Revenue

Influx or other enhancement of assets of an entity or settlements of liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. (ASC 606-10-20)

Revenue versus Gains

The FASB distinguishes revenues from gains. Gains are defined in Statement of Financial Accounting Concept 6 (CON 6), Elements of Financial Statements, as:

Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.

Revenues are commonly distinguished in GAAP from gains for the three reasons listed in the chart below.

Exhibit—Distinguishing Between Revenue and Gains in GAAP

The New Standard

ASU 2014-09:

• Superseded 200 separate items FASB Accounting Standards Codification (ASC) guidance, most of it industry specific.
• Created Topic 606, Revenue from Contracts with Customers, and Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers.
• Created Topic ASC 610, Other Income.

  ASU 2014-09 is over 700 pages and was released in the following sections:

• Amendments to the FASB Accounting Standards Codification:
  • Section A—Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs—Contracts with Customers (Subtopic 340-40)
  • Section B—Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables
• Background Information and Basis for Conclusions:
  • Appendix: Comparison of Topic 606 and IFRS 15
• Amendments to XBRL Taxonomy.

Project Goals

The FASB believes the final documents meet two major goals—simplification of revenue recognition guidance and consistency globally and across entities, jurisdictions, markets and industries.

The revenue standard provides:

• a robust framework that is expected to simplify preparation of financial statements by reducing the sources of guidance and replacing them with a single source that users can understand
• new guidance for contract modifications and consistent application for service contracts
• guidance for related topics, such as warranties, licenses, and when to capitalize the cost of obtaining a contract and some costs of fulfilling a contract.

Customer Loyalty Programs

In addition, the changes may affect customer loyalty programs, and companies will have to make new estimates. It is expected that entities will be reviewing their loyalty programs to evaluate their effects, if any, on revenue, and some companies may choose to amend their contracts with customers.

Scope Exceptions

The following are outside the scope of the standard:

• Lease contracts in the scope of ASC 840, Leases, and ASC 842, Leases, when implemented
• Contracts issued within the scope of ASC Topic 944, Financial Services—Insurance.
• Financial instruments and other contractual rights or obligations in the scope of:
  • ASC 310, Receivables;
  • ASC 320, Investments—Debt and Equity-Securities; (This title changes to Investments in Debt Securities when ASU 2016-01 is implemented.)
  • ASC 321, Investments in Equity Securities (when implemented);
  • ASC 323, Investments—Equity-Method and Joint Ventures;
  • ASC 325 Investments—Other;
  • ASC 405, Liabilities;
  • ASC 470, Debt;
  • ASC 815, Derivatives and Hedging;
  • ASC 825, Financial Instruments;
  • ASC 860, Transfers and Servicing.
• Guarantees other than product or service warranties, in the scope of ASC 460, Guarantees (Entities should look to ASC 815 for guidance on guarantees accounted for as derivatives.)
• Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers.

  (ASC 606-10-15-2)

Revenue from transactions or events that do not arise from contracts with customers is not in the scope of the Standard, such as:

• Dividends
• Non-exchange transactions, like donations or contribution
• Changes in regulatory assets and liabilities arising from alternative revenue programs for rate-regulated activities in the scope of ASC 930, Regulated Operations.

The guidance included in new subtopic ASC 340-40 applies only if the costs are incurred related to a contract under ASC 606. (ASC 606-10-15-5) The guidance in new topic ASC 610 specifies the standards for income that is not in the scope of ASC 606, including gains and losses from the derecognition of nonfinancial assets and from gains and losses on involuntary conversions.

Contracts Partially in Scope

If a contract is partially within the scope of the Standard and partially within the scope of other guidance, the entity should apply the other guidance first. That is, if the other standard specifies how to separate or initially measure parts of the contract, then the entity should apply those requirements first. The remaining portion is accounted for under the requirements of the new Standard. If the other standard does not have applicable separate and/or initial measurement guidance, the entity should apply the revenue standard to separate and/or initially measure the contract. (ASC 606-10-15-4)

Sale or Transfer of Nonfinancial Assets

Transactions that are not part of the entity's ordinary activities, such as the sale of property, plant, and equipment, nonetheless fall under certain aspects of the standard. An entity involved in such activities applies the guidance related to transfer of control and measurement of the transaction price to evaluate the timing and amount of the gain or loss. Entities should also apply the guidance in the standard to determine whether the parties are committed to perform under the contract and, therefore, whether a contract exists.

Full Retrospective Approach

Under this method, all prior periods presented must be restated in equity in accordance with ASC 250, Accounting Changes and Error Corrections. That is, entities must report the cumulative effect for the earliest year reported.

Modified Retrospective Approach

Using the modified retrospective approach, the entity recognizes the cumulative effect of initially adopting the standard as an adjustment to the opening balance of retained earnings in the annual period when the standard is adopted. If the entity issues comparative statements, then it reports revenue for prior years under the guidance in effect before adoption.

Five steps

Achieve the core principle, entities should follow these five steps:

1. Identify the contract with customer. (ASC 606-10-25-1 through 25-13)
2. Identify performance obligations (promises) in the contract. (ASC 606-10-25-1 through 25-13)
3. Determine the transaction price. (ASC 606-10-32-2 through 32-27)
4. Allocate the transaction price. (ASC 606-10-32-28 through 25-41)
5. Recognize revenue when or as the entity satisfies a performance obligation by transferring promised goods or services to a customer. (ASC 606-10-25-23 through 25-30)

In reviewing a transaction, each of the five steps above may not be needed, and they may not always be applied sequentially. Be aware that the standard is not organized by these five steps, but the Boards believe the steps offer a methodology for entities to use when deciding the appropriate accounting for a transaction. As was mentioned, the model is based on an assets and liabilities or control approach as opposed to the risk and rewards approach under previous standards. However, risk and rewards are a factor when determining control for point in time revenue recognition.

Each of the steps encompasses new concepts, and entities will have to carefully analyze their contracts with customers as they transition to the new guidance.

Enforceable Rights and Obligations

The enforceability of the contract:

• Is a matter of law
• Varies across legal jurisdictions, industries, and entities
• May vary within an entity
• May depend on the class of customer or nature of goods or services.

Determining whether an arrangement has created enforceable rights is a matter of law and evaluating the legal enforceability of the contract can be particularly challenging. This is particularly true if multiple jurisdictions are involved. Entities also need to consider whether, in order to comply with jurisdictional or trade regulation, a written contract is required. Significant judgment may be involved for some cases and qualified legal counsel may need to be consulted.

The Boards clarified that even though the contract must be legally enforceable to be within the scope of the guidance, the performance obligations within the contract may not be legally enforceable, but may be based on the reasonable expectations of the customer.

The Five Contract Criteria

The standard lists five criteria that are assessed at contract inception and that must be met for agreements to be considered contracts subject to the guidance of the standard. A contract exists if:

1. The contract has approval and commitment of the parties
2. Rights of the parties are identifiable
3. Payment terms are identifiable
4. The contract has commercial substance
5. Collectibiliy of substantially all of the consideration is probable.

   (ASC 606-10-25-1)

The five criteria above are essentially a financial accounting definition of a contract. The entity needs to exercise judgment when applying the criteria. The entity must also be aware that the parties may enter into amendments or side agreements that change the substance of the contract. So, it is important to understand the entire contract, including the amendments and side agreements. A contract that has enforceable rights and obligations between two or more parties is within the scope of the revenue standard when all five of the above criteria are met.

