Entities must disclose the methods, inputs, and assumptions used to estimate variable consideration, as well as any subsequent changes to those estimates. This transparency allows stakeholders to understand the potential impact on future financial statements. Examples include a sales-based royalty for intellectual property, a performance bonus for early project completion, or a range of price concessions based on volume purchases. This method works well for more straightforward contracts where there are fewer possible outcomes or one dominates. To ensure that variable consideration is recognized appropriately, companies must consider the probability of occurrence, measurement, and timeliness of the expected revenue. By following these guidelines, SaaS companies can maintain transparent and compliant revenue recognition practices.

Introducing Uncertainty

On the other hand, if that variable consideration accounted for 25 percent of the total contract consideration, the company would likely need more extensive experience with similar contracts to support the inclusion of that amount. The expected value approach works particularly well with the portfolio method of aggregating customer contracts. Even if the company is not using the portfolio method practical expedient, but still has many similar contracts, this approach may be appropriate. If management makes reasonable estimates and applies them to a large number of similar contracts, the aggregate amount of revenue should reflect the sum of all the expected amounts from the individual variable consideration contracts.

3.2.2 Uncertainty not expected to be resolved in the near term

If the agreement includes a tiered revenue share based on the number of downloads, the developer could use regression analysis to predict future downloads based on past trends and marketing efforts. Analysis and illustrative examples of the two criteria given in ASC 606 for allocating variable consideration to performance obligations. In this case, although the variable payments relate solely to the transfer of Licence Y (the subsequent royalty payments), allocating the variable consideration only to Licence Y would be inappropriate. This is because allocating $300 to Licence X and $1,500 to Licence Y would not reflect a reasonable allocation based on the stand-alone selling prices of those two licences (i.e. $800 for Licence X and $1,000 for Licence Y). Assume each licence represents a separate performance obligation, which is satisfied at a point in time (the transfer of each licence to the customer).

3.5 Royalties received in exchange for licenses of IP

This means that when estimating the variable consideration, IFRS 15 sets a higher hurdle than the previous IFRS standards which may defer the recognition of some revenue. More substantive support may also be necessary if a company determines that variable consideration in a contract falls near the range considered to be probable. The standard does not provide percentage thresholds to determine what is considered probable or significant; the following is merely an example.

The Importance of Estimating Variable Consideration

Auditors must evaluate the processes and controls in place for estimating variable consideration and test the accuracy of past estimates against actual outcomes. Given that it is equally likely that each of these scenarios could come to fruition, the value of the transaction price could range from $10,000 — $21,000. Therefore, if we assessed the transaction price at $15,000, it is likely that there will be significant reversal of revenue recognized to date should the customer only use 1,000 units before the end of the year.

• “The Company evaluated and concluded no constraint would be necessary on the variable consideration of cost-plus-fixed-fee development contracts with the United States Government (USG).
• The table below shows a summary of the calculations for the fixed contract price and the royalty from the first month.
• It requires judgment and the use of multiple inputs, including historical data, current market conditions, and forecasts of future events.
• Furthermore, purchase of each additional kit is an optional purchase because Biotech is not obligated to supply any kits to Hospital until Hospital submits a purchase order.
• The Company performs similar analysis on variable consideration and the related constraint (or lack thereof) at each reporting period” (January 2019 letter to the SEC).
• More substantive support may also be necessary if a company determines that variable consideration in a contract falls near the range considered to be probable.

3.1.2 Subsequent changes in the estimate of price concessions

Market trends, regulatory changes, and even economic downturns can dramatically influence the actual outcomes of contracts. For instance, a company may plan for a performance bonus but miss it due to unfavorable market conditions. These external factors make it difficult to predict revenue reliably and can lead to significant deviations from initial estimates. For a contractor, variable consideration may include unit-priced contracts (price per unit is fixed, but the quantities are uncertain), incentive bonuses, liquidated damages, shared savings, change orders, and claims. From the perspective of accounting standards, the shift has been towards greater transparency and comparability. The introduction of ASC 606 and IFRS 15 has brought about a framework that requires entities to estimate the amount of variable consideration to which they will be entitled in a way that is both reasonable and supportable.

Should the constraint on variable consideration be applied at the contract level or performance obligation level?

The SEC staff asked WABCO to explain why they felt the most likely method was better than the expected value method for their volume discounts. Each of the customer relationships is managed by a dedicated account team, who is in a position to estimate the sales volume and determine the appropriate volume discount. A contractor must evaluate the amount of variable consideration to include in the transaction price and weigh both the probability and magnitude of a revenue reversal when allocating fixed costs.

• The right is material if it gives the customer a discount that is incremental to other discounts available to the customer.
• A most likely amount assessment estimates the transaction price based on the single most likely amount in a range of possibilities.
• This means that when estimating the variable consideration, IFRS 15 sets a higher hurdle than the previous IFRS standards which may defer the recognition of some revenue.
• Therefore, the expected value approach may be used on one contract, and the most likely amount approach used on another contract within the same year.
• The $111 of revenue related to License Y is recognized, but the $89 related to License X will be recognized as a liability until the performance obligation has been satisfied (the license is transferred).
• In addition, the entity’s intentions, customary practices, policies or offers on their website can also indicate the existence of variable consideration.
• In such cases, the most likely method may be more appropriate because it produces a better estimate of the consideration the company expects to receive.

Automated systems can now analyze historical data, identify patterns, and predict outcomes with a higher degree of accuracy, thus aiding in the estimation process required by the standards. Investors and analysts pay close attention to a company’s revenue recognition policies, especially how variable consideration is estimated, as it can affect the comparability and reliability of financial statements. They often adjust their models to account for potential reversals of revenue, which can impact their valuation of the company.