What Is Variable Consideration Under ASC 606?

Variable consideration is a component of a contract’s transaction price that is not fixed, as its value is contingent upon future events like the completion of a service or the quantity of goods a customer purchases. This concept is a central element of the revenue recognition standard, Accounting Standards Codification (ASC) 606. The standard requires companies to estimate this uncertain amount at the beginning of a contract to determine the total price, which differs from past practices where such revenue was often deferred.

Identifying Common Forms of Variable Consideration

A key step for any business is recognizing when a contract contains variable consideration. One of the most frequent examples is a discount or volume rebate, where the final price per unit is dependent on the total quantity a customer buys. The uncertainty lies in not knowing the final purchase volume when the contract begins.

Another common form is the right of return or refund. Companies that offer customers the ability to return products for a refund must account for this variability. Credits issued to customers for future purchases also make the initial transaction price variable.

Performance-based payments also introduce variability. A contract might include a bonus for meeting certain milestones by a specific date or a penalty for failing to do so. For instance, a construction company might earn an incentive for completing a project ahead of schedule.

Price concessions are another form that can arise explicitly in a contract or implicitly based on a company’s past business practices. A company might offer a price concession if a customer is dissatisfied with a good or service. The potential for such concessions must be estimated upfront under ASC 606.

Methods for Estimating Variable Consideration

ASC 606 prescribes two methods for estimating the amount of variable consideration. A company must select the method it believes will most accurately predict the final amount it is entitled to receive, based on the nature of the contract.

The first method is the expected value approach. This technique involves calculating the sum of probability-weighted amounts from a range of possible outcomes and is most suitable when a company has a large portfolio of similar contracts. For example, a retailer estimating returns could analyze historical data and determine there is a 70% chance of no return ($100 transaction), a 20% chance of a partial return ($50 revenue), and a 10% chance of a full return ($0 revenue). The expected value would be ($100 0.70) + ($50 0.20) + ($0 0.10), resulting in an estimated transaction price of $80.

The second method is the most likely amount. This approach identifies the single most probable outcome from a range of possibilities as the estimate for variable consideration. It is generally more appropriate when a contract has only two possible outcomes, such as a performance bonus. For instance, if a consulting firm has a contract with a $50,000 performance bonus and assesses it has an 85% chance of achieving the target, the most likely amount of the bonus is $50,000.

Applying the Constraint on Variable Consideration

After estimating the variable consideration, a company cannot automatically include the full amount in its transaction price. ASC 606 introduces a limitation known as the constraint. This rule permits entities to include variable consideration in the transaction price only to the extent that it is “probable that a significant reversal” in the amount of cumulative revenue recognized will not occur later.

Several factors must be assessed to determine if an estimated amount should be constrained. A primary consideration is the degree to which factors outside the company’s control could affect the outcome, such as market volatility or the actions of third parties. If the uncertainty is highly susceptible to such external influences, the likelihood of a revenue reversal increases.

The length of time until the uncertainty is resolved is another factor. The longer the period, the more risk there is that circumstances could change. A company’s experience with similar types of contracts also plays a role, as limited experience may lead to a less reliable estimate. Finally, a wide range of possible consideration amounts can indicate high uncertainty, signaling that a portion of the estimate may need to be excluded.

Reassessing Estimates Each Reporting Period

Companies are required to reassess the transaction price at the end of each reporting period for the entire duration of the contract. This ongoing evaluation ensures that the recognized revenue reflects the most current information and expectations available. Circumstances can change, and an estimate that was appropriate at the start of a contract may no longer be accurate months later.

Any changes to the estimated transaction price are recognized as a cumulative catch-up adjustment to revenue. This adjustment is recorded in the period the estimate is revised, not by restating prior periods. For example, if a company initially estimated a performance bonus of $50,000 but later determines it is no longer likely to be achieved, it would reduce its transaction price and recognize a corresponding decrease in revenue in the current reporting period.

This requirement to update estimates ensures that the financial statements provide a more accurate picture of the revenue a company expects to ultimately realize.