Accounting for Multiple Deliverable Revenue Arrangements

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New guidance from McGladrey for companies on applying ASC 605-25, Revenue Recognition – Multiple-Deliverable Arrangements

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Accounting for Multiple Deliverable Revenue Arrangements

  1. 1. Accounting for multiple-deliverable revenue arrangements Prepared by: Paige Kuroyama, Partner, Western Region Professional Practice Office, McGladrey LLP 213.330.4640, paige.kuroyama@mcgladrey.com Brian H. Marshall, Partner, National Professional Standards Group, McGladrey LLP 203.312.9329, brian.marshall@mcgladrey.com December 2013 Introduction Vendors often provide multiple products or services to their customers as part of a single arrangement or a series of related arrangements. These deliverables may be provided at different points in time or over different time periods. As a simple example, a vendor may enter into an arrangement with a customer to deliver and install a tangible product along with providing one year of maintenance services. In this arrangement, there are three deliverables: (1) the product, (2) installation and (3) maintenance services. Issues often arise regarding how and whether to separate these deliverables and how to allocate the overall arrangement consideration. Subtopic 605-25, Revenue Recognition – Multiple-Element Arrangements, of the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) provides the guidance that should be followed in accounting for this and many other revenue arrangements with multiple deliverables. While ASC 605-25 has been in effect for some time, many application issues continue to arise in practice – from recognizing that a multiple-deliverable arrangement should be accounted for in accordance with ASC 605-25 to applying the provisions of ASC 605-25 in an appropriate manner. These practice issues, if not appropriately addressed, could have significant consequences on a vendor’s financial statements, including a misstatement of the vendor’s revenue for the period. We have prepared this white paper to be used as a first-line resource in addressing some of these practice issues. The overall model in ASC 605-25 requires a vendor to determine whether the multiple deliverables in an arrangement should be separated and, if so, to allocate the arrangement consideration using a relative selling price method. Each of these requirements is discussed in this white paper. The scope of ASC 605-25 and its disclosure requirements are touched on as well. Before discussing ASC 605-25 in more detail, it is worth noting that the FASB is expected to issue a comprehensive standard on revenue recognition in the first quarter of 2014. This standard will supersede virtually all revenue recognition guidance in the ASC, including the guidance in ASC 605-25. While the separation and allocation guidance in the new standard is expected to be similar in some respects to the
  2. 2. guidance in ASC 605-25, some changes are anticipated. Entities will have plenty of time to implement the new standard as it will be effective for calendar year-end public companies in 2017 and calendar year-end private companies in 2018. Until then, the guidance in ASC 605-25 and this white paper continue to be applicable to multiple-deliverable arrangements. Scope If an arrangement includes deliverables for which there is other applicable guidance in the ASC on how to account for multiple-deliverable arrangements (e.g., software, leases), that guidance should be followed. Otherwise, the guidance in ASC 605-25 should be followed. Refer to ASC 605-25-15 for more guidance on the scope of ASC 605-25 and how it interacts with other guidance in the ASC on accounting for multipledeliverable arrangements. Separation of multiple deliverables Pursuant to ASC 605-25-25-5, a delivered item is accounted for as a separate unit of accounting if both of the following criteria are met: yy The delivered item has standalone value to the customer. yy If the customer has a general right of return on the delivered item, delivery or performance of the undelivered item(s) is probable and substantially within the vendor’s control. If only one or neither of these criteria are met, the deliverable being evaluated must be bundled together with other deliverables in the arrangement for accounting purposes. If both of these criteria are met, separation is not optional. In other words, a vendor cannot choose to bundle deliverables together if they otherwise meet the criteria for separation. A delivered item has standalone value to the customer when either of the following is true: yy The delivered item is sold separately by any vendor (separate-sale criterion). yy The delivered item can be resold by the customer on a standalone basis (resale criterion). The separate-sale criterion is met if the vendor or another entity sells the delivered item separately. This criterion is also met if another entity sells a similar product or service separately that could