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.
Cousins Properties Incorporated SEC Correspondence
Cousins Properties Incorporated (CP) is a Real Estate Investment Trust company that has entered into multiple contracts with Norfolk Southern Railway Company. The contracts consist of a land, building purchase & lease, development, and consulting agreements. In correspondence with the SEC in August 2019, CP was asked to provide more information about how it determined that the contracts associated with Norfolk Southern Railway should be combined and accounted for as a single performance obligation. The SEC asked CP to provide the authoritative accounting literature that it relied upon that supports the accounting treatment.
In CP’s response, it analyzed each of the criteria described in ASC 606-10-25-9.
The first sentence of ASC 606-10-25-9 mentions that the first requirement to qualify for contract combinations is that said contracts must be entered in “at or near the same time.”
CP described in detail that all contracts executed in connection with the transaction were negotiated and executed simultaneously with Norfolk Southern Railway. It noted that this arrangement was to achieve a single commercial objective. CP noted that some of the contracts stipulated were contingent upon the execution of other contracts; therefore, supporting Criterion A.
CP continued explaining that Criterion B and C are met as these contracts would not have been executed individually. CP told the SEC that although the consideration for each of these contracts does not contractually depend on the others, they would not have otherwise been entered into independently; and therefore, the consideration that is to be paid under each of the contracts depends on the performance of the other. CP explained that the economics of their arrangement with NS would not be properly reflected in their consolidated financial statements if they accounted for each of the contracts individually, thereby indicating there is a price independency.
As such, CP concluded that the contracts would be combined and accounted for as a single arrangement as per ASC 606 meeting all requirements.
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.
Company M, a full service dealer of fleet vehicles, recently entered into a contract with Customer P for the sale of 50 used pick-up trucks at a price of $23,500 per vehicle. Two days later Company M enters into a second contract with Customer P for five years of fleet vehicle maintenance at a price of $1,200 per vehicle. Further, this contract stipulates that Company M must concede a 50 percent discount in the per vehicle maintenance price for each of the 50 trucks that does not pass Customer P’s performance tests.
In the facts above, Company M enters into two contracts with the same party at about the same time which indicates that combination of contracts may be required. In this case, criterion B is met because the consideration to be received in the second contract is tied to the performance in the first contract. Specifically, Company M must reduce the per vehicle maintenance price if the used fleet vehicles do not meet the customer’s required quality specifications. Therefore, Company M is required to combine the contracts for revenue recognition.
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.)
Company X sells learning management systems (LMS). LMS is provided as a web-based application for customers to manage organizational training. Among other offerings, Company X provides (1) basic access to a unique portal that is customizable by the customer and (2) a range of implementation services.
Company X enters into a contract with Customer Y for access to its LMS application for a period of 36 months at a total price of $18,000. The following day, Company X negotiates a second contract with Customer Y for implementation services for $3,500. Under the second contract, Customer Y will receive a significantly customized portal that is beyond Company X’s common implementation services that use pre-designed templates. The implementation will require the professional services department’s involvement to be completed.
In the facts above, Company X enters into two contracts with the same party at about the same time which indicates that combination of contracts may be required. In this case, criterion C is met because the implementation services “significantly modify or customize” the service provided in the first contract. As such, the two services are not distinct within the context of the combined contract. Therefore, Company X is required to combine the contracts for revenue recognition.
Spark Therapeutics, Inc. SEC Correspondence
Spark Therapeutics, Inc. (ST) is a biotech company that has entered into a single contract with a pharmaceutical company, Novartis. This contract consists of two agreements—a License Agreement and a Supply Agreement. In correspondence with the SEC in January 2019, ST explained why it accounted for the agreements with Novartis as a single contract.
ST relies on the fact that the agreements were entered into “at or near the same time.” The company focuses on the third criterion in ASC 606-10-25-9 in justifying the combination of the contracts, which states:
“The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation in accordance with paragraphs 606-10-25-14 through 25-22.”
ST references ASC 606-10-25-14 and concludes that the performance obligations contained in the agreements are not distinct because Novartis could not benefit from the License Agreement without the specific obligated services in the Supply Agreement. ST then references ASC 606-10-25-22, which states:
“If a good or service is not distinct, an entity shall combine the good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation.”
ST’s situation is subject to change if the goods or services ever become distinct. However, with a single performance obligation in play, ST meets the criterion in ASC 606-10-25-9(c) and is justified in combining the agreements into a single 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.
- ASC 605-25-25-3, 35-25-5 to 25-9
- ASC 606-10-25-9
- ASC 985-605-55-4
- ASU 2014-09: “Revenue from Contracts with Customers.” BC71-BC75.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” December 2021.
- PWC, “Revenue from contracts with customers.” February 2022.