Handling Contract Incentives or Penalties through Variable Consideration

Basics of Revenue recognition in five steps

1. Identify the contract with a customer.

2. Identify the performance obligations in the contract.

3. Determine the transaction price.

4. Allocate the transaction price.

5. Recognize revenue when the entity satisfies a performance obligation.

Allocate  the Transaction Price 

 Step 4 involves allocating the transaction price, which is done at the beginning of the contract, well before the revenue is recognized. Step 5 involves recognizing or releasing the revenue allocated in Step 4 when the relevant performance obligation is met.

Complexity arises when there are significant changes in the allocated transaction price. One primary cause of these changes is contract amendments, which are addressed by ASC 606/IFRS 15 guidelines. Additionally, incentives for early completion or penalties for late completion of the contract can impact the allocation. These incentives or penalties are often known only at the middle or end of the contract, complicating the accounting treatment.

Accounting Policies of Prudence

Under the principle of prudence, penalties for delayed delivery are considered contingent liabilities and should be accounted for once they become certain. Prudence in accounting means being cautious and conservative in judgments and estimates, ensuring that revenues are not overstated and expenses are not understated. Expenses should be recognized when incurred or when their occurrence is likely, regardless of payment status.

Handling of  Incentives and or Penalties

Penalties and incentives are managed under ASC 606/IFRS 15 through the concept of Variable Consideration (VC). Variable Consideration can fluctuate between incentives and penalties, affecting the total contract value (TCV) and receivables. 

Positive Variable Consideration: If the possibility of an incentive for early contract completion is certain, it increases TCV and receivables.

Negative Variable Consideration: If a penalty for delayed completion is certain, it decreases TCV and receivables.

Variable Consideration is initially recorded in the sub-ledger and then must be reflected in the general ledger (GL) and customer (personal) accounts. Because VC can change period by period, it must be recalculated and adjusted accordingly at each period end.

Example:-

Scenario: ABC construction company enters into a contract to build Metro rail for $10 million in 5 years (60 months). The contract includes an incentive of $500,000 if the project is completed before 59 months.Only at the end of the 4th year (after 48th month) ABC Construction identifies that they will certainly complete  the Project one month before the agreed date hence eligible for Incentive.

Variable Consideration:

• Initial Estimate: At the start, the construction company NOT able to estimates that completing the project early is possible or NOT hence No provision upto end of 4 years.

• At the end of the 4th year (End of 48th month)construction company  able to estimates that completing the project early is possible by end of 57 month, so they include the $500,000 incentive as part of the transaction price. 

• This is increase the Amount receivable for contract hence Positive VC.

• The estimated total transaction price is $10.5 million. (10 Million + 0.5 million positive VC)

• Now during the end of every month after the 4the year, ie. Month 49, month 50, month 51,month 52 review the Possibility of early completion by 57th month and account for the Positive VC of 0.05 million. 

• Estimate/Revised Estimate As the project progresses and the company is confident they will meet the early completion deadline, they update their estimate to reflect the full $500,000 incentive Estimate every month up to the end of 56th month.   

• Actual At the end 57th month, once all tasks are completed,  ABC construction will post a True up entry converting the Estimate into Actual Incentive realized.

• OR ABC Construction will reverse all Estimates and Post entry for Actual Incentive Amount in the month of 57 or 58). 

• Recognition:Thus, ABC Construction recognize revenue based on the total transaction price of $10.5 million.

  
  

Outcome: If the ABC Construction company finishes the project early, they will receive the additional $500,000. If not, the revenue recognized will be based on the original $10 million transaction price. If there is delay then ABC Construction will pay a penalty.

Penalties for Late Completion

Penalty Example:

Scenario: In case in the same above contract there is a agreement clause which says  if there is a delay  in delivering the contract Contractor has to pay a fixed penalty up to 500,000$ for the delay.  .In the above example we noticed that the possibility of the Early Completion and Incentive was certain only after the 4th year (end of 48th month). 

Assume when the possible completion is the 57th month (3 months before end date) a Serious accident happened in the site during the end of 56th month because of which the scenario changes.  Now based on the new assessment and Project Projections after the accident that project will go upto end of 61st or 62nd month and now the ABC Construction is in a situation to pay penalty for the delay.

Incentive / Positive VC was estimated and accounted up to end of the 49th to 55th month.  But the accident happened during 56th month and new assessment happened.  Now at the end of 56th month ABC Construction  should do two things on the part of variable consideration.

