a present contract to provide goods or services without an additional customer decision.
When an option is considered as a material right, variable consideration pertains to the material right should be incorporated in the estimation of the material right, which then is combined with the existing performance obligations of the contract containing the material right.
Volume rebates and/or discounts on goods or services as variable consideration vs. customer options to acquire additional goods or services at a discount
It is often challenging to distinguish between a contract that includes customer options to purchase additional goods and services and the one that includes variable consideration based on a variable quantity (e.g., a usage-based fee) because, under both types of contracts, the ultimate quantity of goods or services to be transferred to the customer is often unknown at contract inception.
If a seller concludes that a customer option for additional goods or services provides a material right, the option itself is deemed a performance obligation in the contract, but the underlying goods or services are not included in the contract until the option is exercised. However, if the contract includes variable consideration (rather than a customer option), the seller has to estimate at contract inception the variable consideration expected over the life of the contract and update that estimate for each reporting period (subject to a constraint).
The first step in determining whether a contract involving variable quantities of goods or services should be accounted for as a contract containing customer options or variable consideration is for the seller to determine the nature of its promise in providing goods or services to the customer and the rights and obligations of the parties.
In a contract in which the variable quantity of goods or services results in variable consideration, the nature of the seller’s promise is to transfer to the customer an overall service. In providing this overall service, the seller may perform individual tasks or activities. At contract inception, the seller is presently obligated by the terms and conditions of the contract to transfer all promised goods or services provided under the contract, and the customer is obligated to pay for those promised goods or services. This is because the customer entered into a contract that obligates the seller to transfer those goods or services.
Example a. volume rebates and/or discounts on goods or services as variable consideration
In customer contracts where a seller offers one overall promise, such as building a network with coverage availability above a certain % threshold, these discounts shall be considered variable consideration if discounts are offered for additional network equipment required to reach the availability ratio.
Example b. Volume rebates and/or discounts on goods or services as customer options
In many customer contracts, a seller offers options to customers to purchase additional goods and services with or without discount(s), in which cases, the seller is not legally obligated to provide the additional goods or services until customers exercise the options. Those rebates or discounts shall be considered part of the customer options to be evaluated under the material right and contract modification guidance.
Variable consideration vs. warranty provisions
Most liquidated damages, penalties, and similar payments should be accounted for as variable considerations. However, in limited situations, amounts that are based on the actual performance of a delivered good or service may be considered similarly to warranty payments (e.g., in situations in which a seller pays the customer’s direct costs to remediate a defect), which is required for an additional analysis between the warranty guidance and ASC 606.
The uncertainty is not expected to be resolved for a long period of time
In general, a long period of time until the uncertainty is resolved makes it more difficult to assert that it is probable (US GAAP) or highly probable (IFRS) that a significant reversal of cumulative revenue recognized will not occur.
A seller should consider all facts and circumstances because in some situations, a longer period of time until the uncertainty is resolved could make it easier to conclude that a significant reversal of cumulative revenue will not occur. For example, a performance bonus based on a specific project performance target can be easily met due to the long duration of the contract, depending on the existing and historical performance of similar projects.
Lack of experience in estimating variable consideration
In rare cases, a seller has limited experience in a project and might not be able to predict the likelihood or magnitude of a revenue reversal if the estimate of variable consideration changes. In such cases, A seller should seek after, evaluate, and rely on other evidence, such as similar contracts offered by competitors or other market information.
Variable consideration vs. refund liability
According to ASC-606-10-55-25, a seller should apply the guidance in paragraphs 606-10-32-2 through 32-27 (including the guidance on constraining estimates of variable consideration in paragraphs 606-10-32-11 through 32-13) to determine the amount of consideration to which a seller expects to be entitled (that is, excluding the products expected to be returned).
For any amounts received (or receivable) for which a seller does not expect to be entitled, a seller should not recognize revenue when it transfers products to customers but should recognize those amounts received (or receivable) as a refund liability. Subsequently, at the end of each reporting period, the seller should update its assessment of amounts for which it expects to be entitled in exchange for the transferred products and make a corresponding change to the transaction price of the revenue contract.
Fixed contractual rate per unit with undefined contractual quantity
ASC 606 TRG members generally agreed that if a contract includes an unknown quantity of tasks throughout the contract period for which the entity has enforceable rights and obligations (i.e., the unknown quantity of tasks is not an option to purchase additional goods and services) and the consideration received is contingent upon the quantity completed, the total transaction price would be variable.
In this case, a seller would need to consider contractual minimums or best estimates that would make some or all of the consideration fixed in determining the contract price.
Price protection or price matching clauses
Revenue contracts may include price protection or price matching clauses in some cases, especially with governmental agencies.
Consideration subject to price protection or price matching clauses requiring an entity to refund a portion of the consideration back to the customer in certain situations should be considered variable consideration under ASC 606.
When it happens, a seller should evaluate whether it must retroactively apply lower prices to previous purchases made by a customer (or has a past business practice of doing so even if the contractual terms would only require a prospective application). If determined so, the consideration would be accounted for as variable consideration.
Contracts with customers also may contain “most favored nation” or “most favored customer” clauses under which the entity guarantees that the price of any products sold to the customer after contract inception will be the lowest price a seller offers to any other customer. In such cases, prospectively providing a customer with a seller’s best prices on any purchases of products after the execution of a contract have no effect on the revenue recognized for goods or services already transferred to the customer (i.e., the consideration would not be accounted for as variable consideration).
Implicit price concessions
For some contracts, the consideration may be variable because the facts and circumstances, outside the contract language, indicate that the seller may accept a lower price than the amount stated in the contract (i.e., it expects to provide an implicit price concession). For example, this could result from the customer's reasonable expectation that the seller will reduce its price based on its customary business practices, published policies, or statements.
