The economic impact from the novel coronavirus has been a significant challenge for most companies, whether due to changes in customer demand, shuttering of operations or constraints on labor and supply chain. Considering these ramifications, companies may be more inclined in the COVID-19 pandemic environment to implement pricing changes in order to improve customer retention. Such steps may include incremental discounting in the form of marketing offers, broad ranging price concessions, or specific customer contract modifications. The revenue recognition implications from these actions can be complex; we will delve into each to highlight the nuances and accounting considerations of each.
An offer or option to a customer to acquire additional goods or services is a separate performance obligation, known as a material right, if the option provides for a discount that is incremental to discounts typically given for those goods or services to that class of customer. If the option provides a material right to the customer, the customer effectively pays the entity in advance for the right to obtain future goods or services at reduced prices, and at contract inception the entity is required to allocate a portion of the transaction price to those future goods or services. The revenue allocated to the material right is then recognized when (or as) the option is exercised and the underlying future goods or services are transferred or when the option expires.
Conversely, if the offer to the customer is not deemed to be a material right, it is considered a marketing offer. Marketing offers do not require accounting for the option or underlying goods or services until those subsequent purchases occur. A marketing offer creates an opportunity to attract and retain customers, but without a potentially complex accounting impact. However, the determination likely requires an entity to exercise significant judgment and consider all facts and circumstances about the structure of these types of offers.
Material Right vs Marketing Offer
When determining if the option is a material right or marketing offer, an entity should first consider whether the offer exists independently of the existing contract with the customer. This analysis can be made by comparing the discount in the option to discounts provided to similar customers that were not dependent on prior purchases. If the pricing is independent (e.g. no prior purchase necessary), the option is considered a marketing offer. This consideration should include quantitative and qualitative aspects, in order to determine whether the discount is independent of the existing contract. The organization would need to consider past, current and future activities with the customer. It would also determine whether the same class of customer in the same geography obtains the future goods or services at the same discounted price regardless of entering into the existing contract.
Consider a scenario where a customer purchases a television that includes the option to buy a stereo at a 50% discount, and such a steep discount on the stereo has not been offered previously. In this example, the entity selling the stereo would need to consider if a customer that has not purchased a television would have been able to receive the 50% discount on the stereo to determine if the 50% discount is a material right. It would not be appropriate to compare this purchase with a discount offered to another customer that also purchased a television and received a 50% off coupon for the stereo, because it would not allow the entity to determine if the 50% discount was independent of the purchase of the television.
A marketing offer has no accounting impact on the existing contract with the customer. Rather, the entity would separately account for the option if and when exercised by the customer. A marketing offer is also not a contract modification, and is not indicative of a customer price concession.
Customer Price Concessions
A customer price concession, in context of ASC 606, is compensating an existing customer by reducing the transaction price as stated in the contract, typically subsequent to the execution of the contract. Price concessions are accounted for as variable consideration under Step 3 of the ASC Topic 606 5-step process when the customer has a valid expectation through the sellers past business practice, statements, or other facts and circumstances that existed when the contract was entered into that the entity will accept or offer a lower price.
The presence of potential price concessions is based on the entity’s intent when entering into the contract. In other words, the anticipated actions that may reduce the transaction price in future. Intent is typically indicated by a history of granting price concessions or an expectation of future concessions for other reasons. If a future reduction of the transaction price is expected at contract execution, the entity estimates the amount of variable consideration to which it expects to be entitled, after any price concessions, using either of the expected value or most-likely-amount methods. Judgment will be required to accurately and reasonably estimate the variable consideration attributed to concessions, as well as determining that concessions do not relate to collectability concerns that should be accounted for as a credit loss or require reassessment of Step 1 of the 5-step process.
Because price concessions affect Step 3 of the ASC 606 assessment, they are applied at either a unique contract level, or a portfolio of contracts level (e.g. by contract type, class of customer, geography, etc.). The recognition of expected price concessions through variable consideration is typically at a level that is broader than individual contracts, and oftentimes it affects more than one contract.
If an entity estimates a price concession through variable consideration, it later adjusts the transaction price for any changes in the estimate, or ultimately trues up the estimate to the actual concession amount. In contrast, if an entity grants a price concession when there was no previous pattern of such concessions, and therefore no concession was estimated in the initial transaction price, the entity accounts for that price concession as a contract modification that affects price only. It is the prevalence of contract modifications to reduce contract prices that leads to establishing a history of concessions, which in turn are then accounted for through variable consideration. This leads us to the next topic in this discussion: contract modifications.
