Sales contracts often include an option for the customer to receive additional goods or services in the future. These options for additional goods or services may include sales incentives, customer loyalty programs, contract renewal options, or other discounts. In this article, we explain how to account for these options under ASC 606.
Additional Goods or Services and Material Rights
When a sales contract gives a customer the option to receive additional goods or services in the future, the option represents a performance obligation only if the right is material (Accounting Standards Codification 606-10-55-42). The right is considered material if it gives the customer a discount they would not have received had they not entered into a contract, meaning the discount is greater than the discount that would be given to customers for other reasons, like promotional sales.
The guidance does not provide a bright line threshold for deciding what incremental discount (above the typical [JW1] discount given) is considered material. Consequently, financial statement preparers must use professional judgment in determining what constitutes a material discount, which will likely vary based on industry, region, and customer base.
Note that if the option allows the customer to purchase goods or services at a price that reflects the standalone selling price, then no material right exists even if the future purchase can only be made after entering into a previous contract. If the option does provide a material right, then the customer is essentially paying for the future goods or services in advance, and the revenue related to the material right should not be recognized until the future goods or services have been transferred or the option expires. The vendor must allocate the transaction price in the current contract among the goods and services delivered now and the goods and services promised in the future based on each unit’s relative standalone selling price. Oftentimes there is no observable selling price for the option so management will need to estimate that number. The estimate is then adjusted for the average discount offered to customers for other reasons and the likelihood that the option will be exercised.
Example With Calculations
The following fictitious scenario will help illustrate the concepts described above:
Vendor A sells Product X to Customer C for $1,000 and gives the customer a 40 percent discount voucher to be used on a future purchase within the next thirty days. The vendor plans on offering a 15 percent discount on all transactions in the next thirty days as part of a promotional event. The 40 percent discount voucher cannot be combined with the 15 percent promotional offer. When evaluating for material rights, the Vendor only considers the discount that is incremental to any promotional discounts offered, which in this case is 25 percent (40 percent discount voucher less the 15 percent promotional event). Vendor A estimates that 80 percent of customers that receive the discount voucher will make additional purchases, and on average, each customer will purchase $1,000 of additional products. The standalone value of the discount voucher is therefore $200 ($1,000 additional products * 25% incremental discount * 80% probability the voucher is used). This calculation results in the following allocation of the original $1,000 transaction fee:
Vendor A will recognize $833 from the original transaction when control [JW1] of Product X transfers to the customer. If Customer C does not use the voucher, the remaining $167 is recognized when the voucher expires. The accounting for the remaining $167 if the voucher is exercised is discussed below in Issue 1.
Accounting for a material right requires judgment, and a number of issues arise when making this judgment. We discuss three common issues below.
Issue 1: Accounting for the exercise of a material right
Some hold the view that the exercise of a material right should be accounted for as a continuation of the current contract because the current contract anticipates the additional goods or services to be provided as part of the exercise of the material right. That is, at the time of the exercise, an entity should update the transaction price of the current contract to include the additional consideration expected to be received. The additional consideration should be allocated to the performance obligation underlying the material right, and revenue should be recognized as that performance obligation is fulfilled.
Using the example above, Customer C purchases Product Z 15 days later. The price of Product Z is normally $1,000, but is sold to any customer for only $850 due to the store-wide 15% discount. Customer C uses the 40% voucher from the previous purchase and buys Product Z for only $600. Under view A, the original transaction price would be increased to $1,600, and the additional $600 would be added to the $167 already allocated to the material right at contract inception. The combined amount of $767 would be recognized when Vendor A transfers control of Product Z to Customer C.
Others hold the view that the exercise of a material right should be accounted for as a contract modification because the additional consideration received and the additional goods and services provided represent a change in the scope and/or price of the contract. (For additional guidance on contract modifications, see Contract Modifications Part II – Contract Modifications.) Under this view, the contract modification can be accounted for prospectively or as a cumulative catch-up.
Using the example above, the contract is deemed to be modified when Customer C purchases Product Z using the voucher. If Vendor A accounts for the modification prospectively, then the accounting would leave unchanged the previously recognized revenue of $833 for Product X and would recognize $767 ($600 + $167) for Product Z. This treatment results in the same accounting as View A. In contrast, if Vendor A accounts for the modification using the cumulative catch-up method, then the new $1,600 contract includes two performance obligations: Product X (with a separate selling price or SSP of $1,000) and Product Z (with an SSP of $850). The new total transaction price of $1,600 is allocated pro-rata to the two performance obligations: $865 (54 percent of the transaction price) to Product X and $735 to Product Z. The adjustment to Product X revenue of $32 ($865- $833) should be recognized immediately when the contract is modified, and the remaining $735 is recognized when Vendor A transfers control of Product Z to Customer A.
