Technology Highlights — Challenges Associated With Applying the New Revenue Standard — Highly Variable or Uncertain Pricing
For public entities, the new revenue standard (ASC 6061) became effective for annual reporting periods beginning after December 15, 2017.
The standard is effective for all other entities for annual reporting periods beginning
after December 15, 2018. Early adoption is permitted for annual reporting periods
beginning after December 15, 2016.
While ASC 606 will affect organizations differently depending on their
facts and circumstances, we have identified certain aspects of its application that are
especially challenging for technology companies. This Technology Alert is part of
a series intended to help technology entities better understand the
new guidance, particularly private organizations that are currently adopting the
standard’s requirements.
Executive Summary
ASC 606 generally requires entities to allocate a contract’s transaction price
among distinct performance obligations by using the relative stand-alone selling
price (SSP) of each distinct performance obligation. However, certain goods or
services can be sold for a wide range of prices, which may make it difficult to
establish the SSPs. This is especially true in the software industry, in which
incremental costs incurred to sell additional software licenses are often
minimal, thus allowing entities to sell their software at a wide range of
discount prices or even premiums. Such pricing practices present challenges when
entities attempt to determine the SSP by using traditional models that depend on
the identification of consistent pricing practices in observable historical
sales transactions. To address these challenges, the FASB established the
residual approach as a means of determining the SSP and noted that in these
types of situations, such an approach2 will often be “the most reliable way of determining the [SSP].”3
The questions and answers (Q&As) below address a number of challenges
associated with the residual approach, including (1) determining when its use is
appropriate, (2) deciding whether an entity must reassess the appropriateness of
its use in each reporting period, and (3) identifying material rights in
contracts that include highly variable or uncertain pricing for optional future
goods or services.
Interpretive Guidance
Q&A 1 Appropriateness of Using the Residual Approach
Question
When is it appropriate to use the residual approach?
Answer
Under ASC 606, an entity must maximize the use of observable inputs but
is not required to use a particular method to determine the SSP.
However, various criteria must be met for the residual approach to be
applied, including those discussed below.
Pricing Is Highly Variable or Uncertain
ASC 606-10-32-34(c) indicates that the residual approach may be used only
if the selling price of a good or service (or bundle of goods or
services) meets either of the following conditions:
-
The selling price is highly variable. This is the case when an “entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts” so that a single-point estimate of SSP or even a sufficiently narrow range of values representing SSP is “not discernible from past transactions or other observable evidence.” For example, the selling price of a software product may be highly variable if an entity has historically sold the software product for prices between $1,000 and $20,000 and there is no discernable concentration around a single price, range of prices, or other metric.
-
The selling price is uncertain. This is the case when an “entity has not yet established a price for [a] good or service, and the good or service has not previously been sold on a standalone basis.”
In determining whether one of the above conditions is met, an entity
should disaggregate (i.e., stratify) its selling prices into different
populations to the extent that pricing practices differ for each
population. In doing so, the entity should take into account market
conditions, entity-specific factors, and information about the customer
or class of customer (e.g., by product, by geography, by customer size,
by distribution channel, or by contract value). However, the entity
should also consider whether there are enough data points for it to
determine a meaningful SSP relative to its pricing practices.
The Allocation Objective Is Met
In addition to assessing whether one of the two pricing conditions above
has been met, an entity must determine whether the resulting amount
allocated to a performance obligation under the residual approach
satisfies the allocation objective in ASC 606-10-32-28 (i.e., an
allocation that depicts the amount of consideration to which an entity
expects to be entitled in exchange for a good or service). If the
application of the residual approach to a particular contract results in
either an SSP that is not within a range of reasonable SSPs or an
outcome that is not aligned with the entity’s observable evidence, use
of the residual approach would not be appropriate even if one of the
conditions in ASC 606-10-32-34(c) is met. An entity should use all
available information to determine whether the SSP is reasonable, which
may include an assessment of market conditions adjusted for
entity-specific factors. When such an analysis results in a highly
variable or broad range and the residual approach is used to estimate
the SSP, this observable information should still be used to support the
reasonableness of the resulting residual amount. In addition, as the
FASB states in paragraph BC273 of ASU 2014-09, “if the residual approach
in paragraph 606-10-32-34(c) results in no, or very little,
consideration being allocated to a good or service or a bundle of goods
or services, the entity should consider whether that estimate is
appropriate in those circumstances.”
The requirement that the amount allocated to a performance obligation
under the residual approach must meet the allocation objective is not
the same as the previous requirement under legacy GAAP in ASC 985-605
related to the use of a stated renewal rate to establish vendor-specific
objective evidence of the selling price. Under ASC 985-605, the
determination of whether an amount or rate is substantive was often made
by comparing the stated renewal rate to industry norms and historical
rates, including evaluating whether the rates were within a reasonable
range. While the guidance in ASC 606 on determining the SSP is not
aligned with ASC 985-605, we nevertheless believe that they are similar
because in both cases, the SSP must be substantive. That is, the SSP
must be consistent with a vendor’s normal pricing practices.