A contract modification occurs when the entity and its customer agree to a change in the scope and/or price of a contract, oftentimes referred to as a change order or amendment. ASC 606 includes specific guidance when contract modifications occur, which entities should carefully evaluate in order to properly apply the appropriate modification accounting model.
A contract modification is accounted for as a separate contract if both of the following conditions are present:
- The scope of the contract increases because of the addition of promised goods or services that are distinct.
- The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract.
In this scenario, the new contract is simply accounted for separate from the existing contract.
Modifications that are not separate contracts includes scenarios that modify or remove previously agreed-upon goods and services, or reduce the price of the contract. This type of modification is most applicable in context of this publication, and it can be further broken down into two possible scenarios:
- A modification is a termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. For example, adding distinct goods at a discounted price.
- If the remaining goods and services to be provided after the contract modification are not distinct from those goods and services already partially provided, the entity should account for the contract modification as if it were part of the original contract.
When a modification is a termination of the old contract and creation of a new contract, revenue recognized from satisfied performance obligations on the original contract is not adjusted. Instead, the remaining portion of the original contract and the modification are accounted for together on a prospective basis by allocating the remaining consideration (i.e., the unrecognized transaction price from the existing contract plus the additional transaction price from the modification) to the remaining performance obligations, including those added in the modification. For example, consider a three-year contract to clean offices at the standalone selling price of $100,000 per year. At the end of the second year, the contract is modified and the fee for the third year is reduced to $80,000. In addition, the customer agrees to extend the contract for three additional years for consideration of $200,000 payable in three equal annual installments of $66,667 at the beginning of years four, five, and six, below the standalone selling price. At contract inception, the entity concluded the weekly cleaning services are a series of distinct services that are substantially the same and have the same pattern of transfer to the customer. At the date of the modification, the entity assesses the additional services to be provided and concludes that they are distinct under the series accounting guidance. However, the price change does not reflect the standalone selling price. Consequently, the entity accounts for the modification as a termination of the original contract and the creation of a new contract with consideration of $280,000 for four years of cleaning service. The entity recognizes revenue of $70,000 per year ($280,000 ÷ 4 years) as the services are provided over the new four years.
For these modifications, the entity adjusts revenue previously recognized on a cumulative catch-up basis, by reflecting the effect of the modification on the transaction price and measure of progress. For example, a construction company enters into a contract to construct a building on customer land for $1 million. The entity accounts for the building, a combined output, as a single performance obligation satisfied over time because the customer controls the building during construction. At the inception of the contract, the entity expects total costs of $700,000. By the end of the first year, using an input measure on the basis of costs incurred, the entity has satisfied 60% percent of its performance obligation on the basis of costs incurred to date ($420,000) relative to total expected costs ($700,000). At the start of the second year, the parties agree to modify the contract by changing the floor plan of the building. As a result, the fixed consideration and expected costs increase by $200,000 and $120,000, respectively. Total consideration after the modification is $1.2 million. In assessing the modification, the entity concludes that the remaining goods and services per the modified contract are not distinct from the goods and services transferred on or before the date of contract modification; that is, the contract remains a single performance obligation. Consequently, the entity accounts for the contract modification as if it were part of the original contract. The entity updates its measure of progress and estimates that it has satisfied 51.2% of its performance obligation ($420,000 actual costs incurred ÷ $820,000 total expected costs). The entity recognizes additional revenue of $14,400 [(51.2% complete × $1,200,000 modified transaction price) – $600,000 revenue recognized to date] at the date of the modification as a cumulative catch-up adjustment.
In some cases a contract modification may result in a combination of the above scenarios, i.e. adding distinct and non-distinct performance obligations to an existing arrangement. In that case, the entity should account for the effects of the modification under a combination of the methods described above, which may include allocation of the modified consideration to the remaining performance obligations based on the relative standalone selling prices.
The presence of contract modifications may require significant judgment when navigating the contract modification accounting guidance. In addition to the judgments necessary to determine the appropriate way to account for a contract modification, the guidance on contract modifications also has its practical challenges, including how to properly identify all modifications, which is a risk that entities should assess and address through its internal control structure if needed.
Companies may offer, or accept, a variety of incentives and modifications to contracts with customers in these unusual and uncertain economic times. Most commonly, these changes will fall into the buckets of material rights, marketing offers, variable consideration or contract modifications. It will remain important for accounting teams to work closely with sales teams to ensure that control processes work appropriately, and all necessary information is provided timely, to properly evaluate and account for such offers. Management should carefully consider all aspects of the 5-step process applicable to their specific facts and circumstances, and may find additional areas that require consideration.
For more information about how price changes may affect revenue recognition accounting, please contact Pieter Combrink at firstname.lastname@example.org or 858.232.8681.
Published on August 04, 2020