Revenue Recognition (Topic 605) Multiple-Deliverable Revenue Arrangements A consensus of the FASB Emerging Issues Task Force

Overview  

• Affects accounting and reporting for all vendors that enter into multiple-deliverable arrangements with their customers
  • Example: A Company that sells a product bundled with a service.
   
• Does not affect arrangements for which industry specific allocation and measurement guidance exists (e.g., software transactions; long term construction contracts)
• Update provides amendments to the criteria in subtopic 605-25 for separating consideration in multiple element arrangements
  • Eliminate the fair value criteria for treating elements as separate units of accounting
  • Replaces “Fair Value” with “Selling Price” in the criteria for allocating consideration
   

Current Guidance – Separation Criteria 

• To separate multiple deliverables under an arrangement into separate units of accounting, the following three criteria must be met:
  • The delivered item must have value on a stand alone basis. The items have value on a stand alone basis if they are sold separately by any vendor or could be resold by the customer. Does not require the existence of an observable market
  • There is objective and reliable evidence of the fair value of the undelivered item
  • If a general right of return exists relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in control of the vendor
   

Amended Guidance – Separation Criteria 

• Removes the criteria “There is objective and reliable evidence of the fair value of the undelivered item” for determining whether or not elements can be broken out into separate units of accounting
  • Companies will no longer need to show that they sell the item separately on a consistent basis, at a certain price; or demonstrate that there are other vendors selling the same product at a certain price
   

Observation: This should have a favorable impact on early stage technology companies. Early stage technology companies that are just beginning to sell their product are often required to provide significant discounts, thus resulting in a wide range of prices, and have often not had an opportunity to sell any of the elements on a stand alone basis. In addition, their solutions are often very unique, making it very difficult, if not impossible to find another vendor selling the same product or service. Where these companies were in the past unable to treat the multiple elements under the arrangement as separate units of accounting because they did not meet the VSOE or third party evidence of fair value criteria, they may now find it easier to do so given the elimination of this criteria.

Current Guidance – Allocation of Consideration 

• If there exists objective and reliable evidence of fair value of all units of accounting, then the arrangement consideration is allocated to the separate units based on their relative fair value
• Residual method may be used if there is only objective and reliable fair value for the undelivered elements — under this method, consideration is allocated to the undelivered elements based on fair value and the remaining consideration is allocated to the delivered elements.
• Arrangement consideration is now allocated to all deliverables at inception based on their relative selling price (the relative selling price method)
  • If VSOE exists based on that value
  • IF VSOE does not exist, then third party evidence of selling price should be used
  • If neither of the above exist, then consideration should be allocated based the vendor’s best estimate of the selling price for that deliverable
   
• Residual method is no longer permitted

Vendor Specific Objective Evidence (VSOE) of Selling Price  

• Retains the definition of VSOE of fair value under current guidance.
• Vendor Specific objective evidence of selling price is limited to either of the following:
  • The price charged for a deliverable when it is sold separately
  • For a deliverable not being sold separately, the price established by management having the relevant authority (it must be probable that the price, once established, will not change before the separate introduction of the deliverable into the marketplace)
   

Third Party Evidence of Selling Price 

• Retains the guidance of Third Party Evidence of Fair Value
• Third party evidence of selling price is the price of the vendor’s or any competitor’s largely interchangeable products or services in a standalone sales to similarly situated customers.

Vendor’s Best Estimate of Selling Price (New) 

• The Vendor’s best estimate of selling price shall be consistent with the objective of determining vendor-specific objective evidence of selling price for that deliverable; that is, the price at which the vendor would transact if the deliverable were sold by the vendor regularly on a standalone basis. The vendor shall consider market conditions as well as entity-specific factors when estimating the sales price.
• Contractually stated prices for individual products or services shall not be presumed to be representative of VSOE evidence, third-party evidence or a vendor’s best estimate.

