Some stakeholders have questions about how to distinguish between a contract that contains an option to purchase additional goods and services and a contract that includes variable consideration based on a variable quantity (such as a usage-based fee) because variable quantities can give rise to variable consideration in some contracts.

Contracts that contain options to purchase additional goods or services could result in variable quantities of goods or services being purchased by the customer. That variability is caused by the customer’s ability to exercise its option. Paragraph 606-10-55-42 notes that a customer option is accounted for only if it provides a material right to the customer. In that case, the option (material right), but not the underlying goods or services, is the performance obligation.

Some stakeholders think there is an inconsistency between paragraphs BC50 and BC391 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). Those stakeholders think that paragraph BC50 indicates that any time a vendor has a stand-ready obligation, any future purchases under that contract (optional or not) should be considered a part of the initial contract and should be estimated to determine the transaction price. That is because the vendor is obligated to stand ready and that contract has created enforceable rights and obligations between the parties. However, other stakeholders think that paragraphs BC50 and BC391 should be considered together. That is, if the customer has the option to terminate a contract, the customer’s right is in effect an option to purchase additional goods or services that would be a performance obligation only if it provides the customer with a material right.

Accounting for a contract that contains an option to purchase additional goods and services and a contract that includes variable consideration sometimes would result in minimal differences in the timing and measurement of revenue recognized in a reporting period. For example, the accounting for a contract that requires an entity to process transactions for a constant amount of consideration per transaction over a specified period would likely result in revenue recognized as each transaction is processed. This would be the case regardless of whether each transaction processed was considered an optional purchase or, instead, variable consideration for the entity’s service of processing transactions over the specified period.

However, there could be a difference in required disclosures. If each transaction was considered an optional purchase, an entity would not be required to disclose an estimate of the consideration received from the exercise of future options. In contrast, if each transaction processed was considered variable consideration, the entity would be required to estimate the remaining transactions to be processed in order to disclose the transaction price allocated to the remaining performance obligations in paragraphs 606-10-50-13 through 50-16 unless it qualifies for one of the practical expedients in paragraph 606-10-50-14.

In addition to disclosure differences, the distinction between optional purchases and variable consideration can have a significant effect on contracts with multiple performance obligations.

Consider the following example:

The staff thinks sometimes judgment will be needed to distinguish between contracts with an option to purchase additional goods or services and contracts that have variable consideration (in particular, distinguishing between optional purchases and usage-based fees). The staff thinks the first step (which is a critical step) is to appropriately identify the nature of the promises in the contract as well as the rights and obligations of the parties. In the staff’s view, the following are some differences between optional purchases and variable consideration that may be helpful when evaluating a contract under Topic 606:

Topic 606 does not define the term customer option. However, Topic 606 discusses customer options to acquire additional goods or services. Paragraph BC386 of Update 2014-09 states that if the option is deemed to be a marketing offer, then it is not part of the contract and paragraph 606-10-55-42 states that in those cases the marketing offer is only accounted for when the customer exercises its option. Because an option that is a marketing offer is considered a new contract if it is exercised, the staff thinks that an analogy to the contract modification guidance in paragraphs 606-10-25-12 through 25-13 could be helpful when an entity is distinguishing between optional purchases and variable consideration. This is because the modification guidance provides an example of the customer changing the amount of goods or services provided. For a modification to be considered a separate contract, one of the criteria is that the modification results in the addition of promised goods or services that are distinct. Similarly, the staff thinks the exercise of a customer option for additional goods and services would typically result in the addition of promised goods or services that are distinct.

The staff does not think paragraph BC50 implies that any time a vendor is obligated to stand ready to perform that the contract always contains a single performance obligation of standing ready to provide goods or services (and, therefore, that the entity must include an estimate of expected purchases in the transaction price). The staff thinks that paragraphs BC50 and BC391 should be considered together and that an entity should consider the present legally enforceable rights in the contract when identifying the performance obligation(s). In some contracts, the present legally enforceable rights merely give the customer a right to purchase additional goods or services.