be used instead of the delivered item. The resale criterion is met if a customer is able to sell the delivered item to a third party and receive a significant portion of the amount that the customer paid to purchase it. The existence of a separate resale market is not a prerequisite for concluding that the customer could resell the delivered item on a standalone basis. The following examples illustrate how to assess whether a delivered item has standalone value to the customer. Example 1: Standalone value – Smartphone and wireless services contract Background: A customer receives a free smartphone from Wireless Phone Company (WPC) when it enters into a two-year contract for wireless phone services. While WPC does not sell this smartphone without a wireless services contract, some of its competitors do sell this smartphone on its own. A secondary market exists for this smartphone. Evaluation: The smartphone given to the customer at contract inception has standalone value to the customer as the smartphone is regularly sold on a standalone basis by other vendors and because a secondary market exists in which the customer could resell the phone. 2
  3. 3. Example 2: Standalone value – Equipment and installation Background: A customer purchases equipment and related installation services from a vendor. Highly skilled technicians are employed by the vendor to install the equipment. The vendor also sells the same piece of equipment without the installation services in some cases. In those situations, the customer generally uses another service provider with the requisite skills to perform the installation services. Evaluation: The equipment has standalone value to the customer upon its delivery because the equipment is sometimes sold by the vendor on a standalone basis. Allocation of arrangement consideration ASC 605-25-30-2 requires arrangement consideration to be allocated at the inception of the arrangement to all units of accounting on the basis of their relative selling prices. ASC 605-25-30 further establishes the following hierarchy to use in estimating the selling price for a separate unit of accounting: First: Vendor-specific objective evidence (VSOE) of selling price, if it exists, must be used as the selling price for a separate unit of accounting. Second: Third-party evidence (TPE) of selling price, if it exists, must be used as the selling price for a separate unit of accounting when VSOE of selling price does not exist. Third: Best estimate of selling price must be used as the selling price for a separate unit of accounting when neither VSOE nor TPE of selling price exist. Best estimate of selling price cannot be used if VSOE or TPE of selling price exists (i.e., best estimate of selling price cannot be used as a default for the selling price). The relative selling price method is the only acceptable method for allocating consideration in a multipledeliverable arrangement to the identified units of accounting. No form of the residual method is allowed. If a multiple-deliverable arrangement includes a unit of accounting for which other guidance in the ASC requires initial and subsequent measurement at fair value, then the allocated amount for that unit of accounting is its fair value. Otherwise, the arrangement consideration is allocated based on the relative selling prices of the separate units of accounting. The amount allocated to a delivered unit of accounting using the relative selling price method is subject to certain limitations. As a result, the amount ultimately allocated to a delivered unit of accounting for accounting purposes could be less than the amount allocated using the relative selling price method. Those limitations are discussed later in this white paper. 3
  4. 4. The following example illustrates the relative selling price method. Example 3: Relative selling price method Background: Sew Me, Inc. is a manufacturer and distributor of two different types of industrial embroidery machines (Machine A and Machine B). Both machines have value to a customer on a standalone basis and neither is sold with any rights of return. Machine A is a standard machine that is regularly sold separately while Machine B is unique and proprietary and never sold separately. To buy Machine B, a customer must order both Machines A and B together. On November 20, 20X3, Sew Me enters into an arrangement with Seamstress Inc. in which Seamstress is buying one each of Machine A and Machine B for $2 million in total. Due to Sew Me’s manufacturing schedule, Machine A will be delivered to Seamstress on December 31, 20X3 and Machine B will be delivered to Seamstress on January 5, 20X4. Sew Me has a calendar year end for financial reporting purposes. Sew Me concludes it has two units of accounting in its arrangement with Seamstress because: (a) Machine A and Machine B have value to the customer on a standalone basis and (b) the customer does not have a general right of return on Machine A (the delivered item). As a result, Sew Me must allocate the arrangement consideration between