Customer options for additional goods or services
In short – An entity accounts for a customer option to acquire additional goods or services as a performance obligation if the option provides the customer with a material right. The standard provides guidance on calculating the stand-alone selling price of a customer option when it is a material right.
When an entity grants the customer an option to acquire additional goods or services, that option is a performance obligation under the contract if it provides a material right that the customer would not receive without entering into that contract. (IFRS 15.B40)
The following decision tree helps analyse whether a customer option is a performance obligation. (IFRS 15.B40-B41)
If the stand-alone selling price for a customer’s option to acquire additional goods or services that is a material right is not directly observable, then an entity will need to estimate it. This estimate reflects the discount that the customer would obtain when exercising the option, adjusted for:
- any discount that the customer would receive without exercising the option; and
- the likelihood that the option will be exercised. (IFRS 15.B42)
Revenue for material rights is recognised when the future goods or services are transferred or when the option expires. If the option is a single right with a binary outcome – i.e. it will either be exercised in full or expire unexercised – then there is nothing to recognise before the option is exercised or expires. Conversely, if the option represents multiple rights or does not expire, then it appears that an entity may apply the guidance on unexercised rights – i.e. breakage. (IFRS 15.B40, B46)
Case – Cable television service and additional premium channels
Cable Company B contracts with Customer D to provide television services for a fixed monthly fee for 24 months. The base television services package gives D the right to purchase additional premium channels. In Month 3, D adds a premium sports channel for an additional 5 per month, which is the price that all customers pay for the premium sports channel (i.e. it is priced at its stand-alone selling price).
The premium channel can be added or dropped by D without affecting the base cable television service. Therefore, the ability to add the premium channel to the package represents an option to purchase additional goods or services.
At contract inception, B concludes that because the option to purchase the premium channel is priced at its stand-alone selling price, the option is not a material right. Therefore, the option is not identified as a performance obligation at contract inception. B recognises revenue for the premium channel in Month 3 when it provides the services.
Case – Product sold with a discount voucher
Retailer R sells a computer to Customer C for 2,000. As part of this arrangement, R gives C a voucher. The voucher entitles C to a 25% discount on any purchases up to 1,000 in R’s store during the next 60 days. R intends to offer a 10% discount on all sales to other customers during the next 60 days as its seasonal promotion. R regularly sells this model of computer for 2,000 without the voucher.
R notes that the discount voucher provides a material right that C would not receive without entering into the original sales transaction. This is because C receives a 15% incremental discount compared with the discount expected to be offered to other customers (25% discount voucher – 10% discount for all customers). Therefore, the discount voucher is a separate performance obligation.
R estimates that there is an 80% likelihood that C will redeem the voucher and will purchase additional products with an undiscounted price of 500.
R allocates the transaction price between the computer and the voucher on a relative selling price basis as follows.
C purchases 200 of additional products (pre-discount) within 30 days of the original purchase for 150 cash payment.
C makes no additional purchases before the voucher expires. Therefore, at the expiry date R recognises the remaining amount allocated to the voucher as revenue.
R records the following journal entries.
Determining whether a material right exists requires an evaluation of both quantitative and qualitative factors
An entity considers whether a customer option for additional goods or services is a material right at contract inception based on both quantitative and qualitative factors. Although the evaluation is judgemental, an entity considers whether the option would be likely to impact the customer’s decision to buy the entity’s product or service in the future. This is consistent with the notion that an entity considers valid expectations of the customer when identifying promised goods or services (follow this link for more).
Customers’ options that provide accumulating rights are assessed in aggregate
In many cases, the rights that an entity grants to its customers accumulate as the customer makes additional purchases. For example, in a customer loyalty programme the points granted in an initial transaction are typically used in conjunction with points granted in subsequent transactions. Further, the value of the points granted in a single transaction may be low, but the combined value of points granted over an accumulation of transactions may be much higher. In these cases, the accumulating nature of the right is an essential part of the arrangement.
When assessing whether these customer options represent a material right, an entity considers the cumulative value of the rights received in the transaction, the rights that have accumulated from past transactions and additional rights expected from future transactions.
