Chapter 6 — Step 3: Determine the Transaction Price

6.3 Variable Consideration

ASC 606-10

32-6 An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

32-7 The variability relating to the consideration promised by a customer may be explicitly stated in the contract. In addition to the terms of the contract, the promised consideration is variable if either of the following circumstances exists:

The customer has a valid expectation arising from an entity’s customary business practices, published policies, or specific statements that the entity will accept an amount of consideration that is less than the price stated in the contract. That is, it is expected that the entity will offer a price concession. Depending on the jurisdiction, industry, or customer this offer may be referred to as a discount, rebate, refund, or credit.
Other facts and circumstances indicate that the entity’s intention, when entering into the contract with the customer, is to offer a price concession to the customer.

As noted above, ASC 606 creates a single framework under which an entity assesses variable consideration in a contract with a customer to determine the amount to include in its transaction price. The decision tree below illustrates the application of that framework.

6.3.1 Identifying Variable Consideration

As the FASB and IASB acknowledge in paragraph BC190 of ASU 2014-09, consideration in a contract with a customer may vary as a result of many different factors, and variability may arise in many different circumstances. Variable consideration is easiest to identify in a contract when price (P) or quantity (Q), or both, are not fixed and known at the contract’s inception.

For example, an entity may enter into a contract with a customer to sell 1,000 barrels of crude oil every month for 12 months at the prevailing market index price for the contract’s delivery location. The entity determines that (1) the contract meets the criteria in ASC 606-10-25-1 to be accounted for as a contract with a customer and (2) each barrel of oil delivered is a distinct performance obligation in accordance with ASC 606-10-25-14(a). In this arrangement, Q is fixed, but P varies on the basis of changes in the market price of oil. As a result, the total transaction price calculation of P × Q is variable.

The identification of variable consideration may become more complicated when only part of P or Q, or both, is not fixed and known at the contract’s inception. Assume the facts of the preceding example, except that the price of each barrel of crude oil is the prevailing market index price plus $5. Now, part of the transaction price is fixed because regardless of the market price of oil, the entity will receive consideration of at least P × Q = $5 × (1,000 × 12) = $60,000.

The boards acknowledge in paragraphs BC190 through BC194 of ASU 2014-09 that consideration in a contract may vary as a result of unresolved contingencies (i.e., variability in transaction price inputs other than P or Q). In these instances, the occurrence or nonoccurrence of a future event would trigger a cash flow stream in the contract. Such contingency-based variability may be explicit in a contract (e.g., a contract providing for a sale with a right of return, as noted in paragraph BC191).

Example 20 in ASC 606 illustrates a performance penalty (bonus) as a form of explicit contingency-based variable consideration.

ASC 606-10

Example 20 — Penalty Gives Rise to Variable Consideration

55-194 An entity enters into a contract with a customer to build an asset for $1 million. In addition, the terms of the contract include a penalty of $100,000 if the construction is not completed within 3 months of a date specified in the contract.

55-195 The entity concludes that the consideration promised in the contract includes a fixed amount of $900,000 and a variable amount of $100,000 (arising from the penalty).

55-196 The entity estimates the variable consideration in accordance with paragraphs 606-10-32-5 through 32-9 and considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration.

The boards also note in paragraph BC192 of ASU 2014-09 that they decided to include in the determination of the transaction price consideration that is implicitly variable in the arrangement. The consideration to which an entity is ultimately entitled may be less than the price stated in the contract because the customer may be offered, or expects, a price concession. This creates variability in the amount to which an entity expects to be entitled and is thus a form of variable consideration even though there is no explicitly stated price concession in the contractual terms. Accordingly, an entity should consider all facts and circumstances in a contract with a customer to determine whether it would accept an amount that is lower than the consideration stated in the contract. If so, the total transaction price is variable because it is contingent on the occurrence or nonoccurrence of an event (i.e., the entity’s grant of an implicit price concession to the customer).

Entities will need to use significant judgment in determining whether they have provided an implicit price concession (i.e., whether they have the expectation of accepting less than the contractual amount of consideration in exchange for goods or services) or have accepted a customer’s credit risk (i.e., whether they have accepted the risk of collecting less consideration than what they legitimately expected to collect from the customer). Credit risk, as noted in Section 6.1.2, is generally not measured as part of the transaction price (except in the determination of the discount rate an entity should use when adjusting the transaction price for a significant financing component [see Section 6.4.4] or in the determination of potential concessions associated with credit risk [see Section 6.1.2]) but is addressed in step 1 of the revenue model as part of the gating analysis of whether revenue from a contract with a customer should be recognized in accordance with ASC 606. Further, Section 4.3.5.2 discusses indicators of when the variability between the contractually stated price and the amount the entity expects to collect is due to a price concession.

In addition to the forms of variability already discussed, the following are common features in contracts with customers that also may be more difficult to identify as variable consideration but nevertheless drive variability in contract consideration:

Royalty arrangements (further discussed in Section 6.3.5.1).
Product returns and other customer credits (further discussed in Sections 6.3.5.2 and 6.3.5.3).
Variable quantities and volumetric optionality (further discussed in Section 6.3.5.4).
Rebates (volume-based rebates are further discussed in Section 6.3.5.4.2).
Discounts (cash discounts are further discussed in Section 6.3.5.5.3; and volume discounts are discussed in Example 24 from ASC 606, which is included in Section 6.3.5.4.2).
Performance-based bonuses or penalties (further discussed in the context of bonuses in Section 6.3.2.1; and also further discussed in the context of both bonuses and penalties and in Example 21 of ASC 606, which is included in Section 6.3.2.3).

6.3.2 Estimating Variable Consideration

Regardless of the form of variability or its complexity, once variable consideration is identified, an entity must estimate the amount of variable consideration to determine the transaction price in a contract with a customer.

ASC 606-10

32-5 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.

32-8 An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

The expected value — The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.
The most likely amount — The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

32-9 An entity shall apply one method consistently throughout the contract when estimating the effect of an uncertainty on an amount of variable consideration to which the entity will be entitled. In addition, an entity shall consider all the information (historical, current, and forecast) that is reasonably available to the entity and shall identify a reasonable number of possible consideration amounts. The information that an entity uses to estimate the amount of variable consideration typically would be similar to the information that the entity’s management uses during the bid-and-proposal process and in establishing prices for promised goods or services.

Paragraph BC199 of ASU 2014-09 notes that when the FASB and IASB deliberated the guidance to be included in the revenue standard, they “observed that users of financial statements are most interested in knowing the total amount of consideration that ultimately will be realized from the contract.” The boards decided that the most decision-useful information about the transaction price in a contract with a customer is an estimate that will better predict the amount of consideration to which the entity will be entitled. The concept of transaction price (i.e., the amount to which the entity expects to be entitled) differs from that of fair value. The transaction price is a contract-specific measurement that is determined on the basis of the entity’s estimation process (which inherently incorporates historical practice and forward expectations), whereas fair value is a market-based measurement.

Initially, the boards decided that a probability-weighted model of measuring the transaction price at its expected value best allowed entities to predict the amount of consideration to which they will ultimately be entitled. In the boards’ 2010 exposure draft on revenue (issued by the FASB as a proposed ASU), the boards proposed requiring a single estimation technique of expected value. However, in light of feedback on the practical challenges of such an approach, the boards were sympathetic to stakeholders’ concerns about fact patterns with, for example, an “all or nothing” performance bonus (in which the entity would either receive the entire performance bonus or nothing). Specifically, as noted in paragraph BC200 of ASU 2014-09, the boards acknowledged that in a contract with variable consideration that could result in only one of two outcomes upon the occurrence of a binary event (such as in the “all or nothing” performance bonus fact patterns), an expected value calculated through probability weighting would not be one of those two possible outcomes and thus would not be a decision-useful estimate. Consequently, the boards decided that both an expected value method and a most likely amount method are acceptable for an entity to consider when selecting the most appropriate method of estimating variable consideration within the parameters of the objective in ASC 606-10-32-8 (see Section 6.3.2.1 for further discussion of selecting the most appropriate method).

Connecting the Dots

As stated in the first sentence of ASC 606-10-32-9, a single method of estimating variable consideration should be used throughout the term of the contract with the customer. That is, the method of estimating variable consideration should not be reassessed or changed once it is selected as the most appropriate.