The assessment of collectibility must reflect the customer's ability and intent to pay. This criterion acts as a collectibility threshold. A more detailed discussion of the collectibility threshold can be found below.

Assessing Collectibility

To be accounted for under the standard, a contract must have commercial substance. To have commercial substance, the consideration must be collectible. So, the underlying objective of the collectibility assessment is to determine if there is a substantive transaction.

Collectibility is a “gating” question designed to prevent entities from applying the standard to problematic contracts and recognizing revenue and an impairment loss at the same time.

Reassessment

When an arrangement has been assessed and is considered a contract under the revenue standard, the entity is not required to reassess the contract unless there is an indication of a significant change. A significant change might be, for example, a significant deterioration in the customer's ability to pay. (ASC 606-10-25-5) In that case, the entity needs to assess whether it is probable the customer will pay the consideration for the remaining goods or services. In contrast, if the arrangement is not initially considered a contract and if there is an indication that there has been a significant change in facts and circumstances, the entity should reassess to determine whether the criteria are met subsequently. (ASC 606-10-25-6) The entity applies the provisions of the Standard from the date the criteria are met.

Only the rights and obligations that have not transferred are reassessed. Therefore, a reassessment will not result in any reversal of revenue, receivables, or assets already recognized. Those assets are assessed for impairment under the relevant financial instruments standard. The entity does not recognize any additional revenue from the agreement.

TRG members have acknowledged the assessment of whether significant changes have occurred that require a reassessment of collectibility or even a determination that a contract no longer exists under the Standard will be situation specific and require judgment.

A Practical Expedient

An entity normally applies the revenue standard to individual contracts. However, in certain circumstances, an entity may use a practical expedient and apply the revenue standard to a group of contracts. This expedient allows for the portfolio approach—applying the revenue standard to a group of contracts or performance obligations under these conditions:

• The contracts must have similar characteristics, and
• The entity must reasonably expect that the effects of applying the guidance to a portfolio would not differ materially from applying it to individual contracts or performance obligations.

  (ASC 606-10-10-4)

Combination of Contracts Required

Under legacy GAAP (ASC 605-25-25-3), the entity is allowed to combine contracts if certain conditions are met. The new standard requires a combination of contracts under certain circumstances. Entities have to assess existing contracts to determine whether combination is required and should also be mindful of the combination requirement when writing new contracts. The decision to combine contracts is made at the inception of the contracts.

The entity needs to assess whether the substance of the contract is that the pricing or economics of the contracts are interdependent. The standard offers guidance to help make that judgment. The contracts should be accounted for as a single contract when the contracts are entered into at or near the same time with the same customers or parties related to the customer and if any of the following conditions are met:

1. The entity negotiates the contracts as a package with a single commercial objective.
2. The amount of consideration to be paid in the contract depends on the price or performance of the other contract.
3. The goods or services promised in the contracts (or some goods or services promised in the contracts) constitute a single performance obligation.

   (ASC 606-10-25-9)

The entity should apply the guidance on identifying performance obligations when assessing “c.” (See information later in this chapter.)

The fact that multiple contracts are negotiated at the same time is not sufficient evidence to demonstrate that the contracts represent a single arrangement. (ASU 2014-09 BC73)

If the criteria are met, contracts between the same customer or related parties of the customer should be combined. Related parties are those defined in the guidance, ASC 850, Related Parties Disclosures. See the chapter on ASC 850 for a list of related parties.

Assessing Collectability of a Portfolio of Contracts

An issue was raised with the TRG regarding how to deal with situations in a portfolio of homogeneous contracts where some customers will pay amounts owed, but the entity has historical experience indicating that some customers will not pay the full consideration. In that case, the entity should record revenue, but separately evaluate the contract asset or receivable for impairment. The entity will have to exercise judgment regarding whether to record a bad debt expense or reduce revenue for an anticipated price concession.

Collaborative Arrangements

A collaborative arrangement is not in the scope of the Standard unless the collaboration meets the definition of a customer. In most cases, the identification of the customer is straightforward. However, the Boards decided not to offer additional application guidance and, therefore, a collaborative arrangement requires more careful analysis of the facts and circumstances. For example, an arrangement with a counterparty where both parties share the risks and benefits will most likely not result in a counterparty meeting the definition of customer, and, therefore, the arrangement will not fall under the revenue standard. (ASC 606-10-15-3) On the other hand, an arrangement where the entity is selling a good or service, even if the arrangement is labeled a collaboration, will likely fall under the scope of the revenue standard.

It is also possible that portions of the contract will be collaboration, while other portions will be a contract with a customer. The latter portion will be in the scope of the revenue standard. After a thorough analysis of the agreement, the entity should decide whether to apply the revenue standard and/or other guidance, such as ASC 808, Collaborative Arrangements.

Arrangements with Multiple Parties

There are cases where multiple parties are involved in the transaction. For example, pharmaceutical companies provide products to customers and parts of the fees are paid by an insurer and the remaining fees are paid by the customer. Or, manufacturers issue coupons directly to the consumer and reimburse the retailer for the coupons.

The entity must also determine if it is the principal or agent in the transaction. This matters because the principal recognizes the revenue for the gross amount, and the agent recognizes the transaction at net—the amount that the entity expects to retain after paying the other party for goods or services provided. Principal versus agent guidance is discussed later in this chapter.

Implicit Promises

In addition to promised goods or services explicitly detailed in the contract, a contract may include implicit promises for goods or services. Promises are normally specified, but may include those implied by, for example:

• Customary business practices of a particular industry,
• An entity's published policies, and
• Specific statements.

These implicit promises may create a reasonable expectation on the part of the customer that the entity will transfer a good or service. (ASC 606-10-25-16) It is important, therefore, to understand the entity's customary business practices, marketing materials, and representations made during contract negotiations. The entity must determine if the customer has a valid or reasonable expectation that the entity will provide a good or service.

Goods to be Provided in the Future

The Boards also concluded that goods or services to be provided in the future give rise to performance obligations. In some industries it is common practice to provide services to the customer's customer. For example, an automotive manufacturer may promise to provide service to a vehicle sold by a dealer. This type of promise is a performance obligation if it can be identified in the contract with the customer, either explicitly or implicitly.

Activities not Included as Performance Obligations

Only promises that transfer goods or services to the customer can be performance obligations. An entity may need to undertake set-up activities to fulfill performance obligations. If those activities transfer goods or services to the customer, they are part of the performance obligations. However, activities that do not transfer goods or services, like administrative tasks, are not promised goods or services in the contract with the customer. (ASC 606-10-25-17) Some organizations may have a significant number of performance obligations, especially, for example, if “free” items are included and they have to be recognized under the standard.

What is a Promised Good or Service?

The Standard offers some clarity by providing examples of promised goods or services. Bear in mind this is not an exhaustive list. Promised goods or services may include:

• Sale of goods produced by an entity
• Resale of goods purchased by an entity
• Resale of rights to goods or services purchased by an entity
• A contractually agreed-upon task for a customer
• Standing ready to provide goods or services
• Arranging for another party to transfer goods or services to a customer
• Rights to goods or services to be provided in the future that a customer can resell or provide to its customer
• Licenses
• Constructing, manufacturing, or developing an asset on behalf of a customer
• Options to purchase additional goods or services.

