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Question 14: How is the class of customer considered when evaluating whether a customer option gives rise to a material right?
Publication date: 31 Jan 2020
us FASB Staff Q&A Revenue 14
Reference(s): Section 606-10-25 and Paragraphs 606-10-55-42 through 55-43
Paragraph 606-10-55-42 explains that a customer option to acquire additional goods or services gives rise to a performance obligation only if the option provides a material right to the customer that it would not receive without entering into the contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). Paragraph 606-10-55-42 further explains that a customer option that provides a material right to a customer, in effect, represents an advanced payment by the customer for future goods or services.
Paragraph 606-10-55-43 states that if a customer has the option to acquire an additional good or service at a price that would reflect the standalone selling price for that good or service, that option does not provide the customer with a material right even if the option can be exercised only by entering into a previous contract. Rather, the entity has made a marketing offer that it should account for when the customer exercises the option to purchase the additional goods or services. Stated differently, paragraph 606-10-55-43 is intended to make clear that a customer option to acquire additional goods or services would not give rise to a material right if a customer could execute a separate contract to obtain the same goods or services at the same price.
Paragraph 606-10-32-33 states that when estimating a standalone selling price, an entity should consider all available information, including information about the customer or class of customer.
Paragraph BC386 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), explains that the purpose of the guidance in paragraphs 606-10-55-42 through 55-43 is to distinguish between:
(a) An option that the customer pays for as part of an existing contract [that is, a customer pays in advance for future goods or services]
(b) A marketing or promotional offer that the customer did not pay for and, although made at the time of entering into a contract, is not part of the contract [that is, an effort by an entity to obtain future contracts with a customer].
Stated differently, the guidance in paragraphs 606-10-55-42 through 55-43 is intended to make clear that customer options that would exist independently of an existing contract with a customer do not constitute performance obligations in that existing contract.
For some contracts, determining whether a contract includes an option that provides a material right will be clear. However, in other cases the determination will require significant judgment. Similar judgment is required under current GAAP. For example, under current GAAP some entities might need to apply significant judgment to determine whether a discount offered on future goods or services is significant and incremental to the range of discounts reflected in the pricing of other elements in a contract and to the range of discounts typically given in comparable transactions.
An entity also will need to consider any disclosures required under Topic 606 related to its determination of whether a customer option gives rise to a material right. For example, Topic 606 requires an entity to disclose certain information about significant judgments made in applying the guidance in Topic 606. It also requires an entity to disclose certain information about its performance obligations and how the transaction price has been allocated to those performance obligations, including disclosures related to how an entity estimated the standalone selling prices of its performance obligations.
The following examples illustrate the staff’s views on how the class of customer is considered when evaluating whether a customer option gives rise to a material right.
Example 1—Preferred customer pricing
Professional Consultants LLP (PCon) is one of the largest consulting firms in the world. PCon hires only the best and brightest professionals in the industry and typically charges its customers $1,000 per hour for consulting services. Goody Corporation (Goody) owns and operates a chain of bakeries across the United States. Goody currently has a long-term master services agreement with a consulting firm that will expire in the next year. Goody has requested that its current consulting firm and several other firms, including PCon, submit proposals for a new long-term master services agreement.
PCon knows that Goody and its current consulting firm entered into several contracts under the existing master services agreement for projects that required a significant number of consulting hours. PCon submits a proposal to provide Goody with an unspecified amount of consulting services under a master services agreement for $800 per hour even though PCon has provided consulting services to Goody in the past at a rate of $1,000 per hour. None of PCon’s prior contracts with Goody included a material right (that is, there are no prior contracts between PCon and Goody that would have created an expectation for Goody to receive favorable pricing in the future or that would have created an expectation for PCon to provide favorable pricing in the future).
After considering all proposals, Goody decides to enter into a long-term master services agreement with PCon. The agreement does not specify the scope of service to be provided by PCon, but specifies that the price per hour for any consulting services provided under the master services agreement will remain at $800 throughout the duration of the agreement (that is, each time Goody enters into a contract with PCon for a consulting project, the scope of services are separately negotiated, but the agreed upon hourly rate of $800 is used to determine the price). Goody subsequently enters into a contract with PCon to perform consulting services for a specific project over the next 6 months under the terms in the master services agreement (that is, PCon will provide consulting services for $800 per hour).
Although PCon agrees to charge Goody a rate that is less than what it typically would charge a customer (or had charged Goody in the past), the staff’s view is that the contract between PCon and Goody does not include a material right. This is because the hourly rate that is offered to Goody in each contract exists independently (for example, the hourly rate that Goody would be charged if it enters into a contract for a second specific project would be the same even if it had not entered into the first contract). Rather, the pricing offered by PCon in this example is a marketing offer made in an effort to obtain future contracts with Goody.
In this example, PCon does not need to consider Goody’s class of customer because the price at which PCon will provide consulting services to Goody (that is, $800 per hour) is not dependent on any existing or prior contracts with Goody. The staff included this example to illustrate a fact pattern in which future services are offered at a “discount,” but in which it is clear that the “discount” does not give rise to a material right.
Example 2—Significant discount on future purchase
Ziggy’s Electronics (Ziggy) owns and operates several retail electronics stores in New York City. Ziggy currently provides customers who purchase a 50-inch television with a coupon for 50% off the purchase of one new Supersonic stereo system. Ziggy typically sells a 50-inch television and the stereo system for $1,000 each. The coupon is redeemable only at one of Ziggy’s stores and must be redeemed within 1 year of purchasing the television. Ziggy has never offered a discount of this magnitude to a customer that does not purchase a television (or an item of similar value).