There Are Observable SSPs for Other Goods or Services in the
Contract
The residual approach is applied by subtracting observable SSPs from the
total transaction price and allocating the remainder (i.e., the
residual) to the performance obligation or obligations for which pricing
is highly variable or uncertain. Accordingly, for an entity to apply the
residual approach to a contract containing performance obligations whose
pricing is highly variable or uncertain, that contract must include at
least one performance obligation for which the SSP is observable. If a
contract contains multiple performance obligations with pricing that is
highly variable or uncertain, a combination of approaches (including the
residual approach) may be necessary as described in ASC 606-10-32-35.
For more information about allocating the transaction price under the
residual approach when the pricing of more than one good or service in a
licensing contract is highly variable or uncertain, see Deloitte’s June
12, 2019, Technology
Alert.
The examples below illustrate the application of the concepts described
above.
Example 1-1
Entity S licenses its software to customers for
terms ranging from one to five years. Along with
its software licenses, S frequently sells other
services such as postcontract customer support
(PCS), professional services, or training, and it
has observable SSPs for such services. Taking into
account market conditions, entity-specific
factors, and information about customers or
classes of customers, S stratifies its historical
software sales data. It analyzes the pricing of
stand-alone license transactions as well as the
pricing of the software when sold with other goods
or services and determines the following:
-
Fifteen percent of software transactions are priced between $150 and $1,200.
-
Thirty-five percent of software transactions are priced between $1,201 and $1,800 (plus or minus 20 percent concentration around a midpoint).
-
Thirty percent of software transactions are priced between $1,801 and $2,700 (plus or minus 20 percent concentration around a midpoint).
-
Twenty percent of software transactions are priced above $2,700.
There are no discernable concentrations within
the above ranges.
Question
Is it reasonable for S to use the residual
approach to determine the SSP of its software
license?
Answer
Yes.
On the basis of an analysis of the available
observable data, including appropriate
stratification of that data, S may conclude that
it sells software licenses for a broad range of
amounts and that therefore there is no discernible
SSP. Accordingly, the selling price of software
licenses is highly variable. In addition, there
are observable SSPs for the other services in S’s
contracts. If the resulting allocation under the
residual approach meets the objective in ASC
606-10-32-28, the use of that method is
acceptable.
Example 1-2
Assume the same facts as Example 1-1 except that
in this case, the software vendor, Entity K,
determines the following:
-
Fifteen percent of software transactions are priced between $150 and $1,200.
-
Sixty-five percent of software transactions are priced between $1,201 and $1,800 (plus or minus 20 percent concentration around a midpoint).
-
Fifteen percent of software transactions are priced between $1,801 and $2,700 (plus or minus 20 percent concentration around a midpoint).
-
Five percent of software transactions are priced above $2,700.
Entity K determines that enough data points exist
for it to conclude that there is a sufficient
concentration of selling prices between $1,201 and
$1,800.
Question
Is it reasonable for K to estimate the SSP of its
software license by using its historical software
data rather than by using the residual
approach?
Answer
Yes.
While K sells software licenses for a broad range
of amounts, there is a discernible range of SSPs
given the sufficient concentration of selling
prices between $1,201 and $1,800. Accordingly, K
may conclude that the selling price of its
software license is not highly variable or
uncertain.
For more information about establishing SSP as a
range, see Deloitte’s December 14, 2018, Technology
Alert.
Example 1-3
Entity B licenses its software to customers for
terms ranging from one to five years. Along with
its software licenses, B frequently sells other
services such as PCS, professional services, or
training, and it has observable SSPs for such
services. Taking into account market conditions,
entity-specific factors, and information about the
customer or class of customer, B stratifies its
historical software sales data and analyzes the
pricing of stand-alone license transactions as
well as the pricing of the software when sold with
other goods or services. Entity B determines that
the vast majority of its software transactions are
priced between $500 and $2,400 and that there are
no discernable concentrations within that range.
Further, the selling-price range is consistent
with B’s normal pricing policies and
practices.
Entity B concludes that it is appropriate to use
the residual approach to estimate the SSP of its
software license in contracts that contain other
services. In a few of its contracts, application
of the residual approach results in the allocation
of between $0 and $50 to the software license
performance obligation.
Question
Is it reasonable for B to use the residual
approach to determine the SSP of the software
license for those contracts for which the residual
approach results in the allocation of between $0
and $50 to the software license performance
obligation?
Answer
No.
