Contracts frequently include options for customers to purchase additional goods or services in the future. Customer options that provide a material right to the customer (such as a free or discounted good or service) give rise to a separate performance obligation. In this case, the performance obligation is the option itself, rather than the underlying goods or services. Management will allocate a portion of the transaction price to such options, and recognize revenue allocated to the option when the additional goods or services are transferred to the customer, or when the option expires. Refer to RR 7
for further considerations related to customer options.
The additional consideration that would result from a customer exercising an option in the future is not included in the transaction price for the current contract. This is the case even if management concludes it is probable, or even virtually certain, that the customer will purchase additional goods or services. For example, customers could be economically compelled to make additional purchases due to exclusivity clauses or other facts and circumstances. Management should not include an estimate of future purchases as a promise in the current contract unless those purchases are enforceable by law regardless of the probability that the customer will make additional purchases. Judgment may be required to identify the enforceable rights and obligations in a contract, as well as the existence of implied or explicit contracts that should be combined with the present contract.
Judgment may also be required to distinguish optional goods or services from promises to provide goods or services in exchange for a variable fee. An example is a contract to deliver a photocopy machine to a customer in exchange for a fee based on the number of copies made by the customer. In this example, the promise to the customer is to transfer the machine. The number of photocopies that the customer will make is unknown at contract inception; however, the customer’s future actions (that create photocopies) are not a separate buying decision to purchase additional distinct goods or services from the reporting entity. The fee in this case is variable consideration (refer to RR 4.3
for further discussion).
In contrast, consider a contract to deliver a photocopy machine that also provides pricing for replacement ink cartridges that the customer can elect to purchase in the future. The future purchases of ink cartridges are options to purchase goods in the future and, therefore, should not be considered a promise in the current contract. The reporting entity should evaluate, however, whether the customer option provides a material right. Refer to Revenue TRG Memo No. 48
and the related meeting minutes in Revenue TRG Memo No. 49
for further discussion of this topic.
The assessment of whether future purchases are optional could have a significant impact on the accounting for a contract when the transaction price is allocated to multiple performance obligations. Disclosures are also affected. For example, reporting entities would not include optional goods or services in their disclosures of the remaining transaction price for a contract and the expected periods of recognition. Refer to FSP 33.4 for further discussion of the disclosure requirements.
Example RR 3-6 illustrates the assessment of whether goods and services are optional purchases.
EXAMPLE RR 3-6
Optional purchases — sale of equipment and consumables
DeviceCo, a medical device company, sells a highly complex surgical instrument and consumables that are used in conjunction with the instrument. DeviceCo sells the instrument for $100,000 and the consumables for $100 per unit. A customer purchases the instrument, but does not commit to any specific level of consumable purchases. The customer cannot operate the instrument without the consumables and cannot purchase the consumables from any other vendor. DeviceCo expects that the customer will purchase 1,000 consumables each year throughout the estimated life of the instrument. DeviceCo concludes that the instrument and the consumables are distinct.
Should DeviceCo include the estimated consumable purchases as a performance obligation in the current contract?
DeviceCo should not include the estimated consumable purchases as part of the current contract as they are optional purchases. Even though the customer needs the consumables to operate the instrument, there is no enforceable obligation for the customer to make the purchases. The customer makes a decision to purchase additional distinct goods each time it submits a purchase order for consumables.
DeviceCo should consider whether the option to purchase consumables in the future provides a material right to the customer (for example, if the customer receives a discount on future purchases of the consumables that is incremental to the range of discounts typically given to other customers as a result of entering into the current contract). A material right is accounted for as a performance obligation, as discussed in RR 7