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Revenue accounting reset – Variable consideration · PwC's accounting podcast

• 0:00
  SPEAKER_02: Thought Leadership from PWC's National Office.
• 0:06
  SPEAKER_00: Hello, and welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_00: I'm Heather Horn.
• 0:11
  SPEAKER_00: As we continue our revenue accounting miniseries, today's episode is taking a closer look at variable consideration, a critical component in determining transaction price under ASC 606.
• 0:23
  SPEAKER_00: Whether it's performance bonuses, volume-based rebates, price concessions, or royalties, variable consideration shows up in all kinds of contracts and often requires significant judgment to estimate appropriately.
• 0:47
  SPEAKER_00: So Angela, it's funny when I was doing that opening, I was saying this often requires significant judgment.
• 0:53
  SPEAKER_00: I think that might be the whole of ASC 606.
• 0:58
  SPEAKER_00: But maybe to get into this topic and so we can have some foundation to understand some of the judgments, can you explain why variable consideration is such a critical component in the revenue model?
• 1:09
  SPEAKER_01: Sure, Heather.
• 1:10
  SPEAKER_01: So the one of the reasons why we wanted to cover variable consideration in this mini-series is because it is so common, right?
• 1:18
  SPEAKER_01: It comes up in so many contracts.
• 1:20
  SPEAKER_01: Almost every contract has some element of variable consideration.
• 1:25
  SPEAKER_01: And as we go through the different examples, you'll see how it can pop up in lots of different situations.
• 1:31
  SPEAKER_01: And as our as you already mentioned, accounting for variable consideration can require judgment.
• 1:38
  SPEAKER_01: It's going to directly impact the timing of revenue recognition.
• 1:41
  SPEAKER_01: So it's important to get it right.
• 1:43
  SPEAKER_01: If you go back to sort of the old pre-606 guidance, and now we're going back a w a ways.
• 1:49
  SPEAKER_01: But some people will still remember that in that old guidance, you had to wait until fees were fixed or determinable in order to recognize revenue.
• 2:00
  SPEAKER_01: So it was actually a little bit easier because if it was uncertain, you waited until the uncertainty was resolved.
• 2:07
  SPEAKER_01: Well, now, under the current guidance, you can't just simply wait until the uncertainty is resolved.
• 2:14
  SPEAKER_01: You do have to estimate variable consideration.
• 2:18
  SPEAKER_01: And so there's obviously some complexity to that.
• 2:21
  SPEAKER_01: There's also some guidance around constraining variable consideration that we'll get into.
• 2:26
  SPEAKER_01: But there's plenty, plenty to talk about.
• 2:28
  SPEAKER_01: Always on these topics.
• 2:29
  SPEAKER_00: So, Angela, maybe now that we kind of understand why it's so important, can you give us some examples of what variable consideration is, and in particular, some examples of what we may see in specific contracts?
• 2:43
  SPEAKER_01: Sure.
• 2:43
  SPEAKER_01: So variable consideration is pretty much exactly what it sounds like.
• 2:48
  SPEAKER_01: It's a fee that isn't fixed.
• 2:51
  SPEAKER_01: It's variable, usually because there's some sort of uncertainty, or the amount is going to vary based on the occurrence or non-occurrence of a future event.
• 3:01
  SPEAKER_01: So a few common examples include rebates or refunds.
• 3:07
  SPEAKER_01: You may have a refund right upon returning a product, for example, which is very common.
• 3:13
  SPEAKER_01: Or you could have rebates that are based on volumes of purchases where a rebate is given to the customer.
• 3:21
  SPEAKER_01: Performance bonuses that are earned by the vendor are a form of variable consideration.
• 3:26
  SPEAKER_01: So this may be an amount that's earned upon meeting some sort of performance target in the contract.
• 3:33
  SPEAKER_01: And on the flip side, penalties that you might have to pay the customer if you don't meet some sort of performance target, say a service level agreement in a service contract is a very common type of potential penalty.
• 3:48
  SPEAKER_01: And we're talking here about penalties related to performance under the contract.
• 3:53
  SPEAKER_01: Sometimes we see fees that are adjustments that can be made because of price protection clauses.
• 4:01
  SPEAKER_01: So if you charge a price to another customer that's lower than you've agreed to give a price adjustment to your customer, for example.
• 4:10
  SPEAKER_01: And there's a few different forms that that can take.
• 4:14
  SPEAKER_01: We also often see variable fees in the form of royalties, either usage-based royalties or sales-based royalties, obviously common in many types of arrangements, and those are variable based on some sort of event in the future.
• 4:29
  SPEAKER_03: Angela, I would also add that variable consideration may not necessarily be explicitly stated in the contract, but it could be implied based on the company's past practices or communications they have with their customer.
• 4:42
  SPEAKER_03: So one example would be price concessions, when a company has a history of providing concessions to a specific customer or specific type of customers, such as those in a particular geography.
• 4:53
  SPEAKER_03: And another example is when the sale of a product does not have a stated return right.
