Contract Combination Under ASC 606: When to Combine

The core principle of Accounting Standards Codification (ASC) 606 is to recognize revenue from customer contracts in a way that reflects the transfer of goods or services for the expected payment. A provision within this framework, known as contract combination, addresses situations where a company enters into multiple contracts with the same customer at or near the same time.

Contract combination is a mandatory requirement under ASC 606, not an optional policy. It involves treating multiple legally separate contracts as a single accounting contract when specific criteria are met. This ensures the accounting reflects the economic substance of the arrangement, not just its legal form. This determination is made at the inception of the agreements and alters how a company recognizes revenue.

The Criteria for Combining Contracts

ASC 606-10-25-9 requires a company to combine two or more contracts with the same customer, entered into at or near the same time, if one of three criteria is met. The term “at or near the same time” suggests the contracts are economically linked. Meeting just one criterion triggers the combination requirement, which changes the unit of account for revenue recognition.

The first criterion is that the contracts were negotiated as a package with a single commercial objective. If a company and customer negotiated multiple agreements with a unified goal, the contracts are linked. For example, a manufacturer might sell industrial machinery for $1.5 million and a separate, mandatory two-year service agreement for $50,000. If the machinery price was lowered because the customer agreed to the service package, they were negotiated as a single deal.

A second criterion is met if the payment in one contract depends on the price or performance of another. For example, a company sells a software license for $100,000 and, in a separate contract, offers services for $30,000. If the services contract includes a $10,000 rebate on the software license upon completion of the services, the consideration is interdependent and the contracts must be combined.

The final criterion requires combination if the goods or services promised in the contracts form a single performance obligation. A performance obligation is a promise to transfer a distinct good or service. If items from different contracts are so integrated that they are not distinct, they form one obligation. For instance, a company sells a medical device and, in a second contract, the proprietary software required for it to function. The customer cannot benefit from the hardware without the software, so they are not distinct and must be accounted for as one.

Accounting Implications of Combination

When contracts are combined, they are treated as a single unit under the five-step revenue recognition model in ASC 606. This impacts the identification of performance obligations, the calculation of the transaction price, and the allocation of that price. The combined contract becomes the new starting point for analysis, often changing the timing of revenue recognition.

The first impact is on identifying performance obligations (Step 2). Promises from separate agreements may be bundled into a single performance obligation. For example, a software license and a separate contract for its significant customization might be combined. If the customization is required for the software’s utility, they become one performance obligation, preventing the company from recognizing revenue for the license upfront.

Combination also affects the determination of the transaction price (Step 3). The price for the new contract is the sum of all consideration from the original agreements, including fixed amounts and variable consideration like bonuses or rebates. For instance, if one contract is for $200,000 and a linked contract is for $50,000 plus a potential $10,000 bonus, the combined transaction price is estimated at up to $260,000.

The greatest impact is often on allocating the transaction price (Step 4). The single transaction price is allocated to all distinct performance obligations based on their relative standalone selling prices. A discount embedded in one original contract is now spread across all items in the combined package. For example, if hardware is sold at a discounted $80,000 (standalone price $100,000) and a service plan is sold at its $20,000 standalone price, the total price is $100,000. The $20,000 discount would be allocated proportionally to both the hardware and the service plan.

Application Scenarios and Examples

Practical scenarios illustrate how the rules are applied and the judgment required. The outcome depends on the specific facts and circumstances of the arrangement.

In a scenario requiring combination, a company, BioGen, sells a gene sequencing machine for $750,000 and a mandatory installation service for $50,000 in separate contracts. The machine cannot be operated without this specific service, which BioGen does not sell separately. This arrangement meets the criterion for a single performance obligation, as the hospital cannot benefit from the machine without the service. BioGen must account for the agreements as a single contract with a transaction price of $800,000, and revenue is recognized only after the installation and integration are complete.

In a contrasting scenario, combination may not be required. An office supply company, OfficeCorp, sells a printer for $10,000 and a separate, optional three-year maintenance plan for $1,200. OfficeCorp and other vendors sell this standard maintenance plan separately, and the printer is fully functional without it.

Here, the criteria for combination are not met. The contracts were not negotiated as a package, the consideration is not interdependent, and the goods and services are distinct. OfficeCorp would account for these as two separate contracts, recognizing $10,000 for the printer upon delivery and the $1,200 for maintenance over the three-year service period.

Financial Statement Disclosure Requirements

Combining contracts involves judgments that must be communicated to financial statement users. The disclosure requirements under ASC 606 are designed to provide transparency into a company’s revenue. Contract combination impacts several of these disclosures.

One disclosure affected is information about performance obligations. Companies must describe when they satisfy performance obligations. If equipment and installation contracts are combined into a single performance obligation, the disclosure must state that revenue is recognized when the integrated system is fully installed, not as two separate events.

ASC 606 requires disclosing judgments that affect revenue, and the decision to combine contracts is one such judgment. A company should explain why it concluded that multiple contracts met the combination criteria. This includes referencing the specific criterion that was met.

Disclosures for the transaction price and its allocation are also impacted. Companies must disclose the methods used to determine the transaction price, particularly with variable consideration. When contracts are combined, the explanation of how the price was determined and allocated must be based on the combined arrangement, providing a clear picture of how discounts were spread across all promised goods and services.