Understanding Variable Consideration in Construction Contracts

Topic 606: A revenue recognition refresher for construction entities

Since Topic 606 Revenue from Contracts with Customers was introduced, entities have had to evaluate transactions through the unified five step approach to determine when revenue should be recognized based on any performance obligation identified. While the first two steps of the process – “Identify the contract(s) with a customer” and “identify the performance obligations in the contracts” – generally do not pose any challenges, the third step – “determine the transaction price” – could present a challenge to the construction sector.

Determining the transaction price

When determining the transaction price, contractors not only have to take into consideration the agreed upon value of the agreement between them and their customers, but also any possible variable consideration and its likelihood of reversal. Variable consideration exists in a contract when the contract includes consideration that varies based on the occurrence (or nonoccurrence) of a future event. For this reason, transaction price determinations should be revised for each period throughout the life of the contracts. Common examples of variable considerations included in contracts are incentives and penalties clauses, claims, as well as change orders.

Estimating variable consideration

The first step to take if a contract contains provisions for variable consideration from the customer is to estimate the amount of consideration to which the entity will be entitled. Topic 606 provides two methods to estimate entitlement, but entities are only allowed to apply one method consistently throughout the contract:

1. The expected value method, to be used if there are numerous possible outcomes, or if there is a large number of contracts with similar characteristics. If this method is chosen, entities have to calculate the sum of probability-weighted amounts in a range of possible consideration amounts.
2. The most likely amount, to be used if there are only two possible outcomes. In this case, entities would include the single most likely outcome in the contract price determination.

Once entitlement is established, entities have to determine the likelihood and magnitude of a reversal of revenue due to a subsequent change in the estimate. Entities are required to evaluate both internal and external factors, such as market volatility, supply chain disruptions, weather conditions causing possible delays, the entity’s limited experience with similar types of contracts, or the uncertainty about the amount of consideration is not expected to be resolved for a long period of time. After these factors have been evaluated, entities should include variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur.

Conclusion

Entities should include variable consideration in the transaction price if a contract modification has occurred in which there is an enforceable right to additional compensation and if the entity does not foresee a significant reversal in the amount of cumulative revenue recognized when the matter is resolved. As modifications are common for engineering and construction contracts, it is recommended entities evaluate their estimates, especially when it comes to long term contracts, as changes in conditions could have an impact on the original determination on the likelihood of a reversal of revenue.

For more information regarding variable consideration and revenue recognition for contractors, please contact your Keiter Opportunity Advisor or Email, Call: 804.747.0000.