Variable Consideration (It’s Probable)
ASC 606, Revenues from Contracts with Customers
For most privately-held construction companies, ASC 606, Revenues from Contracts with Customers, has been effective for over two years. For many construction companies, the transition to ASC 606 was not too bad, but it did make subtle changes in certain areas that continue to raise questions. One of those areas is estimating the contract price, i.e., total estimated consideration due under the long-term contract. ASC 606-10-32-2 states:
“An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both”.
What’s The Transaction Price?
ASC 606-10-32-4 defines the transaction price as:
“For the purpose of determining the transaction price, an entity shall assume that the goods or services will be transferred to the customer as promised in accordance with the existing contract and that the contract will not be canceled, renewed, or modified”.
In other words, contractual options to modify a contract are ignored when determining the transaction price.
The transaction price consist of 1) fixed consideration, 2) variable consideration, 3) financing components, 4) noncash consideration, and 5) consideration payable to the customer.
The area that seems to be the most contentious and has a significant impact on many contractors is variable consideration.
What is Variable Consideration?
ASC 606-10-32-5 states:
“If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.”.
So, the amount of consideration the company expects to receive should be estimated. Variable consideration is not fixed but is based on uncertain events. For a contractor, variable consideration may include unit-priced contracts (price per unit is fixed, but the quantities are uncertain), incentive bonuses, liquidated damages, shared savings, change orders, and claims.
ASC 606 is a principles-based standard that requires contractors to reasonably estimate profit for variable considerations, even at the early stages of a contract. The amount of variable consideration is determined at the beginning of the contract and is updated each reporting period. It may result in adjustments to the contract amount for incentive bonuses before the contract is complete, recognition of change orders before a formal change order is finalized, and adjustment to the contract price for claims before the claim resolution process is concluded.
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. This probability is based on certain revenue constraints.
Under ASC 606-10-32-8, variable consideration is determined under one of the following probability methods:
- Expected value approach
- Most likely amount approach
The expected value approach is based on the sum of probability-weighted amounts in a range of multiple expected consideration possibilities. The most likely amount approach is used, generally, when there are two possibilities. The possibility that is most likely is chosen as the variable consideration amount.
These two methods are not elections but are determined based on the facts and circumstances. Therefore, the expected value approach may be used on one contract, and the most likely amount approach used on another contract within the same year. However, the method chosen for a particular contract should be consistently applied throughout that contract.
Constraints to Revenue RecognitionASC 606-10-32-11 states:
“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”.
Under ASC 606-10-32-12, when assessing probabilities that a significant reversal in the amount of cumulative revenue will not occur, the contractor should consider both the likelihood and magnitude of the following constraints to revenue recognition:
- Factors outside the contractor’s influence:
- Market volatility
- Weather conditions
- Settled through adjudication or arbitration
- This would generally increase the degree of uncertainty regarding the amount of consideration, causing a delay in revenue recognition until the uncertainty is resolved.
Probable is defined in the ASC 606-10-20 as “The future event or events are likely to occur.”
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. Therefore, it is considered a high bar to reach.
- For example, you adjust the contract amount to include:
- Incentive bonuses for early completion if you are 75%+ confident that the revenue recognized will not reverse later.
- Pending/unsigned or unpriced change orders if you are 75%+ confident that significant revenue will not reverse.
- Same with claims, liquidated damages, shared savings, etc.