An entity may enter into two or more contracts with the same customer at or near the same time. While multiple legal contracts exist under this type of situation, Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, may require these contracts to be combined for the purposes of revenue recognition. For example, if a software company enters into two contracts with the same customer at about the same time (1) for software and (2) for customized implementation of the software, the company may be required to combine these contracts under ASC 606.
A set of contracts should be evaluated for combination in accordance with ASC 606-10-25-9 when the following indicators exist:
- The contracts were entered into at or about the same time, and
- The contracts were entered into with the same customer or with a related party of the customer.
The above indicators signal a potential issue: revenue recognition patterns may differ when multiple contracts are accounted for separately instead of collectively, when in reality, the economics of the set of contracts are interrelated. The Financial Accounting Standards Board (FASB) states that judgment should be used in determining if a contract is entered into “at or near the same time,” noting the importance of the economic circumstances affecting negotiations and that these circumstances are likely to change as time passes between contracts.
The FASB also notes that “related party” in the context of ASC 606 is consistent with the definition included in current related party guidance found at ASC 850, Related Party Disclosures. The existence of these indicators does not automatically require that the set of contracts must be combined. Rather, the indicators signal that further analysis is required. Combination of contracts is required when one or more of the following criteria are met (see ASC 606-10-25-9):
- The contracts are negotiated as a single bundle or package with a single business objective.
- Consideration in one contract is tied to the price or performance of the other contract(s).
- Promised goods or services in the contracts represent a single performance obligation.
Practitioners should look for evidence of a single business objective. For example, one contract is in a loss position when analyzed without the consideration from one or more separate contracts negotiated as a bundle. Other facts and circumstances may provide evidence of one business purpose or objective, and judgment should be used in making this determination.
Company A, a manufacturer of specialized construction equipment, enters into a contract with Customer B to manufacture and deliver a customized boom lift for $95,000. The total cost to Company A of designing, manufacturing, and delivering the boom lift is estimated to be $70,000. Two days later, Company A enters into another contract with Customer B to deliver four boom lift tires that Customer B will use on the customized boom lift in the future after the original tires deteriorate. The contract price per tire is $800; however, the cost of each tire is estimated at $900.
In the facts above, Company A enters into two contracts with the same party at about the same time (within two days), which indicates the need for further analysis. Upon further analysis, Company A determines that criterion A for combining contracts is met because the two contracts are negotiated as a bundle with one business objective. Specifically, Company A would be taking a loss of $400 [($900 - $800) * 4 = $400] on the second contract when considered without the first contract. Therefore, Company A is required to combine the two contracts for revenue recognition.
This criterion deals with the relationship between consideration and contract price or performance of two or more contracts. The criterion is met when the consideration received for one contract depends on the price or performance of another. For example, no payment is required on a later contract if certain deadlines specified in previous contracts are not reached by the entity.
In applying criterion C, practitioners should follow the guidance for identifying performance obligations in step 2 of the five-step process. Specifically, to be distinct, a good or service must be (1) capable of being distinct and (2) separately identifiable or “distinct within the context of the contract.” The following factors may indicate a good or service is not “distinct within the context of the contract”:
- The entity provides a significant service of integrating the good or service with other goods or services in the contract.
- The good or service significantly modifies or customizes another good or service in the contract.
- The good or service is highly dependent on, or highly interrelated with, other goods or services in the contract.
In essence, practitioners should evaluate the set of contracts as if one contract exists to determine if the goods or services promised within the set are a single performance obligation. If the goods or services promised are not distinct, the contracts must be combined. (For more on distinct performance obligations, see our article on Distinct within the Context of the Contract.)
A set of contracts entered into at or about the same time with the same or related party may indicate the need to combine contracts. Practitioners should evaluate the contracts in question using the three criteria set out in ASC 606. When one or more of the criteria are met, the contracts must be combined for revenue recognition.