  (ASC 606-10-25-18)

Shipping and Handling Services

Shipping and handling services performed prior to the customer obtaining control of the goods are not promises to the customer. They are activities to fulfill the promise. (ASC 606-10-25-18A) However, the standard gives the entity the choice to account for shipping and handling services performed after the customer takes control as a fulfillment cost. Entities electing this practical expedient must disclose it in accordance with the standard's disclosure requirements. Be aware this is an election and not a requirement. (ASC 606-10-25-18A and 18B)

Criterion 1: Good or Service is Capable of being Distinct

A good or service is capable of being distinct if the customer can benefit from it on its own or together with other resources readily available to the customer. (ASC 606-10-25-19a)

Criterion 2: Distinct within the Context of the Contract

After an entity has determined a good or service is capable of being distinct, the second step in the assessment of whether the performance obligations are distinct is to determine if they are distinct within the context of the contract. The objective when assessing whether an entity's promise to transfer goods or services to the customer are separately identifiable is to determine whether the nature of the entity's overall promise in the contract is to transfer each of those goods or services or whether the promise is to transfer a combined item or items to which the promised goods or services are inputs. (ASC 606-10-25-21)

Promised Good or Service is not Distinct

Once an entity determines that a promised good or service is not distinct, it must combine it with other promises in the contract until it identifies a bundle of goods or services that is distinct. The result may be that all the promises in a contract are accounted for as a single purchase obligation.

The Series Provision

The second category of performance obligations requires the entity to assess whether the performance obligations are a series of distinct goods or services that are “substantially the same or have the same pattern of transfer to the customer.” Without this part of the definition, some entities would face significant operational challenges. For example, services provided on an hourly or daily basis, like a cleaning service, might meet the criteria for a single performance obligation and the entity would be faced with accounting separately for numerous repetitive services. The series provision is a concept that is introduced by the Standard and does not exist in the legacy standards. This series provision guidance is intended to simplify the application of the revenue recognition model and promote consistency.

To have the same pattern of transfer, both of the following criteria must be met:

• Each distinct good or service in the series that the entity promises to transfer consecutively represents a performance obligation satisfied over time if it were accounted for separately.
• The entity uses the same method of progress to measure the transfer of each distinct good or service in the same series to the customer.

  (ASC 606-10-25-15)

If the criteria are met, the series of goods or services must be treated as a single performance obligation, the so-called “series requirement.” The accounting treatment may vary for this application when accounting for contract modifications, variable consideration, and changes in transaction price.

Exhibit—Series of Distinct Goods or Services—Criteria for Same Pattern of Transfer

The box on the left above is similar to the principles in legacy U.S. GAAP (ASC 605-10-25-13) for multiple element arrangements. The second is a new requirement, and for some entities, this may result in a change in practice.

Determining whether there is a Financing Component

Conceptually, the standard recognizes that a contract with a financing component has two transactions—a sale and a financing. If a contract has a significant financing component, the entity should account for the financing component and adjust the transaction price. (ASC 606-10-32-15) Determining what a “significant” component is may require considerable judgment. Companies that have contracts with a significant financing component may have operational challenges connected to measuring and tracking the time value of money. However, the practical expedient explained earlier should provide some relief.

The consideration recorded should reflect the price the customer would have paid if the customer paid cash when (or as) the goods or services transferred to the customer, that is, the objective is to reflect the cash selling price. The Standard factors in the effects of a significant financing component because excluding it could result in two economically similar transactions recording substantially different revenue amounts.

The determination of whether a contract contains a significant financing component occurs at the contract level, not the contract portfolio level or the performance obligation level. In assessing whether a contract contains a significant financing component, the entity should take into consideration all the facts and circumstances, including both of the following:

• The difference between the amount of promised consideration and the cash selling price upon transfer of the goods or services.
• The combined effects of both of the following:
  • The expected length of time between the transfer of goods or services and when the customer pays.
  • The prevailing interest rates in the relevant market.

  (ASC 606-10-32-16)

And, as with other assessments in the model, it is necessary to look at implicit and explicit contract terms.

Significant Financing Component—Contra Indicative Factors

A time difference between payment of consideration and transfer of goods and services to the customer does not always mean there is a significant financing component. If any of the factors listed in the exhibit below exist, a contract with a customer would not have a significant financing component.

Exhibit—Significant Financing Component—Contra Indicative Factors

Determining the Discount Rate for a Significant Financing Component

The entity should use the discount rate that would be reflected in a separate financing transaction between the entity and its customers at the time of the inception of the contract. (ASC 606-10-32-19) That rate should reflect:

• Inflation,
• The credit risk of the financing party,
• The credit characteristics of the party receiving the financing, and
• Any collateral or security provided, including assets transferred in the contract.

The entity needs to have access to enough information to determine the discount rate.

The rate may be determined by identifying the interest rate that discounts the nominal amount of the promised consideration to the cash the customer would pay when (or as) the goods or services transfer to the customer. If the contract contains an explicit rate, the entity should consider whether that rate reflects the market rate. In some cases, the contract may contain a low rate as a marketing incentive. If the contract does not reflect the market rate, the entity should impute a more representative rate. The rate determined at the inception of the contract is the rate used throughout the terms of the contact. (ASC 606-10-32-19)

Presentation of a Significant Financing Component

The entity should separate the loan component from the revenue component. Interest income or expense resulting from a financing should be presented separately from the revenue component. Once a performance obligation is satisfied, the entity recognizes the present value of the consideration as revenue. The financing component (interest income or expense) is recognized over the financing period. The income or expense is recognized only to the extent that a contract asset, receivable, or contract liability, such as deferred revenue, is recognized for the customer contract. When accounting for the financing component, the entity should look to the relevant guidance on the effective interest method in ASC 835-30, Interest—Imputation of Interest:

• Subsequent measurement guidance in ASC 835-30-45-1A through 45-3
• Application of the interest method in ASC 835-30-55-2 and 55-3.

  (ASC 606-10-32-20)

Types and sources of Variable Consideration

Variable consideration comes in two types:

• Pricing adjustments for transactions that have already been completed, for instance, refunds
• Incentive and performance-based fees, for example, licenses and royalties.

Exhibit—Sources of Variable Consideration

Under legacy guidance, some of these items caused entities to delay revenue recognition. Under the revenue model in the Standard, entities will now have to estimate their effect because the model focuses on when control transfers. Even if a contract has a stated fixed price, the consideration may still be variable. This happens when the consideration is contingent on the occurrence or nonoccurrence of an event.

Determining if Variable Consideration Exists

Variable consideration may be explicitly stated in the contract or may be variable if either of the following exists:

• The customer has a valid expectation arising from an entity's customary business practices, published policies, or specific statements that the entity will accept an amount of consideration that is less than the price stated in the contract. That is, it is expected that the entity will offer a price concession. Depending on the jurisdiction, industry, or customer, this offer may be referred to as a discount, rebate, refund, or credit.
• Other facts and circumstances indicate that the entity's intention, when entering into the contract with the customer, is to offer a price concession to the customer.

  (ASC 606-10-32-7)

Estimating Total Variable Consideration

If the contract's consideration includes a variable amount, the entity must go through a process to determine the effect of that variability on the transaction price. It must:

• Determine the method for estimating the consideration
• Measure the consideration
• Determine if the variable consideration should be constrained
• Account for subsequent changes in transaction price.