In paragraph BC197 of ASU 2014-09, the boards briefly discuss “management’s best estimate” as a method of estimating variable consideration and acknowledge stakeholders who noted in deliberations that such a method “would provide management with the flexibility to estimate on the basis of its experience and available information without the documentation that would be required when a measurement model is specified.” However, as noted in paragraph BC201 of ASU 2014-09, the boards do not anticipate that either the most likely amount method or the expected value method of estimating variable consideration will be too costly or complex for entities to apply to contracts with customers. Specifically, the boards allow that an entity would not be expected to develop complex modeling techniques to identify all possible outcomes of variable consideration when determining the most likely outcome or a probability distribution of outcomes. Thus, the benefits of applying the most likely amount method or the expected value method to estimate variable consideration exceed the costs of doing so.

Although we think that it is appropriate for an entity to be pragmatic in deriving an estimate by using either the most likely amount method or the expected value method as required, we do not think that it is appropriate to use a method described as management’s best estimate as either the most likely amount or the expected value of variable consideration.

6.3.2.1 Selection of Method Used to Estimate Variable Consideration

When determining the appropriate method for estimating variable consideration, an entity should choose whichever method will better predict the amount of consideration to which it will become entitled. When a contract has only two possible outcomes, it will often be appropriate to estimate variable consideration by using a method based on the most likely amount. When the entity has a large number of contracts with similar characteristics and the outcome for each contract is independent of the others, the expected value method may better predict the overall outcome for the contracts in the aggregate. This will be true even when each individual contract has only two possible outcomes (e.g., a sale with a right of return). This is because an entity will often have better information about the probabilities of various outcomes when there are a large number of similar transactions.

It is important, however, to consider carefully whether the outcome for each contract is truly independent of the others. For example, if the outcome is binary but is determined by the occurrence or nonoccurrence of the same event for all contracts (i.e., the variable amount will be received either for all of the contracts or for none of them), the expected value is unlikely to be a good predictor of the overall outcome and the entity may need to use the most likely amount method to estimate the variable consideration in the contracts.

Example 6-1

Each year, Entity X’s performance is ranked against that of its competitors in a particular jurisdiction. All of X’s customer contracts specify that a fixed bonus of $500 will be due to X if it is ranked in the top quartile. Entity X has approximately 1,000 customer contracts.

Entity X should estimate the variable consideration (i.e., the bonus) on the basis of the most likely amount. Although X has a large number of similar contracts, the outcomes are not independent because they all depend on the same criterion (i.e., the ranking of X against its competitors). The bonus will be payable under either all the contracts or none of them. Thus, the overall outcome for the contracts in the aggregate will be binary and the expected value will not be a good predictor of that overall outcome.

6.3.2.2 Using a Portfolio of Data Versus the Portfolio Practical Expedient When Applying the Expected Value Method

When an entity applies the expected value method, it may consider evidence (i.e., a portfolio of data) from other similar contracts to form its estimate of expected value. Stakeholders raised questions about whether the evaluation of a portfolio of data from other similar contracts in estimating an expected value of variable consideration would mean that an entity is applying the “portfolio practical expedient” discussed in Section 3.1.2.2. The concern was exacerbated by the follow-on question of whether an entity using a portfolio of data to estimate an expected value would also need to meet the necessary condition of the portfolio practical expedient that the results of doing so may not differ materially from the results of applying the guidance to the contracts individually.

The example below clarifies that an entity’s use of a portfolio of data from other similar contracts to calculate an estimate of the expected value of variable consideration is not the same as using the portfolio practical expedient.

Example 6-2

Entity B enters into a contract to sell Product X to Customer C for $50. Entity B’s policy allows unused products to be returned within 30 days for a refund. Therefore, the contract includes variable consideration. In addition to the transaction with C, B has a large number of similar sales of Product X (i.e., a homogeneous population of contracts) with the same right of return provision.

There are two methods for estimating variable consideration under ASC 606: (1) the expected value method and (2) the most likely amount method. See Section 6.3.2.1 for guidance on factors to be considered in the selection of the most appropriate method in particular circumstances.

Under the expected value method, B considers a portfolio of historical data that includes contracts for Product X. Entity B concludes that this portfolio of historical data is relevant and consistent with the characteristics of the contract with C. The portfolio of data indicates that 10 out of every 100 products were returned. Using this portfolio of data, B estimates the expected value to be $45, or $50 – ($50 × 10%), for the sale of Product X to C. That is, when a portfolio of data is used to estimate variable consideration under the expected value method, the amount estimated may not represent a possible outcome of an individual contract.

If B were to apply the most likely amount method, it would consider the two possible outcomes for this contract (i.e., $0 and $50) and estimate the variable consideration to be $50.

In accordance with ASC 606-10-32-8, B should estimate variable consideration by using whichever method will better predict the amount of consideration to which it will become entitled. When selecting which method to use to estimate variable consideration in accordance with ASC 606-10-32-8, B concludes that the expected value method will better predict the amount of consideration to which it will become entitled (see Section 6.3.2.1). That is, an estimate of $45 is likely to be consistent with the ultimate resolution of the uncertainty related to the product return right in these circumstances. This is because when there are a large number of similar transactions (i.e., a homogeneous population of contracts), the entity’s expectation of the amount of consideration to which it will be entitled is better predicted by reference to the probabilities of outcomes exhibited by that portfolio of similar data. By using a portfolio of data to make an estimate of variable consideration, an entity considers evidence from other, similar contracts to form an estimate of expected value.

It is important to highlight that in this example, B is not applying the portfolio practical expedient.2 An entity’s election to use a portfolio of contracts to make estimates and judgments about variable consideration (including evaluating the constraint) for a specific contract is not the same as using the portfolio approach as a practical expedient. Therefore, the restriction on using the portfolio practical expedient (i.e., the entity does not expect the results of applying ASC 606 to a portfolio of contracts with similar characteristics to be materially different from the results of applying the guidance to the individual contracts in the portfolio) does not apply.

The above issue is addressed in Q&A 39 (compiled from previously issued TRG Agenda Papers 38 and 44) of the FASB staff’s Revenue Recognition Implementation Q&As (the “Implementation Q&As”). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.3.2.3 Using More Than One Method to Estimate Variable Consideration Within One Contract

When a contract contains multiple elements of variability, an entity can use more than one method (i.e., the expected value method and the most likely amount method) to estimate the amount of variable consideration to include in the transaction price. Example 21 in ASC 606-10-55-197 through 55-200 (reproduced below) shows that an entity should prepare a separate estimate for each element of variable consideration in a contract (i.e., for each uncertainty) by using either the expected value method or the most likely amount method, whichever method better predicts the amount of consideration to which it will be entitled.

ASC 606-10

Example 21 — Estimating Variable Consideration

55-197 An entity enters into a contract with a customer to build a customized asset. The promise to transfer the asset is a performance obligation that is satisfied over time. The promised consideration is $2.5 million, but that amount will be reduced or increased depending on the timing of completion of the asset. Specifically, for each day after March 31, 20X7 that the asset is incomplete, the promised consideration is reduced by $10,000. For each day before March 31, 20X7 that the asset is complete, the promised consideration increases by $10,000.

55-198 In addition, upon completion of the asset, a third party will inspect the asset and assign a rating based on metrics that are defined in the contract. If the asset receives a specified rating, the entity will be entitled to an incentive bonus of $150,000.

55-199 In determining the transaction price, the entity prepares a separate estimate for each element of variable consideration to which the entity will be entitled using the estimation methods described in paragraph 606-10-32-8:

The entity decides to use the expected value method to estimate the variable consideration associated with the daily penalty or incentive (that is, $2.5 million, plus or minus $10,000 per day). This is because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.
The entity decides to use the most likely amount to estimate the variable consideration associated with the incentive bonus. This is because there are only 2 possible outcomes ($150,000 or $0) and it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.

55-200 The entity considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration to determine whether the entity should include some or all of its estimate of variable consideration in the transaction price.

Because ASC 606-10-32-9 requires entities to apply one method consistently to each variable element throughout the contract, it would not be appropriate to switch between the most likely amount and expected value method for a particular variable element during the life of a contract.

An entity should also consider the guidance in ASC 606-10-32-11 through 32-13 on constraining estimates of variable consideration to determine whether it should include some or all of the variable consideration in the transaction price.

Example 6-3

Entity X, an IT service provider, enters into a unique contract with a customer to develop the customer’s Web site. To induce X to complete the project on a timely basis and to provide a solution that drives business growth for the customer, the fee receivable by X under the contract includes variable consideration that is determined as follows:

One element of the fee is based on the performance of the Web site and is determined by using a sliding scale from $500,000 to $1 million. The amount earned is based on a formula that uses a number of metrics (e.g., the number of pages viewed and the number of unique visitors) measured over the two-year period after the Web site is completed and fully functional.
The other element of the fee is based on the timely completion of the Web site and is determined as follows:
- $1 million if the Web site is completed and fully functional within 90 days of the signing of the contract.
- $500,000 if the Web site is completed and fully functional more than 90 days after the contract is signed.

