Chapter 11 — Customer Options for Additional Goods or Services (Material Rights)

11.9 Renewal Options

Paragraph BC391 of ASU 2014-09 explains that contracts could describe renewal options as either (1) renewal options, which are basically extensions of the current contract, or (2) early cancellations, which are the option for a customer to end a long contract earlier than planned. A customer option to renew could be considered an option for additional goods or services, which then opens the door for the entity to consider whether the option is a material right (i.e., a performance obligation).

When options for additional goods or services are considered material rights, an entity is required to estimate the options’ stand-alone selling price so that consideration from the contract can be allocated to the options. Since renewal options are similar to options for additional goods or services, an entity would have to determine an estimate of the options’ stand-alone selling price for each renewal period, which may be complex.

However, as explained in paragraphs BC392 through BC395 of ASU 2014-09, the FASB and IASB decided to provide a practical alternative for renewal options that allows an entity to “include the optional goods or services that it expects to provide (and corresponding expected customer consideration) in the initial measurement of the transaction price.” This practical alternative is included in ASC 606-10-55-45, which states:

If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Typically, those types of options are for contract renewals.

To differentiate contract renewal options from other types of options for additional goods or services (the latter of which are not eligible for the practical alternative if the optional goods or services are not similar to the original goods or services in the contract), the boards developed two criteria that must be met for an entity to apply the practical alternative:

The additional goods or services in the renewal options are similar to those provided in the initial contract.
The renewal options’ terms and conditions related to goods or services are the same as those of the original contract.

These concepts are illustrated by Example 51 in ASC 606.

ASC 606-10

Example 51 — Option That Provides the Customer With a Material Right (Renewal Option)

55-343 An entity enters into 100 separate contracts with customers to provide 1 year of maintenance services for $1,000 per contract. The terms of the contracts specify that at the end of the year, each customer has the option to renew the maintenance contract for a second year by paying an additional $1,000. Customers who renew for a second year also are granted the option to renew for a third year for $1,000. The entity charges significantly higher prices for maintenance services to customers that do not sign up for the maintenance services initially (that is, when the products are new). That is, the entity charges $3,000 in Year 2 and $5,000 in Year 3 for annual maintenance services if a customer does not initially purchase the service or allows the service to lapse.

55-344 The entity concludes that the renewal option provides a material right to the customer that it would not receive without entering into the contract because the price for maintenance services are significantly higher if the customer elects to purchase the services only in Year 2 or 3. Part of each customer’s payment of $1,000 in the first year is, in effect, a nonrefundable prepayment of the services to be provided in a subsequent year. Consequently, the entity concludes that the promise to provide the option is a performance obligation.

55-345 The renewal option is for a continuation of maintenance services, and those services are provided in accordance with the terms of the existing contract. Instead of determining the standalone selling prices for the renewal options directly, the entity allocates the transaction price by determining the consideration that it expects to receive in exchange for all the services that it expects to provide in accordance with paragraph 606-10-55-45.

55-346 The entity expects 90 customers to renew at the end of Year 1 (90 percent of contracts sold) and 81 customers to renew at the end of Year 2 (90 percent of the 90 customers that renewed at the end of Year 1 will also renew at the end of Year 2, that is 81 percent of contracts sold).

55-347 At contract inception, the entity determines the expected consideration for each contract is $2,710 [$1,000 + (90 percent × $1,000) + (81 percent × $1,000)]. The entity also determines that recognizing revenue on the basis of costs incurred relative to the total expected costs depicts the transfer of services to the customer. Estimated costs for a three-year contract are as follows:

55-348 Accordingly, the pattern of revenue recognition expected at contract inception for each contract is as follows:

55-349 Consequently, at contract inception, the entity allocates to the option to renew at the end of Year 1 $22,000 of the consideration received to date [cash of $100,000 – revenue to be recognized in Year 1 of $78,000 ($780 × 100)].

55-350 Assuming there is no change in the entity’s expectations and the 90 customers renew as expected, at the end of the first year, the entity has collected cash of $190,000 [(100 × $1,000) + (90 × $1,000)], has recognized revenue of $78,000 ($780 × 100), and has recognized a contract liability of $112,000.

