Distinguishing between variable consideration and optional purchases can sometimes be difficult. Because the accounting and disclosure requirements can vary significantly between these two elements, entities should carefully evaluate contracts that appear to contain variable consideration or optional purchases to determine which accounting treatment is more appropriate.
Why the Confusion?
When a contract contains an unknown quantity of outputs, this uncertainty may be accounted for as either variable consideration or optional purchases, depending on the nature of the contract. Entities initially disagreed about whether a contract with an unknown quantity of outputs could qualify as variable consideration; however, members of the Transition Resource Group (TRG) later clarified that, if a promise exists to perform an unknown quantity of tasks, and consideration depends on the quantity of tasks completed, the transaction price is variable. The TRG justified this conclusion by stating that such consideration is contingent on the occurrence or nonoccurrence of events outside the entity’s control, which agrees with the definition of variable consideration in Accounting Standards Codification (ASC) 606-10-32-6.
To eliminate confusion about the difference between variable consideration and optional purchases, the TRG addressed this issue in TRG Memo 48. The memo explains that “the determination of whether a contract contains variable consideration or an optional purchase is highly dependent upon the evaluation of the nature of the promise in the contract.” The TRG provided characteristics of variable consideration and optional purchases to help entities evaluate the nature of the promise in a contract. The following table, which displays these general characteristics, can assist in identifying whether a contract contains variable consideration or an optional purchase:
|Characteristic||Variable Consideration||Optional Purchase|
|Purchasing Decision||The contract does not require the customer to make a separate purchasing decision because the purchasing decision was already made as part of the original contract.||The contract requires the customer to make a separate purchasing decision because the contract provides a contractual right – not an obligation – to the customer.|
|Performance Obligations||The performance obligation in the contract is to transfer control of the goods or services, the quantity or usage of which is unknown.||If material, the option to purchase the additional distinct goods or services is the performance obligation in the contract.|
|Result of Customer Action||The customer action that results in additional consideration does not create a new performance obligation for the vendor.||The customer action that results in additional consideration (i.e., option exercise) creates a new performance obligation for the vendor.|
|Stand-ready Element (if present)||The promise to stand ready or provide continuous access to a service is central to the contract.||The promise to stand ready or provide continuous access to a service is only incidental to the primary obligation(s) in the contract.|
|Volume-based Discounts||The discount is applied retrospectively once a target volume is reached.||The discount is applied prospectively once a target volume is reached.|
Example 1 – Variable Consideration
Biotech enters into a contract to permanently transfer control of medical equipment to Hospital. Payment is based only on usage of the equipment at a fixed rate per kilowatt hour.
The usage-based fee is variable consideration because the only performance obligation in the contract—to transfer control of the equipment—has already been satisfied prior to receipt of consideration. In addition, usage of the equipment does not create a new performance obligation for Biotech, nor does it require a separate purchasing decision by Hospital.
Example 2 – Optional Purchases
Biotech enters into a Master Service Agreement (MSA) with Hospital to supply custom diagnostic testing kits for two years. The MSA requires an upfront fee, and kits are supplied at a discounted rate. Although Hospital is not obligated to purchase from Biotech, it is highly likely to do so because no other supplier exists.
In this example, the upfront fee is essentially a prepayment for the discounted diagnostic testing kits, and Biotech must evaluate whether the upfront fee represents a material right. Furthermore, purchase of each additional kit is an optional purchase because Biotech is not obligated to supply any kits to Hospital until Hospital submits a purchase order. Once Hospital submits a purchase order, Biotech has a new performance obligation to deliver additional distinct goods. In addition, although the MSA certainly contains a stand-ready element, the nature of Biotech’s promise is to deliver kits to Hospital rather than to provide continuous access to certain goods or services.
Notice that a stand-ready service often indicates a single performance obligation that is satisfied over time—which precludes the possibility of an optional purchase because no additional distinct good or service is transferred. However, the TRG has stated that this assumption is not always true. For instance, Example 2 contains a stand-ready element, since Hospital is likely to purchase kits from Biotech, but the stand-ready element is ancillary to the contract’s promise to provide additional goods should the option be exercised (i.e., if a purchase order is submitted). Thus, judgment is required to determine which is the primary obligation in a contract.
Although the distinction between variable consideration and optional purchases is often clear, some arrangements that are nearly identical from an economic standpoint may be accounted for differently based on technicalities in the language of the contract. The following example illustrates two versions of an agreement that may lead to different accounting treatments:
Example 3A – Variable Consideration
Processor offers one-year contracts for transaction processing services and charges customers based only on the volume of transactions processed each month.
Example 3B – Optional Purchases
Processor offers transaction-processing services and charges customers a monthly fee that includes services for the first 500 transactions. If the number of processed transactions reaches 500, customers may pay a fixed fee for each additional transaction processed.
In both contracts, the ultimate number of transactions to be processed is unknown. In Example 3A, however, the promise is to process any number of transactions during a one-year period. This stand-ready element is the primary obligation in the contract, and the customer’s choice to submit more transactions for processing does not necessitate a purchasing decision by the customer, nor does it create additional performance obligations for Processor. Therefore, this contract contains variable consideration.