Having considered the guidance in ASC 606-10-32-8 on selecting an appropriate method for estimating the amount of variable consideration, X applies the following methods to each element of variability in the contract:

The amount of consideration related to the performance of the customer’s Web site is estimated by using the expected value method because X estimates that it could be entitled to a wide range of possible consideration amounts (any amount between $500,000 and $1 million).
The amount of consideration related to the timely completion of the Web site is estimated by using the most likely amount method because this element of variable consideration has only two possible outcomes ($1 million if the Web site is completed and fully functional within 90 days or $500,000 if it is completed and fully functional after more than 90 days). Since the contract is unique, X does not have a pool of similar contracts from which to develop a portfolio of data it would need to use the expected value method.

Entity X should continue to use the selected method for each element consistently for the entire duration of the contract.

It is important to note the distinction between an element of variable consideration and a performance obligation. The former concept refers to a unique, incremental driver of variability or uncertainty in the transaction price, while the latter concept refers to a unit of account identified in step 2 (see Chapter 5). This distinction is intended to clarify that an estimate of variable consideration is performed for each incremental driver of variability at the contract level and not at the performance obligation level. A total transaction price for the contract, including any estimates of variable consideration, must be determined in step 3 before it can be allocated in step 4 to the performance obligations identified in step 2 (unless the invoice practical expedient for measuring progress toward complete satisfaction of a performance obligation [see Section 8.5.8.1] or the variable consideration exception under ASC 606-10-32-40 [see Section 7.5] is applied).

6.3.3 Constraining Estimates of Variable Consideration

Since revenue is one of the most important metrics to users of financial statements, the boards and their constituents agreed that estimates of variable consideration are only useful to the extent that an entity is confident that the revenue recognized as a result of those estimates will not be subsequently reversed. Accordingly, as noted in paragraph BC203 of ASU 2014-09, the boards acknowledged that some estimates of variable consideration should not be included in the transaction price if the inherent uncertainty could prevent a faithful depiction of the consideration to which the entity expects to be entitled in exchange for delivering goods or services. Thus, the focus of the boards’ deliberations on a mechanism to improve the usefulness of estimates in revenue as a predictor of future performance was to limit subsequent downward adjustments in revenue (i.e., reversals of revenue recognized). The result of those deliberations is what is commonly referred to as the “constraint.”

The constraint is thus a biased estimate that focuses on possible future downward revenue adjustments (i.e., revenue reversals) rather than on all revenue adjustments (i.e., both upward or favorable adjustments and downward or unfavorable adjustments). In paragraph BC207 of ASU 2014-09, the boards acknowledge that the constraint requirement “creates a tension with the notion of neutrality in the Boards’ respective conceptual frameworks” because of the downward bias in estimation. However, the boards ultimately accepted this bias in favor of user feedback, which placed primacy on the relevance of the estimate; and in the context of revenue, the preference was for the estimate not to be subject to significant future reversals.

ASC 606-10

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.

Inherent in the language of ASC 606-10-32-11 is a link between the measurement of variable consideration in the transaction price (step 3) and the recognition of an appropriate amount of revenue (step 5; see Chapter 8). That is, the constraint is naturally a measurement concept because it influences the amount of variable consideration included in the transaction price. However, its application is driven by a recognition concept and the avoidance of reversing the cumulative amount of revenue previously recognized.

During the development of the constraint guidance, its placement was debated since, as discussed in paragraph BC221 of ASU 2014-09, the boards concluded that the constraint includes concepts from both step 3 (measurement) and step 5 (recognition). Ultimately, the boards included the constraint in the measurement guidance of step 3, but the constraint guidance’s wording of the phrase “a significant reversal in the amount of cumulative revenue recognized will not occur” draws on recognition concepts. As explained in paragraph BC221, the boards observed that constraining the transaction price and limiting the cumulative amount of revenue recognized “are not truly independent objectives because the measurement of revenue determines the amount of revenue recognized. In other words, the guidance for constraining estimates of variable consideration restricts revenue recognition and uses measurement uncertainty as the basis for determining if (or how much) revenue should be recognized.”

ASC 606-10

32-12 In assessing whether it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur once the uncertainty related to the variable consideration is subsequently resolved, an entity shall consider both the likelihood and the magnitude of the revenue reversal. Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.
The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
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.

Inherent in ASC 606-10-32-12 are three key aspects of the assessment necessary to determine whether an estimate of variable consideration in a contract with a customer should be constrained in an entity’s transaction price:

The likelihood of a reversal in the cumulative amount of revenue recognized (i.e., a qualitative aspect).
The magnitude (or significance) of the potential reversal in the cumulative amount of revenue recognized (i.e., a quantitative aspect).
The threshold that triggers a constrained estimate (i.e., the use of “probable”).

In paragraph BC214 of ASU 2014-09, the boards acknowledge that the application of the constraint was designed to be part of a two-step process: (1) estimate variable consideration (see Section 6.3.2) and then (2) assess whether it is probable that a significant reversal in the amount of revenue recognized from that estimate of variable consideration will occur once the underlying uncertainty is resolved. However, the boards go on to explain in paragraph BC215 that an entity is not required to perform a two-step process if the entity “already incorporates the principles on which the guidance for constraining estimates of variable consideration is based.” The boards recognized that an entity may incorporate into its existing estimation processes today the qualitative principles inherent in applying the constraint. This notion is illustrated by the boards’ use of the indicators in ASC 606-10-32-12, which were derived from legacy, qualitative revenue guidance related to sales returns.

Further, in paragraph BC212 of ASU 2014-09, the boards address stakeholder concerns raised during the deliberations on the ASU that the application of the constraint would require a significantly quantitative process. The boards expressly acknowledge in their cost-benefit analysis of the standard’s revenue guidance that a quantitative process is not always required, and a qualitative analysis is expected to be sufficient for applying the constraint guidance in many cases.

The term “probable” in ASC 606-10-32-11 is intended to mean that “the future event or events are likely to occur,” which is consistent with the definition in ASC 450. Paragraph 56 of IFRS 15, the IFRS counterpart of ASC 606-10-32-11, uses the term “highly probable” rather than “probable.” Since “probable” is defined in IFRS 5 as “more likely than not,” paragraph 56 of IFRS 15 uses “highly probable” to achieve the same meaning as “probable” in ASC 606-10-32-11. Therefore, despite the difference in wording, there is no difference between the intended meaning of ASC 606-10-32-11 and that of paragraph 56 of IFRS 15. For a list of differences between U.S. GAAP and IFRS Accounting Standards regarding revenue-related issues on which the boards could not converge, see Appendix A.

Connecting the Dots

Although the guidance on constraining estimates of variable consideration is intended to avoid significant downward adjustments in revenue after it has been recognized, we generally do not think that it would be appropriate to constrain 100 percent of an estimate of variable consideration. That is, we do not think that the factors in ASC 606-10-32-12 could be so significant that an estimate of variable consideration should be entirely constrained from the transaction price. This concept is different from a $0 estimate of variable consideration. A 100 percent constraint on an estimate of variable consideration that is not $0, however, would generally go against the measurement principle of ASC 606, which is to include in the transaction price the amount to which an entity expects to be entitled for its performance so that the entity can provide financial statement users a better prediction of future revenues.

While the above is a general interpretation, there are exceptions in the revenue standard that may allow for a 100 percent constraint on an estimate of variable consideration. Example 25 in ASC 606-10-55 discusses an exception in which market-based factors are a significant driver of variability in the transaction price. Also, in paragraph BC415 of ASU 2014-09, the boards discuss their rationale for providing an exception for sales- or usage-based royalties in a license of intellectual property (IP). See Sections 6.3.5.1 and 12.7 for further discussion of sales- or usage-based royalties. Outside of these exceptions, an entity should include a minimum amount of variable consideration in the transaction price if management believes that this minimum amount is not constrained. While a minimum revenue amount stated in a contract may help an entity estimate this amount, management should not choose by default to make its estimate the minimum amount stated in the contract since there may be an amount of variable consideration in excess of that minimum for which it is probable that a significant reversal of revenue will not occur once the uncertainty is resolved.

Example 23 in ASC 606 (reproduced below) illustrates how an entity evaluates the constraint on estimates of variable consideration in the determination of the transaction price at the contract level.

