Accounting for Multiple Element Arrangements Under ASC 606

A multiple-element arrangement is a contract with promises to deliver more than one good or service. These bundled arrangements are common across many industries. The Financial Accounting Standards Board’s (FASB) Topic 606, Revenue from Contracts with Customers, provides guidance for these contracts. ASC 606 establishes that revenue is recognized to show the transfer of goods or services in an amount reflecting the expected payment. To apply this, the standard outlines a five-step framework for contracts with multiple deliverables.

Identifying Separate Performance Obligations

A performance obligation is a promise in a contract to transfer a good or service. For contracts with multiple components, a company must assess each promise to determine if it should be accounted for separately. This analysis determines how the contract is broken down for accounting purposes.

An item is accounted for separately if it is “distinct,” which requires meeting two criteria. The first is that the good or service is “capable of being distinct,” meaning the customer can benefit from it on its own or with other available resources. A vehicle sold with an optional maintenance plan is an example of two distinct items.

The second criterion is that the promise is “distinct within the context of the contract,” meaning it is separately identifiable from other promises. This is not the case if the company integrates items into one output, one item modifies another, or the goods are highly interdependent. If a promise is not distinct, it is bundled with other items until the group of items is distinct.

For example, standard manufacturing equipment and its installation are often two distinct obligations. In contrast, a contract to build highly customized machinery is likely a single performance obligation, as the components are integral to the final product and not sold separately.

Determining and Allocating the Transaction Price

After identifying the distinct performance obligations, the company must calculate the total transaction price. This is the consideration the business expects to receive for transferring all promised goods or services. The calculation must account for variable consideration, such as bonuses, rebates, or discounts.

ASC 606 requires companies to estimate variable consideration using one of two methods. The expected value method is a sum of probability-weighted amounts, while the most likely amount method uses the single most likely outcome.

The transaction price must also be adjusted for any significant financing component and include the fair value of any noncash consideration. Once determined, the total price is allocated to each separate performance obligation based on its relative standalone selling price (SSP). The SSP is the price at which a company would sell a good or service separately.

If an SSP is not directly observable, it must be estimated. The preferred method is the adjusted market assessment approach, which evaluates the market to estimate what customers would pay. Another option is the expected cost plus a margin approach, which forecasts costs and adds a standard profit margin.

The residual approach is used more sparingly, allocating the remainder of the transaction price to an obligation after all others have been allocated. This is only appropriate when the SSP is highly variable or uncertain.

For example, a company signs a $150,000 contract for a software license (SSP $120,000), installation (estimated SSP $10,000), and one year of support (SSP $30,000). The total SSP is $160,000. The $150,000 price is allocated proportionally: $112,500 to the license, $28,125 to support, and $9,375 to installation.

Recognizing Revenue for Each Element

With a price allocated to each obligation, the final step is to recognize revenue at the appropriate time. Revenue is recognized when, or as, the company satisfies a performance obligation by transferring control of the good or service to the customer. Control is the ability to direct the use of and obtain the benefits from the asset.

Revenue is recognized over time if any one of three criteria is met. The first is that the customer simultaneously receives and consumes the benefits as the entity performs, such as with a monthly subscription. The second is that the company’s performance creates or enhances an asset the customer controls as it is created, like a building on the customer’s land.

The third criterion is met if performance creates an asset with no alternative use, and the company has an enforceable right to payment for performance completed. This often applies to highly specialized goods. If none of these criteria are met, revenue is recognized at a single point in time when control transfers.

Indicators that control has transferred to the customer include:

• The company has a present right to payment.
• The customer has legal title to the asset.
• The customer has physical possession of the asset.
• The customer has the significant risks and rewards of ownership.
• The customer has accepted the asset.

In the earlier software example, the $112,500 for the license is recognized when delivered. The $9,375 for installation is recognized upon completion. The $28,125 for technical support is recognized on a straight-line basis over the one-year term.

Key Disclosure Requirements

ASC 606 includes extensive disclosure requirements to provide users of financial statements with information about a company’s revenue. These disclosures require qualitative and quantitative information on the nature, amount, timing, and uncertainty of revenue from customer contracts.

A primary requirement is the disaggregation of revenue into categories that show how economic factors affect it. Common categories include revenue by:

• Major product line or service type
• Geographical region
• Market or customer type
• Contract duration

Companies must also disclose information about contract balances, including the opening and closing balances of contract assets and liabilities. A contract liability arises when a customer pays in advance, while a contract asset arises when a company has earned revenue but lacks an unconditional right to payment.

Another disclosure relates to remaining performance obligations. Companies must disclose the aggregate transaction price allocated to unsatisfied obligations at the end of the period. They must also explain when they expect to recognize this remaining revenue, often by providing time bands.

Finally, the standard requires disclosure of the significant judgments made in applying the guidance. This includes judgments used in determining the timing of revenue recognition and allocating the transaction price, such as estimating variable consideration and standalone selling prices.