Refund Liability

If an entity receives consideration from the customer and expects to refund some or all of that consideration, the entity must recognize a refund liability. The liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled. The refund liability should be updated at the end of each reporting period for changes in circumstances. (ASC 606-10-32-10) See information later in this chapter on rights of return.

Constraining Estimates of Variable Consideration

Because revenue is a critical metric, it is important to include estimates of consideration that are robust and give useful information. Some estimates of variable consideration are too uncertain and should not be included in the transaction price. After estimating the amount of variable consideration, the entity then should apply the following constraint focused on the probability of a significant reversal of cumulative revenue recognized:

The entity should include some or all of the variable consideration in the transaction price to the extent that it is probable that a subsequent change in the estimate would not result in a significant reversal of cumulative revenue recognized. (ASC 606-10-32-11)

The constraint of variable consideration addresses concerns about premature recognition of revenue, that is, recognizing revenue based in the future before there is sufficient certainty that the amount will be realized. Focusing on the potential for significant reversals of revenue helps lower the risk that revenue will be overstated. Revenue that would not reverse significantly in a subsequent period is more predictive of future revenues.

Reassessing the Transaction Price for Variable Consideration

The estimated transaction price should be reassessed and updated at the end of each reporting period until the underlying uncertainty is resolved. Included in this update is an assessment of whether an estimate of variable consideration is constrained. Changes in the estimate are treated the same way as any other changes in the transaction price. These updates will then represent faithfully at the end of the reporting period the circumstances present at that time and a change in circumstance during that period. (ASC 606-10-32-14) (See Step 5 in this chapter for more information about updating changes in transaction price.)

Sales-Based or Usage-Based Royalty Exception to Variable Constraint Guidance

A narrow exception to the guidance on constraints in variable consideration involves sales-based or usage-based royalty consideration promised in exchange for a license of intellectual property only. For those types of consideration the entity should recognize only when (or as) the later of the following events occur:

• The subsequent sale or usage occurs.
• The performance obligation to which some or all of the sales-based or usage-based royalty allocated has been satisfied (or partially satisfied).

  (ASC 606-10-55-65; IFRS 15.58)

The royalty in its entirety should be either within or not within the scope of the royalties exception. The royalties exception applies when the license of intellectual property is the predominant item to which the royalty relates. Determining when a license is the predominant item requires judgment on the part of the entity. In making this judgment, the entity may want to consider the value the customer places on the license in comparison with the other goods or services in the bundle. (ASC 606-10-55-65A-B)

Measurement

Unless consideration payable to a customer is for distinct goods or services received in return, it should be accounted for as a reduction of the transaction price. “Distinct” in this context is consistent with the guidance in Step 2. If the amount is variable, the entity should estimate the amount in accordance with the guidance on variable consideration. (ASC 610-10-32-25)

If consideration payable to the customer is for a distinct good or service, the entity should account for it in the same way it accounts for other purchases from suppliers. If consideration payable to the customer is not for a distinct good or service, the consideration should be treated as a reduction in transaction price. The consideration payable to the customer may be greater than the fair value of the good or service received. In that case, to depict revenue faithfully, the entity should account for the excess as a reduction of the transaction price. If the fair value of the goods or services is not reasonably estimable, the entity should account for all the consideration payable to the customer as a reduction of the transaction price. (ASC 610-10-32-25)

Recognition

For recognition of consideration payable to a customer accounted for as a reduction in transaction price, the standard provides the following guidance:

…the entity shall recognize the reduction when (or as) the later of either of the following events occurs:

• The entity recognizes revenue for the transfer of the related goods or services to the customer.
• The entity pays or promises to pay the consideration (even if payment is conditional on a future event). That promise may be implied by the entity's customary business practices.

  (ASC 606-10-32-27)

The TRG brought to the Boards an issue related to variable consideration payable to a customer and the timing of recognition. Some stakeholders questioned whether the guidance above is inconsistent with that on variable consideration, which might be interpreted to require earlier recognition under some circumstances. The staff view that the board members deemed reasonable was that entities should consider both areas of guidance and record the reduction in revenue at the earlier of when it would be required under the variable consideration guidance as a change in transaction price and the consideration is payable to a customer—when a promise is made or implied.

Standalone Selling Price Directly Observable

The best evidence of the standalone selling price is the observable price charged by the entity when the entity sells those goods or services separately in similar circumstances to similar customers. However, goods or services are not always sold separately. If the standalone selling price is not directly observable, the entity must estimate it.

Estimating a Standalone Selling Price that is not Directly Observable

If the product or service is not sold separately, the entity must use another method to determine the standalone selling price. The Standard does not allow for postponement of revenue recognition because of a lack of reliable evidence. If the standalone selling price is not directly observable, it must be estimated. When estimating the standalone selling price, entities need to exercise judgment. Some entities may have robust procedures in place to estimate prices; others may need to put procedures in place. In estimating the standalone selling prices, the entity should maximize the use of observable inputs and consider all reasonably available and relevant information, including:

• Reasonably available data points, such as:
  • Standalone prices,
  • Manufacturing costs,
  • Margins,
  • Price listings, and
  • Third-party pricing,
• Market conditions, such as:
  • Demand,
  • Competition,
  • Constraints, and
  • Trends,
• Entity-specific factors, such as:
  • Pricing strategies,
  • Objectives,
  • Market share, and
• Information about the customer or class of customer, such as:
  • Geographical distribution,
  • Type, and
  • Distribution channels.

The entity must apply estimation methods consistently for similar circumstances. The Standard does not prescribe or preclude any one method. It indicates that the method used to estimate the standalone selling prices should result in an estimate that represents faithfully the price an entity would charge for the goods or services if they were sold separately. The Standard does describe three estimation methods, and they are listed in the exhibit below. (ASC 606-10-32-33)

Exhibit—Estimation Methods

Other approaches may be appropriate as long as the objective of those approaches is to identify the amount the entity would charge if selling the underlying goods or services on their own.

The Residual Approach

The use of this approach is restricted. Entities may use this approach only if the standalone selling price is uncertain or highly variable.

• Uncertain. A standalone selling price is highly uncertain if the entity has not yet established a price for the good or service and the good or service has not previously been sold on a standalone basis.
• Highly variable. A standalone selling price is highly variable if the entity sells the same good or service to different customers, at or near the same time, for a broad range of amounts.

  [ASC 606-10-32-34(c)]

The use of the residual approach is intentionally limited. The entity should not use the residual approach in cases where, for example,

• there is no remaining transaction price to allocate to the remaining performance obligations or
• the allocated amount is not within a range of the entity's observable selling prices for the good or service.

The entity should be wary if applying the residual approach results in consideration of zero or very little consideration. Such an outcome may not be reasonable unless other GAAP applies, for instance, in cases where the obligation is partially out of scope of ASC 606.

Some arrangements may include a discount that specifically relates to only certain performance obligations that are typically sold together as a bundle. In those cases, when using the residual approach, the discount must be allocated to those performance obligations before deducting the standalone selling price from the total transaction price. (ASC 606-10-32-38)

In arrangements where price can be highly variable because there is little incremental cost in order for the entity to provide the goods or services, the residual approach may be the most reliable approach to determine the standalone selling price. This may be especially relevant to intellectual property and other intangible assets. In addition, determining standalone selling prices for intangible property, including intellectual property, can be especially challenging because those items may often be sold as part of a widely priced bundle. For example, an entity may license software using a wide price band. Using the residual approach allows entities to bring in elements of the arrangement where prices are more reliable and to use the remainder to price the intangibles.