ASC 606-10

Example 23 — Price Concessions

55-208 An entity enters into a contract with a customer, a distributor, on December 1, 20X7. The entity transfers 1,000 products at contract inception for a price stated in the contract of $100 per product (total consideration is $100,000). Payment from the customer is due when the customer sells the products to the end customers. The entity’s customer generally sells the products within 90 days of obtaining them. Control of the products transfers to the customer on December 1, 20X7.

55-209 On the basis of its past practices and to maintain its relationship with the customer, the entity anticipates granting a price concession to its customer because this will enable the customer to discount the product and thereby move the product through the distribution chain. Consequently, the consideration in the contract is variable.

Case A — Estimate of Variable Consideration Is Not Constrained

55-210 The entity has significant experience selling this and similar products. The observable data indicate that historically the entity grants a price concession of approximately 20 percent of the sales price for these products. Current market information suggests that a 20 percent reduction in price will be sufficient to move the products through the distribution chain. The entity has not granted a price concession significantly greater than 20 percent in many years.

55-211 To estimate the variable consideration to which the entity will be entitled, the entity decides to use the expected value method (see paragraph 606-10-32-8(a)) because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates the transaction price to be $80,000 ($80 × 1,000 products).

55-212 The entity also considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration to determine whether the estimated amount of variable consideration of $80,000 can be included in the transaction price. The entity considers the factors in paragraph 606-10-32-12 and determines that it has significant previous experience with this product and current market information that supports its estimate. In addition, despite some uncertainty resulting from factors outside its influence, based on its current market estimates, the entity expects the price to be resolved within a short time frame. Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $80,000) will not occur when the uncertainty is resolved (that is, when the total amount of price concessions is determined). Consequently, the entity recognizes $80,000 as revenue when the products are transferred on December 1, 20X7.

Case B — Estimate of Variable Consideration Is Constrained

55-213 The entity has experience selling similar products. However, the entity’s products have a high risk of obsolescence, and the entity is experiencing high volatility in the pricing of its products. The observable data indicate that historically the entity grants a broad range of price concessions ranging from 20 to 60 percent of the sales price for similar products. Current market information also suggests that a 15 to 50 percent reduction in price may be necessary to move the products through the distribution chain.

55-214 To estimate the variable consideration to which the entity will be entitled, the entity decides to use the expected value method (see paragraph 606-10-32-8(a)) because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates that a discount of 40 percent will be provided and, therefore, the estimate of the variable consideration is $60,000 ($60 × 1,000 products).

55-215 The entity also considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration to determine whether some or all of the estimated amount of variable consideration of $60,000 can be included in the transaction price. The entity considers the factors in paragraph 606-10-32-12 and observes that the amount of consideration is highly susceptible to factors outside the entity’s influence (that is, risk of obsolescence) and it is likely that the entity may be required to provide a broad range of price concessions to move the products through the distribution chain. Consequently, the entity cannot include its estimate of $60,000 (that is, a discount of 40 percent) in the transaction price because it cannot conclude that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Although the entity’s historical price concessions have ranged from 20 to 60 percent, market information currently suggests that a price concession of 15 to 50 percent will be necessary. The entity’s actual results have been consistent with then-current market information in previous, similar transactions. Consequently, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized will not occur if the entity includes $50,000 in the transaction price ($100 sales price and a 50 percent price concession) and, therefore, recognizes revenue at that amount. Therefore, the entity recognizes revenue of $50,000 when the products are transferred and reassesses the estimates of the transaction price at each reporting date until the uncertainty is resolved in accordance with paragraph 606-10-32-14.

Note that in the Codification example above, it is assumed as part of the fact pattern that control of the products is transferred to the distributor at contract inception. However, the fact that the distributor becomes obliged to pay for the products only when it sells them to end customers is an indication that this might be a consignment arrangement. Consignment arrangements are discussed in Section 8.6.8.

6.3.3.1 Constraint on Variable Consideration Assessed at the Contract Level

As described in Section 3.1.2, the transaction price for the contract is determined in step 3 of the revenue model and, hence, the unit of account for determining the transaction price is the contract level. The revenue constraint forms part of the determination of the transaction price; accordingly, the likelihood and significance of a potential revenue reversal should be assessed at the contract level

Example 6-4

An entity enters into a contract with a customer to provide equipment and consulting services. The contractual price for the equipment is $10 million. The consulting services are priced at a fee of $100,000, of which $55,000 is fixed and $45,000 is contingent on the customer’s reducing its manufacturing costs by 5 percent over a one-year period.

It is also concluded that:

The equipment and consulting services are separate performance obligations.
The stand-alone selling prices of the equipment and consulting services are $10 million and $100,000, respectively.

The entity believes that there is a 60 percent likelihood that it will be entitled to the performance-based element of the consulting services fee. As a result, by using the most likely amount approach described in ASC 606-10-32-8(b), the entity estimates the amount of the variable consideration as $45,000.

The total transaction price of the contract before the entity considers the constraint is, therefore, $10.1 million.

The entity then considers the constraint to determine whether it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. The entity considers both the likelihood and the magnitude of a revenue reversal at the contract level.

There is a 40 percent chance that the contingent consulting services fee of $45,000 will not be receivable. Accordingly, the entity concludes that it is not probable that the entity will be entitled to the variable consideration. However, the significance of the potential revenue reversal of $45,000 is evaluated in the context of the contract ($45,000 as a proportion of $10.1 million, or 0.45 percent of the transaction price) and not in the context of the performance obligation ($45,000 as a proportion of $100,000, or 45 percent of the amount assigned to the performance obligation). Therefore, the entity concludes that all of the variable consideration should be included in the transaction price because it is probable that a significant revenue reversal will not occur.

The above issue is addressed in Implementation Q&A 30 (compiled from previously issued TRG Agenda Papers 14 and 25). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.3.3.2 Estimating Multiple Elements of Variable Consideration and Assessing the Constraint on Variable Consideration

As stated in Section 6.3.2.3, Example 21 in ASC 606-10-55-197 through 55-200 shows that when a contract contains multiple elements of variability (e.g., sales returns, discounts, performance bonuses), an entity should prepare a separate estimate for each element of variable consideration in a contract (i.e., for each uncertainty) by using either the expected value method or the most likely amount method, whichever method better predicts the amount of consideration to which it will be entitled. Since the revenue constraint forms part of the determination of the transaction price, the likelihood and significance of a potential revenue reversal should be assessed at the contract level. Therefore, it is important for entities to be aware of the distinction between (1) preparing separate estimates for each element of variable consideration in a contract and (2) separately evaluating the constraint on estimates of variable consideration in the determination of the transaction price at the contract level.

Example 25 in ASC 606 (reproduced below) illustrates how an entity evaluates the constraint on estimates of each element of variable consideration in the determination of the transaction price at the contract level.

ASC 606-10

Example 25 — Management Fees Subject to the Constraint

55-221 On January 1, 20X8, an entity enters into a contract with a client to provide asset management services for five years. The entity receives a 2 percent quarterly management fee based on the client’s assets under management at the end of each quarter. In addition, the entity receives a performance-based incentive fee of 20 percent of the fund’s return in excess of the return of an observable market index over the 5-year period. Consequently, both the management fee and the performance fee in the contract are variable consideration.

55-222 The entity accounts for the services as a single performance obligation in accordance with paragraph 606-10-25-14(b), because it is providing a series of distinct services that are substantially the same and have the same pattern of transfer (the services transfer to the customer over time and use the same method to measure progress — that is, a time-based measure of progress).

55-223 At contract inception, the entity considers the guidance in paragraphs 606-10-32-5 through 32-9 on estimating variable consideration and the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration, including the factors in paragraph 606-10-32-12. The entity observes that the promised consideration is dependent on the market and, thus, is highly susceptible to factors outside the entity’s influence. In addition, the incentive fee has a large number and a broad range of possible consideration amounts. The entity also observes that although it has experience with similar contracts, that experience is of little predictive value in determining the future performance of the market. Therefore, at contract inception, the entity cannot conclude that it is probable that a significant reversal in the cumulative amount of revenue recognized would not occur if the entity included its estimate of the management fee or the incentive fee in the transaction price.