• Reverse the all estimated Positive VC or Incentives [which is not possible because of the accident occurred in the current period] . 

• Provide  for a New Negative Variable Consideration, penalty estimate for possible delay in project completion.

Now continue with the Step(2) for Negative VC during the each month close and Reverse old estimate, account for new estimate up to the end of the Project completion.

On Project Completion either Reverse all Estimate and Account for Actual Penalty or post a True-up adjustment between Estimates and Actual.

Variable Consideration Journal entries:

Accounting for Incentives (Positive VC)

Period-mm-2024

Accounting as estimate for Possible Incentive

VC Liability                     500,000$

To  Contract Liability                     500,000$

Contract Liability         500,000$

                  To VC Revenue                                500,000$  (+ve VC -Credit Revenue)

Period-(mm+1)-2024

Accounting for Revised estimate for Possible Incentive

Reverse previous month Estimate

Contract Liability                 500,000$

To  VC Liability                                500,000$

VC Revenue                 500,000$

                  To Contract Liability                        500,000$  

Post new Entry for Latest Revised Estimate

VC Liability                     500,000$

To  Contract Liability                     500,000$

Contract Liability         500,000$

                  To VC Revenue                                500,000$  (+ve VC -Credit Revenue)

Follow the above entry until final moth and ascertain the actual VC Incentive-Revenue

Reverse previous month Estimate

Contract Liability                 500,000$

To  VC Liability                                500,000$

VC Revenue                 500,000$

                  To Contract Liability                        500,000$  

Post new ACTUAL Entry for Latest Revised Estimate

VC Liability                     450,000$

To  Contract Liability                     450,000$

Contract Liability         450,000$

                  To VC Revenue                                450,000$  (+ve VC -CR Rev -Actual Incentive)

                                                                                                     Credit all Income and Gains

OR   Just post a true-up for Difference only to adjust between the Estimates and Actual.

Contract Liability                 50,000$

To  VC Liability                                50,000$

VC Revenue                 50,000$                     Adjusting the VC to actual (*)

                  To Contract Liability                        50,000$        (True-up entry)

(*) This true-up entry will reduce the Incentive from Initially Estimated 500,000$ to (assumed) finally worked out and realized Actual 450,000$.

Accounting for Penalty (Negative VC)

Second example where the Scenario changes from the possible Incentive (+ve VC) to a penalty (-ve VC) due to an unexpected accident occurred at the Contract Site.

Now in this case ABC Construction should

1. (1)First Reverse all the previouse estimates for a Incentive (+ve VC)

2. (2)Provide for the estimated penalty (-ve VC). assume 400,000$ in first estimate. 

(This 400,000$ penalty got increased to 500,000$ during the 2nd estimate)

First Reverse Lastest Incentive (+ve VC Estimate) immediately in current month after accident occurred..

Contract Liability                 500,000$

To  VC Liability                                500,000$

VC Revenue                 500,000$

                  To Contract Liability                        500,000$  

Provide for the Penalty  (-ve VC Estimate) immeditely in current month itself because the delay in project completion is certain because of the unexpected accident at the site.

Contract Liability                 400,000$

To  VC Liability                                400,000$

VC Revenue                400,000$  ---------------------(**)     

                  To Contract Liability                        400,000$   

(**) VC Revenue is debited  due   to   expected reduction in TCV because of Penalty - Debit all expenses and losses )

As mentioned above for Incentive (+ve VC) review the estimated Pentalty (-ve VC) during every period / month close and account for the latest Penalty based on the recent estimate reversing old estimates.

Reversing Old Estimated Loss/Penalty

VC Liability                     400,000$

To  Contract Liability                     400,000$

Contract Liability         400,000$

                  To VC Revenue                                400,000$  (Reversing previous VC Rev Debit)

Accounting for the Latest Pentalty Estimated based on the latest Scenario.

Contract Liability                 500,000$

To  VC Liability                                500,000$

VC Revenue                500,000$           (Accounting for Latest estimated penalty)

                  To Contract Liability                        500,000$   

As mentioned in the Positive VC Scenario, same way  on Completion of the Contract - ascertain the Actual Penalty and then Post a True-up entry adjusting the difference between the latest Estimate and Actual  OR  Reverse  all of estimated penalty live (not reversed already) in current month and  book for the Actual penalty fully in the current period.