the two units of accounting (Machine A and Machine B) using the relative selling price method. Machine A is regularly sold separately by Sew Me for $1.8 million, which is considered to be VSOE of selling price. Machine B is never sold separately and, as a result, neither VSOE nor TPE of selling price for Machine B exists. Therefore, Sew Me must determine the best estimate of selling price for Machine B in order to allocate the arrangement consideration. Sew Me determined the best estimate of selling price for Machine B to be $600,000. Evaluation: The overall arrangement fee of $2 million should be allocated on a relative selling price basis in the amounts of $1.5 million to Machine A and $500,000 to Machine B, calculated as follows: (i) (ii) = (i)/Total Each machine’s SP Selling price (SP) Machine A Machine B Total $1,800,000 (ii) x $2,000,000 Allocated arrangement relative to total SP consideration 75% $1,500,000 600,000 25% 500,000 $2,400,000 100% $2,000,000 Once the arrangement consideration for a multiple-deliverable arrangement is allocated to its separate units of accounting, the timing of revenue recognition is determined for each unit of accounting based on other applicable guidance in the ASC, including ASC 605-15, Revenue Recognition – Products, and ASC 605-20, Revenue Recognition – Services. As discussed earlier, the only acceptable method of allocating arrangement consideration in a multipledeliverable arrangement is the relative selling price method. No form of a residual method should be used. The following example illustrates the accounting effects of inappropriately applying a residual method by presenting two variations of facts in a multiple-deliverable arrangement. 4
  5. 5. Example 4: Effects of inappropriately using a residual method Background: Equipment Manufacturer, Inc. (EMI) manufactures equipment used in the production of consumer products. EMI has a calendar year end for financial reporting purposes. On November 20, 20X3, EMI enters into an arrangement with Consumer Goods Producer, Inc. (CGPI) in which three pieces of manufacturing equipment are sold to CGPI – Machine X, Machine Y and Machine Z. The arrangement consideration is $400,000. Machine X and Machine Y are delivered to CGPI on December 27, 20X3 and Machine Z is delivered to CGPI on January 10, 20X4. EMI concludes that each machine has standalone value to CGPI and there is no general right of return on Machine X and Machine Y (the delivered items). As a result, each machine is treated as a separate unit of accounting. The following two variations of the remaining facts are analyzed below: Variation A: EMI has VSOE of selling price for Machine X ($250,000) and Machine Y ($100,000) and a best estimate of selling price for Machine Z ($150,000). Variation B: EMI has VSOE of selling price for Machine X ($250,000) and Machine Y ($100,000), but not for Machine Z. Instead of determining a best estimate of selling price for Machine Z, EMI erroneously uses a residual method to allocate the arrangement consideration to each machine. Evaluation: The following illustrates the allocation of the arrangement consideration in EMI’s multipledeliverable arrangement with CGPI under both Variation A and Variation B: Variation A: Relative selling price method Variation B: Residual method (i) (ii) = (i)/Total (ii) x $400,000 (Note 1) Selling price (SP) Each machine’s SP relative to total SP Allocated arrangement consideration Allocated arrangement consideration Selling price Machine X $250,000 50% $200,000 $250,000 $250,000 Machine Y 100,000 20% 80,000 100,000 100,000 Machine Z 150,000 30% 120,000 Unknown 50,000 $500,000 100% $400,000 Total $400,000 Note 1: The residual method erroneously used in allocating arrangement consideration in Variation B results in allocating: (a) arrangement consideration in the amount of the VSOE of selling price for Machine X and Machine Y (the delivered units of accounting at the end of the reporting period) to those units of accounting and (b) the residual arrangement consideration ($400,000 – [$250,000 + $100,000]) to Machine Z (the undelivered unit of accounting at the end of the reporting period). Under the relative selling price method, $280,000 ($200,000 + $80,000) should be allocated to the machines delivered before the end of 20X3 and $120,000 should be allocated to the machine delivered in 20X4. In contrast, erroneous use of the residual method presented would result in allocation of $350,000 ($250,000 + $100,000) to the machines delivered in 20X3 and allocation of $50,000 to the machine delivered in 20X4. As a result, inappropriate use of the residual method in this situation would overstate revenue by $70,000 ($350,000 – $280,000) in 20X3. This example illustrates the need to identify a selling price for each unit of accounting. If VSOE or TPE of selling price do not exist, an entity must determine the best estimate of selling price. Defaulting to a residual method in those situations will, in all likelihood, result in a misstatement of revenue. 5
