Step 3: variable consideration and the constraint

• Identify sources of variable consideration in a contract and in business practice
• Choose between the expected value and most likely amount methods
• Apply the constraint using the likelihood and magnitude of a reversal
• Update the estimate at each reporting date and account for the change

What counts as variable

The transaction price is the consideration the entity expects to be entitled to, excluding amounts collected for third parties. Under 606-10-32-6, consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties and similar items, or because entitlement depends on a future event. A right of return makes consideration variable. So does a fixed bonus paid only if a milestone is hit.

Variability can come from the entity's practice, not just the contract. If the entity has a history of granting concessions or the customer has a valid expectation of one, the price is variable even when the contract states a fixed amount.

Two estimation methods

Under 606-10-32-8, the entity uses whichever method better predicts the amount it will be entitled to:

• Expected value: the sum of probability-weighted amounts across the range. Suits a large number of contracts with similar characteristics, such as volume rebates on many customers.
• Most likely amount: the single most likely outcome. Suits a binary result, such as a bonus that is either earned or not.

The method is chosen per type of uncertainty and applied consistently through the contract. Use all reasonably available historical, current and forecast information.

The constraint

Under 606-10-32-11, the entity includes variable consideration 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. "Probable" in US GAAP means likely to occur. The test looks at both likelihood and magnitude.

606-10-32-12 lists factors that increase the likelihood or magnitude of a reversal:

• the amount is highly susceptible to factors outside the entity's influence (market volatility, third-party judgment, weather, obsolescence);
• the uncertainty will not be resolved for a long time;
• experience with similar contracts is limited or has limited predictive value;
• the entity has a practice of offering a broad range of price concessions or changing terms; and
• the contract has a large number and broad range of possible amounts.

The constraint applies to the estimate, not all-or-nothing. An entity can include the portion of a bonus that is not at risk of reversal and exclude the rest.

Exceptions and related items

• Sales-based or usage-based royalties on licenses of intellectual property follow the royalty exception in 606-10-55-65: revenue is recognized at the later of the subsequent sale or usage, or satisfaction of the related performance obligation. The general constraint is not applied to them.
• Returns. Revenue is recognized net of expected returns, with a refund liability and an asset for the right to recover products, measured at former carrying amount less expected recovery costs.
• Price concessions versus credit losses. An expected concession reduces revenue. An impairment of a receivable after the price is agreed is a credit loss under Topic 326.

Reassessment

Under 606-10-32-14, the entity updates the estimated transaction price, including the constraint, at the end of each reporting period. Changes are allocated to performance obligations on the same basis as at inception. Amounts allocated to satisfied performance obligations hit revenue in the period of the change.

What auditors look for

Variable consideration is an accounting estimate, so AU-C 540 applies. Test the data (historical rebate and return rates), the assumptions (customer volume forecasts) and the method. Compare last year's estimate with actual outcomes as a retrospective review. The variable consideration audit guide and the calculator show the mechanics.

A volume rebate across a year