11.2 Determining Whether an Option for Additional Goods or Services Represents a Material Right

If an entity applied the residual approach to establish the stand-alone selling price of goods or services because the stand-alone selling price of those goods or services is highly variable or uncertain, the entity is required to assess whether an option (e.g., a renewal option) to acquire more of those goods or services conveys a material right to the customer. Under ASC 606-10-55-41 through 55-45, a customer option to purchase additional goods or services gives rise to a material right if the option provides the entity’s customer with a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer (e.g., a customer in a particular geographic area or market). It would not be appropriate for the entity to conclude that no material right was conveyed to the customer simply because the stand-alone selling price of the goods or services that are subject to the option is highly variable or uncertain and the residual approach was therefore applied.

When the residual approach is used to determine the stand-alone selling price of a good or service because pricing is highly variable or uncertain, assessing whether option pricing for that good or service provides a material right may require significant judgment because of the lack of a point estimate or sufficiently consistent range representing the stand-alone selling price. While we believe that entities are likely to identify fewer material rights in such cases, they are nonetheless required to base their determination of whether a material right was provided on all reasonably available information. Although the presence of highly variable or uncertain pricing complicates the identification of material rights, we believe that when doing so, an entity should consider (1) the definition of a material right2 and (2) the allocation objective in ASC 606-10-32-28. In other words, an entity must determine whether the pricing of the optional good or service (1) indicates that preferential pricing would not have been received “but for” the initial contract or (2) reflects the amount to which the entity expects to be entitled in exchange for transferring that good or service to the customer. If the pricing does not meet the allocation objective (i.e., it is a discount that is incremental to what other similar customers would receive), a material right should be identified. We believe that an entity might find the following factors useful in determining whether a material right is present when the pricing of optional future purchases is highly variable or uncertain:

• How the pricing of the optional future purchase aligns with current pricing policies and practices — For example, if a good or service is not typically sold below a certain amount because it is a premium offering, an option to buy the good or service at an amount below that floor would be at odds with standard pricing practices and may therefore convey a material right to the customer.
• How the pricing of the optional future purchase compares to historical amounts allocated to the good or service in similar situations — Such a comparison is likely to require an entity to look to historical data and stand-alone selling prices that were derived by using the residual approach. Accordingly, while there will not be an established point estimate or narrow range of stand-alone selling prices against which to compare the pricing of the optional future purchase, ASC 606-10-32-34(c) indicates that the residual approach is a method of establishing a stand-alone selling price. Therefore, the amounts determined under that approach represent the stand-alone selling price for that good or service. Consequently, we believe that in assessing whether a customer has been given a material right, an entity may obtain useful information by comparing the pricing of an optional future purchase with historical stand-alone selling prices that were determined as a result of applying the residual approach. In addition, to determine which range of historical stand-alone selling prices to compare with the pricing of the optional future purchase, entities should consider only those transactions that are similar to the transaction in question. For example, an entity might disaggregate historical stand-alone selling price data by one or more of the following characteristics: class of customer, geography, distribution channel, or contract value.
• How the pricing of the optional future purchase compares to historical contractually stated pricing (if any) of the good or service in similar situations — While the contractually stated pricing may not necessarily represent the stand-alone selling price (see ASC 606-10-32-32), the historical price across a range of different contracts may nevertheless be relevant evidence of an entity’s pricing practices and discounts it may offer on future purchases.
• Whether the pricing of the optional future purchase is intended to incorporate a discount — If the intent during negotiations was to give the customer a discount on future purchases, a material right may exist since the allocation objective is less likely to be met in such cases. For example, a customer may only have agreed to enter into an initial contract if the vendor offered discounted pricing on future purchases.
• Whether the pricing of the optional future purchase is discounted relative to (1) the price of similar goods or services sold under the initial contract or (2) the list price when compared with the discounted list prices of all goods or services (whether similar or not) sold under the initial contract — We acknowledge that this factor conflicts with the FASB’s reasons for departing from its definition of a significant incremental discount in legacy GAAP under ASC 985-605. In paragraph BC387 of ASU 2014-09, the Board indicates its rationale for defining “incremental” solely by reference to other comparable transactions:

  [T]he Boards observed that even if the offered discount is not incremental to other discounts in the contract, it nonetheless could, in some cases, give rise to a material right to the customer. Consequently, the Boards decided not to carry forward that part of the previous revenue recognition guidance from U.S. GAAP into Topic 606.
  However, we believe that when evaluated in conjunction with all other available evidence, a comparison of the pricing of the optional future purchase with any discounts offered in the initial contract may provide insight into an entity’s pricing practices and discounting intentions. Pricing of the optional future purchase at an amount that is lower than the price under the original contract may indicate the presence of a material right. Conversely, pricing of the optional future purchase at an amount that is lower than the list price but is nevertheless consistent with the discounted price charged under the original contract may be evidence to support a conclusion that the discounted price represents the stand-alone selling price.
• How the pricing of the optional future purchase aligns with any intended future pricing for similar goods or services — For example, an option to buy add-on software at a set price may not give the customer a material right if that price approximates the amount at which management intends to sell that software on a stand-alone basis in the near future.
• The relative negotiating power of the entity and the customer — In certain situations, customers may have a greater ability to demand discounted pricing on optional future purchases if the customers represent significantly larger, well-known brands that are dominant in their markets, are more mature, or are otherwise better positioned than the entity selling the goods or services.

The above factors are not intended to be all-inclusive or prescriptive, and each factor on its own may not be determinative. Entities may need to use significant judgment when determining whether a material right has been granted. Entities with highly variable or uncertain pricing should establish a policy for evaluating material rights and apply that policy consistently in similar situations.

The examples below demonstrate the application of some of the concepts described above.