55-224 At each reporting date, the entity updates its estimate of the transaction price. Consequently, at the end of each quarter, the entity concludes that it can include in the transaction price the actual amount of the quarterly management fee because the uncertainty is resolved. However, the entity concludes that it cannot include its estimate of the incentive fee in the transaction price at those dates. This is because there has not been a change in its assessment from contract inception — the variability of the fee based on the market index indicates that the entity cannot conclude that it is probable that a significant reversal in the cumulative amount of revenue recognized would not occur if the entity included its estimate of the incentive fee in the transaction price. At March 31, 20X8, the client’s assets under management are $100 million. Therefore, the resulting quarterly management fee and the transaction price is $2 million.

55-225 At the end of each quarter, the entity allocates the quarterly management fee to the distinct services provided during the quarter in accordance with paragraphs 606-10-32-39(b) and 606-10-32-40. This is because the fee relates specifically to the entity’s efforts to transfer the services for that quarter, which are distinct from the services provided in other quarters, and the resulting allocation will be consistent with the allocation objective in paragraph 606-10-32-28. Consequently, the entity recognizes $2 million as revenue for the quarter ended March 31, 20X8.

6.3.4 Evaluating the Impact of Subsequent Events on Estimates of Variable Consideration

In certain circumstances, the uncertainty related to variable consideration may be resolved shortly after the end of the reporting period. When additional information (e.g., regulatory approval notification or denial) is received after the end of the reporting period and before the date on which financial statements are issued or available to be issued, an entity should refer to the guidance in ASC 855 on accounting for subsequent events. Paragraph BC228 of ASU 2014-09 states the following:

The Boards noted that in some cases, an entity might make an estimate of the amount of variable consideration to include in the transaction price at the end of a reporting period. However, information relating to the variable consideration might arise between the end of the reporting period and the date when the financial statements are authorized for issue. The Boards decided not to provide guidance on the accounting in these situations because they noted that the accounting for subsequent events is already addressed in Topic 855, Subsequent Events, and IAS 10, Events after the Reporting Period.

ASC 855 distinguishes between recognized subsequent events (ASC 855-10-25-1) and nonrecognized 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 date of the balance sheet 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 nonrecognized subsequent events.

In the life sciences industry, it is common for a life sciences entity to enter into a contract with a customer that entitles the life sciences entity to variable consideration in the event that the customer receives regulatory approval as a result of the R&D activities performed by the life sciences entity. Because the variable consideration is contingent on the customer’s receipt of regulatory approval, the life sciences entity is required to estimate the amount of variable consideration to include in the transaction price. The life sciences entity may conclude that such variable consideration should be constrained until regulatory approval is obtained.

However, ASC 855 does not provide direct guidance on how to account for additional information about regulatory approval or denial that is received after the end of the reporting period and before the date on which the financial statements are issued or are available to be issued. We believe that the conclusion to account for information received about the regulatory approval process as either a recognized or a nonrecognized subsequent event will be based on the facts and circumstances and may require significant judgment. Accordingly, entities are encouraged to consult with their accounting advisers.

6.3.5 Application to Different Forms of Variable Consideration

6.3.5.1 Sales- or Usage-Based Royalties

ASC 606-10

32-13 An entity shall apply paragraph 606-10-55-65 to account for consideration in the form of a sales-based or usage-based royalty that is promised in exchange for a license of intellectual property.

ASC 606-10-55-65 states that an entity may not recognize revenue from sales- or usage-based royalties related to licenses of IP until the later of (1) the subsequent sale or usage or (2) the satisfaction of the performance obligation to which some or all of the royalty has been allocated. See Section 12.7 for further discussion of sales- or usage-based royalties related to licenses of IP.

Consideration in the form of sales- or usage-based royalties is inherently variable depending on future customer actions. However, the FASB and IASB decided that the variability in the transaction price from sales- or usage-based royalties related to licenses of IP should be accounted for differently from the variability attributable to sales- or usage-based royalties that are not related to licenses of IP (see Chapter 12 for further discussion of licensing). Accordingly, ASC 606-10-55-65 effectively provides that the requirements related to estimating and constraining variable consideration are subject to an exception for sales- or usage-based royalties related to licenses of IP.

It is important to note that sales- or usage-based royalties that are not related to licenses of IP are still subject to the requirements related to estimating and constraining variable consideration (discussed in Sections 6.3.2 and 6.3.3, respectively). In light of this, the boards acknowledge in paragraph BC416 of ASU 2014-09 that economically similar transactions could be accounted for differently (e.g., royalty arrangements not related to licenses of IP could result in timing and amounts of revenue recognition that differ from those of royalty arrangements related to licenses of IP).

6.3.5.2 Refund Liabilities

ASC 606-10

32-10 An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer. A refund liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price). The refund liability (and corresponding change in the transaction price and, therefore, the contract liability) shall be updated at the end of each reporting period for changes in circumstances. To account for a refund liability relating to a sale with a right of return, an entity shall apply the guidance in paragraphs 606-10-55-22 through 55-29.

Refund liabilities are first introduced in ASC 606 as a form of variable consideration — specifically, in ASC 606-10-32-10. That is, the fact that an entity may have to refund to its customer some of the consideration it is promised in the contract is a creator of variability in the amount of consideration to which the entity is ultimately expected to be entitled in exchange for delivering the goods or services in the contract. In ASC 606-10-32-10, the FASB expressly linked the accounting for refund liabilities to their most common application, in sales with a right of return (which are discussed in Section 6.3.5.3). However, there could be other circumstances in which refund liabilities arise in revenue contracts. Entities should carefully consider circumstances in which cash is expected to be refunded to a customer when evaluating whether a refund liability should be recognized.

In addition, as discussed in Section 14.3, refund liabilities are to be presented separately from contract liabilities in the balance sheet. Refund liabilities would generally not be presented in Schedule II — Valuation and Qualifying Accounts as described in SEC Regulation S-X, Rules 5-04 and 12-09.

Presentation of refund liabilities is further discussed in Chapter 14.

6.3.5.3 Sales With a Right of Return

ASC 606-10

55-22 In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following:

A full or partial refund of any consideration paid
A credit that can be applied against amounts owed, or that will be owed, to the entity
Another product in exchange.

55-23 To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following:

Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)
A refund liability
An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.

55-24 An entity’s promise to stand ready to accept a returned product during the return period should not be accounted for as a performance obligation in addition to the obligation to provide a refund.

In paragraph BC363 of ASU 2014-09, the FASB and IASB acknowledge that “conceptually, a contract with a right of return includes at least two performance obligations — a performance obligation [i.e., the original promise] to provide the good to the customer and a performance obligation [i.e., a secondary promise] for the return right service, which is a standready obligation to accept the goods returned by the customer during the return period.” However, in paragraph BC366, the boards go on to note that their ultimate conclusions about the implementation guidance on sales with a right of return were driven by practical considerations such that the boards “decided that the incremental information provided to users of financial statements by accounting for the return right service as a performance obligation would not have justified the complexities and costs of doing so.” Thus, because “standing ready” to accept returns is not regarded as a performance obligation in these circumstances, no revenue is recognized as that activity occurs. Further, as with refund liabilities, the return right service is viewed instead as a driver of variability in the amount of consideration to which the entity expects to be entitled for transferring the goods or services in the contract. See Section 5.2.4.2 for further discussion.

Importantly, under the revenue standard, a sale with a right of return is not a separate variable consideration model or a “failed” sale model. Rather, the uncertainty associated with whether a product may be returned is treated, for measurement purposes, consistently with the uncertainty associated with whether an entity will receive all or nothing from a bonus payment of $1 million. Accordingly, the boards decided against dealing with this uncertainty through a step 5, transfer-of-control notion (i.e., a “failed” sale model). In adopting this approach, the boards chose simplicity over creating (1) several different categories of variable consideration and (2) separate measurement models for each of those separate types of variability.

As a result, although the boards provided more specific measurement and remeasurement guidance for sales with a right of return in ASC 606-10-55-25 through 55-27 (paragraphs B23 through B25 of IFRS 15), the guidance remains consistent with the standard’s overall measurement principles for variable consideration.

ASC 606-10

55-25 An entity 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 the entity expects to be entitled (that is, excluding the products expected to be returned). For any amounts received (or receivable) for which an entity does not expect to be entitled, the entity 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 entity 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 and, therefore, in the amount of revenue recognized.

55-26 An entity should update the measurement of the refund liability at the end of each reporting period for changes in expectations about the amount of refunds. An entity should recognize corresponding adjustments as revenue (or reductions of revenue).

55-27 An asset recognized for an entity’s right to recover products from a customer on settling a refund liability initially should be measured by reference to the former carrying amount of the product (for example, inventory) less any expected costs to recover those products (including potential decreases in the value to the entity of returned products). At the end of each reporting period, an entity should update the measurement of the asset arising from changes in expectations about products to be returned. An entity should present the asset separately from the refund liability.

