How to measure construction contract revenue: variable consideration – variable pricing? Construction – Variable pricing
If the consideration promised in a contract includes a variable amount, then an entity estimates the amount of consideration to which it expects to be entitled. Consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items. [IFRS 15 50–54, IFRS 15 IE 101 – 108 Example 20 and Example 21]
To estimate the total variable contract price, an entity uses one of the following methods to estimate the amount of consideration to which it expects to be entitled:
- the expected value – the sum of probability-weighted amounts in a range of possible consideration amounts; or
- the most likely amount – the single most likely outcome of the contract (which may be more appropriate if the transaction amount only has two possible outcomes, e.g. when there is a success fee that either will or will not be receivable). Construction – Variable pricing
The entity uses and documents whichever of these amounts better predicts the amount of consideration to which it expects to be entitled.
Constraining the amount of revenue recognised [IFRS 15 56–58]
An entity includes in the transaction price an amount of variable consideration 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 associated with the variable consideration is subsequently resolved.
Factors indicating that including an estimate of variable consideration in the transaction price could result in a significant revenue reversal include, but are not limited to, the following:
- the amount of consideration is highly susceptible to factors outside the influence of the entity (for example, the judgement of third parties);
- the uncertainty about the amount of consideration is not expected to be resolved for a long period of time;
- 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 entity’s experience with similar types of contracts is limited or has limited predictive value; or
- the contract has a large number and high variability of possible consideration amounts. Construction – Variable pricing
Reassessment of variable consideration [IFRS 15 59]
At the end of each reporting period, the entity updates the estimated transaction price to represent the conditions at period end. IFRS 15 prescribes specific estimation techniques for variable consideration and only permits variable amounts to be included to the extent that it is highly probable that the revenue will not reverse.
IFRS 15 does not specifically require an amount of consideration to be reliably measured. Instead, variable amounts are estimated at either their expected value or most likely amount and included in revenue to the extent that it is highly probable that the revenue will not reverse. Construction – Variable pricing
Highly probable is the threshold in construction contract accounting and there is guidance on how to apply it [IFRS 15 56 -57]. Highly probable is a higher hurdle than probable under IAS 11. This results in later recognition of variable amounts and the deferral of revenue in some cases. Construction – Variable pricing
A critical judgement is whether the entity’s past experience can be considered predictive.
Link between construction contract modifications and construction variable consideration
In construction contract modifications in many cases, a change in scope may be approved, but the change in price may not. In these cases, measurement of revenue will be governed by the guidance on variable consideration which means that even where approval for the modification has been obtained, the price change will be included in revenue only when it is ‘highly probable’ that there will be no significant revenue reversal in the future. Construction – Variable pricing