Janet recently graduated from college and moved to New York City. Janet needs a television for her new apartment and decides to purchase a 50-inch television from Ziggy. At the time Janet purchases the television, she receives a coupon for a 50% discount on the Supersonic stereo system but chooses not to redeem the couplionon at the same time she purchases the television.
When evaluating whether the contract between Ziggy and Janet includes a material right, Ziggy evaluates whether Janet’s option to purchase a Supersonic stereo system at a 50% discount exists independently of the existing contract with Janet (that is, the contract to purchase a television).
Assume Martha is Janet’s next-door neighbor. Martha is not in the market for a new television because she recently purchased a television online from one of Ziggy’s competitors. However, Martha visits the local Ziggy store where Janet purchased her television. The sales associate standing at the front of the store handed every person that walked through the door a coupon for 5% off the purchase of a Supersonic stereo system (which cannot be combined with any other offer).
In evaluating whether the discount offered to Janet exists independently of Janet’s existing contract to purchase a television, Ziggy should compare the discount offered to Janet (that is, 50%) with the discount typically offered to customers similar to Martha (that is, Ziggy should compare the discount offered to Janet with the discount typically offered to a similar customer that receives the discount independent of a prior contract with Ziggy).
Because the objective of the guidance in paragraphs 606-10-55-42 through 55-43 is to determine whether a customer option exists independently of an existing contract with a customer, it would not be appropriate for Ziggy to compare the discount offered to Janet with a discount offered to another customer that purchased a television and received a 50% off coupon for the stereo. Doing so would not help Ziggy determine whether Janet would have received the discount on the stereo system without entering into the contract to purchase the television.
The discounts offered to Janet and typically offered to customers like Martha (that is, customers who are offered a discount independent of a prior contract with Ziggy) are not comparable. Rather, Janet is receiving an incremental discount that she would not have received had she not entered into a contract to purchase a television. In the staff’s view, the incremental discount offered to Janet in connection with her purchase of a television is a material right.
Example 3—Volume discounts
Sprocket Corporation (Sprocket) manufactures component parts that have various uses to multiple customers. Assume for purposes of this fact pattern that the parts are interchangeable and not customized for any particular customer. Sprocket enters into a long-term master services agreement to provide unspecified volumes of parts to Jetson Corporation (Jetson). The price of the parts in a subsequent year is dependent on the volume of purchases Jetson makes in the current year. Sprocket charges Jetson $1.00 per part in Year 1 and the contract stipulates that if Jetson’s purchase volume in Year 1 exceeds 100,000 parts, the price per part will decrease to $0.90 in Year 2. The terms of Sprocket’s contract with Jetson, including the reduced price in Year 2 if the purchasing threshold in Year 1 is met, are similar to the terms offered to many of its customers. Early in Year 1, Jetson enters into a contract with Sprocket to purchase 8,000 parts. Jetson is required to pay $1.00 for each of those 8,000 parts.
When evaluating whether the contract between Sprocket and Jetson includes a material right, Sprocket first evaluates whether Jetson’s option to receive a $0.10 per part discount in Year 2 exists independently of the existing contract.
Assume Astro Corporation (Astro) is an existing customer that places a single order with Sprocket for 105,000 parts. Astro has purchased parts from Sprocket in the past, but none of its prior contracts with Sprocket created an expectation to purchase parts in the future at a specified price (and did not create an expectation for Sprocket to sell parts in the future at a specified price).
In evaluating whether the discount offered to Jetson exists independently of the existing contract, Sprocket should compare the price per part offered to Jetson in Year 2 (that is, $0.90) with the price charged to customers similar to Astro (that is, Sprocket should compare the price offered to Jetson in Year 2 with the price typically offered to a similar high-volume customer that is offered a price independent of a prior contract with Sprocket).
Because the objective of the guidance in paragraphs 606-10-55-42 through 55-43 is to determine whether a customer option exists independently of an existing contract with a customer, it would not be appropriate for Sprocket to compare the price offered to Jetson in Year 2 with offers to other customers that receive pricing that is contingent on the volume of purchases in a prior year. Doing so would not help Sprocket determine whether Jetson would have been offered the price in Year 2 had it not entered into the contract(s) to purchase parts with Sprocket in Year 1.
If the price that Sprocket offered to Jetson in Year 2 and the price typically offered to customers like Astro (that is, a similar high-volume customer that is offered a price independent of a prior contract with Sprocket) are comparable, this might indicate that the price offered to Jetson exists independently of the existing contract (that is, the price offered to Jetson does not include a discount that is incremental to the discount typically offered to a similar high-volume customer). If the price Sprocket charged Jetson and Astro are not comparable, this might indicate that a portion of the price Jetson pays for parts in Year 1 is a prepayment for the parts purchased in Year 2.
In the staff’s view, significant judgment will be required to determine whether the prices charged to Jetson and customers such as Astro are comparable, whether Jetson and Astro are comparable customers, and whether any difference in price is significant. The staff is not in a position to reach broad conclusions about these types of fact patterns because there are many variations of contracts and variations in facts and circumstances that can affect the conclusion in each fact pattern.
If Sprocket concludes that the contract with Jetson includes a material right, it would need to use significant judgment to account for that material right (for example, to estimate the amount of the transaction price that should be allocated to the material right and the period in (or over) which the performance obligation associated with material right should be recognized as revenue).
The staff reminds stakeholders that Topic 606 includes a practical expedient in paragraph 606-10-10-4 that permits an entity to apply the guidance to a portfolio of contracts or performance obligations in certain circumstances. This practical expedient might simplify the accounting for contracts that include material rights.
The staff also reminds stakeholders that Topic 606 includes disclosure requirements about the judgments, and changes in the judgments, made in applying the guidance that significantly affect the determination of the amount and timing of revenue from contracts with customers.
Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.
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