Even though the selling price for the software
license is highly variable, the allocation
objective in ASC 606-10-32-28 is not met. This is
because the amount allocated to the software
license in a given transaction ($0 to $50) does
not faithfully depict “the amount of consideration
to which the entity expects to be entitled in
exchange for transferring the promised goods or
services to the customer.”
Since B typically prices its software between
$500 and $2,400 and has no substantive history of
selling software licenses for a price below $50
(i.e., such pricing is not indicative of its
normal pricing policies and practices), those
amounts do not represent substantive pricing.
Accordingly, B must use another method or methods
to determine the SSP of its software license
performance obligations.4 This conclusion is consistent with that in
Case C in Example 34 in ASC 606-10-55-269. By
contrast, if B’s application of the residual
approach resulted in the allocation of between
$500 and $2,400 to software license performance
obligations, use of the residual may be reasonable
since these amounts appear to be within B’s normal
pricing policies and practices.
Q&A 2 Reassessment
Question
Is an entity required to reassess whether the residual approach remains
appropriate prospectively?
Answer
Yes.
ASC 606 requires entities to maximize the use of observable data in
determining an SSP. The observable data available for a good or service
may change over time. In addition, an entity’s pricing practices may
change as a result of market or entity-specific factors. Therefore, the
appropriateness of the residual approach for a particular good or
service may also change from one period to another. For example, an
entity may implement pricing policies that cause the price of a good or
service that was previously highly variable to become consistent enough
for an SSP to be estimated (either as a point estimate or a range).
Entities that use the residual approach to determine an SSP should
continually assess whether its use remains appropriate prospectively. In
making this determination, entities should monitor and consider
entity-specific and market conditions. A change from the residual
approach to another method for determining an SSP should be accounted
for prospectively, and corresponding changes may need to be made to
disclosures about the determination of the SSP and allocation of the
transaction price (e.g., ASC 606-10-50-17).
Q&A 3 Material Right
Question
Is an entity required to assess whether a customer option to purchase
additional goods or services conveys a material right to the customer
when the residual approach was used to establish the SSPs of the goods
or services that are subject to the option?
Answer
Yes.
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 gives the entity’s customer 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 geographical 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 selling
prices of the goods or services that are subject to the option are
highly variable or uncertain and the residual approach was therefore
applied.
Q&A 4 Identification of Material Right
Question
How should an entity determine whether a customer has obtained a material
right as a result of the pricing of an optional future purchase of a
good or service for which the entity used the residual approach to
determine the SSP (i.e., pricing is highly variable or uncertain)?
Answer
When the residual approach is used to determine the SSP of a good or
service because pricing is highly variable or uncertain, an entity may
need to use significant judgment when assessing whether option pricing
for that good or service provides a material right because of the lack
of a point estimate or sufficiently consistent range representing the
SSP. 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 right5 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 that 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 SSPs that were derived by using the residual approach. Accordingly, while there will not be an established point estimate or narrow range of SSPs 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 SSP. Therefore, the amounts determined under that approach represent the SSP for that good or service.6 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 SSPs that were determined as a result of applying the residual approach. In addition, to determine which range of historical SSPs 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 SSP 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 represent the SSP (see ASC 606-10-32-32), it may be indicative 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.
- 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.
Example 4-1
Entity J, an early-stage software developer,
enters into an arrangement with Customer T, a
large U.S.-based company, to license its software
on a term basis and provide PCS for one year. The
arrangement also includes hardware and
professional services. The total transaction price
is $2 million, and J has established that the
license, PCS, hardware, and professional services
each represent a distinct performance
obligation.
Entity J has concluded that the pricing of
software licenses is highly variable and uses the
residual approach to determine the SSP. The
observable SSPs of the other performance
obligations are as follows:
-
PCS — $200,000.
-
Professional services — $500,000.
-
Hardware — $300,000.
Under the residual approach, $1 million is
allocated to the software license, which J
determines is consistent with the allocation
objective. The contract also indicates that the
customer may renew the software license for
$250,000 per additional year and that the pricing
for other products and services will be at their
SSPs.
Entity J reviews historical transaction data for
sales of software licenses to large customers in
the United States to determine the amounts that
have been allocated to the software license under
the residual approach. Over the past year, a range
of $500,000 to $3 million has been allocated to
the software license, which is consistent with J’s
pricing policies. While J did not initially intend
to give T a discount, it was willing to negotiate
on renewal pricing because it wanted to secure the
large contract and is able to enhance the
marketability of its products by obtaining T as a
customer (T is a well-known brand and dominant in
its market). Therefore, J concludes that the
pricing of the optional future purchase has given
T a material right.
Question
Can J’s approach be considered a reasonable basis
for its conclusion that the pricing of the
optional future purchase has given T a material
right?
