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5.5 Impact of variable consideration
Publication date: 28 Feb 2022
us Revenue guide 5.5
Some contracts contain an element of consideration that is variable or contingent upon certain thresholds or events being met or achieved. The variable consideration included in the transaction price is measured using a probability-weighted or most likely amount, and it is subject to a constraint. Refer to RR 4 for further discussion of variable consideration.
Variable consideration adds additional complexity when allocating the transaction price. The amount of variable consideration might also change over time as more information becomes available.
5.5.1 Allocating variable consideration
Variable consideration is generally allocated to all performance obligations in a contract based on their relative standalone selling prices. However, similar to a discount, there are criteria for assessing whether variable consideration is attributable to one or more, but not all, of the performance obligations in an arrangement. This allocation guidance is a requirement, not a policy election. This concept is illustrated in Example 35 of the revenue standard (ASC 606-10-55-270 through ASC 606-10-55-279).
For example, a reporting entity could have the right to additional consideration upon early delivery of a particular product in an arrangement that includes multiple products. Allocating the variable consideration to all of the products in the arrangement might not reflect the substance of the arrangement in this situation.
Variable consideration (and subsequent changes in the measure of that consideration) should be allocated entirely to a single performance obligation only if both of the following criteria are met.
An entity shall allocate a variable amount (and subsequent changes to that amount) entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation … if both of the following criteria are met:
a. The terms of a variable payment relate specifically to the entity's efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).
b. Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective … when considering all of the performance obligations and payment terms in the contract.
Question RR 5-3 addresses the assessment of whether the allocation objective is met as required by ASC 606-10-32-40(b).
Question RR 5-3
Does a reporting entity have to perform a relative standalone selling price allocation to conclude that the allocation of variable consideration to one or more, but not all, performance obligations is consistent with the allocation objective?
Does a reporting entity have to perform a relative standalone selling price allocation to conclude that the allocation of variable consideration to one or more, but not all, performance obligations is consistent with the allocation objective?
PwC response
The boards noted in the basis for conclusions that standalone selling price is the “default method” for determining whether the allocation objective is met; however, other methods could be used in certain cases. Therefore, a relative standalone selling price allocation could be utilized, but is not required, to assess the reasonableness of the allocation. In the absence of specific guidance on other methods, reporting entities will have to apply judgment to determine whether the allocation results in a reasonable outcome. Refer to Revenue TRG Memo No. 39 and the related meeting minutes in Revenue TRG Memo No. 44 for further discussion of this topic.
Question RR 5-4 addresses which allocation guidance an entity should apply when a discount causes the transaction price to be variable.
Question RR 5-4
Which guidance should a reporting entity apply to determine how to allocate a discount that causes the transaction price to be variable?
Which guidance should a reporting entity apply to determine how to allocate a discount that causes the transaction price to be variable?
PwC response
Certain discounts are also variable consideration within a contract. For example, an electronics store may sell a customer a television, speakers, and a DVD player at their standalone selling prices, but also grant the customer a $50 mail-in rebate on the total purchase. There is a $50 discount on the bundle, but it is variable as it is contingent on the customer redeeming the rebate.
Reporting entities should first apply the guidance for allocating variable consideration to a discount that is also variable. If those criteria are not met, reporting entities should then consider whether the criteria for allocating a discount, discussed in RR 5.4, are met. A contract might have both variable and fixed discounts. The guidance on allocating a discount should be applied to any fixed discount. Refer to Revenue TRG Memo No. 31 and the related meeting minutes in Revenue TRG Memo No. 34 for further discussion of this topic.
5.5.1.1 Allocating variable consideration to a series
A series of distinct goods or services is accounted for as a single performance obligation if it meets certain criteria (see further discussion in RR 3). When a contract includes a series accounted for as a single performance obligation and also includes an element of variable consideration, management should consider the distinct goods or services (rather than the series) for the purpose of allocating variable consideration. In other words, the series is not treated as a single performance obligation for purposes of allocating variable consideration. Management should apply the guidance in ASC 606-10-32-40 (refer to RR 5.5.1) to determine whether variable consideration should be allocated entirely to a distinct good or service within a series.
