EXAMPLE RR 4-3Variable consideration – consideration is constrained
Land Owner sells land to Developer for $1 million. Land Owner is also entitled to receive 5% of any future sales price of the developed land in excess of $5 million. Land Owner determines that its experience with similar contracts is of little predictive value because the future performance of the real estate market will cause the amount of variable consideration to be highly susceptible to factors outside of the reporting entity’s influence. Additionally, the uncertainty is not expected to be resolved in a short period of time because Developer does not have current plans to sell the land.
Should Land Owner include variable consideration in the transaction price?
Analysis
No amount of variable consideration should be included in the transaction price. It is not probable that a significant reversal of cumulative revenue recognized will not occur resulting from a change in estimate of the consideration Land Owner will receive upon future sale of the land. The transaction price at contract inception is therefore $1 million. Land Owner will update its estimate, including application of the constraint, at each reporting date until the uncertainty is resolved. This includes considering whether any minimum amount should be recorded.
EXAMPLE RR 4-4Variable consideration – subsequent reassessment
Land Owner sells land to Developer for $1 million. Land Owner is also entitled to receive 5% of any future sales price of the developed land in excess of $5 million. Land Owner determines that its experience with similar contracts is of little predictive value, because the future performance of the real estate market will cause the amount of variable consideration to be highly susceptible to factors outside of the reporting entity’s influence. Additionally, the uncertainty is not expected to be resolved in a short period of time because Developer does not have current plans to sell the land.
Two years after contract inception:
• Land prices have significantly appreciated in the market
• Land Owner estimates that it is probable that a significant reversal of cumulative revenue recognized will not occur related to $100,000 of variable consideration based on sales of comparable land in the area
• Developer is actively marketing the land for sale
How should Land Owner account for the change in circumstances?
Analysis
Land Owner should adjust the transaction price to include $100,000 of variable consideration for which it is probable a significant reversal of cumulative revenue recognized will not occur. Land Owner will update its estimate, either upward or downward, at each reporting date until the uncertainty is resolved.
EXAMPLE RR 4-5Variable consideration – multiple forms of variable consideration
Construction Inc. contracts to build a production facility for Manufacturer for $10 million. The arrangement includes two performance bonuses as follows:
• Bonus A: $2 million if the facility is completed within six months
• Bonus B: $1 million if the facility receives a stipulated environmental certification upon completion
Construction Inc. believes that the facility will take at least eight months to complete but that it is probable it will receive the environmental certification, as it has received the required certification on other similar projects.
How should Construction Inc. determine the transaction price?
Analysis
The transaction price is $11 million. Construction Inc. should assess each form of variable consideration separately. Bonus A is not included in the transaction price as Construction Inc. does not believe it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Bonus B should be included in the transaction price as Construction Inc. has concluded it is probable based on the most likely outcome, that a significant reversal in the amount of cumulative revenue recognized will not occur. Construction Inc. will update its estimate at each reporting date until the uncertainty is resolved.
EXAMPLE RR 4-6Variable consideration — milestone payments
Biotech licenses a drug compound that is currently in Phase II development to Pharma. Biotech also performs clinical trial services as part of the arrangement. In addition to an upfront payment, Biotech is eligible to receive additional consideration in the form of milestone payments as follows:
• Milestone A: $25 million upon the completion of Phase II clinical trials
• Milestone B: $50 million upon regulatory approval of the drug compound
Biotech has concluded it is probable that it will achieve Milestone A because Biotech has extensive experience performing clinical trial services in similar arrangements and the drug compound has successfully completed Phase I clinical trials. There are significant uncertainties related to achieving regulatory approval of the drug compound, which is subject to the judgments and actions of a third party. Biotech has concluded the milestone payments are outside the scope of guidance for financial instruments.
How should Biotech determine the transaction price?
Analysis
Both milestone payments are forms of variable consideration. The $25 million payable upon achieving Milestone A should be included in the transaction price because it is probable that a significant reversal of cumulative revenue recognized will not occur in the future when the uncertainty relating to Milestone A is subsequently resolved.
Biotech would likely conclude that the $50 million payable upon achieving Milestone B is constrained. The current stage of development of the drug compound, uncertainties related to obtaining approval, and the fact that regulatory approval is subject to factors outside Biotech’s influence would support this conclusion. Therefore, Biotech would exclude the $50 million payable upon achieving Milestone B from the transaction price at contract inception.
Biotech will need to update its estimates for both milestones at each reporting date until the uncertainty associated with each milestone is resolved.
EXAMPLE RR 4-7Variable consideration — expected value method and applying the constraint
Entity L is a law firm that offers various legal services to its customers. For some services (“Specific Services”), Entity L will only collect payment from its customer if the customer wins the case. The payment for Entity L in each case is $1,000. Management has determined that revenue for these services should be recognized over time.
Entity L has a group of 1,000 similar contracts on homogeneous cases that include Specific Services. Management’s experience with contracts with similar characteristics to this group over the last five years is that 60% of Entity L’s customers won their cases, and success rates varied between 50% and 70% on a monthly basis throughout the period. Management has used this data to conclude that it is probable that it would collect payment in 50% of cases.
Management believes that the expected value approach provides a better prediction of the transaction price than the most likely amount.
How should Entity L determine the transaction price?
Analysis
Management of Entity L can use the data from previous contracts to estimate the transaction price and to apply the constraint on variable consideration. Management therefore would include $500,000 (equating to $500 per contract) of the variable consideration in the transaction price. The evidence provided by its experience with previous transactions would support its conclusion that it is probable that there would not be a significant revenue reversal if $500 is estimated as the transaction price for each contract. In making this assessment, management will have applied a consistent approach in estimating the transaction price and applying the constraint of variable consideration guidance.