An entity considers all relevant quantitative and qualitative factors.
Exercise of a material right
When a customer exercises a material right for additional goods or services, an entity may account for it using one of the following approaches.
Continuation of the original contract: Under this approach, an entity treats the consideration allocated to the material right as an addition to the consideration for the goods or services under the contract option – i.e. as a change in the transaction price.
For example, Service Provider S enters into a contract with Customer M to provide Service D for two years for 100 and an option to purchase Service E for two years for 300, which is typically priced at 400. S determines that the option is a material right and therefore a separate performance obligation. Assume that S initially allocates the transaction price of 100 as follows: 75 to D and 25 to the option to purchase E. Six months into the contract, M exercises the option to purchase E.
On exercise of the option, S recognises revenue of 325 (25 + 300) for E over two years. There are no changes to the amount or timing of revenue recognition for D – i.e. 75 continues to be recognised over two years from contract inception.
Contract modification: Under this approach, an entity applies the contract modification guidance to evaluate whether the goods or services transferred on exercise of the option are distinct from the other goods or services in the contract. The outcome of this evaluation will determine whether the modification is accounted for prospectively or with a cumulative catch-up adjustment. Follow this link for further guidance on contract modifications.
Estimate of the likelihood of exercise of an option is not revised
When determining the stand-alone selling price of a customer option for additional goods or services, an entity estimates the likelihood that the customer will exercise the option. This initial estimate is not subsequently revised because it is an input into the estimate of the stand-alone selling price of the option. Under the standard, an entity does not reallocate the transaction price to reflect changes in stand-alone selling prices after contract inception. (IFRS 15.88)
The customer’s decision to exercise the option or allow the option to expire affects the timing of recognition of the amount allocated to the option, but it does not result in reallocation of the transaction price.
Estimating the stand-alone selling price of ‘free’ gift cards and coupons
In some cases, an entity may sell gift cards or coupons in stand-alone transactions with customers. In addition, the entity may grant gift cards or coupons in the same denomination in transactions in which customers purchase other goods and services. In the latter case, the gift cards or coupons may be identified as conveying a material right to the customer – e.g. an entity offers a free gift card or coupon with a value of 15 with every 100 of goods purchased. (IFRS 15.42)
In these cases, the stand-alone selling price of the gift card or coupon identified as a material right may differ from the stand-alone selling price of a separately sold gift card or coupon. This is because customers who receive the gift card or coupon as a material right may be significantly less likely to redeem them than customers who purchase a gift card or coupon in a separate transaction.
Therefore, an entity may conclude that there is no directly observable stand-alone selling price for a free gift card or coupon provided to a customer in connection with the purchase of another good or service. In this case, the entity estimates the stand-alone selling price using the guidance in Step 4 of the model.
Coupons issued at the point of sale
Retail stores often print coupons at the register after a purchase is completed (sometimes referred to as ‘Catalina coupons’ or ‘bounce-back coupons’ that can be redeemed for a short period of time). The coupons are handed to customers at the point of sale or packaged with the goods that customers have contracted to purchase. Often, customers are not aware that they will receive these coupons.
Customers can often access similar discounts without making a purchase – e.g. if coupons are printed in a newspaper or freely available in-store or online. This type of general marketing offer may indicate that the coupon does not provide a material right because the discount is available to the customer independently of a prior purchase. As a result, the coupons are often recognised as a reduction in revenue on redemption.
Conversely, if there is no general marketing offer then the entity assesses whether the coupon conveys a material right. This assessment includes consideration of the likelihood of redemption, which will often be low and therefore reduces the likelihood that the coupon will be identified as a material right.
Volume discounts and rebates
Prospective volume discounts (or rebates) that are earned once a customer has completed a specified volume of optional purchases are evaluated for the presence of a material right and do not give rise to variable consideration.
To evaluate whether an option represents a material right, an entity evaluates whether a similar class of customer could receive the discount independently of a contract with the entity. This analysis involves comparing the discount in the current transaction with discounts provided to similar customers in transactions that were not dependent on prior purchases – i.e. discounts not offered through options embedded in similar contracts with other customers. The fact that discounts given to similar customers in stand-alone transactions are similar to the discount offered in the current contract indicates that the customer could obtain the discount without entering into the current contract.
