Joint Meeting on Revenue — November 2015

In considering how to apply the guidance on optional purchases under which an entity does not identify a material right, stakeholders have questioned whether and, if so, when customer options to acquire additional goods or services would be considered (1) a separate contract that arises when the option is exercised or (2) variable consideration for which an entity would be required to estimate the amount of consideration to include in the original contract’s transaction price (subject to the standard’s constraint on variable consideration). Specifically, the following three issues have been raised:

• Issue 1: What optional purchases are, and why optional purchases are different from variable consideration — To address this issue, the FASB and IASB staffs analyzed examples related to IT outsourcing, transaction processing, and supply agreements. The staffs prefaced their views by stating that an entity will need to use judgment to determine whether a contract contains an option to purchase additional goods or services or variable consideration. In addition,the staffs noted that a critical first step would be for an entity to identify (1) the nature of its promises and (2) the rights or obligations of each party to the contract.
  Further, the staffs noted differences between optional goods or services and variable consideration. As indicated in TRG Agenda Paper 48, they observed:
  • A contract providing for optional goods or services (1) gives the customer of an entity a present right to choose the amount of additional goods or services that can be purchased (i.e., a choice constituting a purchasing decision separate from the current contract) but (2) does not impose on the entity a present obligation to deliver those goods or services.
  • Conversely, under a contract providing for variable consideration, the entity (1) has a present obligation to transfer goods or services to the customer but (2) is not obligated by the customer’s actions “to provide additional distinct goods or services (or change the goods or services to be transferred).”
• Issue 2: Assessing the effects of termination rights and penalties when only the customerhas the right to terminate the contract6 — The staffs discussed this issue within the context of two examples: (1) a four-year service contract giving the customer the right to cancel at the end of each year (“Contract 1”) and (2) a contract giving the customer an option to purchase parts along with equipment (“Contract 2”). The staffs analyzed the termination penalties in Contract 1 (an additional payment that decreases annually throughout the contract term) and Contract 2 (repayment of all or part of an up-front discount on the equipment) and concluded that the penalties in each contract were substantive.
  Accordingly, the staffs viewed the penalties as evidence of enforceable rights and obligations. On the basis of this evidence, they concluded that (1) the duration of Contract 1 was four years and (2) some of the transaction price in Contract 2 should be allocated to the parts because the contract’s penalty effectively created a minimum purchase obligation for the customer. That is, the staffs believed that the substantive penalties in each contract constituted evidence of enforceable rights and obligations regardless of whether both parties or only the customer had the ability to cancel the contract. Further, the staffs rejected an alternative view that the termination penalties represent options that create material rights.
• Issue 3: When optional purchases would be considered separate performance obligations —As indicated in TRG Agenda Paper 48, the staffs noted two views (Views A and B). Proponents of View A maintain that options for goods or services, like other contractual rights and obligations, must be legally enforceable (i.e., enforceable as “a matter of law,” as discussed in ASC 606-10-25-2 (paragraph 10 of IFRS 15)). Proponents of View B believe that “[j]udgment is required to determine if the legal options represent in substance promised goods or services in the contract.” Under View B, an entity would consider economic compulsion, exclusivity of the arrangement (i.e., whether the customer can obtain the goods or services from other suppliers), and other circumstances when assessing whether optional purchases should be reflected in the transaction price of the current contract.
  The staffs believed that View A is consistent with the new revenue standard given that the standard does not require an entity to estimate the transaction price of future contracts that it will enter into with its customers (unless there are legal enforceable rights or options for future goods and services that are material rights).

See TRG Agenda Paper 48 for additional information.

Summary: TRG members discussed the issue of whether and, if so, when an entity would be required to estimate future purchases in a current contract with a customer. They reiterated the staffs’ view that the new revenue standard does not require an entity to estimate the transaction price of future contracts into which it will enter with a customer. In addition, they generally agreed with the framework outlined in TRG Agenda Paper 48, under which an entity would perform an evaluation of the nature of its promises in a contract with a customer, including a careful evaluation of the enforceable rights and obligations in the present contract (not future contracts). That is, there is a distinction between (1) customer options and (2) uncertainty that is accounted for as variable consideration. Customer options are predicated on a separate customer action (namely, the customer’s decision to exercise the option), which would not be embodied in the present contract; unless an option is a material right, such options would not factor into the accounting for the present contract. Uncertainty is accounted for as variable consideration when the entity has enforceable rights and obligations under a present contract to provide goods or services without an additional customer decision. The TRG also generally agreed with the staffs’ view on Issue 3 that enforceable rights and obligations in a contract are only those for which the entity has legal rights and obligations under the contract and would not take economic or other penalties into account (e.g., (1) economic compulsion or (2) exclusivity because the entity is the sole provider of the goods or services, which may make the future deliverables highly probable of occurring).