  6. 6. Limitations on the allocated amount The amount allocated to a delivered unit(s) of accounting is limited to the amount that is not contingent upon the vendor’s future performance, such as delivery of the undelivered units of accounting. The fact that any of the amount allocated to a delivered unit of accounting is contingent upon the vendor’s future delivery of the undelivered units of accounting, for example, is the trigger for the limitation on the allocated amount, not the likelihood of the vendor delivering the undelivered units of accounting. In other words, neither the likelihood that the vendor will deliver the undelivered units of accounting nor its history of delivering the undelivered units of accounting factors into determining whether there is a limitation on the amount allocated to a delivered item. The limitation on the amount allocated to a delivered item is an additional step that must be applied in the overall model and is something that is overlooked in some cases in practice. The vendor should first determine the amount allocable to a delivered unit of accounting using the relative selling price method and then determine whether any part of that amount is contingent on delivery of other goods or services in the future. If the amount not contingent on delivery of other goods or services in the future (i.e., the noncontingent amount) is less than the amount otherwise allocable to the delivered unit of accounting, then the amount ultimately allocated to the delivered unit of accounting for accounting purposes is the noncontingent (i.e., lower) amount. For purposes of this analysis, the vendor should assume that the multiple-deliverable arrangement will not be cancelled. As such, cancellation fees generally do not factor into the determination of the noncontingent amount. Example 5: Limitation on allocated amount – Smartphone and wireless services contract Background: Refer to Example 1 for the initial background. The customer will pay fees of $50 per month under the two-year contract for wireless phone services. The amount charged by WPC’s competitors when they sell the smartphone on its own is $300. When a customer with a smartphone transfers its wireless phone services to WPC, WPC charges the customer $50 per month. In addition, if an existing customer’s contract expires, WPC continues to charge them $50 per month. Evaluation: The selling price of the smartphone for purposes of allocating arrangement consideration is $300 because that represents TPE of selling price. The selling price of the wireless services to be provided over the contract period is $1,200 ($50 per month multiplied by 24 months) because $50 per month represents VSOE of selling price. The amounts initially allocable to the smartphone and ongoing services (e.g., the units of accounting) are calculated as follows: (i) (ii) = (i)/Total (ii) x $1,200 Each unit of accounting’s SP relative Selling price (SP) Smartphone Ongoing services Total $300 Allocated arrangement to total SP consideration 20% $240 1,200 80% 960 $1,500 100% $1,200 While $240 is initially allocable to the smartphone, the fact that the entire $240 is contingent upon WPC’s future performance in the form of providing ongoing services to the customer results in the amount ultimately allocated to the smartphone for accounting purposes being $0. 6
  7. 7. Estimating selling prices As discussed earlier, VSOE of selling price is the first level in the hierarchy used to estimate the selling price for a separate unit of accounting. The most commonly used form of VSOE of selling price is the price the vendor charges on a relatively consistent basis for a good or service when it sells the good or service separately. VSOE of selling price also may exist if the vendor is not yet selling the good or service separately, but plans to do so in the future. In that situation, VSOE of selling price could be the price management with the relevant authority plans on charging for the good or service provided it is probable that the price will not change before the good or service is actually sold separately. This second approach is rarely used in practice. As discussed earlier, TPE of selling price is the second level in the hierarchy used to estimate the selling price for a separate unit of accounting. The following attributes must exist to conclude that TPE of selling price exists: (a) the price must be for a largely interchangeable good or service, (b) the price must represent what is charged for the largely interchangeable good or service on a standalone basis and (c) the price must be what is charged to a similarly situated customer. If VSOE of selling price exists, it must be used ahead of TPE of selling price or the best estimate of selling price. If VSOE of selling price does not exist, but TPE of selling price does exist, it must be used ahead of best estimate of selling price. To determine whether VSOE or TPE of selling price exists, a vendor needs to consider all information reasonably available without undue cost and effort. Exhaustive efforts do not