Disclosure 

• Objective: Provide both qualitative and quantitative information about a vendor’s revenue arrangements and about the significant judgments made and how the application of this new guidance may change the timing and amount of revenue recognition
• Vendor shall disclose
  • The nature if its multiple-deliverable arrangements
  • The significant deliverables within the arrangements
  • The general timing of delivery or performance of service for the deliverables within the arrangements
  • Performance, cancellation, termination, and refund-type provisions
  • A discussion of the significant factors, inputs, assumptions, and methods used to determine selling price (whether VSOE, third party evidence, or estimated selling price) for the significant deliverables
  • Whether the significant deliverables in the arrangements qualify as separate units of accounting, and the reasons that they do not qualify as separate units of accounting, if applicable
  • The general timing of revenue recognition for significant units of accounting
  • Separately, the effect of changes in either the selling price or the method or assumptions used to determine selling price for a specific unit of accounting if either one of those changes has a significant effect on the allocation of the arrangement consideration
   

Adoption 

• This update is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010.
• Early adoption is permitted. If adopted early, and the period of adoption is not the beginning of the entity’s fiscal year, the entity will be required to apply the provisions of this update retrospectively from the beginning of the fiscal year.
  • Early adopters will also be required to disclose the following information at a minimum for all previously reported interim periods in the fiscal year of adoption: revenue, income before income taxes, net income, earnings per share and the effect of the change for those captions
   

Comparison to IFRS 

• IFRS provides little guidance about the allocation revenue under multiple element arrangements
• Requires companies to evaluate the substance of a transaction when determining whether deliverables should be separated or combined for accounting purposes.
• The provisions of this update are expected to more closely align the accounting for multiple-deliverable revenue arrangements in US GAAP with IFRS

Example:

A company sells a piece of hardware and a subscription to use a hosted software solution for one year. The company has never sold either the hardware of the subscription to software separately. The arrangement priced the deliverables as follows.

Hardware     - $50,000
Subscription - $10,000 per month ($120,000 annually)

The company is not aware of any other vendor selling an interchangeable solution. In the current arrangement, the company discounted the subscription to use software by 50%. The company plans to continue to work off the standard price of $240,000 for an annual subscription when selling to future customers and may discount from the standard price for future customer arrangements.

Example - Analysis of Scope 

Does this arrangement fall into the multiple deliverable guidance?

The customer is purchasing a subscription to use software and does not take ownership of the software. In effect the customer is purchasing a service, not a software license. As a result, software revenue recognition guidance does not apply and instead the multiple deliverables literature controls.

Example – Current Guidance 

How would the arrangement be accounted for under current guidance?

• Since the company (vendor) does not sell the deliverables on a standalone basis and the company may discount from their standard price in future arrangements, the company cannot demonstrate VSOE of fair value for the deliverables.
• In addition, there are no other vendors selling a largely interchangeable solution.
• As a result, there is no stand alone fair value for the deliverables. Therefore, the units cannot be broken into the separate units of accounting and must be accounted for as one unit of accounting.
• The entire arrangement consideration of $170,000 would be recognized as all of the elements under the contract are delivered, in effect, ratably over the 12 month subscription period.

Example – Amended Guidance Separation 

• How does the amended guidance change the accounting for the above transaction?
  • Company still does not have VSOE of selling price
  • Company also still does not have third party evidence of selling price
   
• Since there is no longer a requirement to have objective and reliable evidence of fair value for the elements to be treated as separate units of accounting, assuming the other criteria have been met, the company can account for the equipment and the subscription as separate units.

Example – Amended Guidance Allocation 

Allocation: The company’s best estimate of the selling price for the subscription is $240,000. Even though they may discount in other sales contracts to varying extent, they believe this price best represents the value of the deliverable and is the price at which they will seek to sell the service.

As a result, the company would allocate arrangement consideration to the separate units of accounting as follows: 

 

	Stated Price	Best Estimate of Selling Price	Allocation
Hardware	50,000	50,000	17.2%
Subscription	120,000	240,000	82.8%
	170,000	290,000	100.0%

 

Example – Amended Guidance Allocation: 

• Hardware 170,000 x 17.2% = $29,240
• Subscription 170,000 x 82.8% = $140,760
• The amount allocated to the hardware of $29,240 would be recognized upon delivery of the hardware.
• The amount allocated to the subscription of $140,760 would be recognized monthly over the subscription term.