• 4:59
  SPEAKER_03: However, the company has a history of accepting returns from customers.
• 5:03
  SPEAKER_00: All right, so definitely a lot to think about.
• 5:04
  SPEAKER_00: And I started by saying uh variable consideration in a contract.
• 5:08
  SPEAKER_00: So I think it's helpful for Chris to give us that reminder.
• 5:11
  SPEAKER_00: Angela, I do have one question because you mentioned penalties based on performance.
• 5:17
  SPEAKER_00: And so that would be, for example, a case where you committed you're buying a certain number of items and you don't meet that commitment, or what types of penalties were you thinking of?
• 5:28
  SPEAKER_01: No, this is where like the company didn't perform in accordance with some like target in the contract.
• 5:35
  SPEAKER_01: So say you you agree to um build something and you don't complete it in a certain time frame, and so you have to pay a penalty because you didn't complete it on time.
• 5:46
  SPEAKER_01: Or the service level arrangement or SLA is pretty common in like service agreements where we're gonna have uptime of 99%.
• 5:55
  SPEAKER_01: And so if like our platform goes down, then we're gonna owe money back to the customer.
• 6:01
  SPEAKER_01: So that's the kind of penalty I was thinking of.
• 6:04
  SPEAKER_01: And I wanted to emphasize it has to be related to performance because you can get into other parts of GAP if you have other penalties related to somebody else's performance.
• 6:15
  SPEAKER_01: And we're not gonna get into that today.
• 6:16
  SPEAKER_01: Okay.
• 6:17
  SPEAKER_00: And I know this isn't really about these examples.
• 6:19
  SPEAKER_00: I just wanted to kind of set the stage to make sure that people understand what types of things we're talking about.
• 6:25
  SPEAKER_00: So you're basically saying, like if I put it in my terms, going back to my power and utilities days, you would have a commitment, you're gonna build a power plant, it's gonna be done by July 1st, 2025.
• 6:35
  SPEAKER_00: And if it's not finished, you're gonna pay a certain amount every single day until it's finished.
• 6:40
  SPEAKER_00: That's the type of penalty that you're talking about.
• 6:42
  SPEAKER_01: Right.
• 6:42
  SPEAKER_01: So that's going to be a reduction in the transaction price from the customer.
• 6:47
  SPEAKER_01: It kind of ties back to something we're gonna talk about on next week's podcast, which is consideration payable to a customer.
• 6:54
  SPEAKER_01: And there's definitely overlap in these two topics.
• 6:56
  SPEAKER_00: Okay, well, we'll stay focused on this one then.
• 6:58
  SPEAKER_00: So if staying focused on this, what would be the accounting model for the variable consideration?
• 7:05
  SPEAKER_01: Yeah, the general model, and there are some exceptions that we'll get back to, but just to say the general model is that variable consideration is estimated at contract inception and included in the transaction price.
• 7:19
  SPEAKER_01: The variable consideration is subject to a constraint, which we'll talk about some more.
• 7:24
  SPEAKER_01: And then that estimate gets updated each reporting period until the uncertainty is resolved and we no longer have any variability.
• 7:34
  SPEAKER_01: When you're updating estimates of variable consideration, you're generally doing that on a cumulative catch-up basis.
• 7:42
  SPEAKER_01: Um, there's two methods in the standard for estimating variable consideration.
• 7:47
  SPEAKER_01: The first is called the expected value method.
• 7:51
  SPEAKER_01: And this is where you look at all the possible outcomes, you basically apply probabilities to all those outcomes and you come up with this one amount, the expected value.
• 8:01
  SPEAKER_01: This is most appropriate when perhaps you have a large volume of similar contracts.
• 8:06
  SPEAKER_01: Maybe you're trying to estimate sales returns, right?
• 8:10
  SPEAKER_01: And you would use all that data to come up with an estimate for returns, a return rate.
• 8:16
  SPEAKER_01: The other method is called the most likely amount method.
• 8:20
  SPEAKER_01: And this is where you are estimating the single most likely amount in all the potential outcomes.
• 8:27
  SPEAKER_01: And this is most common when there's really just one amount or or nothing.
• 8:32
  SPEAKER_01: So, like that performance bonus, where maybe if you built your plant on time, you get an extra bonus.
• 8:38
  SPEAKER_01: You're either gonna get it or you're not.
• 8:40
  SPEAKER_01: So one of those is gonna be the most likely amount.
• 8:44
  SPEAKER_01: So the method selected between these two is not necessarily a policy choice.
• 8:49
  SPEAKER_01: You're supposed to pick the method that best predicts the amount of consideration.
• 8:55
  SPEAKER_01: But you would want to apply it consistently if you've got similar contracts with similar types of variable consideration.
• 9:02
  SPEAKER_01: All right.
• 9:03
  SPEAKER_00: And then, Angela, you mentioned a constraint.
• 9:05
  SPEAKER_00: So, Chris, if we, when we're thinking about a constraint, what is that and how is it applied then in this estimation?
• 9:12
  SPEAKER_03: Yeah, sure.
• 9:13
  SPEAKER_03: So the the standard introduced a layer of conservatism into the process here.
• 9:17
  SPEAKER_03: So um the principle introduced in the standard is that the variable consideration should be included only to the extent that it's probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is resolved.
• 9:34
  SPEAKER_03: Uh and probable in this context is used in the same way that we use that term in other uh elements of GAAP, and is usually viewed as having 75% or higher likelihood.
• 9:45
  SPEAKER_03: Um there's some other factors to think about um when considering uh consideration and when it should be constrained.
• 9:53
  SPEAKER_03: Circumstances like when there's variability based on factors outside the company's control, such as when consideration is based on a market price uh at a specified future date, or is based on the actions of other parties, or instances when a company's experience with similar contracts is limited or is not predictive.
• 10:14
  SPEAKER_03: There's also instances uh where there may be a broad range of possible consideration amounts, or finally instances where the uncertainty is not expected to be resolved in the near term.
• 10:25
  SPEAKER_00: All right, so then if I'm thinking about the constraints, and I know you gave that quote that it's probable that a significant reversal in the amount of cumulative revenue recognized will not occur when it's resolved.
• 10:37
  SPEAKER_00: So basically what you're saying is that you should not be recognizing revenue that you're ultimately going to need to reverse.
• 10:42
  SPEAKER_00: Is that overseas?
• 10:43
  SPEAKER_01: That's the conservatism that we're baking in here.
• 10:46
  SPEAKER_00: Yeah.
• 10:46
  SPEAKER_00: And it's interesting, right?
• 10:47
  SPEAKER_00: Because we often don't see in GAP anymore that type of conservatism built in.
• 10:52
  SPEAKER_00: But I think here they wanted to make sure you weren't recognizing revenue just to reverse it later.
• 10:57
  SPEAKER_01: Later.
• 10:57
  SPEAKER_01: And it's not an absolute, right?
• 10:59
  SPEAKER_01: I mean you could still have situations where you end up reversing revenue.
• 11:03
  SPEAKER_01: And that doesn't mean it's necessarily an error.
• 11:05
  SPEAKER_01: Yeah.
• 11:06
  SPEAKER_01: But you do have to meet this pretty high threshold that it's probable you're not going to reverse the revenue at some point in the future.
• 11:13
  SPEAKER_00: Yeah.
• 11:14
  SPEAKER_00: And I guess if we even go back to this example, Angela, of the plant that you're going to get a performance bonus if you complete on time and you have a history of you always hit your deadlines, and so you you recognize because you think it's probable, but then there's some particular issue with that particular plant.
• 11:30
  SPEAKER_00: It doesn't mean there was an error to begin with, but it does mean that then you may need to make an adjustment, which I think we'll we'll get into, right?
• 11:38
  SPEAKER_00: Yep, no, that's that's exactly right.
• 11:39
  SPEAKER_00: Okay.
• 11:40
  SPEAKER_00: So, Chris, if I come back to you, we said this was a two-step process.
• 11:44
  SPEAKER_00: So then you first estimate variable consideration.
• 11:46
  SPEAKER_00: So that's all of what Angela was talking about.
• 11:49
  SPEAKER_00: And then you apply the constraints that you were just talking about.
• 11:53
  SPEAKER_03: Aaron Ross Powell That's right.
• 11:54
  SPEAKER_03: The model does set it up as two different steps in the determination of variable consideration.
• 11:59
  SPEAKER_03: However, practically speaking, companies often bake in the conservatism when coming up with their estimate.
• 12:05
  SPEAKER_03: So it isn't always two discrete steps.
• 12:07
  SPEAKER_00: Aaron Powell Oh, so basically, even when I'm figuring out my cons uh variable consideration, it's not like I say, oh, it could be zero to one hundred, but I think most probable is 75.
• 12:17
  SPEAKER_00: I just I kind of say my variable consideration is 75.
• 12:20
  SPEAKER_00: Yes.
• 12:22
  SPEAKER_01: I think operationally you don't necessarily break it into the same thing.
• 12:24
  SPEAKER_00: Yeah, these two very distinct.
• 12:26
  SPEAKER_00: So then, Chris, could you give an example of when you would be constraining?
• 12:30
  SPEAKER_00: Yeah.
• 12:30
  SPEAKER_03: Sure.
• 12:31
  SPEAKER_03: And I think you just mentioned performance bonuses.
• 12:33
  SPEAKER_03: So performance bonuses and a revenue contract that they're really only received from a customer if the project is completed within a certain time frame.
• 12:42
  SPEAKER_03: So if it's a very long-term contract uh over multiple years, that may make it more difficult to conclude that the bonus is not constrained, as there's uncertainty that's not expected to be resolved in the near term.
• 12:55
  SPEAKER_03: And there also may be uncertainty in that situation regarding what's going to happen during the intervening period.
• 13:02
  SPEAKER_03: So it could challenge uh your ability to make an estimate.
• 13:06
  SPEAKER_00: Aaron Powell So wait, let me jump in here because I gave the example earlier where I said, oh, well, I have this history, I always complete them on time, so I'm gonna recognize.
• 13:13
  SPEAKER_00: But you're saying, well, but if it's gonna take you five years to build this power plant, doesn't really necessarily mean that you are gonna hit it again.
• 13:22
  SPEAKER_03: Aaron Powell That's true, but you also could have an instance where a company has some past experience with that type of project and that and that type of customer, and you've demonstrated in the past that you're able to hit the deadlines and hit the project requirements.
• 13:36
  SPEAKER_03: And in those type of circumstances, uh perhaps the uh variable consideration isn't constrained.
• 13:42
  SPEAKER_01: Aaron Powell So it's a balance, right?
• 13:43
  SPEAKER_01: And those factors that Chris went through, you might, you know, they may kind of offset each other.
• 13:48
  SPEAKER_01: So then it's really looking at it in totality, and here's where all the judgment comes in.
• 13:53
  SPEAKER_00: Yeah.
• 13:53
  SPEAKER_00: I mean, obviously, again, I think it's fair to say if there's a shorter time frame that may help with making some of these estimates, because if you have to deliver something next month versus three years from now, it seems like there's it would be easier to make that estimate.
• 14:08
  SPEAKER_00: What could happen in a month, right?
• 14:10
  SPEAKER_00: Well, okay, fair.
• 14:11
  SPEAKER_00: Actually, to be fair, a lot could happen in a month.
• 14:13
  SPEAKER_00: So so maybe uh anyway, if we we can move on from that point.
• 14:18
  SPEAKER_00: So then the let's go back then.
• 14:20
  SPEAKER_00: So we talked about these different factors.
• 14:22
  SPEAKER_00: Does this mean that you automatically then do constrain, or it really depends?
• 14:27
  SPEAKER_01: Right.
• 14:27
  SPEAKER_01: So sometimes the the thinking is if I check all those boxes, right, I'm automatically going to completely constrain all the consideration or assume zero, right?
• 14:37
  SPEAKER_01: And that's not always the case.
• 14:39
  SPEAKER_01: I mean, if you thought about um if you were a company launching a brand new product and you're giving maybe a 30-day standard return right, and you don't have history yet of how company, you know, how the customers are going to behave and whether they're gonna return the product, you do check some of those boxes because um you don't have history to look to.
• 15:03
  SPEAKER_01: Um, some of this is outside of your control because it's the customers that are deciding to return the product.
• 15:10
  SPEAKER_01: However, it would be very unusual to say, okay, I'm just gonna default to zero revenue and assume everybody is gonna return the product.
• 15:19
  SPEAKER_01: But there's probably some minimum amount that's probable of not being reversed.
• 15:25
  SPEAKER_01: So it's not quite that easy as just um defaulting to zero.
• 15:30
  SPEAKER_01: Um, but even if you were very early on in a situation and you know, the return one is probably not the best uh example, but even if you were like earning that performance bonus and very early on you said, oh, it's it's a ways off.
• 15:44
  SPEAKER_01: I think I'm fully constrained, that's not a set it and forget it estimate.
• 15:50
  SPEAKER_01: You would continue to reevaluate that as you get closer to the time when you would earn the bonus and continue to update your estimate based on the current facts and circumstances.
• 16:03
  SPEAKER_00: And I guess that's where it comes back to what Chris was saying about probability and using that same definition of probable that we see in other parts of gap.
• 16:11
  SPEAKER_00: So, in your example you just gave, maybe with passage of time, you would have a better estimate of whether or not something is probable.
• 16:19
  SPEAKER_01: Exactly, exactly.
• 16:20
  SPEAKER_01: And I would say though, that there are a couple scenarios where we do see variable consideration being fully constrained, so worth mentioning.
• 16:30
  SPEAKER_01: Uh, one is pretty common in the uh pharma and life sciences space, and this is where milestone payments are received upon receiving regulatory approval for some sort of like drug or product.
• 16:44
  SPEAKER_01: And not always, but typically that's considered to be fully constrained because uh the you know the regulator is the one in control of making that decision, and it's difficult to predict what they're going to do.
• 16:59
  SPEAKER_01: Um, the other example we see is more common in the financial services space.
• 17:05
  SPEAKER_01: And this is where a fee is based on some sort of market price.
• 17:10
  SPEAKER_01: So, say you're managing a fund and you get a certain fee if the fund has some sort of return over a period of time.
• 17:20
  SPEAKER_01: Uh we typically don't try to estimate or predict what's gonna happen in the market.
• 17:25
  SPEAKER_01: So generally, people would say that's fully constrained until the variability is resolved.
• 17:32
  SPEAKER_00: And I guess maybe a question for either of you do we typically see that there's a bias to try to lean towards constraining because people are very conservative.
• 17:43
  SPEAKER_00: Exactly.
• 17:43
  SPEAKER_00: That's what I was gonna say, because people really don't want to record revenue that they're going to have to reverse in the future.
• 17:49
  SPEAKER_01: Yeah, I mean, generally I'd say the bias is to constrain more.
• 17:52
  SPEAKER_01: I mean, different companies have different motivations, of course.
• 17:55
  SPEAKER_01: But uh yeah, I mean, you you definitely don't want to be in a situation where you're reversing revenue and then having to explain yourself because that you will bring up, well, was that the right judgment to begin with?
• 18:06
  SPEAKER_00: Yeah.
• 18:06
  SPEAKER_00: Anything to add, Chris, from your point?
• 18:08
  SPEAKER_03: No, I think that is absolutely the the uh uh practice that we see uh from our clients is um trying to avoid a reversal.
• 18:16
  SPEAKER_00: Yeah, but on the other hand, then you don't want to not recognize revenue you sh should be, so it's a balancing act, I think you said that.
• 18:24
  SPEAKER_00: So you gave some examples of types of variable consideration earlier on, but uh Angela, can you give some more sort of specifics in terms of some that we commonly see and what some of the considerations may be?
• 18:37
  SPEAKER_01: Sure.
• 18:38
  SPEAKER_01: I mean, one very common type is a volume-based rebate or discount.
• 18:43
  SPEAKER_01: So for example, uh a vendor is selling widgets to a customer, and if the customer buys a certain volume of widgets, they get a rebate.
• 18:53
  SPEAKER_01: So let's say if they purchase$100,000 worth, they get a 5% rebate.
• 18:58
  SPEAKER_01: If you purchase$200,000 worth, you get a 10% rebate.
• 19:03
  SPEAKER_01: So the price of each widget is variable because we don't know if it'll be full price, 5% off, or 10% off, right?
• 19:11
  SPEAKER_01: So we're having to estimate the transaction price for each widget that's being purchased by the customer.
• 19:18
  SPEAKER_01: And that would be based on your expectation of whether they're gonna hit these volume-based targets.
• 19:24
  SPEAKER_01: And you would continue to update that estimate as additional information is known.
• 19:30
  SPEAKER_01: Um, another version of this that is possibly even more common is a prospective volume discount.
• 19:38
  SPEAKER_01: So instead of the example I just explained, you the the customer pays a certain price for the first thousand widgets and then a lower price for the next thousand widgets and so on.
• 19:52
  SPEAKER_01: So the price of the first 1,000 widgets is not variable, it's fixed.
• 19:58
  SPEAKER_01: The price is just gonna go down for future purchases.
• 20:02
  SPEAKER_01: So in this case, it's not really variable consideration.
• 20:05
  SPEAKER_01: However, you do need to think about whether the future discount provides a material right, which is a whole nother concept in 606.
• 20:14
  SPEAKER_01: And you likely would need to be deferring some revenue from those earlier purchases because of the discount that's being provided on the future purchases.
• 20:25
  SPEAKER_01: So at the end of the day, you really get back to a similar answer, which is nice, right?
• 20:30
  SPEAKER_01: It's two different models, but generally you're gonna be in a similar place at the end of the day as far as how much revenue you're recognizing for each widget.
• 20:38
  SPEAKER_00: And in that case, then, Angela, you it's really because you're saying that you're the same average price is what you're earning for each widget, or that you're really selling each widget for this average price under both of those types of contracts, even though they're structured differently.
• 20:54
  SPEAKER_00: Right.
• 20:54
  SPEAKER_00: Yes.
• 20:54
  SPEAKER_00: All right.
• 20:55
  SPEAKER_00: So it's always helpful to your point when accounting matches up like that.
• 20:58
  SPEAKER_00: So that's good.
• 20:59
  SPEAKER_00: And then let me go back because we did mention that there's some exceptions to this general model.
• 21:04
  SPEAKER_00: So, Chris, can you give us some examples or walk us through what those exceptions are?
• 21:09
  SPEAKER_03: Sure.
• 21:10
  SPEAKER_03: So one exception relates to uh licenses of intellectual property and the associated royalties and usage-based fees that are frequently paid during that licensing arrangement.
• 21:21
  SPEAKER_03: Um, for example, a company licenses its IP to a customer, and the customer uses that IP and its products, and as consideration, the company would receive a percentage of that customer's sales of that product.
• 21:38
  SPEAKER_03: And the FASBI decided when they wrote the standard uh to provide an exception, uh, whereas those those fees or those license fees wouldn't have to be recognized until that underlying sale or usage occurs.
• 21:51
  SPEAKER_03: In finalizing the standard, the FASBE decided trying to estimate the royalties uh wouldn't prov necessarily provide useful information to users of.
• 22:01
  SPEAKER_00: Trevor Burrus, Jr.: Yeah, I'm sure that uh people with these types of arrangements were glad that that exception was provided because it seems quite difficult.
• 22:07
  SPEAKER_00: Trevor Burrus, Jr.: That was certain certainly appreciated in practice.
• 22:10
  SPEAKER_00: Yeah.
• 22:11
  SPEAKER_03: So a few other reminders that come to mind.
• 22:14
  SPEAKER_03: So if the if the licensee is reporting their sales on a lag basis, so for example, the month after their sales occur or the quarter after their sales occur, the the company is still obligated and required to estimate uh the royalties it's earned uh through the period end, and then obviously the statements would occur or be received uh after the fact.
• 22:41
  SPEAKER_00: Aaron Ross Powell So wait, so again, jumping in here, it's so basically what we're saying is you don't have to estimate, but once the time has passed, even if you haven't received the information from your customer, that that point you do you just don't have to estimate for future.
• 22:54
  SPEAKER_00: That's right.
• 22:55
  SPEAKER_00: Okay, that's a very important distinction.
• 22:56
  SPEAKER_00: Right.
• 22:57
  SPEAKER_01: The exception doesn't allow you to wait until you get the report.
• 23:00
  SPEAKER_01: It allows you to wait until the sales occur.
• 23:03
  SPEAKER_01: So it's an important distinction.
• 23:05
  SPEAKER_00: So you want to make sure in your contracts you're negotiating for quick reporting.
• 23:09
  SPEAKER_00: Yes.
• 23:09
  SPEAKER_00: All right.
• 23:10
  SPEAKER_00: So sorry, Chris.
• 23:10
  SPEAKER_03: And then just a couple other things.
• 23:12
  SPEAKER_03: Um it's important to emphasize this relates to licenses of intellectual property.
• 23:17
  SPEAKER_03: So if you're getting royalties on a product sale, for example, uh, and there isn't a licensing of intellectual property along with it, this exception wouldn't apply.
• 23:27
  SPEAKER_03: And then lastly, the exception doesn't apply to fixed amounts that may become uh payable under the terms of the contract.
• 23:34
  SPEAKER_01: Yeah, I mean that point about it only applies to licenses of IP is really important because there can be arrangements that feel very similar.
• 23:43
  SPEAKER_01: And so, like, oh, it should be the same reasons that I don't need to estimate.
• 23:47
  SPEAKER_01: But this is an exception that was written in the guidance, so it it's very narrow, and you have to meet the the uh you know the details of the exception in order to use it.
• 23:57
  SPEAKER_00: All right, it's helpful clarification.
• 23:59
  SPEAKER_00: Let me come back though to the final point you made, Chris, about these minimum royalties.
• 24:03
  SPEAKER_00: So can you explain a little bit more what we mean when we say that?
• 24:07
  SPEAKER_03: Yeah, sure.
• 24:08
  SPEAKER_03: So uh contracts in with intellectual property uh that have these sales or usage-based royalties frequently have both fixed amounts that are paid and variable amounts that are paid.
• 24:19
  SPEAKER_03: So, for example, assume you have a five-year license agreement, and those fees include 5% of the sales of the product that include the the IP that was licensed, and that it and the contract also calls for annual minimum payments of$100,000 a year.
• 24:36
  SPEAKER_03: So the minimum fee in that situation of$500,000 or$100,000 times five years in the contract is not variable consideration.
• 24:46
  SPEAKER_03: So if the licensed IP is functional IP, which requires upfront revenue consideration, the$500,000 fixed royalty payment in that contract would be recognized up front.
• 24:59
  SPEAKER_03: And the sale, any sales-based royalty in excess of that would would then be subject to the royalty exception and not recognized until the sale occurs.
• 25:12
  SPEAKER_00: One question there, because you made the point that the licensed IP needs to be functional IP.
• 25:17
  SPEAKER_00: So does that just mean it works, or what does we mean?
• 25:26
  SPEAKER_01: That was just designated in order to determine the timing of recognition.
• 25:31
  SPEAKER_01: So functional IP is recognized up front and symbolic IP is recognized over time.
• 25:37
  SPEAKER_01: But functional IP is anything that has an immediate functionality like media or software or a drug compound, all those things are considered functional IP.
• 25:50
  SPEAKER_01: Symbolic IP is like trade names.
• 25:55
  SPEAKER_00: The functional is a bit uh misleading for someone who doesn't know what 606 folks use throw that term around all the time.
• 26:02
  SPEAKER_01: So yeah.
• 26:03
  SPEAKER_00: Okay.
• 26:04
  SPEAKER_00: Um so Angela, maybe sticky with you.
• 26:07
  SPEAKER_00: Any other exceptions to the general model?
• 26:10
  SPEAKER_01: Yeah, there are a couple other situations where you don't necessarily have to estimate all the variable consideration up front.
• 26:19
  SPEAKER_01: Um so the first one is called the variable consideration allocation exception.
• 26:26
  SPEAKER_01: So that's a little bit of a mouthful.
• 26:28
  SPEAKER_01: Um and this occurs when you can you can basically conclude that the variable consideration should be allocated to just part of the contract instead of the whole contract.
• 26:40
  SPEAKER_01: Um this commonly comes up when the arrangement is a service arrangement, and even more so when you have something that we call a series of distinct good or services.
• 26:52
  SPEAKER_01: So these are services that are kind of repetitive services over time.
• 26:56
  SPEAKER_01: Uh one example, and it's actually the example in the standard, is hotel management services.
• 27:01
  SPEAKER_01: So you're providing hotel management services for some period of time, say a year.
• 27:07
  SPEAKER_01: And then the fee in that agreement, let's say, is based on a percentage of the monthly hotel revenue.
• 27:14
  SPEAKER_01: So you have a variable fee, it's a percentage of the revenue each month.
• 27:19
  SPEAKER_01: So if we were following the general model, you would have to estimate all of that variable consideration up front.
• 27:26
  SPEAKER_01: Well, obviously that's going to be a little challenging here.
• 27:29
  SPEAKER_01: And under this exception, what you would look at is whether that monthly fee can be allocated to that month of services.
• 27:40
  SPEAKER_01: There's a couple of criteria you have to meet.
• 27:42
  SPEAKER_01: You have to look to whether the terms of the variable payment relate specifically to the entity's efforts for that period.
• 27:50
  SPEAKER_01: And we would generally say that that would apply in this hotel management example.
• 27:55
  SPEAKER_01: And then you also have to conclude that the end result is consistent with the overall allocation objective.
• 28:03
  SPEAKER_01: And really what that means in plain English is like when you step back, does it make sense?
• 28:09
  SPEAKER_01: So in that case, where you end up is that variable monthly fee you allocate to each month of services.
• 28:18
  SPEAKER_01: So you don't have to estimate all of it in advance.
• 28:22
  SPEAKER_01: You're just going to take it, recognize it in the month when you incur the or you when you receive the fee.
• 28:29
  SPEAKER_01: If that makes sense.
• 28:30
  SPEAKER_00: So from a practical point of view, is it hard to recognize when you're in the that particular exception?
• 28:35
  SPEAKER_00: Or is it really there's a limited, there's limited types of contracts that would really apply to?
• 28:40
  SPEAKER_01: Well, I think there's a lot of contracts it applies to, because it also applies to like software as a service or SaaS arrangements, very common, um, other kinds of like stand-ready obligations.
• 28:51
  SPEAKER_01: It's interesting because I think sometimes people just assume, well, I'm going to recognize the variable fee each each month when I earn it.
• 28:58
  SPEAKER_01: Yeah.
• 28:59
  SPEAKER_01: Um, so they maybe don't even think about it that hard.
• 29:02
  SPEAKER_01: But that's what that's how what they're applying is that exception, because otherwise you would have to estimate all the variable consideration up front.
• 29:11
  SPEAKER_01: Now there's situations where you end up having to go back to the general model.
• 29:17
  SPEAKER_01: Like let's say this monthly fee starts out as a 1% of monthly revenue, and then then in the later months it increases to 3% or 5% by the end of the contract.
• 29:31
  SPEAKER_01: Well, in that case, when you do that, let's step back and see if it makes sense.
• 29:36
  SPEAKER_01: It doesn't really make sense that your revenue would be lower at the beginning and then be higher at the end.
• 29:42
  SPEAKER_01: Or minus the same services.
• 29:45
  SPEAKER_01: Right.
• 29:45
  SPEAKER_01: Assuming exactly.
• 29:46
  SPEAKER_01: Sometimes there is a reason, and that's what we would dig into.
• 29:49
  SPEAKER_01: Okay, what's the reason for why the rate's going up?
• 29:52
  SPEAKER_01: But if there really isn't a reason, if performance is essentially the same through the contract, then you'd say, okay, well, we can't apply the exception.
• 30:00
  SPEAKER_01: And unfortunately, in that case, you may be back to the general model, which is estimate all the variable consideration and recognize it over the period.
• 30:10
  SPEAKER_01: Um so I mean, sometimes what I advise people is, you know, the more complicated you make the fee structure, I mean, unfortunately, the more complicated the accounting is gonna be.
• 30:22
  SPEAKER_00: Yeah, that's that's a good point.
• 30:24
  SPEAKER_00: So I know I jumped in there.
• 30:25
  SPEAKER_00: Is there another exception you were gonna cover?
• 30:28
  SPEAKER_01: Um yeah.
• 30:29
  SPEAKER_01: So the second exception is um a type of a measure of progress that you can use for overtime revenue contracts, and it's called the right to invoice uh measure of progress.
• 30:42
  SPEAKER_01: And again, you have to meet some criteria to be in this.
• 30:46
  SPEAKER_01: But if you can assert that the fee you're charging directly corresponds to the value that the customer is receiving, then you can basically recognize revenue as you invoice.
• 30:59
  SPEAKER_01: Um, this is most common in, say, like a consulting or advisory type services where you're billing time and materials.
• 31:08
  SPEAKER_01: And so basically, as you bill, that's the value that the customer is getting.
• 31:14
  SPEAKER_00: All right.
• 31:15
  SPEAKER_00: So from listening to this discussion with both of you, it sounds like this is definitely a case where it's important to understand the base model and then layer these exceptions on to make sure you're gonna land in the right place.
• 31:26
  SPEAKER_00: Right, right.
• 31:27
  SPEAKER_00: You're both nodding at me.
• 31:28
  SPEAKER_00: Okay, well, so definitely a lot for uh companies to think about, and it seems like this can definitely get very complicated very quickly.
• 31:36
  SPEAKER_00: So, from a practical point of view, just taking a step back, um, as Angela knows, I always like to end the podcast by asking for some words of wisdom.
• 31:43
  SPEAKER_00: So maybe starting with you, Angela, is any sort of words of wisdom that you would give to companies or engagement teams as they're dealing with these types of contracts.
• 31:52
  SPEAKER_01: Well, I think I'd go back to an earlier comment I made about like the estimate not being a set it and forget it policy.
• 32:00
  SPEAKER_01: And I know in order to operationalize some of this accounting, you obviously have to put policies in place.
• 32:06
  SPEAKER_01: And that would include things like when do you apply the constraint or how do you apply the constraint?
• 32:12
  SPEAKER_01: But you want to keep in mind that facts and circumstances change, right?
• 32:17
  SPEAKER_01: So you can set a policy, but that's something that you need to be revisiting and making sure that the policy still makes sense given the facts and circumstances.
• 32:26
  SPEAKER_01: Have you gained more historical information, or is there something changing about the uncertainty in the environment that would cause you to update your policy?
• 32:38
  SPEAKER_01: So I think that'd be my advice.
• 32:39
  SPEAKER_01: I mean, I know people like to set policies and then follow them forever.
• 32:44
  SPEAKER_01: But this is one where it's it's pretty hard to do that.
• 32:47
  SPEAKER_00: And then Chris, how about from your perspective, either from your days as an audit partner or as you've been answering uh questions, what advice would you give in in dealing with contracts that may have variable consideration?
• 32:58
  SPEAKER_03: I think I think the reason why we're talking about it is because contracts typically have variable consideration in some form.
• 33:05
  SPEAKER_03: We talked at the very beginning that it could be explicit, it could be implicit, and it's really uh a requirement in the accounting process here to study the terms of the contract and really think through uh the constraints and the exceptions that we've been talking about here today to truly ensure that you get the accounting right because there's there's quite a bit of judgment involved and it can take some time and input throughout the organization in order to get the accounting right.
• 33:34
  SPEAKER_00: Yeah, and I guess just chiming into that final point you made, then this sounds like it's definitely a case where the accountants don't want to sit at their desks and just look at the contract and make some decisions.
• 33:44
  SPEAKER_00: They really need to understand the business side of the contracts as well.
• 33:48
  SPEAKER_01: Yeah, I mean, and something that we you have been seeing more often, and this is not necessarily a new trend, but it's where companies are looking at different ways to price their offerings, and maybe customers don't want to pay a fixed price, they want to pay for what they use.
• 34:04
  SPEAKER_01: Well, that's a variable fee.
• 34:06
  SPEAKER_01: Yeah.
• 34:06
  SPEAKER_01: And so trying to run that through the model, okay, are we under the general model?
• 34:10
  SPEAKER_01: Do we have to try to estimate that?
• 34:13
  SPEAKER_01: Or do one of these exceptions apply?
• 34:15
  SPEAKER_01: And maybe we can allocate that variable fee to a certain part of the contract.
• 34:21
  SPEAKER_00: Okay.
• 34:21
  SPEAKER_00: Well, definitely very helpful uh and a lot here to think about.
• 34:25
  SPEAKER_00: So, Chris, you made the point that almost all contracts have this in some form, or many contracts in some form.
• 34:31
  SPEAKER_00: So if we have listeners that now want to know more after listening to the two of you, where should they go for more information?
• 34:37
  SPEAKER_03: Yeah, I would really encourage uh the listeners to go to our Revenue from Contracts and Customers guide.
• 34:42
  SPEAKER_03: So we have chapter four that addresses variable consideration.
• 34:46
  SPEAKER_03: And really within that chapter, we go through a lot of the examples uh that we see in practice.
• 34:51
  SPEAKER_03: So I think it's a very helpful guide to analyze the topic.
• 34:55
  SPEAKER_00: Yes, I think this definitely sounds like a case where some examples could be helpful.
• 34:59
  SPEAKER_00: So thank you for that.
• 35:00
  SPEAKER_00: And thank you both for joining me today.
• 35:02
  SPEAKER_00: It's a pleasure to talk to you.
• 35:03
  SPEAKER_00: Yep, thanks for having us.
• 35:05
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• 35:27
  SPEAKER_00: From Thought Leadership at PWC, I'm Heather Horn.
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