ASC 606 Variable Consideration, Constraint and Audit Tests

Step 3 of ASC 606 sets the transaction price, and variable consideration is where that step turns into an estimate. Rebates, volume discounts, refunds, credits, performance bonuses and price concessions all make the amount a customer pays uncertain. The standard requires management to estimate the amount, then limit what enters revenue. Both parts are judgments an auditor tests. The five-step model is in ASC 606 revenue recognition, and the broader testing approach is in revenue recognition audit procedures. This post covers the estimation and constraint mechanics and the procedures that test them.

What counts as variable consideration

Variability arises from discounts, rebates, refunds, credits and similar items, whether stated in the contract or implied by customary business practices. Two sources of variability need separate attention in file review:

Stated terms: a rebate schedule, a performance bonus, a penalty for missed service levels, a right of return.
Implied terms: a history of granting price concessions or accepting returns that creates a valid expectation with the customer, even where the contract is silent.

The second source is the one clients overlook. A contract with fixed prices still holds variable consideration when the entity has a practice of granting concessions.

Step one: choose the estimation method

ASC 606-10-32-8 gives two methods and one selection rule. The entity uses the method it expects to better predict the amount of consideration to which it will be entitled.

Expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. It fits an entity with a large number of contracts that have similar characteristics.

Most likely amount is the single most likely amount in a range of possible amounts. It fits a contract with two possible outcomes, such as earning or not earning a performance bonus.

The method is a prediction tool, not a free choice between a higher and a lower number.

Worked example. A manufacturer sells to many distributors under a volume rebate. For a distributor's year, the rebate outcomes are $0 with 15% probability, $50,000 with 40% and $100,000 with 45%. Because the manufacturer holds many similar contracts, expected value applies: 15% times $0, plus 40% times $50,000, plus 45% times $100,000 equals $65,000. A contract-level view shows that $65,000 is not a possible outcome for any one distributor, and the TRG discussion confirms that is acceptable under the expected value method: the estimated transaction price is not required to be a possible outcome in an individual contract. The portfolio of contracts is what makes the estimate predictive.

A single construction contract with a $200,000 bonus for finishing by a fixed date has two outcomes. Most likely amount applies, and the estimate is either $200,000 or $0 on the assessment of which outcome is more probable.

Step two: apply the constraint

Estimating the amount is not the end. ASC 606-10-32-11 allows an entity to include some or all of the estimated variable consideration in the transaction price only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is resolved. The assessment weighs both the likelihood and the magnitude of a reversal.

ASC 606-10-32-12 lists factors that increase the likelihood or magnitude of a reversal. Each is a prompt for an inquiry and a document request:

Consideration highly susceptible to factors outside the entity's influence, such as market volatility, judgment or actions of third parties, or weather.
Uncertainty not expected to resolve for a long period.
Limited experience with similar contracts, or experience with limited predictive value.
A practice of offering a broad range of price concessions or changing payment terms for similar contracts.
A large number and broad range of possible consideration amounts.

Constraint with expected value. In the manufacturer example, the question arises whether the constraint cuts the $65,000 to the highest outcome that is both possible and probable, which is $50,000. The TRG discussion records two views. A few members favored limiting the estimate to $50,000. Most members held that the constraint does not automatically reduce the amount, because that approach would not produce revenue consistent with the core principle of Topic 606. Under the majority view, the entity does not switch to the most likely amount to apply the constraint. It applies the constraint using the expected value method, and still considers whether a reduction below $65,000 is warranted.

Step three: reassess every reporting period

The estimate is not set at contract inception. At each reporting period the entity revisits the estimate of variable consideration, including whether the estimate is constrained. ASC 606-10-32-14 requires the entity to update the estimated transaction price at the end of each reporting period, including the assessment of the constraint. Subsequent changes in the transaction price are accounted for under ASC 606-10-32-42 through 32-45. A rebate accrued at 4% in the first quarter that is tracking to 6% at year-end produces a cumulative catch-up in the period of the change, and the audit file should show the update at each reporting date, not only at year-end.

How the estimate shows up in the books

Variable consideration reduces revenue and creates a liability or a contra-asset. In a QuickBooks-based client, look for:

an accrued rebate or customer-incentive liability that is a round number or never changes between periods,
credit memos posted in the first weeks of the next year for prior-year sales,
a returns reserve with no calculation behind it,
revenue booked at the full contract price with bonus or penalty clauses unrecorded.

Each pattern points to a missing or unsupported estimate. The deferred revenue schedule is a related account, since refunds and rebates sit alongside contract liabilities on the same lead schedule. Principal-versus-agent conclusions also affect which amounts are variable, so read gross vs net revenue together with this post.

Audit procedures

Treat the estimate as an accounting estimate under AU-C 540, with a risk assessment that covers the method, the data, the assumptions and management's point estimate.

1. Identify the population of variable terms. Read a sample of contracts, price lists, rebate programs, return policies and side letters. Ask sales management, not only accounting, about concessions granted outside written terms. Compare the list to the client's accrual schedule and flag each term with no accrual.

2. Evaluate the method selection. Confirm management documented why expected value or most likely amount better predicts the outcome for each source of variability, and that the choice is applied consistently from period to period.

3. Test the inputs. Recompute probabilities and historical outcome data from source records: rebate payout history, return rates, credit memo registers. Check completeness of the data set by reconciling it to the general ledger.

4. Evaluate the constraint. Obtain management's assessment against each of the five factors in 606-10-32-12 and evaluate it against what you know of the client: new product with no history, volatile end market, a customer base with a record of negotiated concessions. A constraint memo that lists the five factors and concludes "no constraint" without client-specific evidence is not support.

5. Use subsequent events and settlements. Examine credit memos, rebate payments and returns after year-end for the period up to the report date. A settlement that differs from the accrual measures the estimate's accuracy and informs the assessment of management bias.

6. Develop a point estimate or range where the risk is significant, and compare it to management's number. Where management's estimate sits at one edge of the range every period, report the indicator under the bias evaluation in AU-C 540.

7. Test cutoff and the reassessment. Confirm the estimate was updated at each reporting date, and trace credit memos issued after year-end to the period of the related sale.

8. Check disclosures. Confirm the revenue note describes variable consideration, the methods used and the significant judgments.

Documentation to request at planning

Contract inventory with variable terms flagged
Rebate, incentive and returns accrual schedule by customer or program
Management's method and constraint memo
Credit memo register for the year and the first 60 days after year-end
Historical payout and return data used in the estimate

Add these to the PBC list at planning so the data arrives before fieldwork.

Sources

CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.

Part of CORAA University · US GAAP for private companies: related guides, calculators and templates.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error

ASC 606 Variable Consideration and the Constraint: Estimation Methods and Audit Procedures