This method of recognizing revenue contrasts with current GAAP, which would not recognize any variability but rather would recognize revenue based on the invoiced amount at the associated discount level. Clearly the accounting complexities are increasing.
Most likely amount method
The most likely amount method would be more likely to be used in situations where there is a binary decision about how much revenue to recognize. As in situations where an entity contracts to deliver a product or service for a fixed price on a particular date; but has the opportunity to earn a bonus if it can deliver the product within a specified time period. In this scenario, the entity considers whether or not it can earn the bonus. If it believes it is probable (subject to the constraint discussed below), it would recognize the higher amount of revenue over the contract period. If not, it would recognize the base price and reconsider its estimate at each reporting period.2
Generally speaking, the concept of variable consideration is only relevant for those contracts where the revenue will be recognized over time rather than at a point in time.
Constraining estimates of variable consideration
While ASC 606 requires entities to estimate how much revenue will be recognized in connection with a contract, the standard also requires entities to consider constraints on such revenue. Entities may only recognize revenue to the extent that it is not probable that there will be significant reversal of such revenue. Entities shall consider not only the likelihood of a reversal but also the potential magnitude. Here, again, probable is defined as it is in other GAAP, which is a probability in excess of 75-80+ percent.
The standard provides indicators of when a revenue reversal may be probable, as follows:
a. The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.
b. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
c. The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
d. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
e. The contract has a large number and broad range of possible consideration amounts.3
Note that the standard permits an entity to recognize some of the variable consideration when applying the constraint. When the expected value is used, an entity may determine that all of the expected consideration is subject to the constraint; it may also determine that some of the expected consideration should be used as the basis for recognizing the revenue over the contract period. That entity continues to evaluate the probability of significant reversal, as part of its reassessment of variable consideration at each reporting period.
Significant financing component
ASC 606 also brings the concept of a financing component into revenue recognition. For contracts where the entity expects to deliver the goods or services in a time period of less than one year, entities may elect a practical expedient to disregard the consideration of the time value of money. But for all other longer term contracts, an entity must consider whether the contract has a financing component and, if so, recognize interest income (when customer payments are deferred) or interest expense (when customer payments are accelerated).
The standard provides the following indicators of a financing component:
a) The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services
b) The combined effect of both of the following:
a. The expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services
b. The prevailing interest rates in the relevant market4
The standard provides for certain situations which would not indicate a financing component, as follows:
a) The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.
b) A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity (for example, if the consideration is a sales-based royalty).
c) The difference between the promised consideration and the cash selling price of the good or service (as described in paragraph 606-10-32-16) arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract.
The following examples, derived from the standard, illustrate the concept:
An entity sells a product to a customer for $121,000 that is payable 24 months from the delivery date. The customer obtains control of the product upon delivery. The cash selling price for the product is $100,000. As such the entity determines there is a significant financing component. The entity determines there is an implicit discount rate of 10% in the contract. Here the entity must determine if the implicit interest rate is comparable to the rate in a separate financing arrangement and concludes that it is.
Upon delivery, the entity would record the following:
