Question

Variable Consideration Henderson Farms Inc. sells land to Harris Development Corporation for $2,000,000 It is also entitled to receive 6% of any future sales price of the developed land in excess of $5 million. Henderson Farms Inc. determines that its experience with similar contracts is of little predictive value, because the future performance of the real estate market will cause the amount of variable consideration to be highly susceptible to factors outside of the company’s influence. Additionally, the uncertainty is not expected to be resolved in a short period of time because Harris Development Corporation does not have current plans to sell the land. However, the following additional information becomes known to Henderson Farms Inc. two years after the contract was signed: Land prices have significantly appreciated in the market. Henderson Farms Inc. estimates that it is probable that a significant reversal of cumulative revenue recognized will not occur related to $150,000 of variable consideration based on sales of comparable land in the area. Harris Development Corporation is actively marketing the land for sale.

Required: Should Henderson Farms Inc. include variable consideration in the transaction price upon signing the contract? How should Henderson Farms Inc. account for the new information?

Answer 1

ariable consideration includes discounts, credits, rebates, performance bonus, penalties, sales returns, refunds, price concessions, incentives, etc.

The transaction price includes such variable considerations, whether explicitly stated in the contract or implicitly stated. A variable consideration exists even if the promised consideration is based upon the occurrence or nonoccurrence of a future event. For example, the performance bonus earned on the completion of a project in the future or a volume discount upon achieving certain volume. In addition, the entity’s intentions, customary practices, policies or offers on their website can also indicate the existence of variable consideration.

Variable consideration can be estimated in two methods:

• The expected value approach – This method is the sum of probability-weighted amounts in a range of possible consideration amounts. This method is appropriate when the entity has a large number of contracts with similar characteristics.
• The most likely amount – This method is appropriate when there is a single most likely outcome from the contract of the two possible outcomes.

An entity should select and apply one method consistently for similar types of contracts when estimating the variable consideration amount. In order to estimate the variable consideration, an entity should consider using historical data, current data or reasonable projections that are available at the time. The data used for estimation would typically correlate with information used for budgeting, proposals and bids, and setting process of goods and services.

Constraining estimates of variable consideration

An entity should include in the transaction price some or all of an amount of variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved subsequently.

The magnitude and possibility of the reversal in revenue should be determined in order to assess such probability. The risk of revenue reversal increases if the following factors exist:

• The estimate is sensitive and can be impacted greatly by market volatility, weather conditions, legal and regulatory changes, internal factors, etc.
• The entity has limited experience with similar contracts or situations
• 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
• The contract has a large number and broad range of possible consideration amounts
• The uncertainty about the amount of consideration is not expected to be resolved for a long period of time

These estimates should be revised at the end of each reporting period and any changes to the transaction price as a result of the change in estimate should be made in the reporting period.

Hence,Henderson Farms Inc. should include variable consideration in the transaction price upon signing the contract.

Henderson Farms Inc account at the end of each reporting period and changes to the transaction price should be made in the reporting period.