What Is Variable Consideration?
Variable consideration is any part of the price in a contract with a customer that can change after the contract is signed: rebates, discounts, refunds, price concessions, performance bonuses, penalties, or fees that depend on a future event. Under IFRS 15 (and ASC 606), the entity does not wait for the uncertainty to resolve. It applies three steps:
- Estimate the amount to which it expects to be entitled, using the expected value or most likely amount method.
- Constrain the estimate, including only the amount for which it is highly probable that a significant reversal of cumulative revenue will not occur.
- Reassess the estimate at each reporting date, with changes recognised through a cumulative catch-up.
Variable consideration is one of the elements of the transaction price in step 3 of the five-step model, alongside the significant financing component, non-cash consideration and consideration payable to a customer. The complete guide to IFRS 15 sets out where it sits in the model as a whole.
Forms of Variable Consideration
The variability may be stated in the contract or implied by the entity's conduct.
| Source | Examples |
|---|---|
| Price adjustments after sale | Volume rebates, prompt payment discounts, price protection clauses, credits |
| Performance-linked amounts | Completion bonuses, late delivery penalties, incentive fees, service level credits |
| Contingent entitlement | Success fees, fees based on asset values or market indices, rights of return |
| Implied variability | A customary practice of granting price concessions, or an intention at inception to accept less than the stated price |
A fixed price can still be variable consideration. Where an entity has a history of accepting less than the invoiced amount from a class of customer, the customer has a valid expectation of a concession, and the transaction price reflects it from the outset.
Variable payments in leases
IFRS 16 takes a different approach. Lease payments that vary with an index or rate are included in the lease liability, but payments linked to sales or usage are excluded and recognised as they occur. See variable lease payments under IFRS 16.
Expected Value vs Most Likely Amount
The entity uses whichever method better predicts the amount to which it will be entitled. This is not a free policy choice; it follows from the nature of the uncertainty.
| Expected value | Most likely amount | |
|---|---|---|
| Calculation | Sum of probability-weighted possible amounts | The single most likely amount in the range |
| Suited to | A range of possible outcomes, or a large portfolio of similar contracts | Two possible outcomes, such as a bonus earned in full or not at all |
| Example | Expected returns on a portfolio of retail sales | A single rebate triggered by a purchase threshold |
The expected value may be an amount that cannot occur. Where a bonus of 1,000,000 is 60 per cent likely, the expected value is 600,000, but the actual outcome will be either nil or 1,000,000. That is why the most likely amount suits binary outcomes.
The method chosen is applied consistently throughout the contract. A contract with more than one uncertainty can use different methods for each: the expected value for a range of penalties, and the most likely amount for a single completion bonus.
The Constraint
Variable consideration is included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty is resolved.
Both the likelihood and the magnitude of a reversal are considered. The magnitude is measured against cumulative revenue for the contract, including the fixed consideration, not against the variable amount alone. Factors that increase the risk of reversal include:
- the amount is highly susceptible to factors outside the entity's influence, such as market movements, weather or the actions of third parties;
- the uncertainty is not expected to be resolved for a long time;
- the entity's experience with similar contracts is limited or of little predictive value;
- the entity has a practice of offering a broad range of price concessions; and
- the contract has a large number and broad range of possible outcomes.
The constraint does not operate on an all-or-nothing basis. Where part of the variable amount is highly probable not to reverse, that part is included.
Performance fees
An investment manager earns a quarterly management fee of 0.3 per cent of assets at quarter end, plus 15 per cent of any outperformance of an index over three years. The management fee is variable, but the uncertainty is resolved at each quarter end, so it is recognised each quarter. The performance fee depends on market movements over a long period and is constrained, usually to nil, until the outcome is largely settled.
