Examining Contracts Under ASC 606: Material Rights
Examining Contracts Under ASC 606: Material Rights

Examining Contracts Under ASC 606: Material Rights

Since the issuance of ASC 606, Revenue from Contracts with Customers, accountants have worked to understand the new five-step model and how it affects revenue recognition for their companies. Step 2 of the new revenue recognition model requires the identification of performance obligations in contracts with customers. This step can present a certain level of difficulty if an entity does not have standard contract terms, the contract contains multiple products or services, or if there are options included for the acquisition of future products or services. This option to acquire future products or services can give rise to a customer material right and affect the revenue recognized. Let’s examine this concept of material rights a little more.

ASC 606-55-42 states, “if, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contact (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customers in that geographical area or market).” If a material right gives rise to a performance obligation, then when we reach Step 4 of the new revenue recognition model an allocation of the transaction price to this performance obligation is required.

However, having the option to acquire future products and services at a discount that would not be received without entering into the contract is not the only thing to consider in determining if a material right exists. We must also consider the price at which those products and services can be acquired. ASC 606-55-43 states, “if a customer has the option to acquire an additional good or service at a price that would reflect the standalone selling price for that good or service, that option does not provide the customer with a material right even if the option can be exercised only by entering into a previous contract.”

As you might have guessed, determining if a material right exists takes some analysis and judgment to come to a conclusion. The decision flowchart below walks through the process to determine whether the option to acquire additional goods or services by a customer constitutes a material right or not.

Having the guidance from the standard summarized in this decision flowchart helps to understand the concept of material rights; however, walking through the following example will further clarify the decision points and how material rights affect revenue recognition.

In reviewing the example, ask yourself, does the option to purchase security services in the future give rise to a material right? Of course, the answer is . . . it depends. Utilizing the decision flowchart above, let’s walk through the steps.

Step 1: Based on the facts from the example, FFS has granted the customer the option to acquire additional goods or services (i.e. security services).

Step 2: Could the customer receive the right to acquire the additional goods or services without entering into the contract? FFS would have to determine if the purchase of security services at this discounted rate would be offered separately to other customers. This would require a look at their business practices and other contracts that they currently have in place. If FFS determines that the customer could receive the right to acquire the additional security services without entering into this contract, the option would not represent a material right. However, if FFS determines that the right to acquire the security services could not be obtained without entering into the contract, then they would move on to Step 3.

Step 3: Is the option to acquire the additional goods or services at the individual stand-alone price? The facts from our example indicate that the normal sales price for security services is $30,000/year; however, that may not represent the standalone selling price. The standalone selling price is defined as the price at which an entity would sell a promised good or service separately to a customer. ASC 606-55-44 states that “if the standalone selling price for a customer’s option to acquire additional goods or services is not directly observable, an entity should estimate it. That estimate should reflect the discount the customer would obtain when exercising the option and be adjusted for both of the following:

  1. The discount that the customer could receive without exercising the option and 
  2. The likelihood that the option will be exercised.”

If FFS performs the analysis of the standalone selling price and determines that the option is priced at the standalone selling price, the option does not represent a material right and does not give rise to a performance obligation. However, if FFS determines that the option is not priced at the standalone selling price, the option represents a material right and gives rise to a performance obligation.

Step 4: FFS determined that the option to acquire additional security services in this contract are a material rate and that the estimated standalone selling price of this option is $4,300, including the probability of exercise. FFS must allocate the $10,000 transaction price to the two performance obligations – the cleaning services and the material right. The transaction price should be allocated as follows:

Cleaning Services = $7,000
($10,000 / ($10,000 + $4,300) * $10,000)

Material Right - $3,000

($4,300 / ($10,000 + $4,300) * $10,000)

So, there you have it, a quick exploration of material rights. If you have questions or want more clarity on the new revenue recognition model, check out our Step-By-Step Guide that will give you a high-level overview of the requirements, mircolearnings, and examples of the significant changes from the previous accounting guidance.

Disclaimer  

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.

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