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.
Wave Life Sciences Ltd. (SEC Comment Letter Dec. 2019): Material Right and Recognition of Revenue
Wave Life Sciences (Wave) is a genetic medicines company that focuses on pharmaceutical development. In February 2018, Wave entered into an exclusive agreement with Takeda Pharmaceutical Company Ltd. (Takeda) to collaborate on the research, development, and commercialization of certain pharmaceuticals. In a comment letter to Wave in December 2019, the SEC asked Wave to “provide us the following terms governing the Takeda collaboration… [and] quantify the amount allocated to each performance obligation.”
While describing the agreement with Takeda, Wave explains that the “exclusive options to license, co-develop and co-commercialize each [pharmaceutical] were priced at a discount and, as such, provide material rights to Takeda, representing three separate performance obligations” in accordance with ASC 606-10-55-42.
Wave determined that Takeda had received a discount by comparing the difference between the net present value of the discounted cash flows resulting from the sale of the pharmaceuticals to the payments that Takeda was required to make. “The resulting probability-adjusted discount was considered a material right and was determined to be the estimated standalone selling price” for the related performance obligations.
After determining that the discount provided to Takeda constituted a material right, “approximately $X [amount redacted] of the $170 million transaction price was allocated to the performance obligation associated with the material right provided for the exclusive option to license, co-develop and co-commercialize Wave’s… program.” Following the guidance set out in ASC 606-10-55-42, Wave explains that “the amount allocated to the material right for each… program option will be recognized on the date that Takeda exercises each respective option, or immediately as each option expires unexercised. The amounts received that have not yet been recognized as revenue are recorded in deferred revenue on the Company’s consolidated balance sheet.”[\toggle]
Delta Airlines (Delta) provides a loyalty program to individuals who frequently fly with Delta. Part of this loyalty program includes “status” related benefits to customers who achieve certain milestones. These benefits include being able to move to the front of the line while boarding and waived fees.
In a comment letter to Delta in August 2018, the SEC asked “if [Delta] consider[s] loyalty status to be a material right that must be accounted for a separate performance obligation or a marketing program pursuant to ASC 606-10-55-42 to 43.” In response, Delta explains that it has consulted the AICPA Airlines Revenue Recognition position paper and argues why status is not accounted for as a material right:
- “Status on Delta can be achieved through activity on partner airlines that retain the bulk of the consideration for the flight”
- “[Delta does] not separately sell status and status is not transferable to others”
Delta utilized professional judgment and other available resources to make this determination. As it determined that no material right is given to the customer, “status” is a marketing incentive and therefore no performance obligation is created.
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:
|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 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.
Prothena Corporation (SEC Comment Letter June 2019): Exercising a Material Right
Prothena Corporation (Prothena) is a pharmaceutical company that specializes in developing cures for rare diseases. In March 2018, Prothena and Celgene Switzerland LLC (Celgene) entered into a Master Collaboration Agreement. This Agreement gives Celgene the option for additional goods or services, which is determined to be a material right. In a comment letter from the SEC, Prothena was asked to describe “the consideration [it] gave to allocating the transaction price to each of the material rights.”
In response, Prothena explains that “at such point that the Company transfers control of goods or services to Celgene or when the option expires, the Company will use the continuation of the original contract approach set forth in FASB Transition Resource Group Memo No. 18. Under this approach, the Company will treat the consideration allocated to the material right as an addition to the transaction price for the goods or services underlying the contract option.”
While Prothena is unsure of the exact standalone price of the additional goods and services, it uses a best estimate “based on an adjusted market assessment approach using a discounted cash flow model.”
Prothena accounted for the additional goods and services it provides by using the continuation of the original contract method and by estimating the exact standalone price to allocate the transaction price to each material right.
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.
Royal Caribbean Cruises Ltd. (SEC Comment Letter May 2019): Considering All Transactions When Determining a Material Right
Royal Caribbean Cruises Ltd. (Royal) is a cruise company that offers various cruise options around the world. They operate a loyalty program that gives its customers points that can be redeemed for benefits, such as a free cruise. In a comment letter from the SEC, Royal was asked to “tell us your consideration of identifying the points awarded to guests as a separate performance obligation and allocating the transaction price (i.e. cost of a cruise ticket) to the cruise and the loyalty points.”
In its response, Royal explains that the purpose of the loyalty program is to “encourage repeat business” and that there are two types of benefits: “complimentary cruise benefits and… all other status benefits.” For our purposes we will focus on the complimentary cruise benefit.
Royal argues that the complimentary cruise benefit “provides a ‘material right’ (pursuant to ASC 606-10-25-18) that should be accounted for as a separate performance obligation.” This material right is only awarded “after completing a specific number of cruises,” which is described as a “high volume.”
As the complimentary cruise takes considerable time and repeat purchases to achieve, Royal must look at all expected transactions with a customer to determine that the benefit constitutes a material right. Royal “concluded that the complimentary cruise benefit is a material right requiring allocation of the transaction price (i.e. cost of a cruise ticket) in accordance with ASC 606” because it took all expected transactions into account.
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.
Evertec, Inc. (SEC Comment Letter Sep. 2019): Using Quantitative and Qualitative Factors to Determine a Material Right
Evertec, Inc. (Evertec) is an electronic transactions company that provides various ways to accept credit and debit card purchases. Evertec has a policy of using certain thresholds to determine if a right is “immaterial” and should be excluded from total contract value.
In response to an SEC comment letter questioning Evertec’s policy, Evertec explained that “Management’s policy applies both quantitative and qualitative factors to identify material rights,” as follows:
- 5% or less of the TCV [Total Contract Value] is considered immaterial and not a material right
- Equal to or greater than 20% of the TCV, the option is considered a material right and therefore a performance obligation”
- Greater than 5% and equal to or less than 20% of the TCV, the option is analyzed considering qualitative factors [emphasis added]
Because ASC 606 does not provide a bright line threshold for determining a material right, Evertec used judgment and “determined these quantitative thresholds based on an analysis of historical average contract values.” Furthermore, “from a qualitative standpoint, Management evaluates options from the customer’s perspective in order to determine if the option could influence the customer’s behavior towards the contract.”
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.