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

IntroductionVendors 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

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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.

ScopeIf 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 multiple-

deliverable arrangements.

Separation of multiple deliverablesPursuant 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:

y The delivered item has standalone value to the customer.

y 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:

y The delivered item is sold separately by any vendor (separate-sale criterion).

y 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.

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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 considerationASC 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 multiple-

deliverable 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.

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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 (ii) x $2,000,000

Selling price (SP)

Each machine’s SP

relative to total SP

Allocated arrangement

consideration

Machine A $1,800,000 75% $1,500,000

Machine B 600,000 25% 500,000

Total $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 multiple-

deliverable 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.

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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 multiple-

deliverable 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 Selling price

Allocated arrangement consideration

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

Total $500,000 100% $400,000 $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.

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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

Selling price (SP)

Each unit of

accounting’s SP relative

to total SP

Allocated arrangement

consideration

Smartphone $300 20% $240

Ongoing services 1,200 80% 960

Total $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.

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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:

y Costs to manufacture the good or provide the service

y Expected profit margins and (or) profit objectives

y Pricing practices used to develop the overall price of the multiple-deliverable arrangement

y Price of standalone sales, if any

y Contractually stated prices or published price lists

y Market constraints that may limit the selling price, such as the price charged by competitors for similar

goods or services

y 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

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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.

DisclosuresASC 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.

ClosingThere 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.

800.274.3978 www.mcgladrey.com

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