Sales contracts often include an option for the customer to receive additional goods or services in the future. Options to receive these goods or services may come in a variety of forms, such as sales incentives, customer loyalty programs, contract renewal options, or other discounts.
When a sales contract gives a customer the option to receive additional goods or services in the future, the option represents a performance obligation 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 average discount 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 average discount given) is considered material. In fact, practitioners asked if the discount would be considered material if calculated to be at least 10 percent of the consideration of the original transaction and standard setters chose not to respond. Consequently, financial statement preparers will have to 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 among the goods and services delivered now and the future performance obligation 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 it. The estimate is then adjusted for the average discount offered to customers for other reasons and the likelihood that the option will be exercised.
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 actually 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:
|Performance Obligation||Standalone Selling Price||% of Total||Allocation|
|1. Product X||1,000||83.30%||833||(1,000*83.3%)|
|2. Discount Voucher||200||16.70%||167||(1,000*16.7%)|
Vendor A will recognize $833 from the original transaction when ownership 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.
Diversity in Thought
Evaluating the existence of and the accounting for a material right requires judgment based on facts and circumstances unique to each entity. Several differing viewpoints have formed since the issuance of ASC 606. The Transition Resource Group (TRG) considered these differing viewpoints and identified and responded to three issues. Below are the issues, the viewpoints for each question, and the TRG’s consensus.
- Issue 1: How should an entity account for a customer’s exercise of a material right?
- Issue 2: When determining if a material right exists, should each transaction be considered individually, or should all transactions with a customer be considered?
- Issue 3: Is the evaluation of whether a material right exists purely quantitative, or are there qualitative factors that should be considered?
Issue 1: Accounting for the exercise of a material right
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 discount. Customer C uses the voucher from the previous purchase, and buys Product Z for only $600. Under view A, the transaction price would be increased to $1,600, and the additional $600 would be allocated to the existing performance obligation (2) for a total allocated transaction price of $767 ($167 original allocation + $600 increase). This revenue of $767 is recognized when Vendor A transfers Product Z to Customer C.
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. The guidance for accounting for contract modifications is found in Contract Modifications Part II – Contract Modifications.
Using the example above, the contract is deemed to be modified when Customer C purchases Product Z using the voucher. If Vendor A finds that the prospective method should be used, then the new contract would include the $833 previously recognized for Product X and $600 + $167 = $767 for Product Z. This treatment is the same as View A. If the cumulative catch-up method is used, then the new $1,600 contract includes two performance obligations: Product X, with an 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 new contract is formed, and the remaining $735 is recognized when Vendor A delivers Product Z to Customer A.
The exercise of the material right should be accounted for as a variable consideration.
The TRG concluded that View C was not supported by the revenue standard, but Views A and B are supported and should be applied according to the facts and circumstances of the transaction. Most TRG members leaned toward View A, though 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.
Each transaction should be evaluated individually. Supporters of this viewpoint cite 606-10-10-4, which states that the evaluation of whether an option provides a material right should be based only on the facts and circumstances of the current transaction. This method requires less evaluation as only the facts in the current transaction are used in the evaluation and no external circumstances are considered.
To illustrate 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. In the current transaction, Customer X purchases a flight for $500 and receives 500 miles. Airline A determines that each mile has a standalone value of $.01. Airline A would evaluate if the miles earned (with a standalone value of $5) represent a material right in the current transaction, independent of any other transactions.
All transactions with a customer should be considered. This view stems from the new standard, which states that a vendor needs to compare any discounts to “discounts typically given for those goods or services to that class of customer in that geographical area or market.” In order 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 to customers with similar demographics. By doing so, the vendor can make a more relevant comparison between the discount in the current transaction and discounts in other transactions, which is an essential part of determining if the option provides a material right.
To understand this view, consider the same scenario described above in View A. Under View B, Airline A would consider whether the miles earned contribute to a material right that the customer has or will eventually accumulate. In other words, the entity would consider all miles earned by a customer when deciding if there is a material right.
View B is superior in evaluating if a single contract creates a material right. This is particularly relevant for companies with point-type loyalty programs—such as the airline in the above example—because its customers can accumulate incentives for future use. An entity using View A may determine that the $5 of miles earned is not a material right when evaluating the transaction in isolation. This viewpoint 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.
- 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.