Views A and B are both supported by ASC 606 and should be applied according to the facts and circumstances of the transaction. In most cases the financial reporting impact of View A and View B will be very similar, as seen in the examples above. Whichever view is applied, that accounting treatment should be consistently applied across all similar transactions.
Issue 2: Breadth of transactions to consider when determining if a material right exists.
When determining the typical discounts given for goods and services, all transactions with similar customers in similar markets should be considered. This view stems from ASC 606-10-55-42, which states that a vendor needs to compare any promised discounts to “discounts typically given for those goods or services to that class of customer in that geographical area or market.” For the company to reasonably evaluate the current transaction, it needs to consider past and future transactions with the customer, as well as other transactions with similar customers purchasing the same goods and services in that geographic area. By doing so, the vendor can make a more relevant comparison between the discount in the current transaction and discounts in other transactions.
To understand this view, consider Airline A, which offers its customers one mile for every dollar spent. Points may be exchanged for free future flights when the customer has earned sufficient points. Customer X purchases a flight for $500 and receives 500 miles (with a standalone value of $5). Airline A would consider whether the miles earned contribute to a material right that the customer has or will eventually accumulate through future transactions. In other words, the entity must consider all miles a customer is likely to earn when deciding if there is a material right. This approach is particularly relevant for companies with point-type loyalty programs—such as airlines and rental car companies—because its customers can accumulate incentives over multiple transactions for future use. An entity that does not consider all transactions with a customer may determine that the $5 of miles earned is not a material right when evaluating the transaction in isolation. This approach fails to consider two things:
- When a loyalty program allows customers to use the rewards accumulated over multiple transactions, then it is possible that a material right exists as a result of multiple transactions. Considering a single purchase of airfare in isolation would not represent the economics of the customer relationship as the customer would have a material right once sufficient miles had been accumulated to trade in for a free flight (TRG Memo No.6).
- When an option with some form of discount is offered, the vendor is likely trying to incentivize the customer to make a future purchase. In other words, the vendor is trying to create repeat business through incentives. Consequently, it makes sense to consider the entire relationship to better capture the intent of the discount and more accurately evaluate for a material right (TRG Memo No.6).
In summary, the evaluation of a material right in these circumstances should consider all relevant transactions with a customer, including past, present, and future transactions.
Issue 3: Quantitative and/or qualitative factors when evaluating a material right.
Evaluating a material right may require both quantitative and qualitative analysis. To illustrate, consider a retailer that offers any customer who makes a purchase a 25 percent coupon for a future purchase. The retailer determines that customers typically use such a coupon to purchase a product that is more expensive than what they would otherwise purchase. Using quantitative factors alone, the retailer would consider first whether the discount is more than the standard discount offered to its customers. The retailer would then consider qualitative factors, such as how the discount may affect customer buying behavior.
Separately considering quantitative and qualitative factors is often important when an entity offers to a customer a discount that may be above normal promotional discounts, but not by a significant amount. For example, an entity may offer a 22.5 percent discount to a customer when the typical discount it offers is only 20 percent. The entity may decide that the incremental discount (2.5 percent) is not quantitatively material, but still take a position that the discount is material for other reasons, like the type or amount of products that a customer buys when redeeming the coupon. If the customer is buying planes, the dollar impact of the 2.5 percent discount could be material. Additionally, the vendor may be trying to influence buying behavior by requiring the customer to purchase a certain amount of products.
Each entity must determine what incremental discount qualifies as material Both qualitative and quantitative factors should be considered, including whether the right accumulates over time.
Determining whether an option for additional goods and services represents a material right requires considerable judgment. This article highlights a number of factors an entity must consider when making this judgment, including both quantitative and qualitative factors. Entities that will be most affected by this guidance are those that have loyalty programs, such as the retail, consumer, and airline industries— especially when they have a high volume of transactions with their customers.
- ASC 606-10-55-41 to 55-45
- ASC 985-605-55-82 to 55-85
- FASB TRG Memo 6: "Customer options for additional goods and services and nonrefundable upfront fees." October 31 2014.
- FASB TRG Memo 32: "Accounting for a Customer’s Exercise of a Material Right." 30 March 2015.
- FASB TRG Memo 34: "March 2015 Meeting – Summary of Issues Discussed and Next Steps." 13 July 2015.
- EY, Financial Reporting Developments: "Revenue from Contracts with Customers." September 2021. Section 4.6.
- EY, Technical Line: “A closer look at the new revenue recognition standard.” 16 June 2014.
- KPMG, Issues In-Depth: "Revenues from Contracts with Customers." December 2021. Section 10.4.
- PwC, "Revenue from contracts with customers." February 2022. Chapter 7.