Answer
Yes.
We believe that the following factors indicate
that T has received a material right:
-
A comparison of (1) the price T must pay if it exercises its option to renew the license in the future ($250,000) and (2) the range of SSPs determined under the residual approach in similar historical transactions ($500,000 to $3 million) indicates that the pricing offered to T does not meet the allocation objective because T is receiving a significant discount that is incremental to the range of discounts offered to other similar customers.
-
Although J did not initially intend to give T a discount on future purchases, other facts and circumstances indicate that J nonetheless offered T preferential pricing.
Example 4-2
Entity A enters into an arrangement with Customer
C, a mid-sized company based in Europe, to license
its software on a term basis and provide PCS for
one year. The arrangement also includes hardware
and professional services. The total transaction
price is $20,000, and A has established that the
license, PCS, hardware, and professional services
each represent a distinct performance
obligation.
Entity A has concluded that the pricing of
software licenses is highly variable and uses the
residual approach to determine the SSP. It has
observable SSPs for its other products and
services. The list prices, contractually stated
prices, discounts from list price, and SSPs of
each performance obligation are as follows:
The contract also indicates that the customer may
renew the software license for $3,000 per
additional year, which represents a 60 percent
discount from the list price, and that the pricing
for other products and services remains at the
same contractually stated prices.
Entity A reviews historical transaction data for
sales of software licenses to mid-sized customers
in Europe to determine the contractually stated
prices and related discount from list price for
the software license. Over the past year, the
software license has been priced between $1,000 to
$20,000, thus ranging from a discount of 87
percent to a premium of 167 percent relative to
the list price. Entity A’s internal pricing
policies require that discounts of over 50 percent
must undergo an extensive approval process.
Further, A intended to give C a discount on
renewals of the software license because A is in a
highly competitive market in which customer
retention is difficult. In addition, C indicated
that it would purchase large additional amounts of
hardware. Therefore, A concludes that the pricing
of the optional future purchase gives C a material
right.
Question
Can A’s approach be considered a reasonable basis
for its conclusion that the pricing of the
optional future purchase has given C a material
right?
Answer
Yes.
We believe that the following factors indicate
that C has received a material right:
-
It is not especially meaningful to compare (1) the discount to the list price C receives if it exercises its option to renew the license in the future (60 percent) with (2) the range of discounts and premiums in similar historical transactions (87 percent discount to 167 percent premium) given the significant pricing variation observed in that data. However, A’s internal pricing policies require any discounts of over 50 percent undergo an extensive approval process.
-
On the basis of a comparison of (1) the discount from list price for the renewal pricing (60 percent) with (2) the other discounts offered in the same contract (0 percent to 38 percent for other goods and services and 40 percent for the same software license), A determines that the optional future purchase pricing conveys an incremental discount to C that it did not receive under the initial contract.
-
Entity A’s intention to give C a discount to secure its future business in a competitive market supports a conclusion that “but for the initial contract,” C would not have received favorable pricing on future software license renewals.
-
Customer C’s indication that it would make many additional purchases of hardware supports A’s decision to provide preferential pricing.
Contacts
|
Sandie Kim
Audit & Assurance Partner
National Office Accounting and
Reporting Services
Deloitte & Touche LLP
|
Jeff Jenkins
Audit & Assurance Senior
Manager
National Office Accounting and
Reporting Services
Deloitte & Touche LLP
|
|
Mohana Dissanayake
Audit & Assurance Partner
U.S. Technology, Media &
Telecommunications Industry Leader
Deloitte & Touche LLP
|
Michael Wraith
Audit & Assurance Partner
U.S. Technology Industry
Professional Practice Director
Deloitte & Touche LLP
|
Footnotes
1
For titles of FASB Accounting Standards Codification (ASC) references, see
Deloitte’s “Titles of Topics and Subtopics in
the FASB Accounting Standards Codification.”
2
The residual approach in ASC 606 is different from the “residual method”
in ASC 985-605, which is used to determine the amount of revenue to be
recognized for delivered elements in certain software arrangements (if
there is vendor-specific objective evidence of the selling price for the
undelivered elements).
3
See paragraph BC271 of FASB Accounting Standards Update (ASU) No.
2014-09, Revenue From Contracts With Customers.
4
One method may be to use the range of
observable pricing in other transactions for which
the SSPs were determined to be reasonable and in
line with B’s normal pricing policies and
practices.
5
A material right arises from pricing on an option to acquire
additional goods or services in the future that would not have
been received if the initial contract had not been entered into.
In such cases, the customer with the option has essentially
prepaid for the future purchase.
6
This is the case if the entity has determined that
the output of the residual approach is reasonable
because it is consistent with the allocation
objective in ASC 606-10-32-28.