For example, a prospective rebate arrangement would not give rise to a material right if the discounted price after the threshold is consistent with the unit price offered to other customers that are expected to make purchases at or above the volume target. However, if other customers can receive the discounted price only through a prospective rebate arrangement then this suggests that all customers receive future discounts as a result of prior purchases. In these cases, a prospective rebate arrangement may give rise to a material right.
Evaluating optional purchases at a discount compared with the original contract
In many cases, an option to purchase additional goods or services at a discount from the price in the original contract will give rise to a material right. However, in some scenarios it may be challenging to determine whether the discounted price gives rise to a material right – e.g. when an entity uses the cost plus a margin pricing model and the decrease in price relates to a decrease in costs passed to the customer. In these cases, it appears that an entity should consider the following indicators to determine whether the discounted price for the optional purchases reflects the stand-alone selling price for those goods or services – i.e. whether there is a material right.
Indicators – No material right
Indicators – Material right
Decrease in price reflects the expected decrease in costs
Decrease in price is incremental to the expected decrease in costs
Decrease in price is consistent with price decreases for other similar mature goods or services
Decrease in price is incremental to price decreases for other similar mature goods or services
Discounted price is consistent with reduced price offered to other customers, including new customers – i.e. all current and potential customers benefit from the decrease in costs
Discounted price is lower than the price offered to other customers – i.e. not all customers benefit from the decrease in costs
The right to the discounted price does not accumulate in a manner that incentivizes the customer to make future purchases
The right to the discounted price accumulates in a manner that incentivizes the customer to make future purchases
A cancellable contract may contain a material right
When a contract is cancellable without significant penalty, a material right may exist for the cancellable period of the contract. This is because a contract that can be cancelled without a substantive termination penalty is economically similar to a contract with a renewal right. For example, a three-year contract that allows the customer to cancel at the end of each year without a substantive termination penalty is no different from a one-year contract with two one-year renewal options. Therefore, an entity considers whether the optional renewal periods give rise to a material right.
Case – Custom product with learning curve effect: No material right
Automotive Supplier S enters into a two-year framework agreement with Carmaker M to manufacture a custom part. M is committed to purchasing a minimum of 500 parts for 200 per part. Each part is a distinct good that is transferred at a point in time. If M purchases between 500 and 700 parts, then the price per part for those parts decreases to 180. For purchases above 700 parts, the price per part decreases to 150.
The decreases in the price per part are consistent with the expected reduction in S’s costs along its learning curve. The price reductions are also consistent with S’s typical decrease in price for other mature parts of a similar size and complexity.
S considers that there is some level of accumulation because M achieves the discounted price of 150 only if it purchases more than 700 parts. However, because M is committed to purchasing 500 parts under the contract, S determines that this indicator is not significant to its analysis.
In the absence of any other quantitative or qualitative factors, S concludes that the discounted prices on the optional purchases reflect the stand-alone selling price for those parts and the contract does not include a material right.
Case – Custom product with learning curve effect: Material right
Modifying the above case, the decreases in the price per part are incremental to the expected reduction in Automotive Supplier S’s costs along its learning curve. The price reductions are also incremental to S’s typical decrease in price for other mature parts of a similar size and complexity.
Considering these quantitative and qualitative factors, S concludes that the discounted prices on the optional purchases do not reflect the stand-alone selling price for those parts and the contract includes a material right.
Case – Custom production line: No material right
Shipbuilder B enters into a contract with Customer C to manufacture a highly customised ship. To manufacture this custom ship, B needs to set up a unique production line, which it plans to run for one year. C commits to purchasing five ships at a price of 1,000 per ship. C has the option to purchase additional ships at a price of 500 per ship as long as the order is placed three months before the end of the one-year period during which the production line will be in place.
B estimates the stand-alone selling price of the ship using an expected cost plus a margin approach. The decrease in the price per ship after the first five ships reflects the expected reduction in B’s costs once the production line is configured.