Loyalty programs allow customers to accumulate points upon each purchase of goods or services; the points accumulated may then be redeemed to obtain future goods or services from the same vendor. That is, the customer is granted an option to purchase additional goods or services by redeeming the points. Accordingly, ASC 606-10-25-18(j) requires the option to be recognized as a distinct performance obligation when the option provides the customer with a material right as defined in ASC 606-10-55-41 through 55-45.

We believe that the existence of an accumulation feature in a loyalty program is a strong indicator of a material right, to which an entity would need to allocate a portion of the current contract’s transaction price. We expect it to be a rare conclusion that loyalty programs with accumulation features are not material rights.

In circumstances in which a customer’s loyalty points accumulate with each transaction, the entity should evaluate the current, past, and future transactions made by the customer in evaluating whether the loyalty program provides the customer with a material right. In addition, the entity should consider both qualitative and quantitative factors and, in particular, should consider whether the material right accumulates over time (after multiple transactions). That is, the entity should consider factors related to both the current transaction and the loyalty program in its entirety when analyzing whether an option provides a material right (and should therefore be accounted for as a distinct performance obligation in accordance with ASC 606-10-25-18(j) and ASC 606-10-55-41 through 55-45).

For example, in any given transaction, the number of loyalty points awarded may not be quantitatively material; however, the structure of the loyalty program could be designed to influence customer behavior and therefore be a qualitative indicator that the option provides a material right.

The above issue is addressed in Implementation Q&A 12 (compiled from previously issued TRG Agenda Papers 6 and 11). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

Note that the above discussion focuses on loyalty programs in which points that a customer has earned by purchasing goods or services from a vendor are redeemed for future goods or services from the same vendor. For loyalty programs in which accumulated points can be redeemed for goods or services from a third party or for goods or services from the original vendor that meet the requirement to be a separate performance obligation, the original vendor should evaluate upon redemption whether it is acting as a principal or as an agent in the transaction associated with the deferred recognition of revenue. (See Chapter 10 for additional considerations related to the assessment of whether an entity is a principal or an agent.) For example, suppose that Company X, an airline, offers one point for every $100 a customer spends. The accumulated points can be redeemed for either future flights provided by X or future hotel stays with Hotel Y, a vendor with which X has partnered. Since X has determined that its loyalty programs offer a material right that is a performance obligation, X defers a portion of revenue for the redemption of the loyalty points. Upon a customer’s redemption of points for either a flight or a hotel stay, X evaluates whether it is acting as a principal or as an agent in that transaction.

Further, any changes to an entity’s incentives (e.g., loyalty programs, rebates, method of redeeming points, amounts for which points are earned) should be evaluated under the contract modification guidance discussed in Chapter 9.

ASC 606-10-55-42 states, in part, that an “option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographic area or market).”

Stakeholder views have differed regarding how the class of customer should be considered in an entity’s evaluation of whether a customer option gives rise to a material right. Implementation Q&A 14 (compiled from previously issued TRG Agenda Papers 54 and 55) and TRG Agenda Paper 54 provide the following examples of the FASB staff’s views on this topic:

The FASB staff noted that an entity will be required to use significant judgment to determine whether a material right is provided to the entity’s customers. Further, the staff noted that it “is not in a position to reach broad conclusions about these types of fact patterns because there are many variations of contracts and variations in facts and circumstances that can affect the conclusion in each fact pattern.”3 However, the staff emphasized the following:

• The relative importance placed on the considerations discussed in the examples (or other considerations) will vary on the basis of an entity’s facts and circumstances.
• The objective of the guidance in ASC 606-10-55-42 and 55-43 is to determine whether a customer option to receive discounted goods is independent of an existing contract with a customer.

TRG members debated the application of concepts in the framework the staff used to analyze the examples in Implementation Q&A 14 and TRG Agenda Paper 54 but did not reach general agreement on (1) how or when to consider past transactions in determining the class of customer and (2) how the class of customer should be evaluated in the determination of the stand-alone selling price of an optional good or service.

A few TRG members maintained that discounts or status achieved through past transactions is akin to accumulating features in loyalty programs (and that such features therefore represent material rights). However, others indicated that these programs represent marketing inducements (i.e., discounts) for future transactions that should be evaluated in relation to those offered to other similar customers or potential customers (e.g., other high-volume customers or potential high-volume customers). The TRG members who viewed the programs as marketing inducements believed that considering a customer’s past transactions, among other factors, is appropriate in the evaluation of whether a good or service being offered to the customer reflects the stand-alone selling price for that class of customer in accordance with ASC 606-10-55-42 (particularly for entities that have limited alternative sources of information available upon which to establish a customer’s class). Further, these TRG members focused on the facts that (1) similar discounts on future transactions (like those provided in the form of benefits and other offers in status programs for no additional fees) may be given to other customers who did not make or have the same level of prior purchases with the entity and (2) such discounts may be provided at the stand-alone selling price for that class of customer (i.e., the good or service is not priced at a discount that is incremental to the range of discounts typically offered to that class of customer and therefore do not represent a material right).

Following its stakeholder outreach, the FASB staff indicated that an entity should evaluate whether tier status programs contain material rights or represent a marketing incentive. In making this evaluation, the FASB staff indicated that entities should consider whether discounts offered on future goods or services to customers within a given tier of a status program are incremental to the range of discounts typically given to that class of customer. If an entity never provides customers with tier status other than through past purchases, the discounts provided to customers under the program are likely to be material rights. However, if an entity sometimes provides tier status to customers for reasons other than past purchases, the discounts may be marketing incentives provided to a particular class of customer. The determination of whether discounts under a tier status program are material rights or marketing incentives will require judgment based on an evaluation of the specific facts and circumstances of the specific program.