Example: Retrospective Volume Rebate
A manufacturer sells industrial pumps to a distributor at 25,000 each. If the distributor buys 400 or more pumps in the calendar year, it receives a rebate of 2,000 on every pump bought in that year. At 1 January, based on years of trading with the distributor, the manufacturer assesses a 75 per cent probability that the threshold will be reached.
There are two possible outcomes, so the manufacturer uses the most likely amount: the rebate will be paid. The transaction price is 23,000 per pump. On each sale, the 2,000 expected to be repaid is recognised as a refund liability rather than revenue.
| Quarter | Units | Invoiced | Refund liability | Revenue |
|---|---|---|---|---|
| Q1 | 120 | 3,000,000 | 240,000 | 2,760,000 |
| Q2 | 80 | 2,000,000 | 160,000 | 1,840,000 |
| Q3 | 70 | 1,750,000 | 140,000 | 1,610,000 |
| Q4 | 90 | 2,250,000 | (540,000) | 2,790,000 |
| Total | 360 | 9,000,000 | 0 | 9,000,000 |
The Q1 entry is:
| Q1 sales | Debit | Credit |
|---|---|---|
| Receivable (SFP) | 3,000,000 | |
| Revenue (P/L) | 2,760,000 | |
| Refund liability (SFP) | 240,000 |
The distributor buys 360 pumps in total, so no rebate is paid. At year end the uncertainty is resolved, and the refund liability of 540,000 accumulated over the first three quarters is released to revenue:
| 31 December | Debit | Credit |
|---|---|---|
| Refund liability (SFP) | 540,000 | |
| Revenue (P/L) | 540,000 |
The constraint works in one direction
Suppose that at 30 September the manufacturer had judged the threshold only 30 per cent likely. The most likely amount would now be no rebate, but releasing the 540,000 liability would increase revenue that could still reverse. A 70 per cent likelihood is generally not enough to meet the highly probable threshold, so the liability would be retained until the outcome was clearer.
Where the rebate applies only to purchases above the threshold, or to future purchases, the analysis changes. A discount on future purchases is assessed as a possible material right, a separate performance obligation, rather than as variable consideration on current sales.
Example: Late Completion Penalty
A contractor agrees to fit out an office building for 12,000,000, with completion due by 30 June 2027. Revenue is recognised over time. The contract deducts 400,000 for each month of late completion, up to a maximum of 2,000,000. Based on similar projects, the contractor assigns these probabilities:
| Penalty | Probability | Weighted amount |
|---|---|---|
| 0 | 45% | 0 |
| 400,000 | 25% | 100,000 |
| 800,000 | 15% | 120,000 |
| 1,200,000 | 10% | 120,000 |
| 1,600,000 | 3% | 48,000 |
| 2,000,000 | 2% | 40,000 |
| Expected penalty | 428,000 |
There is a range of outcomes, so the expected value of 428,000 is the starting estimate, giving a transaction price of 11,572,000. The constraint is then applied. There is a 30 per cent chance that the penalty exceeds 428,000, and a penalty of 1,200,000 would reverse 772,000 of revenue. The contractor concludes that it is highly probable only that the penalty will not exceed 1,200,000, so the transaction price is constrained to 10,800,000.
At 31 December 2026 the project is 40 per cent complete, and revenue of 4,320,000 is recognised (40% × 10,800,000).
The project is completed on 31 August 2027, two months late. The penalty is 800,000 and the final transaction price is 11,200,000. Revenue for 2027 is 6,880,000 (11,200,000 − 4,320,000), which includes a catch-up of 160,000 (40% × 400,000) on the work performed in 2026.
The penalty reduces revenue. It is not recognised as an expense or as a provision under IAS 37, because it is a term of the price the customer pays for the fit-out.