The pricing of the committed volume of ships reflects B’s expected margin, including the costs to set up the custom production line. Once the production line is set up, B’s costs are limited to the incremental costs for that specific ship. Therefore, the stand-alone selling price estimated using the expected cost plus a margin approach is lower.
Additionally, B considers that the right does not accumulate because there is a committed volume of ships and any optional orders have the same discounted price. Therefore, in the absence of any other quantitative or qualitative factors B concludes that the reduced price for the optional ship orders represents their stand-alone selling price and there is no material right.
Case – Prospective volume rebate: Material right
Food Company F enters into an arrangement with Customer C to supply Product A. The arrangement includes a fixed price of 1 per unit and an annual rebate. The rebate is paid only for purchases in excess of 501 units. The arrangement includes no minimum purchase quantities but F expects that C will purchase approximately 1,000 units annually.
C makes an initial purchase of 100 units. Because the rebate arrangement is prospective, F evaluates whether the sale gives rise to a material right that needs to be accounted for as a separate performance obligation.
F determines that the arrangement contains a material right. Therefore, F recognises revenue for the initial purchase net of the amount of consideration allocated to the material right liability. F recognises revenue allocated to the material right when the right is exercised in the future – i.e. C purchases in excess of 501 units.
Alternatively, if it is considered that all of the goods to be delivered are substantially the same, then under the alternative approach F may elect to recognise revenue at the average price per unit based on total expected purchases, rather than calculating the value of the material right – i.e. at 0.95 per unit (500 × 1 + 500 × (1 – 0.10)) / 1,000.
Case – Prospective discounts: No material right vs material right
Scenario 1 – Prospective discounts do not provide a material right
Automotive Supplier X produces standard, non-customised parts that are used by various carmakers. X enters into a two-year framework agreement with Carmaker M, a new customer, to manufacture parts for 200 per part. Each part is a distinct good that is transferred at a point in time.
M is committed to purchasing a minimum quantity of 500 parts per year. If M purchases more than 1,000 parts, then the price of future purchase orders is decreased prospectively to 150 per part.
X prices parts of a similar size and complexity consistently, based on expected annual sales volumes to a specific carmaker:
X notes that other carmakers could order similar volumes of parts of similar size and complexity for a price of 150 without a similar prospective price reduction. Therefore, in the absence of any other quantitative or qualitative factors indicating otherwise, X concludes that the pricing on future purchases does not provide M with a material right.
Scenario 2 – Prospective discounts provide a material right
Modifying Scenario 1, X provides the same prospective price reductions to all carmakers similar to M – i.e. no carmaker can buy parts for 150 per part before buying more than 1,000 parts.
In evaluating whether the price reduction provides M with a material right, X notes that:
Therefore, in the absence of any other quantitative or qualitative factors indicating otherwise, X concludes that the prospective price reduction conveys a material right to M.
M places an order for 500 parts in the first year. X expects that M will purchase 1,200 parts in total – i.e. it will receive a discount on 200 parts. This is based on X’s historical experience with framework agreements with similar payment mechanisms.
X concludes that M has, in substance, paid for 50% of the right for future discounted parts because M purchased 500 of the 1,000 parts required for it to be entitled to a price reduction.
X allocates the transaction price between the parts ordered and the material right for a future discount on a relative selling price basis as follows.
Case – Periodic price decreases in a framework agreement: No material right
Automotive Supplier Y enters into a three-year framework agreement with Carmaker T to supply highly complex parts. Each part is a distinct good that is transferred at a point in time.
Under the framework agreement, T is not obliged to purchase a minimum quantity of parts. The price per part set out in the framework agreement declines each year as follows, independently of the quantity of parts purchased.
This declining unit price reflects the expected reduction in Y’s learning curve costs.
Shortly after the framework agreement is signed, T orders 50 parts. Y notes that:
When T submits subsequent purchase orders, Y assess whether they should be combined with the first one (see Step 1 Identify the contract with a customer) and whether the contract modification guidance should be applied (see Contract modifications).
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