Example RR 5-8, Example RR 5-9, and Example RR 5-10 illustrate the allocation of variable consideration in an arrangement that is a series of distinct goods and services. This concept is also illustrated in Example 12A of ASC 606 (606-10-55-157B through ASC 606-10-55-158).
EXAMPLE RR 5-8
Allocating variable consideration to a series – performance bonus
Air Inc enters into a three-year contract to provide air conditioning to the operator of an office building using its proprietary geothermal heating and cooling system. Air Inc is entitled to a semiannual performance bonus if the customer’s cost to heat and cool the building is decreased by at least 10% compared to its prior cost. The comparison of current cost to prior cost is made semi-annually, using the average of the most recent six-months compared to the same six-month period in the prior year.
Air Inc accounts for the series of distinct services provided over the three-year contract as a single performance obligation satisfied over time.
Air Inc has not previously used its systems for buildings in this region. Air Inc therefore does not include any variable consideration related to the performance bonus in the transaction price during the first six months of providing service, as it does not believe that it is probable that a significant reversal of cumulative revenue recognized will not occur if its estimate of customer cost savings changes. At the end of the first six months, the customer's costs have decreased by 12% over the prior comparative period and Air Inc becomes entitled to the performance bonus.
How should Air Inc account for the performance bonus?
Analysis
Air Inc should allocate the performance bonus to the distinct services to which it relates (that is, the related six-month period) if management concludes the results are consistent with the allocation objective. Assuming this is the case, Air Inc would recognize the performance bonus (the change in the estimate of variable consideration) immediately because it relates to distinct services that have already been performed. It would not be appropriate to allocate the change in variable consideration to the entire performance obligation (that is, recognize the amount over the entire three-year contract).
EXAMPLE RR 5-9
Allocating variable consideration to a series – pricing varies based on usage
Transaction Processor (TP) enters into a two-year contract with a customer whereby TP will process all transactions on behalf of the customer. The customer is obligated to use TP’s system to process all of its transactions; however, the ultimate quantity of transactions is unknown. TP charges the customer a monthly fee calculated as $0.03 per transaction processed during the month.
TP concludes that the nature of its promise is a series of distinct monthly processing services and accounts for the two-year contract as a single performance obligation.
How should TP allocate the variable consideration in this arrangement?
Analysis
TP should allocate the variable monthly fee to the distinct monthly service to which it relates, assuming the results are consistent with the allocation objective. TP would determine that the allocation objective is met because the fees are priced consistently throughout the contract and the rates are consistent with the reporting entity’s pricing practices with similar customers.
Assessing whether the allocation objective is met will require judgment. For example, if the rate per transaction processed was not consistent throughout the contract, TP would have to evaluate the reasons for the varying rates to assess whether the results of allocating each month’s fee to the monthly service are reasonable. TP should consider, among other factors, whether the rates are based on market terms and whether changes in the rate are substantive and linked to changes in value provided to the customer. For example, if the terms were structured to simply recognize more revenue earlier in the contract, this is a circumstance when the allocation objective would not be met. Management should also consider whether arrangements with declining prices include a future discount for which revenue should be deferred. Refer to Revenue TRG Memo No. 39 and the related meeting minutes in Revenue TRG Memo No. 44 for further discussion of this topic.
EXAMPLE RR 5-10
Allocating variable consideration to a series – contract with an upfront fee
CloudCo enters into a contract to provide a customer with a cloud-based solution to process payroll over a one-year period. The customer cannot take possession of the software at any time during the hosting period; therefore, the contract does not include a license. CloudCo charges the customer an upfront fee of $1 million and a monthly fee of $2 for each employee’s payroll processed through the cloud-based solution. If the customer renews the contract, it will have to pay a similar upfront fee.
CloudCo concludes that the nature of its promise is a series of distinct monthly services and accounts for the one-year contract as a single performance obligation.
In the first quarter of the year, the monthly fees for payroll processed in January, February, and March are $50,000, $51,000, and $52,000, respectively.