The staff also considered the guidance in paragraphs 606-10-55-340 through 342 (Example 50). In this example, the contract includes a present right (the option) for the customer to purchase additional minutes or text messages, which when purchased are distinct. Furthermore, the customer controls the ability to purchase the minutes or texts.

Based on the guidance above, the staff views an optional purchase as providing the customer with a present right to choose the amount of additional distinct goods or services (or change the current goods or services) it will purchase. In other words, before the exercise of that right, the vendor is not presently obligated to provide the additional distinct goods or services. In the staff’s view, the following is an example of optional purchases:

As discussed above, when contracts contain an optional purchase, the customer’s actions (of exercising the option) result in the vendor’s obligation to provide additional distinct goods or services. However, paragraph BC417 clarifies that a customer’s future actions can also result in variable consideration. As such, to distinguish between an optional purchase and variable consideration based on the customer’s actions, the staff thinks it is important to determine the vendor’s rights and obligations that arise from the customer’s actions.

Some stakeholders question whether a customer’s action that obligates it to pay the vendor would be indicative of an optional purchase. Those stakeholders also might consider the customer’s ability to avoid payment similar to a right to exercise an option. Paragraph BC148(c) discusses how the Board considered the right to payment in Topic 606 and states “In cases in which the customer clearly receives benefits as the entity performs, as in many service contracts, the possibility that the entity ultimately will not retain the payment for its performance is addressed in the measurement of revenue.”

The staff thinks paragraph BC148(c) makes it clear that when an entity transfers goods or services, the possibility it will not be entitled to consideration for its services is addressed in measurement of revenue (that is, Step 3). As such, when paragraph BC148 is taken together with paragraphs BC417 through BC418, the staff thinks that customer actions or events that result in additional payment after (or as) control of the goods or services has transferred would be indicative of variable consideration. In contrast, the customer’s action in an optional purchase results in a new obligation for the vendor to transfer additional distinct goods or services.

Consider the example of a franchise license with a sales-based royalty. The customer’s actions (the use of the license) result in a payment for the service that is already being provided (the right to access the license transferred over time) and the customer actions (use of the license) do not result in additional goods or services to be provided. In the staff’s view, the following are examples of variable consideration:

Consider the following examples:

The staff (and many stakeholders in this industry) views the type of arrangement above as being a single performance obligation (each of the underlying activities are not distinct) for the entire contract term. The staff and those stakeholders think that the nature of the promise is to provide a single continuous integrated service for the contract term.

In the IT outsourcing fact pattern contemplated above, the customer’s actions do not obligate the vendor to transfer additional distinct goods or services. The customer previously made the choice (by entering into the contract) that obligated the vendor to provide services and the customer to only use that vendor’s services for that population of the customer’s IT needs. The customer’s subsequent actions utilize the service to which IT Seller is already committed and performing.

The staff views the nature of the promise (and the rights and obligations) in the IT contracts contemplated above as being different from Example 50 in Topic 606 (the optional purchases of additional calls or text messages). This is because in the telecom example (Example 50) the customer has the choice to acquire additional distinct services (the minute or the message) that obligates the provider to deliver the additional services. In contrast, in the IT outsourcing scenario, the customer’s subsequent action (the usage of the service) does not obligate the vendor to provide additional distinct goods or services because the nature of the promise is the overall service and not the individual activities. That is, the staff (and many stakeholders in this industry) views the quantity of units used to determine the payments as a measure of usage (that is, computing power consumed) of the service being performed (that is, the overall outsourcing service) rather than distinct services purchased by the customer. Finally, the staff views a typical customer option in the outsourcing scenario to be a right to extend the contract term (because the overall daily services are the additional distinct services).

Finally, the type of arrangements the staff is considering would have enforceable rights and obligations in the contract. Under the contract, the vendor is presently obligated to make the IT outsourcing service continuously available to the customer throughout the non-cancellable contract term. The vendor’s performance creates a right to payment, the variability of which is reflected in the measurement of revenue.