Conversely, in Example 3B, Processor promises to provide services for only the first 500 transactions, and the customer has the option to purchase additional services. If the customer requests additional processing services, each transaction processed represents both a separate purchasing decision by the customer and an additional distinct performance obligation for Processor. Although Processor may expect and even prepare for any given customer to exceed 500 transactions, this implicit promise is incidental to the primary promise in the contract. Therefore, this contract contains an option to purchase additional services.
Differences in Accounting
When consideration is variable, the transaction price is unknown and must be estimated using one of two methods—the most likely amount or the expected value approach. This estimated transaction price is then allocated to one or more of the performance obligations in the contract, and revenue is recognized as these obligations are satisfied. For more information, refer to Variable Consideration and the Constraint and Allocating Variable Consideration.
An option to purchase additional goods or services is only a performance obligation if it gives the customer a material right. The right is material if it gives the customer a discount that is incremental to other discounts available to the customer. If the right is material, the transaction price must be allocated to the option based on its standalone selling price (SSP) or an estimate of the SSP if it is unobservable. If an option is exercised, the exercise is accounted for as either an adjustment to the transaction price or a contract modification. Revenue is then recognized when control of the additional goods or services transfers. If the option expires, revenue is immediately recognized. For more information, see Customer Options for Additional Goods or Services.
The TRG admits that, in some cases, the distinction between variable consideration and an optional purchase makes little difference in the timing and measurement of revenue. In Example 3A, for instance, revenue would likely be recognized as each transaction is processed, even if each transaction was considered an optional purchase. Nevertheless, the disclosure requirements may still vary significantly.
Company Example - Athenex Inc.
In a correspondence letter with the SEC, Athenex Inc. (“the Company”) explained its policies in accounting for a contract with one of its main customers. This multi-step contract included conditional clauses that might discontinue further steps of the engagement. The Company recorded its revenue at different completion milestones based on an estimated total transaction price. The Company accounted for the estimated total transaction price as variable consideration, as the original contract included future royalty payments and conditional rights and obligations. The royalty payments, which will increase or decrease the total revenue based on the customer’s usage of IP, are based on a predetermined usage rate; if the customer uses the IP, they are already obligated to pay the royalties.The conditional steps, which were included in the contract as performance obligations, create the need to further estimate the total consideration. But as the conditioned steps are part of the original contract and are not given as a further option to purchase upon completion, the Company does not separate them as an optional purchase.
Company Example - Pegasystems Inc.
In a comment letter to the SEC, Pegasystems Inc. (Pegasystems), an American software company, reported that some of their software license agreements include provisions that allow their customers to purchase additional software usage at a later date. When a customer decides to purchase additional software usage through the exercise of these options, Pegasystems held the adjustments should be accounted for as variable consideration because the customer is exercising an existing right and not entering into a separate agreement. Accordingly, Pegasystems recognizes revenue on these options when the underlying usage occurs.
Differences in Disclosures
Both variable consideration and optional purchases require an entity to disclose the transaction price allocated to any outstanding performance obligations at the end of a reporting period, subject to the short-term contract and right-to-invoice practical expedients (see Disclosures). However, the level of effort to fulfill this disclosure requirement depends on whether a contract contains variable consideration or optional purchases.
If a contract contains variable consideration, an entity must estimate future transactions to determine the correct transaction price to be allocated to outstanding performance obligations, unless it qualifies for one of the following practical expedients unique to variable consideration:
- Variable consideration is a sales- or usage-based royalty for a license of intellectual property
- Variable consideration is allocated entirely to a wholly unsatisfied performance obligation or distinct good or service, subject to certain criteria (ASC 606-10-50-14A)
Additionally, an entity must explain whether any variable consideration is constrained and thus excluded from the transaction price.
In contrast to variable consideration, optional purchases do not require an entity to estimate consideration from the exercise of future options regardless of whether the option confers a material right. This difference arises because the option, not the additional goods or services, is the performance obligation within the contract. However, if the SSP of an unexpired material right is unknown, the entity must estimate the SSP to properly disclose the transaction price allocated to the material right.
Entities may find estimating future transactions under variable consideration more burdensome than estimating the value of a material right with an unknown SSP under optional purchases, or vice-versa. In either case, because the effort required to develop an accurate estimate can be significant, entities should be careful to correctly determine whether a contract contains variable consideration or an optional purchase.
When a contract contains an unknown quantity of outputs, determining whether the uncertainty arises from variable consideration or from optional purchases can be challenging. This determination requires judgment as to the nature of an entity’s promise. Although contracts with variable consideration can appear very similar to contracts with optional purchases, the specific characteristics discussed in this article can help entities distinguish between each type of contract and avoid mistakes in complying with the accounting and disclosure requirements of ASC 606.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” September 2019. Section 4.6.
- FASB TRG Memo 39: “Application of the Series Provision and Allocation of Variable Consideration.” 13 July 2015.
- FASB TRG Memo 48: “Customer options for additional goods and services.” 9 November 2015.
- KPMG, Handbook: “Revenue recognition.” November 2018. Section 15.7.20.