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.
FASB ASC 606 requires that a variable amount that is promised within a contract be included as a consideration. To this end, an entity should estimate the amount of the consideration to which it will be entitled in exchange for transferring the promised goods or services to a customer. Variable consideration includes discounts, credits, rebates, performance bonus, penalties, sales returns, refunds, price concessions, incentives, etc.
The transaction price includes such variable considerations, whether explicitly stated in the contract or implicitly stated. A variable consideration exists even if the promised consideration is based upon the occurrence or nonoccurrence of a future event. For example, the performance bonus earned on the completion of a project in the future or a volume discount upon achieving certain volume. In addition, the entity’s intentions, customary practices, policies or offers on their website can also indicate the existence of variable consideration.
Variable consideration can be estimated in two methods:
- The expected value approach – This method is the sum of probability-weighted amounts in a range of possible consideration amounts. This method is appropriate when the entity has a large number of contracts with similar characteristics.
- The most likely amount – This method is appropriate when there is a single most likely outcome from the contract of the two possible outcomes.
An entity should select and apply one method consistently for similar types of contracts when estimating the variable consideration amount. In order to estimate the variable consideration, an entity should consider using historical data, current data or reasonable projections that are available at the time. The data used for estimation would typically correlate with information used for budgeting, proposals and bids, and setting process of goods and services.
Constraining estimates of variable consideration
An entity should include in the transaction price some or all of an amount of variable consideration 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 resolved subsequently.
The magnitude and possibility of the reversal in revenue should be determined in order to assess such probability. The risk of revenue reversal increases if the following factors exist:
- The estimate is sensitive and can be impacted greatly by market volatility, weather conditions, legal and regulatory changes, internal factors, etc.
- The entity has limited experience with similar contracts or situations
- The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances
- The contract has a large number and broad range of possible consideration amounts
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time
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.
Time value of money
One of the requirements to determine transaction price includes adjusting the consideration for time value of money if the timing of payments provides the customer, or entity, with a significant benefit of financing the transferred goods or services to the customer.
The timing of the payments could be explicitly or implicitly agreed upon between the parties. Such contracts are deemed to have a significant financing component. Essentially, by adjusting the transaction price for a significant financing component, the entity is adjusting the revenue recognized to the amount that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they were transferred to the customer.
The following facts should be considered to assess if a significant financing component exists in the contract and whether it is material to that contract:
- The difference between the cash price of the promised goods or services and the amount of promised consideration, and
- The combined effect of :
- The expected length of time between the payment and the transfer of the promised goods and services
- The prevailing interest rates at the time of the contract
A significant financing component does not exist in the following situations:
- If the customer has prepaid for the goods and services and the timing of the delivery of the goods or services is at the discretion of the customer
- If the consideration is a sales-based royalty or is based on the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity
- The difference between the promised consideration and the cash price of the good or service exists for reasons other than financing either party
When estimating the time value of money, an entity should use the discount rate that would be used in a similar but separate financing transaction between the entity and its customer at contract inception. Once the discount rate is set at contract inception, it should not be adjusted for changes in interest rates or changes in the assessment of the customer’s credit risk.
Interest income or interest expense resulting from the time value of money adjustment should be presented separately from revenue from contracts with customers in the statement of comprehensive income.
Practical Expedient: If the period between when the entity transfers a promised good or service to a customer and the payment is one year or less, the entity need not adjust the amount of consideration for the effect of significant financing component.