Some stakeholders have questioned whether the constraint on variable consideration should be applied at the performance obligation level or the contract level. This question might be particularly pertinent in scenarios in which variable consideration is not allocated proportionately to all performance obligations in a contract, or when one performance obligation is fixed and the other is variable.

Consider the following example:

In the fact pattern above, the entity concludes that CU50,000 is the most likely amount of consideration to which it expects to be entitled using the most likely method. The entity also concludes it is not probable that it will earn the performance-based fee. However, despite the fact that the entity concludes that it is not probable it will earn the fee, the entity also has to evaluate whether inclusion of the amount in the transaction price may result in a significant revenue reversal. Paragraph 606-10-32-12 specifies that an entity must consider both the likelihood and the magnitude of a potential revenue reversal in determining whether the constraint on variable consideration applies.Some stakeholders have questioned whether the significance/magnitude determination is based on an assessment of the potential reversal of revenue against (a) the transaction price allocated to the related performance obligation (in this case, CU50,000) or (b) the total transaction price for the contract (CU10.05 million). Those stakeholders assert that an entity may come to a different conclusion about whether variable consideration must be constrained depending on which approach it follows. For example, some stakeholders assert that the entity would include the CU50,000 in the transaction price (that is, it would not be constrained) because it is not significant to the entire contract transaction price, including the variable consideration, of CU10.05 million. Other stakeholders assert that the CU50,000 should be constrained because any reversal would represent a 100% reversal on revenue recognized related to that performance obligation.

Topic 606 provides guidance (paragraphs 606-10-32-11 and 32-12) that is relevant to determining the magnitude of a potential revenue reversal.

In addition, the basis for conclusions of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), includes some excerpts relevant to this discussion. Based on discussions with stakeholders, it appears that the question outlined in the above paragraph has been raised principally as a result of the paragraphs BC216 through BC217. Also relevant to this issue, in paragraph BC206, the Board provided its reasoning for including the constraint in Topic 606.

While these basis for conclusions paragraphs and the absence of explicit guidance on the level at which the magnitude of a potential revenue reversal is determined in the standard explains why the question has been raised, the unit of account for determining the transaction price (Step 3 of the model) is the contract, not the performance obligation. The staff notes that while the unit of account is not explicitly stated with respect to application of the constraint, a contract unit of account is explicitly noted elsewhere within the basis for conclusions discussion about Step 3 of the model. Specifically, paragraph BC234 of Update 2014-09 relates to identifying a significant financing component in a contract.

The Board’s reasoning with respect to identifying significant financing components explains why an entity should consider significance at the contract level rather than the performance obligation level. Additionally, the practical expedient on applying Topic 606 (paragraph 606-10-10-4) to a portfolio of contracts would permit an entity to evaluate application of the constraint to a portfolio of contracts with similar characteristics (for example, similar variable fee structures) so long as the effects on the financial statements would not differ materially from applying this guidance to the individual contracts. The staff thinks an entity might conclude, for example, that it does not need to evaluate each of its variable consideration arrangements such as the one included in the example above, if the potential cumulative effect of a revenue reversal in all of those contracts would not be material.

Determining the magnitude of a potential revenue reversal, and application of the overall constraint, should not be confused with the core requirement for determining the transaction price. That is, the core principle of Topic 606 is to recognize revenue to depict the transfer of promised goods or services to customers in an amount (that is, the transaction price) that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. If the entity does not expect to be entitled to CU50,000 (for example, it concludes the most likely amount to which it will be entitled is CU0, rather than CU50,000) it would not include that amount in the transaction price regardless of whether a reversal of that amount would be significant or not. That is, the CU50,000 performance-based fee would be excluded from the transaction price before the entity even assesses whether to apply the constraint on variable consideration.

TRG members generally agreed that the constraint on variable consideration should be applied at the contract level. Therefore, the assessment of whether a significant reversal of revenue will occur in the future (the constraint) should consider the estimated transaction price of the contract rather than the amount allocated to a performance obligation.