If the residual approach is used, the entity should be comfortable that the residual approach results in a faithful representation of the standalone selling price.

Combination of Methods

Entities may use the residual approach if more than one good or service in the contract has a highly variable or uncertain standalone selling price. However, in this situation, an entity may have to use a combination of methods to estimate the selling prices. To use a combination of methods, entities should use this process:

1. Apply the residual approach to estimate the aggregate of the standalone selling price for all the goods or services with highly variable or uncertain selling prices.
2. Use another technique to estimate the standalone selling price of each promised good or service with highly variable or uncertain selling prices.

If the entity uses a combination of methods, it needs to evaluate whether allocating the transaction price at those estimated standalone selling prices is consistent with the Standard's allocation objectives and the guidance on estimating standalone selling prices. (ASC 606-10-32-35)

Allocation of a Discount

If an entity sells a bundle of goods or services for an amount less than the total of the standalone selling prices of the individual goods or services, the entity should treat the difference as a discount. The entity generally allocates the discount proportionally based on relative standalone selling prices. There is significant judgment involved in allocating a discount, and entities will need to have robust policies in place. For instance, the entity will need to have a policy that defines “regularly sells.” (ASC 606-10-32-36)

Allocation of Variable Consideration

As discussed earlier, some contracts contain consideration that is variable based on achievement of certain thresholds or goals being met, such as ontime completion of a project. Variable consideration is measured using one of two methods—probability weighted or most likely amount—and is subject to constraint. Variable consideration adds a layer of complexity to allocating the transaction price and may be subject to change over time.

Change in Transaction Price not Related to Modification

The change in transaction price should be recognized as revenue or as a reduction in revenue in the period in which the change takes place. (ASC 606-10-32-43) The cumulative recognized revenue will then represent faithfully the revenue the entity would have recognized at the end of the subsequent reporting period as though the entity had that information at contract inception.

Subsequent information Related to Variable Consideration

In cases where information related to variable consideration comes to the entity's attention between the end of the reporting period and the release of the financial statements, the entity should follow the guidance in Topic 855, Subsequent Events, and IAS 10, Events after the Reporting Period.

Direct the Use of an Asset

A customer may have the future right to direct the use of an asset. However, the customer must have actually obtained that right for control to have transferred. Transfer of control may occur during production or afterwards. Directing the use of an asset means the customer has the right to:

• Deploy the asset,
• Allow another entity to deploy it, or
• Prevent other companies from having control of the asset.

Benefits of the Asset

Conceptually, the benefits of the asset are the potential cash flows—either inflows or savings in outflows. These benefits can be obtained directly or indirectly by, for example:

• Using the asset to:
  • Produce goods
  • Provide services
  • Enhance the value of the assets
  • Settle liabilities
  • Reduce expenses
• Selling the asset
• Exchanging the asset
• Pledging the asset
• Holding the asset.

Other Considerations

When evaluating control, the entity must consider the effect of any agreement to repurchase the assets. (ASC 610-10-25-26) Repurchase agreements are explored in detail later in this chapter.

Note that, unlike other aspects of the standard, Step 5 does not have a practical expedient for contracts with a duration of less than a year. The entity has to analyze all contracts to determine if the obligation is satisfied over time or at a point in time.

Criterion 1—Customer Simultaneously Receives and Consumes the Benefit as the Entity Performs

The Boards created this criterion to clarify that for pure service contracts, services are transferred over time even if the services are received and consumed at the same time. They specified that this criterion does not apply to an asset that is not consumed completely as the asset is received. (ASU 2014-09 BC 125-128)

Contractual or practical limitations that prevent an entity from transferring the remaining obligations to another entity are not part of this assessment. However, the entity should consider the implications of possible termination of the agreement.

Bear in mind that not all service contracts fit this criterion, particularly those that create a work-in-process asset. The criterion does not apply when the entity's performance is not immediately consumed by the customer. For example, an entity may have a contract to provide a professional opinion. During the course of the engagement the entity creates a work in process. These circumstances do not fit Criterion 1. For those cases, the entity must consider Criteria 2 and 3.

Criterion 2—Entity's Performance Creates an Asset that the Customer Controls as the Asset is Created or Enhanced

The customer's control of an asset as it is being created or enhanced indicates that the customer is getting the benefits of the asset. Thus, the entity's performance transfers the assets to a customer over time. This criterion is consistent with the rationale for using the percentage-of-completion method in previous standards. In effect, the entity agrees to a continuous sale of assets as it performs.

Criterion 3—Entity's Performance does not Create an Alternative Use, but Entity has an Enforceable Right to Payment for Performance Completed

In some situations, applying the first two criteria might be challenging, and it might be unclear whether the asset is controlled by the customer. So, the Boards developed Criterion 3 for entities that create assets with no alternative use, but where the entity has the right to payment. This criterion might be useful for goods or services that are specific to a customer.

Criterion 3 may be the criterion most relevant to long-term contracts accounted for under the percentage-of-completion method, although the standard does not use that term. Instead, the standard looks to the terms of the contract. Thus, a reporting entity may not be able to use the same measure of progress as under the percentage-of-completion method. The criterion also puts even greater importance on the way a contract is drafted.

In applying this criterion, entities should consider contractual restriction and practical limitations, but not possible termination.

Determining the point in Time at which a Performance Obligation is Satisfied

To determine the point in time, the entity must consider when control has transferred and the customer has control of the assets. (Control is discussed earlier in this chapter. Remember, control is determined from the customer's perspective.) Also, the standard provides indicators (not conditions that must be met) that help the entity assess when the customer has the ability to direct the use of the asset, tangible or intangible, and obtains the benefits from the asset. Indicators of control include when the customer has:

• Present obligation to pay
• Legal title
• Physical possession
• Risks and rewards of ownership
• Accepted the asset.

Not all of the indicators need to be met. These indicators are not hierarchical, and there is no suggestion that certain indicators should be weighted more heavily than others. (ASC 606-10-25-30) Below is more information about the indicators.

Practical Expedient

If an entity has a right to consideration for an amount that corresponds directly to the value transferred to the customer of the entity's performance obligation completed to date, the entity may, as a practical expedient, recognize revenue for the amount the entity has a right to invoice. (ASC 606-10-55-18) A common example of this is a service contract where the entity bills a fixed amount for each block of time provided. Assessing whether an entity's right to consideration corresponds directly with the value to the customer requires judgment.

The TRG⁴ examined a question regarding situations where an entity may change the price per unit transferred to the customer over the term of the contract. TRG members generally agreed that the resolution depends on the facts and circumstances of the arrangement. The TRG further opined that in contracts with changes in rates, it is possible to meet the practical expedient requirement as long as the rate changes reasonably represent the changes in value to the customer. For example, an IT support services contract where the level of service decreases as the level of effort decreases might qualify. The TRG gave another example: A contract to purchase electricity at prices that change each year based on the forward market price of electricity would qualify for the practical expedient if the rates per unit reflect the value of the provision of those units to the customer. Note of caution to SEC reporters: the SEC observer at the TRG meeting noted that entities need to have strong supporting evidence that variable prices represent the value to the customer.

