Revenue Recognition – Accounting for Variable Consideration

We are now two months into 2019 and non-public companies should have an implementation plan in place to implement new Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606), which became effective for the 2019 calendar year reporting.  As part of our special revenue recognition educational series, Dannible & McKee, LLP has been exploring topics ranging from company readiness to changes in accounting for uninstalled materials and contract fulfillment costs under the new standard.  We have now made it to the final installment – Accounting for Variable Consideration.

A significant change included in the new revenue recognition standard is the treatment of variable consideration.  This change will likely impact every contractor.  Variable consideration is defined broadly and can take many forms, such as incentives, penalty provisions, price concessions, rebates or refunds.  Consideration is also considered variable if the amount an entity will receive is contingent on a future event occurring or not occurring, even though the amount itself is fixed.

The following are examples of variable considerations within a contract:

• Claims and pending change orders;
• Unpriced change orders;
• Incentive and penalty provisions within the contract;
• Shared savings;
• Price concessions;
• Liquidating damages; and
• Unit price contracts with variable consideration.

In accordance with Topic 606, entities are required to estimate variable consideration when determining the contract transaction price by taking into account all the information (historical, current and forecasted) that is reasonably available and identifying a reasonable number of possible consideration amounts.  Management must include an estimate of any variable consideration using either the “expected value” method or the “most likely amount” method.

The “expected value” method estimates variable consideration based on the range of possible outcomes and the probabilities of each outcome.  This method might be most appropriate when an entity has a large number of contracts that have similar characteristics because it will likely have better information about the probabilities of various outcomes when there are a large number of similar transactions.  On the other hand, the “most likely amount” method estimates variable consideration based on the single most likely amount in a range of possible consideration amounts. This method might be the most predictive if the entity will receive one of only two possible amounts.

The method used is not a policy choice and should be applied consistently throughout a contract, however, is subject to guidance on constraining estimates of variable consideration. An entity may only include variable consideration within the transaction price to the extent that it is probable that a significant reversal of revenue will not occur when the uncertainty is subsequently resolved. This assessment will require the application of judgment.  While no single factor is determinative, the revenue standard includes factors to consider when assessing whether variable consideration should be constrained.

The following factors may increase the likelihood or the magnitude of a revenue reversal:

• The amount of consideration is highly susceptible to factors outside the entity’s influence;
• The uncertainty is not expected to be resolved for a long period of time;
• The entity’s experience with similar types of contracts is limited;
• The entity has a practice of offering a broad range of price concessions or changing the payment terms frequently; and
• The contract has a broad range of possible consideration amounts.

Contract modifications resulting in change orders are going to be one of the more likely scenarios for construction contractors that will require evaluation of variable consideration in order to comply with the new revenue recognition standard, so let’s look at an example.

A contractor enters into an 18-month contract with developer to build an office building for $2 Million. The contract for construction of the office building is a single performance obligation. Later the contractor and developer agree to modify the original floor plan at the end of the first six months which will increase the transaction price and expected cost by approximately $400,000 and $350,000, respectively.

How should the contractor account for the modification (change order)?

The contractor should account for the change order as if it were part of the original contract. The change order does not create a separate performance obligation because the remaining goods and services to be provided under the modified contract are not distinct.  The contractor should update its estimate of the transaction price and its measure of progress to account for the effect of the change order, at the time the change order is more likely than not going to be awarded. This will result in a cumulative revenue catch-up adjustment at the date of the contract modification.

The new revenue recognition standard requires contractors to account for variable consideration differently than current generally accepted accounting principles.  Companies will need to develop processes to identify, estimate and allocate variable considerations to be in compliance with the standard.  Please contact us if you have any questions regarding revenue recognition or visit our revenue recognition resource center.