Price Concessions vs Credit Losses
Both reduce the cash an entity collects, but they are accounted for differently.
| Price concession | Credit loss | |
|---|---|---|
| Cause | Entity chooses or expects to accept less than the stated price | Customer is unable to pay what the entity expected to collect |
| Known when | At contract inception, or from customary practice | After inception, from a change in the customer's credit standing |
| Accounting | Reduces the transaction price and revenue | Impairment loss under IFRS 9, presented separately from revenue |
An entity sells goods for 500,000 to a customer in a market where it customarily settles for about 80 per cent of the invoice. Revenue is 400,000. If the customer later pays only 350,000 because its own finances deteriorate, the further 50,000 is an impairment loss on the receivable, not a reduction in revenue.
The distinction also affects the first step of the model. Collectability is assessed against the 400,000 the entity expects to be entitled to, not the 500,000 invoiced.
Reassessment and Allocation
The estimate, including the constraint, is updated at the end of each reporting period. Changes are allocated to performance obligations on the same basis as at contract inception, and stand-alone selling prices are not re-estimated. The portion allocated to obligations already satisfied is recognised immediately, as in both examples above.
Variable consideration is normally allocated across all performance obligations in proportion to stand-alone selling prices. It is allocated entirely to one obligation, or to one distinct good or service within a series, only if both:
- the variable payment relates specifically to the entity's efforts to satisfy that obligation, or to a specific outcome of it; and
- the resulting allocation is consistent with the allocation objective across the contract as a whole.
A completion penalty on an installation service, for example, is allocated to the installation and not to software supplied under the same contract.
Sales-Based and Usage-Based Royalties
Royalties on licences of intellectual property that depend on the customer's sales or usage are an exception. Revenue is recognised at the later of:
- when the customer's subsequent sale or usage occurs; and
- when the performance obligation to which the royalty relates has been satisfied.
No estimate of future royalties is included in the transaction price, and the constraint is not applied. The exception applies only to licences of intellectual property, or where the licence is the predominant item to which the royalty relates. Sales-based fees for goods or other services follow the general requirements.
IFRS 15 vs ASC 606
The requirements for variable consideration are substantially converged.
| Area | IFRS 15 | ASC 606 |
|---|---|---|
| Estimation methods | Expected value or most likely amount | Same |
| Constraint threshold | Highly probable | Probable, meaning likely to occur, intended as the same threshold |
| Royalty exception | Sales-based and usage-based royalties on licences of intellectual property | Same |
| Price concessions vs credit losses | Price concession reduces revenue; credit loss under IFRS 9 | Same distinction; credit loss under ASC 326 |
The analysis and the examples in this article therefore apply equally to entities reporting under US GAAP.
Presentation and Disclosure
Amounts the entity expects to repay, such as rebates and expected returns, are presented as a refund liability, not as a contract liability or a reduction of the receivable. Where a right of return applies, an asset is also recognised for the goods expected to be recovered. The contract assets and contract liabilities guide explains how these balances differ.
IFRS 15 requires disclosure of:
- the methods, inputs and assumptions used to estimate variable consideration and to assess the constraint;
- revenue recognised in the period from performance obligations satisfied in previous periods, such as changes in the transaction price;
- obligations for returns, refunds and similar items; and
- where constrained amounts are excluded from the transaction price allocated to remaining performance obligations, a qualitative explanation of that exclusion.
Estimating variable consideration and applying the constraint are typically significant judgements for entities with material rebate, bonus or penalty arrangements, and are disclosed as such.
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Conclusion
Variable consideration brings expected rebates, bonuses, penalties and concessions into revenue when the related goods or services transfer, rather than when the uncertainty resolves. The estimate uses the expected value for a range of outcomes and the most likely amount for binary ones. The constraint then limits revenue to the amount that is highly probable not to reverse significantly, assessed against cumulative revenue for the contract.
The estimate is updated at every reporting date, and the change is recognised as a cumulative catch-up on obligations already satisfied. Where the price may be reduced, the accounting follows the cause: a concession reduces revenue, while a customer's inability to pay is a credit loss.
The related elements of the transaction price are covered in our guides to the significant financing component and principal versus agent assessments.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.