This article, "Implementing Variable Considerations in Revenue Recognition," originally appeared on CPAJournal.com.
In May 2014, FASB and the IASB released a final, converged standard on revenue recognition [see Accounting Standards Update (ASU) 2014-09 and IFRS 15]. The new standard introduces sweeping changes to the accounting landscape and imposes new challenges on financial statement preparers and users. The new standard, as codified in ASC Topic 606, “Revenue from Contracts with Customers,” and IFRS 15, Revenue from Contracts with Customers, eliminates industry-specific revenue guidance and dramatically changes revenue recognition for many companies, especially for those in the software, media, and telecommunications industries. It replaces nearly all existing U.S. GAAP and IFRS guidance with a single principles-based model for recognizing revenue from customer contracts. The standard is effective for reporting periods beginning after December 15, 2017, and interim and annual reporting periods thereafter.
Introducing Uncertainty
One of the most significant departures from prior GAAP is the treatment of variable consideration. In the past, revenue could only be recognized in the amount of the fixed or determinable portion of the sales price, not any variable consideration. The new revenue standard is instead based on the core principle that revenue is the amount the company expects to receive based upon the contract. It allows a company to recognize estimated variable consideration as revenue subject to a “constraint” rule, which stipulates that the estimated amount must be adjusted downward to exclude any amount for which it is “probable” (U.S. GAAP) or “highly probable” (IFRS) that a significant reversal will occur.
The allowable recognition of variable consideration may lead to earlier revenue recognition for many entities, especially those in the technology industry, where the requirement of a fixed or determinable selling price for revenue to be recognized has been replaced with a requirement to assess whether variable consideration can be included in the transaction price. Under the current guidance for recognizing software revenue (ASC 985-605), technology and software companies must defer revenue recognition when their selling prices involve extended payments that often lead to price concessions, as these prices are not fixed or determinable. Under ASC 606, however, these companies may estimate the amount of concessions that will be offered and recognize the variable revenue up to the amount that is not expected to reverse.
ASU 2014-09 requires entities to examine the consideration promised in a contract and determine the fixed and variable portion. It also emphasizes the uncertainty evaluation that may be required in revenue recognition. Beyond the inherent uncertainty in collectability, the new standard requires a company to specifically estimate the likelihood, as well as the magnitude, of any reversal of cumulative recognized revenue once the contingency is resolved in the future.
A company may estimate its variable consideration by using historical data, current data, or reasonable projections, and it must rely on either the expected value approach or recognize the most likely amount. The expected value approach calculates the sum of probability-weighted amounts in a range of possible consideration amounts; this method is suitable for situations in which there are a large number of contracts with similar characteristics and many different consideration outcomes. The most likely amount approach is appropriate when there is a single most likely estimated outcome from the contract.
In addition, as stated above, companies must adjust the estimated amount of variable consideration downward by excluding any amount that is probably subject to reversal in the future. Specifically, the new standard requires the transaction price to include an amount to the extent that it is “probable” or “highly probable” that a significant reversal will not occur. “Probable” is defined as “the future event or events are likely to occur” (ASC 606-10-32-11). The determination of “(highly) probable” for IFRS purposes requires a careful evaluation of the uncertainty surrounding variable consideration.
Applying the New Standard
The application of ASU 2014-09 requires significant professional judgment. Estimating variable considerations and assessing the likelihood of future revenue reversal requires management to make assumptions that cannot be precisely determined, making for a substantial level of measurement uncertainty. In addition, like any other subjective judgments, variable consideration estimates are prone to errors and biases. The new standard not only creates a challenge for auditors, who must verify management’s assumptions and ensure the reasonableness of the revenue recognition, but also for investors, who may have difficulty understanding the nature of the uncertainty involved in the revenue recognition process. To help with this, ASU 2014-09 significantly increases disclosure requirements by adding new quantitative and qualitative disclosures; companies must disclose disaggregated revenue to depict how economic factors affect the nature, amount, timing, and uncertainty of revenue and cash flows. In addition, management must disclose in the notes to the financial statements the accounting treatments subject to significant measurement uncertainties and discuss the assumptions and methods used to derive the recognized amounts.
Understanding variable consideration may require a greater degree of analysis, but the result should be a greater appreciation of how the entity generates value.
Assessing uncertainty is difficult, but disclosing uncertainty is even more difficult. The constraint rule requires management to assess specific components of uncertainty, such as the likelihood and the magnitude of any future revenue reversal. For example, the standard stipulates that if management uses the most likely amount to derive the outcome of transaction price for revenue recognition, it must disclose the range of values considered, as well as explain whether this amount is the midpoint, endpoint, or some other value within the range. Similarly, when management discloses the likelihood of future revenue reversal, it must decide whether to disclose the probability as a precise point estimate or a range of values. Management faces a wide array of choices in uncertainty disclosure, and must make a tough decision in terms of how much imprecision it wants to communicate to investors. This choice is not an easy one, because imprecision in disclosed information is often viewed as a signal of management uncertainty. As pointed out by Jerry L. Arnold and William W. Holder (“At War: Disclosure of Measurement Uncertainties,” Journal of Accountancy, December 1998, http://bit.ly/2xWZMjX), because well-informed management may disclose more measurement uncertainty information, the financial statements of such companies may appear more uncertain and imprecise when the opposite may actually be the case.
The Future of Uncertainty
Financial statements prepared under ASU 2014-09 will soon be in front of users. Management and auditors should have their strategies for the recognition of variable consideration in place, along with necessary internal controls to ensure the accuracy of reported information. Users, meanwhile, should prepare to digest this new information by familiarizing themselves with the new recognition rules. Understanding how a business reports variable consideration may require a greater degree of analysis and further inspection of disclosures, but the result should be a greater appreciation of how the entity generates value.
Ning Du, PhD is an associate professor at the school of accountancy and MIS, DePaul University, Chicago, Ill.
Ray Whittington, PhD is a professor at the school of accountancy and MIS, DePaul University, Chicago, Ill.