In assessing whether the practical expedient can be applied, entities should also evaluate significant upfront payments or retrospective adjustments to determine if they have a right to invoice for each incremental good or service that corresponds directly to the value to the customer. In addition, entities should be aware that the presence of an agreed-upon customer payment schedule does not mean that the amount an entity has the right to invoice corresponds directly with the value to the customer of the entity's performance completed to date. In addition, the existence of specific contract minimums or volume discounts does not necessarily preclude use of the practical expedients if those clauses are nonsubstantive.

Methods for Measuring Progress

To determine the best method, the entity should look at the nature of the promised goods and services and the nature of the entity's performance. The standards do not prescribe any particular methods, but do present two broad methods to consider. Progress measures may be input or output methods.

Output methods are:

• Based on the value to the customer of the goods or services transferred,
• The results of the efforts expended, and
• Directly measure the value to the customer relative to the total goods or services provided.

“Value to the customer” is an objective measure of the entity's performance. As seen below by the types of output method, value to the customer is not assessed on market prices or standalone selling prices.

Input methods use the entity's efforts, or inputs, devoted to satisfying performance obligation.

Two common methods are the cost-to-cost method (input) and units of delivery method (output).

Inability to Estimate Progress

It may be possible that an entity cannot reasonably estimate its progress toward completion of a performance obligation, for example, if it does not have reliable information or is in the early stages of the contract. In that case, the entity may recognize revenue as the work is performed, but only to the extent of cost incurred if the entity expects to recover costs. However, no profit can be recognized. Once the entity is able to make a reasonable estimate of performance, it should make a cumulative catch-up adjustment for any revenue not previously recognized. This adjustment should be made in the period of the change in the estimate. (ASC 606-10-25-36 and 25-37)

Measuring Progress Toward Satisfaction of a Stand-Ready Obligation

The promise in a stand-ready obligation is the assurance that the customer will have access, not delivery, to a good or service. If the stand-ready obligation is satisfied over time, a time-based measure of progress, like a straight line, may be appropriate. Often, this might be the case for unspecified upgrade rights. However, entities should examine the contract and not automatically default to a straight-line attribution model. For example, straight-line attribution would not be appropriate if the benefits are not spread evenly over the life of the contract. An example of this is a contract with a snow removal provision that obviously provides more benefit in winter.

Determining the Measure of Progress for a Combined Performance Obligation

For a performance obligation consisting of two or more goods or services that is satisfied over time, an entity must select a measure of progress that faithfully depicts the economics of the transfer. Such a determination may be difficult and require significant judgment. Entities should not merely default to an approach, like final deliverable, where revenue would be recognized over the performance period of the last promised goods or services. When choosing a method, entities should consider the reason why the goods or services were bundled in the first place. If a good or service was bundled because it was not capable of being distinct, it may not provide value on its own, and the entity may not want to consider that good or service when determining the pattern of transfer. If a measure of progress does not faithfully depict the economics of the transfer, the entity should consider whether there may actually be more than one performance obligation.

Overview

As any consumer knows, there are different types of warranties. Some warranties may simply provide assurance that the product will function as expected in accordance with certain specifications—assurance-type warranties. Other warranties provide customers with additional protection—service-type warranties. The type of warranty and the benefits provided by the warranty dictate the accounting treatment. So, the entity must first assess the nature of the warranty.

Warranties can be:

• Explicit—written in the contract, or
• Implicit as a result of customary business practices or law.

Warranties can also be standard or extended.

Assessing the Warranty

A warranty purchased separately is a separate performance obligation. Revenue allocated to the warranty is recognized over the warranty period. A warranty not sold separately may still be a performance obligation. Entities have to assess the terms of the warranty and determine under which category below the warranty falls:

• Category 1. These warranties, called assurance-type warranties, provide assurance that the product will function. A warranty that only covers the compliance of the product with agreed-upon specifications is termed “an assurance warranty.” These warranties obligate the entity to repair or replace the product and are accounted for under the guidance in ASC 460, Guarantees.
• Category 2. These warranties, called service-type warranties, provide a service in addition to product assurance. For example, this category of warranty offers additional protection against wear and tear or against certain types of damage. The additional service is accounted for as a separate performance obligation.

When assessing whether the warranty, in addition to product assurance, provides a service that should be accounted for as a separate performance obligation, an entity should consider factors such as:

1. Whether the warranty is required by law—If the entity is required by law to provide a warranty, the existence of the law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.
2. The length of the warranty coverage—The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.
3. The nature of the tasks that the entity promises to perform—If it is necessary for an entity to perform specific tasks to provide the assurance that the product complies with agreed-upon specifications (for example, a return shipping service for defective products), then those tasks likely do not give rise to a performance obligation.(ASC 606-10-55-33)

Overview

More than one party may be involved in providing goods or services to a customer. In those situations, the Standard requires the entity to determine whether for each specified good or service it is a principal or an agent, whether the nature of its promise is a performance obligation:

• To provide the specified goods or services (principal), or
• To arrange for another party to provide them (agent).

Exhibit—Principal versus Agent

As with other issues in the Standard, whether an entity is a principal or an agent depends on control. Before assessing control, the entity must identify the unit of account, that is, the specified good or service being provided to the customer. An entity may be a principal for one or more specified goods or services in a contract and an agent for others in the same contract. The entity must also determine the nature of each specified good or service:

• A good
• A service
• A right to a good or service from the other party that it then combines with other goods or services to provide a specified good or service to the customer.

  (ASC 606-10-55-37A)

The entity must determine whether it has control of the goods or services before they are transferred. If the entity has control before transfer to the customer, it is the principal. The Standard includes indicators to support the assessment of whether an entity controls the specified good or service before it is transferred. These include but are not limited to:

1. The entity is primarily responsible for fulfilling the promise to provide the specified good or service.
2. The entity has inventory risk before or after the goods have been transferred.
3. The entity has discretion in establishing prices for the specified goods or services.

   (ASC 606-10-55-39)

These indicators are meant to support the entity's assessment. They should be considered in context and not be used as a checklist. The relevance of individual indicators to the control evaluation may vary from contract to contract.

Control of inventory is an indicator that one entity is the principal. Having substantive inventory risk may indicate the entity is the principal. An entity may fulfill the performance obligation or it may engage another party to do so.

If control of the specified goods or services is unclear, the entity should recognize revenue net.

Assessing whether the Customer has a Material Right

When assessing whether a customer has a material right, the entity should consider quantitative and qualitative factors. Qualitative factors might be:

• What a new customer would pay for the same service
• The availability and pricing of competitors' alternatives
• Whether the average customer life indicates the fee is an incentive to stay beyond the stated contract term.

In addition, entities should consider not only the current transaction, but also accumulations in programs, such as loyalty programs.

Some contracts restrict customers from selling a good or service and that raised an issue with the Boards. The entity might conclude that the customer cannot benefit from a good or service because it cannot resell the good or service for more than scrap value. On the other hand, the entity might conclude that the customer can benefit from the good together with other readily available resources. The Boards concluded that the assessment should be based on whether the customer could benefit from the good or service on its own rather than how the customer may actually use the good or service. Therefore, in making the assessment, the entity should disregard any contractual limitations.

On the other hand, if the option price reflects the standalone selling price, the entity is deemed to have made a marketing offer. (ASC 606-10-55-43)

Entities must carefully assess contract terms to distinguish between options and marketing offers.

