Revenue recognition for a contract with multiple deliverables begins with allocating the contract fee to the various components. Revenue recognition accounting guidance has many, many sources, so this process is not always simple. This article will lay out the foundation. Later posts will expand on some of the concepts and nuances.
Accounting for a contract with multiple deliverables, or elements, is primarily governed by ASC 605-25, Multiple-Element Arrangements. ASC 605-25 provides no revenue recognition methods; rather, it provides guidance on how to 1) allocate the contract fee among its elements and 2) segregate, or not as the case may be, the elements into separate units of accounting. The allocation process has three major steps. First, identify the GAAP guidance that applies to each element and group the elements according their applicable guidance. Second, allocate the fee to each element group. Third, allocate the fee applicable to each group to its individual elements.
Hardly. What would on the surface appear to be a bright lines separating the various revenue recognition accounting guidance are actually quite blurred. For example, how would you treat a piece of computer hardware sold together with software and implementation services? Is the hardware a tangible product? Should the software be accounted for separately under the software revenue recognition guidance? And what about the services? The correct answer is, as is often the case in accounting, it depends. In this case it depends upon whether the software and/or services are essential to providing the functionality of the hardware, or vice versa, or if the implementation services also involve development, modification or customization of the software. It becomes clear very quickly that having a thorough understanding of the contract terms and deliverables is essential to getting this right.
Identify GAAP Guidance Applicable to Each Element
Basic revenue recognition is addressed in ASC 605. This Topic covers revenue in general (ASC 605-10), sales when there is a right of return or repurchased subject to an operating lease (ASC 605-15), revenue from services (ASC 605-20), certain research and development arrangements (ASC 605-28), construction and production-type contracts (ASC 605-30), and involuntary conversions (ASC 605-40). This topic also includes accounting for multiple elements as noted above (ASC 605-25), as well as accounting guidance covering reporting of revenue gross versus net (ASC 605-45) and customer payments (ASC 605-50). In addition to these, there are 26 industry-specific revenue recognition topics that cover agriculture, airlines, contractors, development stage companies, entertainment, extractive activities, financial services, franchisors, health care entities, not-for-profit entities, real estate, regulated industries and software. On top of the aforementioned revenue recognition guidance, you also need to consider non-revenue guidance such as leases (ASC 840), guarantees (ASC 460), derivatives and other financial instruments (ASC 815 and ASC 825), among others.
This sounds like a lot and it is. Revenue recognition is a slippery slope and this is one of the primary reasons…so much to know and some fairly blurry lines. Until the FASB and IASB issue the new converged revenue recognition standards currently in deliberation (scheduled for January 2013 last I heard), this is our world. The GAAP Logic Revenue Recognition Analysis tool will help significantly in the step since we have already gone through the process of identifying the various GAAP guidance and revenue recognition methods available for most types of deliverable. This tool is not a shortcut. You still need to understand the contract thoroughly.
Allocate the Contract Fee to Each Group
The allocation process is a function of the accounting guidance applicable to the elements in the contract. Most groups will receive fee allocated based on relative selling price while others require a specific allocation based on some other measure. The table below shows the allocation hierarchy:
|Basis for Allocation||Common Deliverables|
|Fair value allocation||Any instrument that is carried at fair value, whether by requirement or election, must have an amount equal to fair value allocated to it. If the fee is insufficient to allocate fair value, then you should consider the possibility that the fair value measurement is not accurate. Instruments falling into this category include derivatives, embedded derivative features and financial guarantees.|
|Specific allocation||Some accounting guidance specifies an initial carrying amount. An extended maintenance agreement or an extended warranty plan must be carried at the contract amount (a liability) at inception.|
|Relative selling price allocation||All elements falling under accounting guidance that does not specify a measurement method should be allocated contract fee based on relative selling price. This includes software, construction services, leases, entertainment properties, franchise sales and many others.|
As the chart implies, you would first allocate fee to any elements that must be reported at fair value (whether voluntarily or as a result of an election), and then to elements that must be carried at an amount as specified in the applicable guidance. Any unallocated fee remaining is then allocated to the other groups based on relative selling price.
So, what is ‘selling price’? ASC 605-25 defines selling price as the price at which that the company would transact a sale. List price or rate card price is quite often not selling price since the company may discount these prices in transacting actual sales. The accounting guidance provides a hierarchy of evidence of selling price that must be followed and documented for each element. The hierarchy is as follows:
- Vendor-specific objective evidence (VSOE) – VSOE is defined as the price of the deliverable when sold separately and is evidenced by actual sales of the deliverable on a stand-alone basis. If the deliverable is not yet sold separately, then price of the deliverable established by management with relevant authority may be used. If this price is subsequently proved wrong by actual sale transactions, then the company will have to consider whether the original price was used in error and correct the previously-issued financial statements.
- Third party evidence – Third party evidence includes prices charged by competitors on a stand-alone basis for products and/or services, as applicable, with substantially similar features. Since many software elements are by nature unique, third party evidence of selling price is infrequently available.
- Management estimate – If neither VSOE or third party evidence is available, then the company should use management’s estimate of selling price on a stand-alone basis.
The term selling price does not always seem to fit the situation. For example, a lease does not have a ‘selling price’. The equivalent for purposes of allocation are aggregate minimum lease payments due to the lessor under the lease (careful…minimum lease payments have different meaning to the lessor and the lessee!).
Once you have the aggregate selling price applicable to each group, allocate the contract fee (or remaining contract fee after allocating to fair value elements and specific allocation elements as noted above) to each group.
Spread the Allocated Group Fee to Individual Elements Within the Group
Now that you have the fee allocated to the groups, you can now spread the group fee to the individual elements. Most of the time this is simple math where the group fee is allocated based on the the relative selling price of each element within the group. Significant complication is introduced when there are significant incremental discounts on future purchases built into the contract. These discounts likely need to be treated as separate elements be allocated to both the current and future purchases. This results in additional revenue deferral that is generally not recognized until the discounts are used or lapse. There is a more detailed discussion of discounts in this software revenue recognition post (which should be used by analogy on elements falling under the multiple-element arrangement guidance of ASC 605-35). I’ll provide further guidance and some example calculations in a later post so stay tuned.
And, of course, the GAAP Logic Revenue Recognition Analysis tool deals with discounts expertly. It’s free! Use it!