The staff views this type of transaction processing service as a single performance obligation (that may be a series of distinct services) that spans the contract period. The staff thinks the nature of the promise is to provide the customer with continuous access to the processing platform so that when the customer’s customer submits a transaction it is processed for the customer.

In the fact patterns contemplated above, the customer does not control the number of transactions processed and is contracting for access to the processing platform. Because the customer does not control the number of transactions processed, entering into the initial contract is the purchasing decision after which the customer does not have the ability to choose quantities processed. As such, because the vendor is already obligated to provide continuous access to the platform (and receive consideration for that service), the events that result in payment occur after (or as) the vendor transfers the service and do not result in an obligation for the vendor to transfer additional goods or services.

Finally, the type of arrangements the staff is considering would have enforceable rights and obligations in the contract. Under the contract, the vendor is presently obligated to make the service continuously available throughout the contract term on the customer’s behalf and the customer has the right to those services. The vendor’s performance creates a right to payment, the variability of which is reflected in the measurement of revenue.

Some stakeholders think that the nature of the promise in this example is a service of standing ready to perform with a single performance obligation. Under that view, the entity would estimate the number of purchases to be made throughout the contract term and continually adjust the transaction price and reallocate the consideration among the transferred goods or services. Stakeholders that view this arrangement as a single performance obligation do not see a difference between this example and the outsourcing or transaction processing examples. They would view the nature of any contract (or most contracts) with a stand-ready obligation and an undefined quantity of items that will be provided, or activities performed as a single service rather than the delivery of the underlying goods or services.

The staff views the nature of the promise in this example as the delivery of the parts, rather than (or in addition to) a service of standing ready. The staff thinks an important distinction between this fact pattern and transaction processing, or outsourcing arrangements is that the contract provides a right to choose the quantity of additional distinct goods versus a right to use the services for which control to the customer has (or is currently being) transferred. Similarly, the supplier is not obligated to transfer any parts until the customer submits the purchase order, while in the other fact patterns the vendor is obligated to make the promised services available to the customer without any additional decisions made by the customer.

In some contracts, the nature of the entity’s promise is primarily that of “standing ready,” or making available a scarce resource to the customer when-and-as it is needed (for example, the service of making the entity’s health club available for the customer’s use when the customer decides to use it). In contrast, in other cases, the nature of the promise is to transfer specified goods or services. For example, a contract to deliver 100 widgets over the next five years when the customer requests the widgets generally would not be a “stand-ready obligation,” nor would a contract that simply sets out terms and conditions for future orders, but requires purchase orders of a specified quantity at a later date to obligate the vendor to perform (and customer to pay). Paragraph 606-10-55-185, which describes a stand-ready obligation, may also help distinguish the differences.

The staff does not view customer purchases under a master supply agreement to be similar to a customer’s use of a health club. When the customer submits a purchase order, it is contracting for a specific number of distinct goods and creates new performance obligations for the supplier. In contrast, in the health club example, the customer is using services that the health club has made available and no new obligations arise from the usage of the service.

The staff thinks the determination of whether a contract has variable consideration, or an optional purchase, is highly dependent upon the evaluation of the nature of the promise in the contract. Consequently, not all outsourcing, transaction processing, and supply agreements automatically would be accounted for consistently with the staff views of the examples in this Q&A. An entity will need to evaluate the facts and circumstances of its contracts to determine the nature of its promise to the customer. Similar to previous GAAP, this sometimes will require the use of judgment.

The staff suggests that when an entity is evaluating the nature of its promises, the entity also should be mindful of the disclosure requirements in Topic 606. Those disclosure requirements include, but are not limited to, a description of the nature of the goods and services that the entity has promised to transfer and significant judgments, and changes in the judgments, made in applying Topic 606 that significantly affect the determination of the amount and timing of revenue. For many entities, the disclosure requirements in Topic 606 are incremental to those required under previous GAAP.