Recognition

Revenue is recognized when future goods and services are transferred or when the option expires. The transaction price is allocated to the performance obligations (including the option based on relative standalone selling prices). The estimate of the standalone selling price of an option reflects the discount a customer receives when exercising the option, adjusted for the discount a customer receives without exercising the option and the likelihood the option will be executed.

Practical Alternative

Estimating the standalone selling price may be difficult because the option may not be sold separately. The Standard provides a practical alternative. Instead of estimating the standalone selling price of the option, the entity can use the practical alternative and evaluate the transaction assuming the option will be exercised. The transaction price is determined by including any consideration estimated to be received from the optional goods and services. The transaction price is then allocated to all goods and services, including those under option. The alternative can be applied if the additional goods or service meet both of the following conditions:

• They are similar to the original goods and services in the contract, and
• They were provided in accordance with the original contract's terms. (ASC 606-10-55-45)

Recognition

Upon receipt of the customer's advance payment, the entity records a contract liability for the amount of the payment. When the contract performance obligations are satisfied, the entity recognizes revenue. A portion of the payment may relate to contractual rights that the entity does not expect the customer to exercise. The timing of revenue recognition related to breakage depends on whether the entity expects to be entitled to a breakage amount. To determine whether it expects to be entitled to a breakage amount, the entity should look to the guidance on constraining amounts of variable consideration found earlier in this chapter. The entity should recognize revenue for breakage proportionately as other balances are redeemed. The assessment of estimated breakage should be updated at each reporting period. Any changes should be accounted for by adjusting the contract liability.

Unclaimed Property (Escheat) Laws

Legal rights related to unexercised rights vary by jurisdiction. Entities may be required to remit payment related to unexercised rights to a governmental entity. These requirements may fall under unclaimed property or “escheat” laws. If the entity must remit unclaimed property to a governmental entity, the entity should not recognize breakage as revenue. In these situations, it is important for the entity to understand its legal rights and obligations.

Overview

In some industries, it is common to charge an upfront fee. An upfront fee relates to an activity that the entity must undertake to fulfill the contract. The activity occurs at or near inception of the contract, and the upfront fee is an advance payment for future goods or services. Examples of upfront fees are:

• Joining, for example, a gym membership,
• Activation, for example, a cell phone,
• Other initial set-up fees.

Recognition

Upon receipt of the fee, the entity should not recognize revenue, even if the fee is nonrefundable, if it does not relate to the performance obligation. Upfront fees are allocated to the transaction price and should be recognized as revenue when the related goods or services are provided. If there is an option to renew the contract and the option provides a material right, the entity should extend the revenue recognition period beyond the initial contract. (ASC 606-10-55-51)

Practical Alternative

If it is determined that the upfront fee should be accounted for as an advance payment for future goods or services, the entity may make use of the practical alternative mentioned in the previous section of this chapter on “Customer Options to Purchase Additional Goods or Services.” (ASC 606-10-55-45)

Set-Up Costs

Some nonrefundable fees are intended to compensate an entity for costs incurred at the beginning of the contract. These costs may be, for example, for the hiring of additional personnel, systems set-up, or moving assets to the service site. These efforts usually do not satisfy performance obligations because goods or services are not transferred to the customer. The fees are advance payment for future goods or services. The underlying costs should not be factored into the measure of progress used for performance obligations satisfied over time if they do not depict the transfer of services to the customer. Some set-up costs might not meet the criteria for capitalization as fulfillment costs.

Renewal Options

In some situations, for instance, a gym membership, a customer does not have to pay an additional upfront fee when the contract is renewed. Thus, the renewal option may give the customer a material right.

If a material right is not provided, the fee would be recognized over the contract term.⁶ If a material right is provided, it is a performance obligation and the entity should allocate part of the transaction price to the material right. The entity has the option to apply the practical alternative for contract renewal if the criteria are met.

As with other aspects of the Standard, the entity has to exercise judgment when determining the amount to allocate to a material right. To make its assessment, the entity should look at historical data, expected renewal rates, marketing analysis, customer input, industry data, etc.

Sale of Intellectual Property

An agreement that calls for the transfer of control of all the worldwide rights, exclusively, in perpetuity, for all possible applications of the intellectual property (IP) may be considered a sale rather than a license. If the use of the IP is limited by, for instance, geographic area, term, or type of application or substantial rights, then the transfer is probably a license. If the agreement represents a sale, the transaction is treated as a sale subject to the five-step model, including the guidance on variable constraint and the recognition constraint to any sale- or usage-based royalties.

Licenses of Intellectual Property

A license arrangement establishes a customer's right to an entity's intellectual property and the entity's obligations to provide these rights. With the prevalence of technology in every business, accounting for IP licenses has become more critical than ever. In addition to the software industry, IP licenses are common in other industries, such as:

• Entertainment and media
• Pharmaceuticals
• Retail and consumer
• Franchise.

Licenses may involve patents, trademarks, and copyrights. Licenses can:

• Be term-based or perpetual
• Be exclusive or nonexclusive
• Carry fixed to variable terms
• Require upfront payments or over time installments.

Assessing whether a License is Distinct

As with other performance obligations, entities should assess if a license represents a distinct performance obligation, including whether the customer can benefit from the license on its own or together with other readily available resources and whether the license is separately identifiable from other goods or services in the contract. Assessing whether a license is distinct may require significant judgment. (For more on determining whether a performance obligation is distinct, see the discussion earlier in this chapter.) The guidance in this section only relates to distinct licenses. Licenses that are not distinct include those that:

• Form a component of a tangible good and that is integral to the functionality of the item
• The customer can benefit from only in conjunction with a related service.

  (ASC 606-10-55-56)

If a license is not distinct, entities should account for the license and other goods and services as single performance obligation and look to the guidance in Step 5 to determine if the revenue should be recognized over time or at a point in time.

Nature of the Entity's Promise

Before identifying when the customer takes control of an asset, it is necessary to identify the nature of the entity's promise. Therefore, when accounting for a performance obligation that includes a license and other goods or services, the entity should consider the nature of its promise in granting a license. (ASC 606-10-55-57) The Standard classifies all distinct licenses of intellectual property into two categories:

1. A right to access the entity's intellectual property throughout the license period (or its remaining economic life, if shorter)
2. A right to use the entity's intellectual property as it exists at the point in time at which the license is granted.

   (Emphasis added.)

   (ASC 606-10-55-58)

When assessing whether a license is a right to use IP or a right to access IP or when identifying the promises in a contract, the entity does not consider restrictions of time, geography, or use of the license and guarantees provided by the licensor that it has a valid patent to the industry IP and that it will maintain and defend the patent. Those attributes define the scope of the customer's rights and not whether the entity satisfies its performance obligation at a point in time or over time. (ASC 606-10-55-64)

Exhibit—Comparison of Right to Access and Right to Use

The entity should assess whether the IP is expected to change during the term of the license. A customer does not meet the criteria for control if the IP is expected to change. If the entity is expected to be involved in the IP and undertake activities that significantly affect the licensed IP, this may be an indication the IP is expected to change.

To determine if a customer could expect the entity to undertake activities that significantly affect the IP, the entity should consider:

• Customary business practices, published policies, or specific statements
• Shared economic interest, such as a sales-based royalty.

