11.7 Customer’s Exercise of a Material Right
When a contract with a customer includes a material right in the
form of an option to acquire additional goods or services, an entity may account for
the customer’s subsequent exercise of the material right either as if it were a
separate contract (“Alternative A,” which we generally believe is preferable) or as
if it were the modification of an existing contract (“Alternative B,” which we
believe is acceptable). Those alternatives may be summarized as follows:
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Alternative A (preferred) — At the time a customer exercises a material right, an entity treats the exercise as a continuation of the original contract such that the additional consideration is allocated only to the additional performance obligation underlying the material right. In effect, therefore, the entity is treating the exercise as if it were a separate contract altogether. Under this alternative, an entity should determine the transaction price of the “new” contract and include any additional consideration to which the entity expects to be entitled as a result of the exercise. This additional consideration, along with the consideration from the original contract that was allocated to the material right, should be allocated to the performance obligation underlying the material right and recognized as revenue when or as this performance obligation is satisfied. That is, the amount allocated to the material right as part of the original contract is added to any additional amounts due (under the “new” contract) as a consequence of the customer’s exercise of the material right, and that total is allocated to the additional goods or services under the “new” contract. The amounts previously allocated to the other goods and services in the original contract are not revised.
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Alternative B (acceptable) — It is also acceptable to account for the exercise of a material right as a contract modification since it results in a change in the scope and the price of the original contract. An entity should apply the modification guidance in ASC 606-10-25-10 through 25-13.Since we believe that the application of Alternative B may be complex, we recommend that entities consider consulting with their accounting advisers before electing to use this method.
The TRG discussed questions raised by stakeholders about the accounting for a
customer’s exercise of a material right. TRG members generally preferred the view
that an entity would account for the exercise of a material right as a change in the
contract’s transaction price4 such that the additional consideration would be allocated to the performance
obligation underlying the material right and would be recognized when or as the
performance obligation underlying the material right is satisfied. This, in effect,
results in accounting for the exercise of a material right as a separate contract.
However, the TRG also believed that it would be acceptable for an entity to account
for the exercise of a material right as a contract modification5 (which may require reallocation of consideration between existing and future
performance obligations). Contract modifications are discussed in Chapter 9.
The method used should be applied consistently by an entity to
similar types of material rights and under similar facts and circumstances.
The above issue is addressed in Implementation Q&A 15 (compiled from previously issued
TRG Agenda Papers 18, 25, 32, and 34). For additional information and Deloitte’s summary of
issues discussed in the Implementation Q&As, see Appendix C.
Example 11-4
An entity enters into a contract with a
customer to provide Product X for $200 and Service Y for
$100. The contract also includes an option for the customer
to purchase Service Z for $300. The stand-alone selling
prices (SSPs) of Product X, Service Y, and Service Z are
$200, $100, and $450, respectively. The entity concludes
that the option to purchase Service Z at a discount provides
the customer with a material right. The entity’s estimate of
the stand-alone selling price of the material right is
$100.
The entity allocates the $300 transaction
price ($200 for Product X plus $100 for Service Y) to each
performance obligation under the contract as follows:
Subsequently, when the entity has delivered
Product X and has delivered 60 percent of Service Y, the
customer exercises its option to purchase Service Z for
$300.
Alternative A
(Preferred)
The entity updates the transaction price to
reflect the additional consideration receivable from the
customer. The additional $300 payable after the exercise of
the option is added to the amount of $75 that was previously
allocated to the option to purchase Service Z, resulting in
a total of $375. The amount of $375 is recognized as revenue
over the period during which Service Z is transferred.
No change is made to the amount of revenue
allocated to Product X and Service Y. The revenue not yet
recognized with respect to Service Y (40% × $75 = $30) is
recognized as revenue over the remaining period during which
Service Y is transferred to the customer.
Alternative B
(Acceptable)
The entity accounts for the customer’s
exercise of its option to purchase Service Z as a contract
modification. The appropriate accounting will be different
depending on whether the remaining services to be provided
after the modification (i.e., Service Z and the rest of
Service Y) are distinct from those transferred to the
customer before the modification.
Accounting if the
Remaining Services Are Distinct
If the entity determines that the remaining
services to be provided after the modification are distinct
from those transferred to the customer before the
modification, the guidance in ASC 606-10-25-13(a) should be
applied. The revenue already recognized with respect to
Product X ($150) and 60 percent of Service Y ($75 × 60% =
$45) is not adjusted.
After the modification, the revenue not yet
recognized is determined as follows:
The revenue not yet recognized is then
allocated to the remaining performance obligations as
follows:
Therefore, $33 is recognized as the
remaining 40 percent of Service Y is delivered, and $372 is
recognized as Service Z is delivered.
Accounting if the
Remaining Services Are Not Distinct
If the entity determines that the remaining
goods or services are not distinct, the guidance in ASC
606-10-25-13(b) should be applied and a cumulative catch-up
adjustment to revenue for performance obligations satisfied
over time should be recognized on the date of the
modification (no adjustment is made for fully satisfied
performance obligations). The updated transaction price is
allocated between the two performance obligations that are
satisfied over time as if the modification had been in place
at the start of the contract.
The cumulative catch-up adjustment is
recorded because the remaining 40 percent of Service Y is
not distinct from the previously delivered 60 percent of
Service Y (Service Y is distinct from Service Z) and is
determined as follows:
Therefore, the remaining $33 ($82 – $49) is
recognized as the entity performs the remaining 40 percent
of Service Y, and $368 is recognized as Service Z is
delivered.