need to be undertaken to identify VSOE or TPE of selling price. As discussed earlier, best estimate of selling price is the third and final level in the hierarchy used to estimate the selling price for a separate unit of accounting. As such, it is used only when VSOE or TPE of selling price do not exist. Determining the best estimate of selling price requires more judgment to be exercised compared to determining VSOE or TPE of selling price, which results in relatively more practice issues arising. The objective in determining the best estimate of selling price is to identify the price at which a vendor would expect to sell a unit of accounting on a standalone basis, which is consistent with the objective in determining VSOE of selling price. ASC 605-25 does not specifically elaborate on how the best estimate of selling price should be determined; however, there are several illustrations in the guidance in which this principle is applied. Based on those illustrations, it is clear that a vendor should do the following when determining the best estimate of selling price: (a) consider all relevant information reasonably available without undue cost and effort and (b) include both market and entity-specific information in its determination. More specifically, the following are some of the data points and other information a vendor should consider when developing the best estimate of selling price: yy Costs to manufacture the good or provide the service yy Expected profit margins and (or) profit objectives yy Pricing practices used to develop the overall price of the multiple-deliverable arrangement yy Price of standalone sales, if any yy Contractually stated prices or published price lists yy Market constraints that may limit the selling price, such as the price charged by competitors for similar goods or services yy Customer demand These data points should be considered in conjunction with one another. In other words, entities should not just pick a single data point and determine their best estimate of selling price based on that alone. For example, situations have arisen in which an entity initially determined its best estimate of selling price based 7
  8. 8. only on the contractually stated prices in a multiple-deliverable arrangement. While a contractual price may, in some cases, be helpful in determining a best estimate of selling price, contractual prices should not be the only data point considered by a vendor. The reasonableness of the contractual price should be analyzed in the context of other relevant data points and information. The process used to determine best estimate of selling price is more subjective than the process used to determine VSOE and TPE of selling price, which means more judgment is required. As such, entities should have a process in place to determine the best estimate of selling price, which should typically also involve personnel outside of the accounting function. In addition, entities should prepare appropriate documentation to support how management arrived at its best estimate of selling price, including discussion of all factors considered. Disclosures ASC 605-25-50 requires an extensive number of disclosures about a vendor’s arrangements with multiple deliverables and how they have been accounted for in the financial statements. For example, a vendor must disclose information regarding whether multiple deliverables represent separate units of accounting and how selling prices are determined. Refer to ASC 605-25-50-2 for a complete list of the disclosures required for multiple-deliverable arrangements. Closing There is always the potential for issues to arise in applying the guidance in ASC 605-25 given its provisions and the seemingly unlimited variations in multiple-deliverable arrangements that could occur in practice. If not appropriately addressed, these issues could have significant consequences on a vendor’s financial statements, including a misstatement of the vendor’s revenue for the period. While this white paper discusses the overall model in ASC 605-25 and provides several examples of how that model should be applied in specific facts and circumstances, there will clearly be many situations in which additional insight is needed. In those situations, contact your McGladrey professional to discuss how to apply the model to your company’s specific situation. 8
  9. 9. 800.274.3978 www.mcgladrey.com This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. McGladrey LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. McGladrey LLP is an Iowa limited liability partnership and the U.S. member firm of RSM International, a global network of independent accounting, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. McGladrey®, the McGladrey logo, the McGladrey Classic logo, The power of being understood®, Power comes from being understood®, and Experience the power of being understood® are registered trademarks of McGladrey LLP. © 2013 McGladrey LLP. All Rights Reserved.

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