Options to purchase additional goods or services – 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.
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. Options to purchase additional goods or services
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 entity. The fee in this case is variable consideration. Options to purchase additional goods or services
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 entity should evaluate, however, whether the customer option provides a material right. Options to purchase additional goods or services
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, 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. Options to purchase additional goods or services
Note that if the option allows the customer to purchase goods or services at a price that reflects the standalone selling price, then no material right exists even if the future purchase can only be made after entering into a previous contract. Options to purchase additional goods or services
If the option does provide a material right, then the customer is essentially paying for the future goods or services in advance, and the revenue related to the material right should not be recognized until the future goods or services have been transferred or the option expires. The vendor must allocate the transaction price among the goods and services delivered now and the future performance obligation based on each unit’s relative standalone selling price. Oftentimes there is no observable selling price for the option so management will need to estimate it. The estimate is then adjusted for the average discount offered to customers for other reasons and the likelihood that the option will be exercised. Options to purchase additional goods or services
Vendor A sells Product X to Customer C for $1,000 and gives the customer a 40% discount voucher to be used on a future purchase within the next thirty days. The vendor plans on offering a 15% discount on all transactions in the next thirty days as part of a promotional event. The 40% discount voucher cannot be combined with the 15% promotional offer.
When evaluating for material rights, the Vendor only considers the discount that is incremental to any promotional discounts offered, which in this case is 25% (40% discount voucher less the 15% promotional event). Vendor A estimates that 80% of customers that receive the discount voucher will actually make additional purchases, and on average, each customer will purchase $1,000 of additional products.
The standalone value of the discount voucher is therefore $200 ($1,000 additional products * 25% incremental discount * 80% probability the voucher is used). This calculation results in the following allocation of the original $1,000 transaction fee:
Vendor A will recognize $833 from the original transaction when ownership of Product X transfers to the customer. If Customer C does not use the voucher, the remaining $167 is recognized when the voucher expires, see the Accounting For The Exercise Of A Material Right.
Accounting For The Exercise Of A Material Right
View A. The exercise of a material right should be accounted for as a continuation of the current contract because the current contract anticipates the additional goods or services to be provided as part of the exercise of the material right. That is, at the time of the exercise, an entity should update the transaction price of the current contract to include the additional consideration expected to be received.
The additional consideration should be allocated to the performance obligation underlying the material right, and revenue should be recognized as that performance obligation is fulfilled.
Using the example above, Customer C purchases Product Z 15 days later. The price of Product Z is normally $1,000, but is sold to any customer for only $850 due to the store-wide discount. Customer C uses the voucher from the previous purchase, and buys Product Z for only $600.
Under view A, the transaction price would be increased to $1,600, and the additional $600 would be allocated to the existing performance obligation (2) for a total allocated transaction price of $767 ($167 original allocation + $600 increase). This revenue of $767 is recognized when Vendor A transfers Product Z to Customer C.
View B. The exercise of a material right should be accounted for as a contract modification because the additional consideration received and the additional goods and services provided represent a change in the scope and/or price of the contract. The guidance for accounting for contract modifications is found in Contract Modifications Part II – Contract Modifications.
Using the example above, the contract is deemed to be modified when Customer C purchases Product Z using the voucher. If Vendor A finds that the prospective method should be used, then the new contract would include the $833 previously recognized for Product X and $600 + $167 = $767 for Product Z. This treatment is the same as View A.
If the cumulative catch-up method is used, then the new $1,600 contract includes two performance obligations: Product X, with an SSP of $1,000; and Product Z, with an SSP of $850. The new total transaction price of $1,600 is allocated pro-rata to the two performance obligations: $865 (54% of the transaction price) to Product X and $735 to Product Z. The adjustment to Product X revenue of $32 ($865- $833) should be recognized immediately when the new contract is formed, and the remaining $735 is recognized when Vendor A delivers Product Z to Customer A.
View C. The exercise of the material right should be accounted for as a variable consideration.
The TRG concluded that View C was not supported by the revenue standard, but Views A and B are supported and should be applied according to the facts and circumstances of the transaction. Most TRG members leaned toward View A, though in most cases the financial reporting impact of View A and View B will be very similar, as seen in the examples above. Whichever view is applied, that accounting treatment should be consistently applied across all similar transactions.
Options to purchase additional goods or services
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