Further, the TRG generally agreed with the staffs’ view on Issue 2 that a substantive termination penalty would provide evidence of enforceable rights and obligations throughout the contract term (e.g., define the duration of the contract).7 However, there was substantial debate about what would constitute a substantive penalty, especially because some TRG members could not conclude that the penalties described in the staffs’ examples were substantive. Rather than trying to define “substantive,” the TRG agreed that an entity would need to use significant judgment when construing the term. Accordingly, TRG members suggested that an entity’s judgment could be informed by data such as how frequently a customer opts to incur a penalty. For example, a high incidence of customers who choose to pay a penalty to cancel a contract would most likely indicate that the penalty is not substantive.

In addition, there was discussion that compared the thresholds for identifying a material right and a substantive penalty. Some TRG and board members observed that in general, the threshold for identifying a substantive penalty should be higher than the threshold for identifying a material right.

However, stakeholders in various industries have raised questions about how an entity should apply the new cost guidance when assessing preproduction activities, including questions related to the scope of the guidance (i.e., the costs to which such guidance would apply). In particular, stakeholders have asked the following:

• Question 1: How should an entity assess whether preproduction activities are a promised good or service? — Some stakeholders have questioned whether certain preproduction activities represent promised goods or services in a contract with a customer because such a determination could affect the timing of revenue recognition. In a manner consistent with the requirements of the new revenue standard and prior TRG meeting discussions,9 the FASB and IASB staffs stated that an entity should first evaluate the nature of its promise to the customer and, in doing so, consider whether a preproduction activity is a promised good or service or a fulfillment activity. While acknowledging that it may be difficult to determine whether a preproduction activity is a promised good or service, the staffs noted that an entity should assess whether the preproduction activity transfers control of a good or service to the customer. Further, the staffs suggested that the criteria for determining whether an entity transfers control of a good or service over time10 may be helpful in this assessment. For example, if an entity determines that a preproduction activity transfers control of a good or service to a customer over time, it should include the preproduction activity in its measure of progress toward complete satisfaction of its performance obligation(s).
• Question 2: How should an entity reporting under U.S. GAAP account for preproduction costs currently accounted for in accordance with guidance in ASC 340-10? — Some stakeholders reporting under U.S. GAAP engage in long-term supply arrangements and have expressed concerns that the cost guidance in ASU 2014-09 changes the assessment of whether preproduction costs currently accounted for under ASC 340-10 should be capitalized or expensed. The FASB staff noted that the analysis for determining whether to capitalize or expense costs incurred for preproduction activities is separate from the assessment of whether preproduction activities represent promised goods or services in a contract (i.e., separate from the analysis discussed in Question 1 above). Accordingly, since the new revenue standard does not amend the guidance in ASC 340-10, the FASB staff thinks that entities that currently account for preproduction costs in accordance with ASC 340-10 should continue to do so after the new revenue standard becomes effective.
• Question 3: Are preproduction costs for contracts previously within the scope of ASC 605-35 considered to be within the scope of ASC 340-10 or ASC 340-40? — Some stakeholders reporting under U.S. GAAP have questioned the accounting for preproduction costs incurred to deliver contracts currently accounted for under ASC 605-35 rather than ASC 340-10. The FASB staff noted that after the new revenue standard becomes effective, preproduction activities related to contracts currently within the scope of ASC 605-35 should be accounted for in accordance with ASC 340-40 because (1) the new revenue standard will supersede ASC 605-35 (and its related cost guidance) and (2) ASC 340-10 does not currently provide guidance on costs related to such contracts.

See TRG Agenda Paper 46 for additional information.