How should CloudCo recognize revenue from this arrangement?
Analysis
CloudCo should determine an appropriate measure of progress to recognize the $1 million upfront fee, which would likely be a time-based measure (that is, ratable recognition over the contract term). CloudCo should allocate the variable monthly fees to the distinct monthly service to which they relate (that is, $50,000 to January, $51,000 to February, and $52,000 to March). The allocation objective is met because the $2 monthly fee per employee is consistent throughout the contract and the variable consideration can be allocated to the distinct service to which it relates, which is the monthly payroll processing service in January, February, and March.
The resulting accounting is that the upfront fee is spread ratably, but the variable fee is not. This does not mean that the reporting entity is using multiple measures of progress. The single measure of progress for the contract is a time-based measure, but the variable fee is allocated to specific time periods in accordance with the allocation guidance as described in RR 5.5.1.
5.5.2 Allocating subsequent changes in transaction price
The estimate of variable consideration is updated at each reporting date, potentially resulting in changes to the transaction price after inception of the contract. Any change to the transaction price (excluding those resulting from contract modifications as discussed in RR 2) is allocated to the performance obligations in the contract.
An entity shall allocate to the performance obligations in the contract any subsequent changes in the transaction price on the same basis as at contract inception. Consequently, an entity shall not reallocate the transaction price to reflect changes in standalone selling prices after contract inception. Amounts allocated to a satisfied performance obligation shall be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes.
Changes in transaction price are allocated to the performance obligations on the same basis as at contract inception (that is, based on the standalone selling prices determined at contract inception). Changes in the amount of variable consideration that relate to one or more specific performance obligations will be allocated only to that (those) performance obligation(s), as discussed in RR 5.5.1.
Amounts allocated to satisfied performance obligations are recognized as revenue immediately on a cumulative catch-up basis. A change in the amount allocated to a performance obligation that is satisfied over time is also adjusted on a cumulative catch-up basis. The result is either additional or less revenue in the period of change for the satisfied portion of the performance obligation. The amount related to the unsatisfied portion is recognized as that portion is satisfied over time.
A reporting entity's standalone selling prices might change over time. Changes in standalone selling prices differ from changes in the transaction price. Reporting entities should not reallocate the transaction price for subsequent changes in the standalone selling prices of the goods or services in the contract.
Example RR 5-11 illustrates the accounting for a change in transaction price after the inception of an arrangement.
EXAMPLE RR 5-11
Allocating transaction price – change in transaction price
On July 1, Contractor enters into an arrangement to build an addition onto a building, re-pave a parking lot, and install outdoor security cameras for $5,000,000. The building of the addition, the parking lot paving, and installation of security cameras are distinct and accounted for as separate performance obligations. Contractor can earn a $500,000 bonus if it completes the building addition by February 1. Contractor will earn a $250,000 bonus if it completes the addition by March 1. No bonus will be earned if the addition is completed after March 1.
Contractor allocates the transaction price on a relative standalone price basis before considering the potential bonus as follows:
Building addition: |
$4,000,000 |
Parking lot: |
$ 600,000 |
Security cameras: |
$ 400,000 |
Contractor anticipates completing the building addition by March 1 and allocates an additional $250,000 to just the building addition performance obligation, resulting in an allocated transaction price of $4,250,000. Contractor concludes that this result is consistent with the allocation objective in these facts and circumstances.
On December 31, Contractor determines that the addition will be complete by February 1 and therefore changes its estimate of the bonus to $500,000. Contractor recognizes revenue over time using an input method based on costs incurred and 75% of the addition was complete as of December 31.
How should Contractor account for the change in estimated bonus as of December 31?
Analysis
As of December 31, Contractor should allocate an incremental bonus of $250,000 to the building addition performance obligation, for a total of $4,500,000. The change to the bonus estimate is allocated entirely to the building addition because the allocation criteria discussed in RR 5.5.1 were met. Contractor should recognize $3,375,000 (75% × $4,500,000) as revenue on a cumulative basis for the building addition as of December 31.
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