55-351 Consequently, upon renewal at the end of the first year, the entity allocates $24,300 to the option to renew at the end of Year 2 [cumulative cash of $190,000 – cumulative revenue recognized in Year 1 and to be recognized in Year 2 of $165,700 ($78,000 + $877 × 100)].

55-352 If the actual number of contract renewals was different than what the entity expected, the entity would update the transaction price and the revenue recognized accordingly.

The example below further illustrates how to allocate consideration to renewal options that provide material rights to a customer.

Example 11-7

ABC Company enters into 100 separate contracts with customers to provide a perpetual software license for $10,000 and one year of PCS for $1,000. The contracts include a customer option to renew PCS for an additional year for $500. ABC Company concluded that the renewal option represents a material right and the license and PCS are distinct performance obligations. ABC Company also determined that both the perpetual license and PCS were sold at stand-alone selling prices and estimated that the customer has a 75 percent probability of renewing at the end of year 1, 50 percent at the end of year 2, 25 percent at the end of year 3, and 0 percent at the end of year 4.

Stand-Alone Selling Price Approach

Year 1 renewal = $375, or ($1,000 − $500) × 75%

Year 2 renewal = $250, or ($1,000 − $500) × 50%

Year 3 renewal = $125, or ($1,000 − $500) × 25%

As a result of applying the stand-alone selling price approach, ABC Company would allocate $702 ($351 + $234 + $117) to the material right. In addition, ABC Company would recognize $10,298 ($9,362 + $936) in year 1.

“Look Through” Approach

If ABC Company chose to apply the practical alternative or “look through” approach,6 the company would estimate a hypothetical transaction price in one of two ways. The first approach is to determine the best estimate of the number of years that a customer would renew. Assume in this case that the company’s best estimate is that the customer will exercise the renewal option for two years.

This would result in recognition of $10,154 in revenue in year 1 ($9,231 + $923) and a deferral of $846 ($11,000 − $10,154) related to the material right.

However, in a manner consistent with Example 51 in ASC 606,7 an entity could also use a portfolio approach to estimate the hypothetical transaction price in the “look through” model. Under this approach, the entity would use the same probabilities applied in the stand-alone selling price model to determine the hypothetical transaction price. The following table illustrates this approach:

This would result in recognition of $9,233 in revenue in year 1 ($8,394 + $839) and a deferral of $1,767 ($11,000 − $9,233) related to the material right.

Note, however, that when a portfolio approach is applied, individual cancellations would not necessarily result in an immediate adjustment. This is because the overall estimates would incorporate a level of cancellations each period. It is only when the cancellation pattern of the overall portfolio changes that an entity would assess a potential change in estimate.

Connecting the Dots

Television studios often enter into contracts with broadcasters for the broadcast of the first season of a new television show, with an exclusive pickup option for the broadcaster to license any subsequent seasons of the show for a fixed fee per season. After contract inception, the value of this option may change depending on the success of the first season.

In accordance with ASC 606-10-55-42, a material right exists if the fixed fee for the option reflects a discount that would not have been offered if the broadcaster had not purchased the license for the first season. Conversely, in accordance with ASC 606-10-55-43, a material right does not exist if the fixed fee for the option represents the option’s stand-alone selling price at contract inception.

In the circumstances described, it may be difficult to estimate the stand-alone selling price of the option (because options of this type are not typically sold separately and their value is affected by the likelihood of success of the initial season, which may be unknown at contract inception). Consequently, entities will need to use judgment in making this evaluation. Although the value of such an option may subsequently increase if a show is successful, whether there is a material right should be assessed only by reference to the value of that option at contract inception.

Footnotes

ABC Company is eligible to apply the practical alternative since the optional purchase is for additional goods or services that are similar to the original goods or services in the contract. Specifically, the PCS subject to the renewal option is the same PCS included in the original contract.

ASC 606-10-55-343 through 55-352.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.