View B makes sense for most transactions. However, an argument can be made for a company to adopt View A, considering each contract independent of the other contracts. This view would make sense if any of the following circumstances existed:
- Options are always priced at the relative selling price. Per ASC 606, any option priced at the relative selling price is not considered a material right, even if the future purchase can only be made after entering into a prior contract (ASC 606-10-55-43). In this case, other contracts are irrelevant and need not be considered.
- Options never provide a discount greater than the range of discounts typically given to customers for other reasons. A material right only exists if the option offers a discount greater than the average discount. For the same reason as the point above, no material right exists regardless of an existing customer relationship so there is no need to consider other contracts.
- Options do not influence customer buying habits. If a vendor has historical information showing that options do not significantly affect whether or not a customer made future purchases, then View A would be viable. This makes sense in light of the Financial Accounting Standards Board’s (FASB) Basis of Conclusions, which states that the intent of the new guidance is to identify and account for transactions where the customer is essentially purchasing future goods in a current transaction. If customers’ future purchases are not impacted by current discounts (options) then considering past and future transactions with the same customer does not add value when analyzing for material rights.
Most TRG members agreed that the evaluation 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.
Evaluation for a material right should only be quantitative. The use of only quantitative analysis is based on the current general application of US GAAP, which requires an entity to evaluate if a discount is incremental to the discounts given in comparable transactions. To illustrate, the TRG provided the example of a retailer that offers any customer who makes a purchase on a certain day a 25 percent coupon for a future purchase. The retailer determines that customers typically use the coupon to purchase a product that is more expensive than what they would typically purchase. Under View A, the retailer would compare the standalone value of the coupon for each individual customer. If the discount is comparable to other discounts the retailer offers, then no material right exists. However, if 25 percent is higher than the standard discount, then the incremental discount could be a material right if it is significant.
Evaluation for a material right has both quantitative and qualitative elements. Proponents of this view propose that considering qualitative factors, like customer expectations, is an essential part of evaluating for a material right. Applying View B to the same scenario described above, the retailer would still consider if the discount is more than the standard discount offered to its customers. The retailer would also consider qualitative factors, such as how the discount may affect customer buying behavior. This view may be most applicable 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 average 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. 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.
View B is more appropriate when evaluating for material rights. The TRG also noted that the standard was not designed to create a bright line percentage of the total transaction an option needs to be to qualify as material. Thus, each entity must determine what incremental discount qualifies as significant.
The TRG concluded that both qualitative and quantitative factors should be considered, including whether the right accumulates over time.
Comparison to 605
No authoritative guidance exists on accounting for customer options to buy future deliverables. The treatment prescribed by ASC 606 is similar to the accounting treatment of software options found in ASC 985-605. Under current codified guidance, an option to buy future products at a discounted price is accounted for as a separate deliverable if it is significant and incremental in two aspects:
- The range of discounts accounted for in the pricing of other elements in the contracts; AND
- The range of discounts typically given in comparable transactions
If the discount is considered significant and incremental, then a portion of the revenue from the original transaction is deferred and recognized when the products are delivered. The deferred revenue is calculated by dividing the estimated discount (in dollars) by the sum of the current transaction price and the estimated price of the future product. This percentage is then multiplied by the current transaction consideration and the result is the amount of revenue to be deferred. ASC 606 does not use the estimated price of the future product (see description above), resulting in a greater percentage of the transaction revenue being deferred. While the existing standard applies only to software products, all entities will defer more revenue from customer options for additional goods and services as a result of the updated standard.
Although it was identified as a subject for potential debate, this section of the new standard is relatively straightforward. When evaluating customer contracts for options that provide a material right, an entity must first decide if it will consider each transaction separately or the entire customer relationship. Then the entity needs to consider quantitative and qualitative analysis on the current transaction and compare it to similar transactions to determine if the option provides a material right.
The entities that will be most affected by the updated standard 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. Companies like Nordstrom’s, Starbucks, and United Airlines will need to evaluate their loyalty programs and determine if a material right is created. If so, then a portion of every transaction will be allocated to the rewards as it constitutes a separate performance obligation.
- 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.” October 2018. Section 4.6.
- EY, Technical Line: “A closer look at the new revenue recognition standard.” 16 June 2014.
- FASB TRG Memo 6: “Customer options for additional goods and services and nonrefundable upfront fees.” 31 October 2014.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 10.4.
- PwC, “Revenue from contracts with customers.” August 2016. Chapter 7.