Variable Considerations in Contracts and Financial Reporting Research Paper

Understanding Variable Consideration

For each product or service sold, any company claims at least a fixed remuneration, the mechanism of which is obvious and, as a rule, documented. Variable consideration is dynamic and refers to the compensation a company expects from a customer based on certain conditions. The form of this phenomenon can vary from discounts and royalties to fines and other incentives (Riley & Jensen, 2020). However, the potential pool of terms that need to be written into the contract and anchored in the valuation is much broader, making variable consideration an exciting topic of discussion from an auditing or accounting perspective.

Requirements for Contracts with Variable Consideration

If a contract contains variable consideration, the company must estimate the variable consideration it expects. In this case, it is necessary to resort to one of two widely used methods: the expected value and most likely approach, which will be described below. The assessment must be based on analyzing all relevant factors, including historical experience, current circumstances, and reasonable expectations of future events that reasonably determine the company’s entitlement to the consideration.

Expected Value vs. Most Likely Approach

The expected value approach involves weighing different possible outcomes by probability to determine the most likely amount of variable consideration. The sum of the weighted potential revenues will be the total transaction price, further considered a constraint (Riley & Jensen, 2020). On the other hand, the most likely sum approach is used when there are only two possible outcomes, and one outcome is more likely than the other. In this case, the company will recognize revenue based on the most probable amount of the variable consideration.

Key Factors in Reversal Analysis and Their Importance

The likelihood and timing of a future event, the uncertainty associated with variable consideration, and whether the consideration is limited affect the accounting and measurement of variable consideration. These are typically the most common causes of this phenomenon in contracts. ASC 606 postulates the need and importance of identifying such determinants to construct correct financial statements and regulate potential manipulation mechanisms. Still, only those close to the probabilistic threshold deserve attention (FASB, ASC 606). The flexibility of such pricing requires a similar adaptive approach to pricing and reporting.

References

FASB (Financial Accounting Standards Board). (n.d.). ASC 606. Web.

Riley, B. & Jensen, K. (2020). Variable Consideration and the Constraint. Revenue Hub. Web.