55-28 Exchanges by customers of one product for another of the same type, quality, condition, and price (for example, one color or size for another) are not considered returns for the purposes of applying the guidance in this Topic.

55-29 Contracts in which a customer may return a defective product in exchange for a functioning product should be evaluated in accordance with the guidance on warranties in paragraphs 606-10-55-30 through 55-35.

6.3.5.3.1 Estimating the Transaction Price When an Entity Promises to Stand Ready to Accept a Returned Product During the Return Period and Provide a Refund

When an entity promises to stand ready to accept a returned product during the return period and provide a refund, the transaction price should be estimated in the same way as any other variable consideration (see Example 22 in ASC 606-10-55-202 through 55-207 below) and should reflect the amount to which the entity expects to be entitled. The entity should adjust that amount to exclude amounts expected to be reimbursed or credited to customers by using either the most likely amount or the expected value method (as discussed in Section 6.3.2.1).

For example, when a retail store has a policy that allows customers to return a product within 30 days (for any reason), no amount of the transaction price is allocated to the “service” of standing ready to accept the returned product. Instead, the transaction price is estimated and constrained to the amount for which the entity expects it is probable that significant reversal will not occur when the uncertainty associated with expected returns is resolved. An adjustment to revenue will then be recognized when the level of returns is known after 30 days or by updating the estimated transaction price as of any reporting date falling within that period. This is illustrated by Example 22 in ASC 606-10-55-202 through 55-207, which is reproduced below.

ASC 606-10

Example 22 — Right of Return

55-202 An entity enters into 100 contracts with customers. Each contract includes the sale of 1 product for $100 (100 total products × $100 = $10,000 total consideration). Cash is received when control of a product transfers. The entity’s customary business practice is to allow a customer to return any unused product within 30 days and receive a full refund. The entity’s cost of each product is $60.

55-203 The entity applies the guidance in this Topic to the portfolio of 100 contracts because it reasonably expects that, in accordance with paragraph 606-10-10-4, the effects on the financial statements from applying this guidance to the portfolio would not differ materially from applying the guidance to the individual contracts within the portfolio.

55-204 Because the contract allows a customer to return the products, the consideration received from the customer is variable. To estimate the variable consideration to which the entity will be entitled, the entity decides to use the expected value method (see paragraph 606-10-32-8(a)) because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates that 97 products will not be returned.

55-205 The entity also considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration to determine whether the estimated amount of variable consideration of $9,700 ($100 × 97 products not expected to be returned) can be included in the transaction price. The entity considers the factors in paragraph 606-10-32-12 and determines that although the returns are outside the entity’s influence, it has significant experience in estimating returns for this product and customer class. In addition, the uncertainty will be resolved within a short time frame (that is, the 30-day return period). Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $9,700) will not occur as the uncertainty is resolved (that is, over the return period).

55-206 The entity estimates that the costs of recovering the products will be immaterial and expects that the returned products can be resold at a profit.

55-207 Upon transfer of control of the 100 products, the entity does not recognize revenue for the 3 products that it expects to be returned. Consequently, in accordance with paragraphs 606-10-32-10 and 606-10-55-23, the entity recognizes the following:

6.3.5.3.2 Accounting for Restocking Fees and Related Costs

In some industries, customers are not entitled to a full refund if they return a previously purchased product to the seller. In effect, the seller charges a fee for accepting returns, sometimes referred to as a “restocking” fee. Restocking fees are typically stated in the contract between the seller and the customer.

Restocking fees can serve a number of purposes for the seller, including (1) to recover some of the costs the seller expects to incur in returning such product to saleable inventory (e.g., repackaging or shipping costs), (2) to mitigate a potential reduced selling price upon resale, and (3) to discourage customers from returning products.

Restocking fees for expected returns should be included in the transaction price. When accounting for restocking fees, an entity will need to consider the guidance in ASC 606-10-32-5 through 32-9 on estimating variable consideration.

In accordance with ASC 606-10-55-27, the costs expected to be incurred when the products are returned should be recognized as of the date on which control is transferred to the customer as a reduction of the carrying amount of the asset expected to be recovered.

Example 6-5

Entity X enters into a contract with Customer Y to sell 10 widgets for $100 each in cash. The cost of each widget to X is $75. Customer Y has the right to return a widget but will be charged a restocking fee of 10 percent (i.e., $10 per widget). Entity X expects to incur costs of $5 per widget to ship and repackage each item returned before it can be resold.

Entity X concludes that because a right of return exists, the consideration promised under the contract includes a variable amount. Entity X uses the expected value method for estimating the variable consideration and estimates that (1) 10 percent of the widgets will be returned and (2) it is probable that returns will not exceed 10 percent. Entity X also expects that the returned widgets can be resold at a profit.

When control of the 10 widgets is transferred to the customer, X therefore recognizes revenue of $900 for 9 widgets sold ($100 × 9) and also includes the restocking fee for 1 widget of $10 ($100 × 10%) in the transaction price. Entity X also recognizes a refund liability of $90 for the 1 widget that is expected to be returned ($100 transaction price less $10 restocking fee). This analysis is reflected in the following journal entry:

On the cost side:

In accordance with ASC 606-10-55-27, X recognizes an asset for its right to recover the widget from Y on settlement of the refund liability. The asset is measured at the former carrying amount of the inventory items as reduced by the expected costs to recover the product. Entity X therefore recognizes an asset of $70 ($75 cost less $5 restocking cost).

The cost of sales is $680, which is the aggregate of (1) the cost of items sold and not expected to be returned of $675 (9 widgets × $75) and (2) the anticipated restocking cost of $5.

This cost analysis is reflected in the following journal entry:

When the widget is returned by Y, $90 is refunded. The widget is returned to inventory. Entity X incurs the restocking cost and includes that cost in the inventory amount as follows:

The above issue is addressed in Implementation Q&As 42 and 77 (compiled from previously issued TRG Agenda Papers 35 and 44). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.3.5.4 Variable Consideration Driven by Variable Volumes

6.3.5.4.1 Distinguishing Between Optional Purchases and Variable Consideration

Under the revenue standard, an entity must determine its contractual rights and obligations, including whether options for future goods or services give rise to performance obligations under a current contract with a customer (see Chapter 11). In considering how to apply the guidance on optional purchases for which an entity does not identify a material right, stakeholders have questioned whether and, if so, when customer options to acquire additional goods or services would be considered (1) a separate contract that arises when the option is exercised or (2) variable consideration for which an entity would be required to estimate the amount of consideration to include in the original contract’s transaction price (subject to the standard’s constraint on variable consideration). That is, stakeholders have raised questions about when an entity, as part of determining its transaction price, should estimate customers’ future purchases that may be made under options for additional goods or services.

The revenue standard does not require or allow an entity to estimate the transaction price of future contracts into which it will enter with a customer. This assertion is supported by the FASB and IASB in paragraph BC186 of ASU 2014-09, which states that “the transaction price should include only amounts (including variable amounts) to which the entity has rights under the present contract” (emphasis added).

Further, an entity should perform an evaluation of the nature of its promises in a contract with a customer, including a careful evaluation of the enforceable rights and obligations in the present contract (not future contracts). That is, there is a distinction between (1) customer options and (2) uncertainty that is accounted for as variable consideration.

Customer options are predicated on a separate customer action (namely, the customer’s decision to exercise the option), which would not be embodied in the present contract; unless an option is a material right, such options would not factor into the accounting for the present contract. If an option to acquire additional goods or services represents a material right, part of the transaction price is allocated to that material right, and recognition of a portion of revenue is deferred (see ASC 606-10-55-41 through 55-45). The additional goods or services are not themselves performance obligations under the contract; instead, the option to acquire them is treated as a performance obligation if it represents a material right.

Enforceable rights and obligations in a contract are only those for which the entity has legal rights and obligations under the contract and would not take economic or other penalties into account (e.g., (1) economic compulsion or (2) exclusivity because the entity is the sole provider of the goods or services, which may make the future deliverables highly probable of occurring). Section 11.4 further expands on this view.

In contrast, uncertainty is accounted for as variable consideration when the entity has enforceable rights and obligations under a present contract to provide goods or services without an additional customer decision. ASC 606 deals separately with the appropriate accounting for “variable consideration” when the consideration promised in a contract includes a variable amount (see ASC 606-10-32-5 through 32-14). For example, there may be uncertainty in a long-term contract that includes variability because of other factors (e.g., variable quantities that affect the consideration due under the contract). Entities should consider the need to take variability of this nature into account in determining the transaction price.

An entity will need to evaluate the nature of its promises under a contract and use judgment to determine whether the contract includes (1) an option to purchase additional goods or services (which the entity would need to evaluate for a material right) or (2) a single performance obligation for which the quantity of goods or services to be transferred is not fixed at the outset (which would give rise to variable consideration).

In exercising such judgment, an entity may find the following indicators helpful:

A determination that an entity’s customer can make a separate purchasing decision with respect to additional distinct goods or services and that the entity is not obliged to provide those goods or services before the customer exercises its rights would be indicative of an option for additional goods or services. For example, suppose that an entity enters into a five-year exclusive master supply agreement with a customer related to components that the customer uses in its products. The customer may purchase components at any time during the term of the agreement, but it is not obliged to purchase any components. Each time the customer elects to purchase a component from the entity represents a separate performance obligation of the entity.
Conversely, if future events (which may include a customer’s own actions) will not oblige an entity to provide a customer with additional distinct goods or services, any additional consideration triggered by those events would be accounted for as variable consideration. For example, suppose that an entity agrees to process all transactions for a customer in exchange for fees that are based on the volume of transactions processed, but the volume of transactions is not known at the outset and is outside the control of both the entity and the customer. The performance obligation is to provide the customer with continuous access to transaction processing for the contract period. The additional transactions processed are not distinct services; rather, they are part of the satisfaction of the single performance obligation to process transactions, and the variability in transactions processed results in variable consideration.

The above issue is addressed in Implementation Q&A 23 (compiled from previously issued TRG Agenda Papers 48 and 49). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.3.5.4.2 Volume-Based Rebates

An entity may offer its customers rebates or discounts on the pricing of products or services once specific volume thresholds have been met. That is, an entity may either retrospectively or prospectively adjust the price of its goods or services once a certain volume threshold has been met.

A volume rebate or discount that is retrospectively applied should be accounted for under ASC 606 as variable consideration (rather than as a customer option to be evaluated as a potential material right). In accordance with ASC 606-10-32-6, which specifically includes discounts and rebates as a form of variable consideration, the “promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event” (emphasis added).

However, an offer to prospectively lower the price per unit (once certain volume thresholds are met) should not be accounted for as variable consideration. Rather, when a volume rebate or discount is applied prospectively, an entity will need to evaluate the facts and circumstances of each contract to determine whether the rebate or discount represents a material right and therefore should be accounted for as a performance obligation. As part of this evaluation, the entity would consider whether the offer to the customer is at a price that would reflect the stand-alone selling price for that good or service, in accordance with ASC 606-10-55-43.

Example 24 in the revenue standard (ASC 606-10-55-216 through 55-220) illustrates how an entity would account for a volume discount incentive as variable consideration.

ASC 606-10

Example 24 — Volume Discount Incentive

55-216 An entity enters into a contract with a customer on January 1, 20X8, to sell Product A for $100 per unit. If the customer purchases more than 1,000 units of Product A in a calendar year, the contract specifies that the price per unit is retrospectively reduced to $90 per unit. Consequently, the consideration in the contract is variable.

55-217 For the first quarter ended March 31, 20X8, the entity sells 75 units of Product A to the customer. The entity estimates that the customer’s purchases will not exceed the 1,000-unit threshold required for the volume discount in the calendar year.

55-218 The entity considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration, including the factors in paragraph 606-10-32-12. The entity determines that it has significant experience with this product and with the purchasing pattern of the entity. Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $100 per unit) will not occur when the uncertainty is resolved (that is, when the total amount of purchases is known). Consequently, the entity recognizes revenue of $7,500 (75 units × $100 per unit) for the quarter ended March 31, 20X8.

55-219 In May 20X8, the entity’s customer acquires another company and in the second quarter ended June 30, 20X8, the entity sells an additional 500 units of Product A to the customer. In light of the new fact, the entity estimates that the customer’s purchases will exceed the 1,000-unit threshold for the calendar year and, therefore, it will be required to retrospectively reduce the price per unit to $90.

55-220 Consequently, the entity recognizes revenue of $44,250 for the quarter ended June 30, 20X8. That amount is calculated from $45,000 for the sale of 500 units (500 units × $90 per unit) less the change in transaction price of $750 (75 units × $10 price reduction) for the reduction of revenue relating to units sold for the quarter ended March 31, 20X8 (see paragraphs 606-10-32-42 through 32-43).

Example 6-6

Rebate Applied Retrospectively

Entity X enters into a contract with a customer to supply widgets. Under the terms of the contract, each widget is sold for $10, but if the customer purchases more than 100 widgets in a calendar year, the price will be reduced retrospectively to $8 per widget. The contract does not include any minimum purchase commitments.

In this example, the volume rebate of $2 is applied retrospectively. It should be accounted for as variable consideration under ASC 606-10-32-5 through 32-14 because X’s entitlement to consideration for each unit sold is contingent on the occurrence of a future event (i.e., the customer’s buying more than 100 units).

Accordingly, X is required to estimate the amount of consideration to which it will be entitled for each widget by using either the expected value method or the most likely amount (whichever is considered to better predict the amount of consideration to which X will be entitled). The $2 variable consideration should only be included in the transaction price if it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur (i.e., it is likely that the customer will not purchase more than 100 units).

Example 6-7

Rebate Applied Prospectively

Entity Y enters into a contract with a customer to supply widgets. Under the terms of the contract, each widget is sold for $10, but if the customer purchases more than 100 widgets in a calendar year, the price will be reduced prospectively to $8 per widget (i.e., the $8 price applies only for subsequent purchases). The contract does not include any minimum purchase commitments.

In this example, the customer has an option to purchase additional widgets at a reduced price of $8 per unit, which should be accounted for in accordance with ASC 606-10-55-41 through 55-45. Entity Y will need to evaluate the facts and circumstances to determine whether the option gives rise to a performance obligation. The option would give rise to a performance obligation if it provides a material right to the customer that the customer would not receive without purchasing the first 100 units. As part of this evaluation, Y should consider whether the reduced price offered to the customer ($8 per unit) reflects the stand-alone selling price for the widgets, in accordance with ASC 606-10-55-43.

Example 6-8

Reassessment of Volume Discounts Applied Retrospectively

Assume the same facts as those in Example 6-6, as well as the following additional information:

Entity X initially estimated total widget sales of 90 items. The $2 variable consideration was included in the transaction price because X believed that it was probable that a significant reversal in the amount of cumulative revenue recognized would not occur (i.e., it was likely that the customer would not purchase more than 100 units).
Entity X sells 10 units during the first quarter, sells 20 units during the second quarter, and sells 60 units during the third quarter.
In light of recent sales activity, X increases its estimate of total sales volume for the year to 120 units.

In this example, X will be required to effectively reduce the price per unit to $8. Accordingly, X should update its calculation of the transaction price to reflect the change in estimate. The updated transaction price is $8 per unit, which is based on the recent increase in sales activity and updated sales volume. Therefore, X should recognize revenue of $420 for the third quarter, which is calculated as follows:

6.3.5.5 Other Forms of Variability

6.3.5.5.1 Contracts That Include Consideration in a Foreign Currency

Despite the broad definition of variable consideration in ASC 606, consideration that is fixed in a foreign currency (i.e., a currency other than the entity’s functional currency) should not be considered variable consideration. This is because the amount of consideration promised in the contract does not vary; instead, that fixed amount of consideration is retranslated into a variable amount of the entity’s functional currency.

Therefore, an entity is not required to consider whether potential future adverse movements in the exchange rate could result in a requirement to limit the amount of revenue recognized in accordance with ASC 606-10-32-11. Instead, the principles of ASC 830 should be applied.

6.3.5.5.2 Variable Consideration in Real Estate Sales

A real estate sales contract may allow the seller to participate in future profits related to the underlying real estate. As discussed in Sections 6.3.2 and 6.3.3, some or all of the estimated variable consideration is included in the transaction price (and therefore eligible for recognition) to the extent that it is probable that the cumulative amount of the revenue recognized will not be subject to significant reversal.

Accordingly, an entity will need to estimate the portion of the contingent (or variable) consideration to include in the transaction price, which may be recognized when the performance obligation is satisfied.

For example, suppose that an entity sells land to a home builder for a fixed amount plus a percentage of the profits that will be realized on the sale of homes once constructed on the land by the home builder. Under the revenue standard, the entity would be required to (1) estimate the consideration expected to be received from the home builder and (2) recognize all or some of the amount as revenue (or other gains and losses, if the transaction is with a noncustomer) up front when the land is sold. Determining the amount of revenue that is not subject to a significant revenue reversal could require significant judgment.