Summary: For each issue discussed, TRG members generally agreed with the staffs’ analyses and acknowledged that in certain situations, it will be challenging for an entity to determine whether a preproduction activity transfers control of a good or service to the customer. As a result, an entity will need to use judgment to make those determinations, and some diversity in practice may result. In addition, TRG members in the United States noted that implementation questions related to whether and, if so, how to apply ASC 340-10 may be resolved if that guidance is either (1) deleted or (2) clarified to enable entities to understand how to apply it in a manner consistent with the control principle in the new revenue standard.

See TRG Agenda Paper 45 for additional information.

Summary: Because inconsistencies have been identified in both the guidance of the new revenue standard and the boards’ proposed amendments to the standard, TRG members noted that some stakeholders have questioned when characteristics of a license should be treated as a right that would define whether a license is distinct (i.e., a separate license) from an attribute of a single license.

TRG members generally agreed with the staffs’ view that the evaluation of whether an entity has provided a single license of IP or multiple licenses to a customer (either in a single contract or through contract modifications) would depend on whether it has granted the customer additional rights (i.e., new or expanded rights). However, the TRG generally did not support — or could not understand — the basis for why the time-based restriction in Issue 1 would be treated differently from the geographical or product restriction in Issue 2. That is, many TRG members viewed the extension of time (i.e., through the contract renewal) as granting a customer an additional right rather than the continued use of the same rights under a license that the entity already delivered to the customer and from which the customer is currently benefiting.

One TRG member noted that one reason why time may be viewed differently is the new revenue standard’s requirement to assess whether a license grants the customer a right to use or a right to access the underlying IP. In effect, time is considered in the initial assessment, and once an entity concludes that the license is a right-to-use (i.e., point-in-time) license, time would not be considered subsequently (i.e., it would be an attribute rather than a right that defines the contract subsequently).

In addition, the SEC observer expressed concern that the staffs’ view regarding the time restriction in Issue 1 would lead to an inconsistent outcome for a similar contract with different counterparties. That is, under the staffs’ view in Issue 1, the entity would recognize revenue on the date the contract is renewed with a current customer (i.e., June 30, 20X3). However, had the entity entered into a contract with the same terms as the renewed contract but with a new customer, it would have been precluded from recognizing revenue until the new contract became effective (i.e., January 1, 20X4).

TRG members generally agreed with the staffs’ view on Issue 3 that the modification of a license arrangement should be treated no differently from the modification of a contract for goods or services. Therefore, an entity should follow the contract modification guidance in the new revenue standard. On Issue 4, there were mixed views about whether additional copies of software would be accounted for as a customer option or as a usage-based royalty; however, in a manner consistent with that of the staffs, the TRG rejected View C.

Because there was no general agreement among TRG members on multiple issues related to this topic, the TRG asked for additional clarifications.

The FASB staff noted its belief that the FASB did not intend to change how entities reporting under U.S. GAAP would account for fixed-odds wagers upon adoption of the new revenue standard. That is, the FASB staff believes that the Board intends for entities reporting under U.S. GAAP to continue accounting for fixed-odds wagering contracts as revenue transactions. On the other hand, the FASB staff further indicated in TRG Agenda Paper 47 that “if fixed odds wagering contracts were excluded from the scope of the new revenue standard, then those arrangements likely would be accounted for as derivatives.”16

See TRG Agenda Paper 47 for additional information.

Summary: Many TRG members in the United States did not object to the FASB staff’s view that entities should continue to account for fixed-odds wagering contracts as revenue transactions after the new revenue standard becomes effective. However, TRG members expressed concern that the current wording in the new revenue standard does not support the staff’s view. Accordingly, TRG members recommended that the Board either (1) clarify its intent through a technical correction to include such contracts within the scope of ASC 606 (by excluding them from the scope of ASC 815) or (2) evaluate further whether its objective was to require entities to account for these contracts under ASC 815. In addition, some TRG members questioned whether fixed-odds wagering contracts meet the definition of a derivative under ASC 815 (and therefore should be accounted for under ASC 815). TRG members urged the Board to publicly expose this topic and perform outreach with affected entities if the FASB pursues the path of deliberating whether fixed-odds wagering contracts are derivatives.