An implicit price concession could also result from other facts and circumstances indicating that a seller intended to offer a price concession to the customer when entering the contract. For example, a seller may accept a lower price than the amount stated in the contract to develop or enhance a customer relationship or because the incremental cost of providing the service to the customer is not significant and the consideration it expects to collect provides a sufficient margin.
It is difficult to determine whether a seller has implicitly offered a price concession or enters into a price reduction contract modification, or has chosen to accept a risk of an impairment loss in such above facts and circumstances. As a result, one must consider all relevant facts and circumstances when analyzing these situations to make a determination.
?Claims against customers.
It is extremely rare for a seller to have claims against its customers because of the indemnification terms in a typical revenue contract. However, there may be cases when a sales contract only has an estimated contract price due to uncertainty involved at the contract inception. In such cases, a seller may be able to submit a claim to customers to recover a portion of the overrun costs.
In those cases, the claim amount is variable consideration. Therefore, a seller should include in the transaction price the estimated amount it will receive, adjusted for any constrained amounts under the variable consideration guidance. When applying the variable consideration constraint, a seller should evaluate factors such as its relevant experience with similar claims and the period of time before resolution of the claim, and whether the amount it will receive is highly susceptible to factors outside of its influence.
Note that a monetary claim is not by itself sufficient to be considered as a form of variable consideration. It can also be a contract modification depends on facts and circumstances around the claim.
VC exception to licenses of intellectual property (IP) with sales- or usage-based royalties
ASC 606-10-55-65 and IFRS 15.B63 provide an exception to the general principles for accounting for variable consideration, and the exception only applies to licenses of IP:
An entity should recognize revenue for a sales-based, or usage-based royalty promised in exchange for a license of intellectual property only when (or as) the later of the following events occurs:
a. The subsequent sale or usage occurs AND
b. The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).
The above “later of” guidance for royalties is intended to prevent revenue recognition before an entity satisfying its performance obligation. Royalties should be recognized as the underlying sales or usages occur, as long as this approach does not accelerate revenue ahead of a seller’s performance. Therefore, a seller should apply judgment to determine whether recognizing royalties due each period results in accelerating revenue recognition ahead of performance for a right to access IP. It may be appropriate, in some instances, to conclude that royalties due each period correlate directly with the value to the customer of the seller’s performance.
Variable consideration and subsequent event
When additional information is received after the end of the reporting period and before the date on which financial statements are issued or available to be issued, a seller should refer to the guidance in ASC 855 on accounting for subsequent events. Paragraph BC228 of ASU 2014-09 directs the accounting of such subsequent events to ASC 855 or IAS 10.
ASC 855 distinguishes between recognized subsequent events (ASC 855-10-25-1) and non-recognized subsequent events (ASC 855-10-25-3) as follows:
25-1 An entity shall recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. See paragraph 855-10-55-1 for examples of recognized subsequent events.
25-3 An entity shall not recognize subsequent events that provide evidence about conditions that did not exist at the balance sheet date but arose after the balance sheet date but before financial statements are issued or are available to be issued. See paragraph 855-10-55-2 for examples of non-recognized subsequent events.
The conclusion to account for information received about the variable consideration as either a recognized or a non-recognized subsequent event will be based on the facts and circumstances and may require significant judgment.
Volume-based prospective and retrospective rebates
A seller may offer customers rebates or discounts on the pricing of products or services once specific volume thresholds have been met. That is, the seller may either retrospectively or prospectively adjust the price of its goods or services once a certain volume threshold has been met.
In the event of the retrospective or cumulative volume-based rebates/discounts, in general, such volume rebates or discounts that are retrospectively applied should be accounted for as variable consideration under ASC 606.
In the event of the prospective volume-based rebates/discounts, a seller should first assess whether these rebates/discounts represent a material right under ASC 606-10-55-43.
Restocking fees and penalties
Related to a customer’s return right discussion above, a seller may charge a fee for accepting returns, sometimes referred to as a “restocking” fee or return penalty.
Restocking fees for expected returns should be included as part of the transaction price. A seller will need to consider the guidance in ASC 606-10-32-5 through 32-9 on estimating variable consideration.?
Variable consideration vs CECL (ASC 326-20)
Under ASC 326-20, a seller is required to evaluate financial assets on a collective (i.e., pool) basis when assets share similar risk characteristics. Accordingly, a seller needs to record an additional allowance for any expected credit losses based on the expected collections across its trade receivables portfolio.
A seller will need to use significant judgment in determining whether recorded receivables are not collectible because the seller had provided an implicit price concession or as a result of incremental credit risk beyond what was contemplated when the transaction price was established. Therefore, the seller will need to evaluate all of the relevant facts and circumstances of arrangements to determine whether the seller has provided implicit price concessions or whether the anticipated receipt of less than the original contractual consideration represents additional credit risk that may require the seller to record additional credit losses upon the adoption of ASC 326-20. Credit losses are measured based on the losses expected to be incurred over the entire contractual term (i.e., the period over which the receivables recorded will be collected).
---------------------------------------------------------------------------------------------------------------Although I cannot possibly cover all VC forms out here, hope this article can be of assistance when you encounter certain difficult VC scenarios. Again, please feel free to join the LinkedIn Group if you are interested in solving revenue accounting and financial reporting issues within ASC 606.
AI & Digital Transformation Advisor | Fintech SME | CEO & Chief Solution Architect at Lightbridge | Author | Husband and Proud Father
1 年Excellent write-up, Ray.