Further, an entity that has entered into a real estate sales contract may need to consider whether the contract contains a significant financing component (see Section 6.4).

6.3.5.5.3 Cash Discounts for Early Payment

Cash discounts for early payment are a form of variable consideration. This is because the amount of consideration to which an entity is entitled in these arrangements depends on a customer’s actions (i.e., a customer’s decision to pay amounts due in time to take advantage of an early payment discount). The example below illustrates how a seller would account for a cash discount it provides to a customer for making an early payment.

Example 6-9

Entity X offers Customer Y a cash discount for immediate or prompt payment (i.e., earlier than required under the normal credit terms). A sale is made for $100 with the balance due within 90 days. If Y pays within 30 days, Y will receive a 10 percent discount on the total invoice. Entity X sells a large volume of similar items on these credit terms (i.e., this transaction is part of a portfolio of similar items). Entity X has elected to apply the practical expedient in ASC 606-10-32-18 and therefore will not adjust the promised amount of consideration for the effects of a significant financing component.

In the circumstances described, revenue is $100 if the discount is not taken and $90 if the discount is taken. As a result, the amount of consideration to which X will be entitled is variable.

Therefore, X should recognize revenue when or as the performance obligation is satisfied net of the amount of cash discount expected to be taken. To determine the amount of revenue to be recognized, X should use either the “expected value” or the “most likely amount” method and consider the effect of the constraint.

For example, if the discount is taken in 40 percent of transactions, the expected value will be calculated as follows:

($100 × 60%) + ($90 × 40%) = $96

If the proportion of transactions for which the discount is taken is always close to 40 percent (i.e., it is within a narrow range of around 40 percent), it is likely that the estimate of variable consideration will not need to be constrained, and revenue of $96 will be recognized.

If, however, the proportion of transactions for which the discount is taken varies significantly, it may be necessary to apply the constraint, which will result in the recognition of less revenue. For example, historical records might show that although the long-term average is 40 percent, there is great variability from month to month and the proportion of transactions for which the discount is taken is frequently as high as 70 percent (but has never been higher than that). In such a scenario, X might conclude that only 30 percent of the variable consideration should be included, because inclusion of a higher amount might result in a significant revenue reversal. In that case, the amount of revenue recognized would be constrained as follows:

($100 × 30%) + ($90 × 70%) = $93

6.3.5.5.4 Accounting for “Trail Commissions”

Another form of variable consideration is trail commissions. For example, in many arrangements between an insurance agent and an insurance carrier, the insurance agent is entitled to additional consideration in the form of trail commissions each time a consumer renews an insurance policy with the insurance carrier. Although the insurance agent may satisfy its performance obligation when it sells an initial policy to a consumer (because it is not the insurance carrier), the ultimate consideration to which the insurance agent is entitled depends on how many times the consumer renews the policy with the insurance carrier (renewals do not require additional performance by the insurance agent). The example below illustrates how an insurance agent would account for additional annual commissions earned for future expected policy renewals.

Example 6-10

IA, an insurance agent, is engaged by IC, an insurance carrier, to sell IC’s insurance to the general public. IA is compensated by IC on a “trail commission” basis, which means that in addition to receiving an initial commission from IC for every consumer IA signs up for IC’s insurance at the time of purchase (e.g., a $100 initial commission), IA receives annual commissions from IC in future years every time those consumers renew their insurance policy with IC (e.g., an additional $50 commission due upon each annual renewal of the consumer’s insurance policy). IA has a right to the trail commission as long as the consumer renews the insurance policy, even if IC cancels its contract with IA.

IA makes many sales to consumers on behalf of IC such that IA has a large pool of homogeneous transactions with historical information about consumer renewal patterns for insurance policies.

IA does not have any ongoing obligation to provide additional services to IC or to the consumers after the initial sale of insurance.

The consideration promised in this arrangement includes both fixed and variable amounts. The initial commission of $100 due to IA upon signing up a customer is fixed consideration and is included in the transaction price. In addition, the transaction price includes variable consideration in the form of potential additional commissions due ($50 per each additional year) if and when the consumer subsequently renews the insurance policy. In accordance with the guidance in ASC 606-10-32-8, IA should estimate the variable consideration to which it expects to be entitled from IC. Since IA has a large pool of homogeneous contracts on which to base its estimate, the expected value approach is used.

IA should consider evidence from other, similar contracts to develop an estimate of variable consideration under the expected value method since there is a population of data with which IA can make such an estimate.

IA will also need to consider the guidance in ASC 606-10-32-11 through 32-13 to constrain the amount of variable consideration that should be included in the transaction price. In considering the factors in ASC 606-10-32-12 that could increase the likelihood or magnitude of a significant revenue reversal, IA should use judgment and take into account all relevant facts and circumstances. This could mean looking to historical experience with similar contracts to (1) make judgments about the constraint on variable consideration and (2) estimate the amount for which a significant reversal is not probable. The greater the likelihood of a reversal of the estimated variable consideration, the greater the likelihood that the estimate should be constrained.

6.3.6 Reassessment of Variable Consideration

ASC 606-10

32-14 At the end of each reporting period, an entity shall update the estimated transaction price (including updating its assessment of whether an estimate of variable consideration is constrained) to represent faithfully the circumstances present at the end of the reporting period and the changes in circumstances during the reporting period. The entity shall account for changes in the transaction price in accordance with paragraphs 606-10-32-42 through 32-45.

After its initial estimate (and potential constraint) of variable consideration at contract inception, an entity must reassess that estimate (and potential constraint) at the end of each reporting period as the uncertainties underlying the variable consideration are resolved or more information about the underlying uncertainties is known. As noted in paragraph BC224 of ASU 2014-09, the FASB and IASB “decided that an entity should update its estimate of the transaction price throughout the contract [because] reflecting current assessments of the amount of consideration to which the entity expects to be entitled will provide more useful information to users of financial statements.”

However, like the assessment of the transaction price at contract inception, reassessment of the transaction price is part of a three-step process for recognizing revenue. That is, once an entity updates an estimate (and potential constraint) of variable consideration after inception, it generally must reallocate the transaction price in accordance with step 4, in the same proportions used in the allocation of the transaction price at inception, to the performance obligations identified in step 2 so that revenue can be recognized in step 5 when (or as) the entity satisfies a performance obligation.3 The example below illustrates how this guidance would be applied

Example 6-11

Assume that an entity enters into a contract with a customer for the delivery of three performance obligations, PO1, PO2, and PO3. The consideration in the contract is wholly variable for an amount up to $600, and the entity’s estimate of variable consideration at contract inception is $300. The entity determines that a constraint of its estimate of variable consideration is unnecessary. The stand-alone selling prices of the three performance obligations are as follows:

PO1 = $100.
PO2 = $200.
PO3 = $300.

Accordingly, the entity allocates the estimate of variable consideration to the performance obligations on a relative stand-alone selling price basis as follows:

PO1 = $100 ÷ $600 × $300 = $50.
PO2 = $200 ÷ $600 × $300 = $100.
PO3 = $300 ÷ $600 × $300 = $150.

If the uncertainty in the contract consideration is subsequently resolved (or the entity’s estimate of variable consideration has changed, subject to an assessment of the constraint) and the entity determines that the updated transaction price is $600, the entity reallocates the updated transaction price to the performance obligations in proportion to their relative stand-alone selling prices at contract inception as follows:

PO1 = $100 ÷ $600 × $600 = $100.
PO2 = $200 ÷ $600 × $600 = $200.
PO3 = $300 ÷ $600 × $600 = $300.

The accounting for a change in the transaction price, including the guidance in ASC 606-10-32-42 through 32-45 on reallocating that change, is further discussed in Section 7.6.

Footnotes

Variable consideration would not need to be estimated if an entity is applying (1) the invoice practical expedient to measure progress toward complete satisfaction of a performance obligation (see Section 8.5.8.1) or (2) the variable consideration allocation exception in ASC 606-10-32-40 (see Section 7.5).

ASC 606-10-10-4 states that an entity is permitted to use a portfolio approach as a practical expedient to account for a group of contracts with similar characteristics rather than account for each contract individually. However, an entity may only apply the practical expedient if it does not expect the results of applying the guidance in ASC 606 to a portfolio of contracts to be materially different from the results of applying that guidance to individual contracts.

An entity would allocate variable consideration and subsequent changes to it “entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation” if the criteria in ASC 606-10-32-40 are met.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.