To determine whether a license is a right to use or a right to access IP, the FASB provides clarified guidance about the nature of the license. The FASB's approach looks to the nature of the IP and focuses on whether activities undertaken by the entity significantly affect the IP. Utility relates to the IP's ability to provide value or benefits. Entities must determine if the license is either functional or symbolic and that category determines whether the license is a right to access or a right to use. For both types of IP, the entity cannot recognize revenue before the beginning of the period in which the customer is able to use and benefit from the license.

Exhibit—Categories of Distinct Licenses of Intellectual Property—FASB's Alternative Approach

Sales- or Usage-Based Royalties

For related information on sales- and usage-based royalties, see the section on Step 3.

Recognition

Revenue from a license of IP that is a right to access should be recognized over time. The entity should use a recognition method that reflects its progress towards completion of the performance obligation. Revenue from a license of IP that is a right to use should be recognized at a point in time. Once the entity determines that the revenue from the license should be recognized over time or at a point in time, the entity should apply the guidance in Step 5 to determine the point in time or to select the appropriate method to measure the revenue over time.

In any case, revenue cannot be recognized from an IP license before:

• The entity has made available a copy of the IP to the customer, and
• The license period has begun.

  (ASC 610-10-55-58C)

A Forward or Call Option

When the entity has an obligation (forward option) or right (call option) to repurchase the asset, the customer may have physical possession, but is limited in its ability to:

• Direct the use of the asset, and
• Obtain substantially all of the remaining benefits from the asset.

Therefore, the conditions as discussed in Step 5 for the customer to have control of the asset are not present, and the customer is deemed not to have control of the asset. The accounting treatment depends on the repurchase amount required. The entity should account for the contract as:

• A lease if the entity can or must repurchase the asset for a lower amount than the original selling price unless the contract is part of a sale-leaseback transaction. If a sale-leaseback transaction, the entity should account for the contract as a financing transaction and not as a sale-leaseback in accordance with ASC 840-40.
• A financing arrangement if the entity can or must repurchase the asset for an amount equal to or more than the original selling price of the asset.

  (ASC 606-10-55-68)

Recognition

When assessing the repurchase price, the entity should consider the time value of money. If the contract is accounted for as a financing arrangement, the entity should continue to recognize the asset, but the entity also recognizes a financial liability for any consideration received. Interest and processing and holding costs, if applicable, are recognized for the difference between the consideration received and the amount of consideration to be paid to the customer. The entity derecognizes the asset and recognizes revenue if the option is not exercised. (ASC 606-10-55-69 through 55-71)

Put Options

A put option gives the customer the right to require the entity to repurchase the asset. If the repurchase price is lower than the original selling price of the asset, the entity must evaluate at contract inception whether the customer has a significant economic incentive to exercise the option. The entity makes that judgment by considering the relationship of the repurchase price to the expected market value of the asset and the amount of time until the right expires.

If the entity concludes that the customer has a significant economic interest and anticipates that the option will be exercised, the option is accounted for as a lease, unless the agreement is part of a sale-leaseback transaction. (ASC 606-10-55-72) If not, the entity accounts for it as a sale with a right of return.

If the repurchase price is greater than or equal to the original selling price and is more than the expected market value of the asset, the entity accounts for the contract as a financing arrangement. The time value of money should be considered when comparing the repurchase price with the selling price. If the option expires unexercised, the entity derecognizes the liability and recognizes revenue.

Approval

A contract modification must be approved by the parties. Like the original contract, the modification should be approved:

• In writing,
• Orally, or
• Implied by customary business practice.

Until the modification is approved, the entity should continue to apply the guidance to the existing contract. (ASC 606-10-25-10)

Recognition

Recognition of contract modifications can be complex and requires careful analysis. The following sections explain the recognition process in detail.

When a modification occurs, entities must determine:

• If the modification has created a new contract and performance obligations, or
• If the existing contract has been modified.

If the entity determines that an existing, ongoing contract has been modified, then it must further analyze the modification to determine if the modification should be accounted for as:

1. A separate contract,
2. Effectively, a termination of the contract and execution of a new contract resulting in a prospective treatment,
3. Part of the original contract, which could result in a catch-up adjustment, or
4. A combination of 2 and 3 above.

The accounting treatment depends on what was changed. Under the Standard, to faithfully depict the rights and obligations of a contract modification, entities must account for modifications on a:

• Prospective basis—when the additional goods or services are distinct, or
• Cumulative catch-up basis—when the additional goods or services are not distinct.

Contract Modification Represents a Separate Contract

The concept underlying accounting for a modification as a separate contract is that there is no substantive economic difference under the given set of circumstances between a new contract and a modification. Therefore, the entity must analyze the agreement and account for the modification as a separate contract if:

1. The scope of the contract increases because of the addition of distinct promised goods or services, and
2. The price of the contract increases by an amount of consideration that reflects the entity's standalone selling prices of the additional promised goods or services and any appropriate adjustment to that price to reflect the circumstances of the particular contract.

   (ASC 606-10-25-12)

Further, to be distinct, two criteria must be met:

1. The customer could benefit from the goods or services.
2. The promise to transfer a good or service is separately identifiable from other promises in the contract.

   (ASC 606-10-25-19)

(See earlier in this chapter for further information on determining whether performance obligations are “distinct.”)

When these criteria are met, there is no economic difference between an entity entering into a separate contract for the additional goods or services and an entity modifying an existing contract.

Note that only modifications that add distinct goods or services can be treated as separate contracts. Modifications that reduce the amount of good or service or change the scope, by their nature, cannot be considered separate contracts. They would be modifications of the original contract.

If the entity determines that the modification should be accounted for as a separate contract, the next step is to assess the agreement using the five contract criteria detailed earlier in this chapter. If the contract meets the criteria, the company should account for the change prospectively, accounting for the change in the current period and in any future period affected. Previously reported results are not changed.

Contract Modification does not Represent a Separate Contract

If the new goods or services are not distinct or not priced at the proper standalone selling price according to the criteria above, the changes are not treated as a separate contract. They are considered changes to the original contract, and the entity must then determine how to account for the remaining goods or services. That accounting depends on whether or not each of the remaining goods or services is distinct from the goods or services transferred on or before the date of the modification. The Standard describes three possible scenarios and the accounting under each:

• Scenario 1—Remaining goods or services are distinct
• Scenario 2—Remaining goods or services are not distinct
• Scenario 3—Remaining goods or services are a combination of distinct and not distinct goods or services.

Account for the remaining goods or services, that is, for the goods or services not transferred as an adjustment to the existing contract, as follows.

Change in Transaction Price Resulting from Modification

If a change in transaction price occurs as a result of a contract modification, the Standard takes an approach that is consistent with other modifications. That is, a contract modification that only affects the transaction price is accounted for like other contract modifications:

• Prospectively if the remaining goods or services are distinct.
• As a cumulative catch-up adjustment if the remaining goods or services are not distinct.

A change in transaction price may occur after a modification, but before fulfillment of performance obligations is completed. In that case, the Standard provides the following guidance:

1. If the modification is accounted for as if it were a termination of the existing contract and the creation of a new contract, the entity allocates the change in the transaction price to the performance obligations identified in the contract before the modification if and to the extent that the change in transaction price is attributable to an amount of variable consideration promised before the modification.
2. If the modification was not accounted for as a separate contract, the entity allocates the change in the transaction price to the performance obligations in the modified contract. These are the performance obligations that were not fully satisfied at the date of the modification.

   (ASC 606-10-32-45)

For more information on changes in transaction price, see the section on transaction prices earlier in this chapter.