Identifying Multi-Element Arrangements and Determining Revenue Recognition under ASC 606

Introduction

Multi-element arrangements, also known as multiple-deliverable arrangements or bundled contracts, involve the sale of multiple goods or services in a single contract. Under ASC 606, Revenue from Contracts with Customers, companies must determine how to account for each element of the arrangement by identifying distinct performance obligations and allocating the transaction price to each one.

ASC 606 has introduced a new five-step model for recognizing revenue, which provides detailed guidance on how to account for contracts with multiple elements. This model ensures that revenue is recognized in a manner that reflects the transfer of goods and services to the customer based on their standalone selling prices. This white paper explores how multi-element arrangements are treated under ASC 606, the process of identifying performance obligations, allocating the transaction price, and recognizing revenue.

Overview of Multi-Element Arrangements under ASC 606

Multi-element arrangements are standard in many industries, such as technology, telecommunications, construction, and healthcare, where companies often provide bundled goods and services under a single contract. Under ASC 606, the revenue from these contracts must be recognized  to accurately reflect the delivery of the individual goods and services to the customer.

Key Concepts

• Performance Obligations: Under ASC 606, companies must identify each distinct good or service promised in a contract as a performance obligation. These obligations may include physical goods, services, warranties, or licenses, among others.

• Transaction Price: The transaction price is the total amount of consideration that the company expects to be entitled to in exchange for transferring the promised goods or services. This may include fixed amounts, variable consideration, or any price adjustments.

• Standalone Selling Price (SSP): The SSP is the price at which a company would sell a good or service separately to a customer. The transaction price in a multi-element arrangement is allocated to the performance obligations based on their relative SSPs.

Five-Step Model for Revenue Recognition under ASC 606

ASC 606 introduces a comprehensive framework for recognizing revenue, known as the five-step model. This model applies to all contracts with customers and provides a structured approach to accounting for multi-element arrangements.

Step 1: Identify the Contract with a Customer

The first step is to identify the contract between the entity and the customer. This includes both written and oral agreements and any implied contractual arrangements. For multi-element arrangements, the contract typically includes multiple promises to transfer goods or services, which must be evaluated to determine whether they are distinct performance obligations.

Step 2: Identify the Performance Obligations in the Contract

In a multi-element arrangement, the company must assess each promised good or service to determine whether it constitutes a distinct performance obligation. A good or service is considered distinct if both of the following criteria are met:

1. Capable of Being Distinct: The customer can benefit from the good or service on its own or together with  other readily available resources.

2. Distinct within the Context of the Contract: The good or service is separately identifiable from other promises in the contract. This means the good or service is not highly integrated with other elements in the arrangement.

For example, a software company selling a bundled product that includes a software license, installation services, and ongoing maintenance must assess whether each component is distinct. If the software can be used independently of the installation and maintenance services, each element would be treated as a separate performance obligation.

Step 3: Determine the Transaction Price

The transaction price is the total amount of consideration that the entity expects to receive in exchange for transferring the goods or services. The transaction price can include fixed consideration, variable consideration (e.g., discounts, rebates, or bonuses), and any adjustments for the time value of money.

In multi-element arrangements, the transaction price may be more complex in determining if it includes variable consideration or contingent payments. Companies must estimate the variable consideration using either the expected value method or the most likely amount method, and apply the constraint to ensure that it is probable that no significant revenue reversal will occur.

Step 4: Allocate the Transaction Price to the Performance Obligations

Once the performance obligations have been identified and the transaction price determined, the next step is to allocate the transaction price to each performance obligation based on their relative standalone selling prices (SSP). The SSP is the price at which a company would sell the good or service on a standalone basis.

If the SSP is not directly observable, the company must estimate it using one of the following methods:

1. Adjusted Market Assessment Approach: The company estimates the price that customers in the market would be willing to pay for the goods or services.

2. Expected Cost Plus Margin Approach: The company estimates the costs to provide the good or service and adds an appropriate margin.

3. Residual Approach: If the SSP for one or more performance obligations is highly variable or uncertain, the company can use the residual approach, which involves subtracting the observable SSPs of other performance obligations from the total transaction price.

Step 5: Recognize Revenue When (or As) the Performance Obligations Are Satisfied

Revenue is recognized when (or as) the company satisfies a performance obligation by transferring control of the good or service to the customer. Performance obligations can be satisfied  at a point in time (e.g., when goods are delivered) or over time (e.g., as services are provided).

For multi-element arrangements, companies must assess whether each performance obligation is satisfied over time or at a point in time and recognize revenue accordingly.

Practical Application of ASC 606 to Multi-Element Arrangements

Example 1: Bundled Sale of Hardware and Software

A technology company sells a package that includes a piece of hardware and pre-installed software for $1,000. The hardware and software are distinct, as the customer can benefit from each on its own. The standalone selling price of the hardware is $700, and the standalone selling price of the software is $400.

• Step 1: The contract includes a hardware and software package.

• Step 2: The hardware and software are distinct performance obligations.

• Step 3: The transaction price is $1,000.

• Step 4: The transaction price is allocated based on the SSPs: $700 to the hardware and $300 to the software.

• Step 5: Revenue is recognized at the point in time when the control of each element is transferred to the customer.

Example 2: Software License with Maintenance Services

A software company enters into a contract to provide a software license and two years of maintenance services for $5,000. The software license is delivered at the contract’s inception, and the maintenance services are provided over the next two years. The standalone selling price of the software license is $4,000, and the standalone selling price of the maintenance services is $2,000.

• Step 1: The contract includes both the software license and maintenance services.

• Step 2: The software license and maintenance services are distinct performance obligations.

• Step 3: The transaction price is $5,000.

• Step 4: The transaction price is allocated based on the SSPs: $4,000 to the software license and $1,000 to the maintenance services.

• Step 5: Revenue from the software license is recognized at the point in time when the license is delivered, and revenue from the maintenance services is recognized over time as the services are provided.

Example 3: Construction Contract with Milestone Payments

A construction company enters into a contract to build a commercial building for $10 million, with milestone payments of $2 million to be paid upon the completion of specific project phases. The project includes several distinct deliverables, such as the design, construction, and installation of certain systems.

• Step 1: The contract includes multiple deliverables for the design, construction, and installation services.

• Step 2: The design, construction, and installation services are distinct performance obligations.

• Step 3: The transaction price is $10 million, with milestone payments based on progress.

• Step 4: The transaction price is allocated to each performance obligation based on their SSPs.

• Step 5: Revenue is recognized over time as the performance obligations are satisfied, with milestone payments used as an input to measure progress.

Challenges and Considerations in Applying ASC 606 to Multi-Element Arrangements

1. Estimating Standalone Selling Prices

One of the key challenges in accounting for multi-element arrangements is determining the SSP of each performance obligation. While some companies may have readily observable prices, others may need to estimate SSP using judgment and market data. The reliability of these estimates is crucial for ensuring accurate revenue recognition.

2. Allocating Variable Consideration

In some contracts, the transaction price includes variable consideration, such as performance bonuses or penalties. Allocating variable consideration to performance obligations requires companies to estimate future outcomes and apply a constraint to ensure that it is probable that no significant revenue reversal will occur when the uncertainty is resolved.

3. Determining the Timing of Revenue Recognition

Companies must assess whether each performance obligation is satisfied at a point in time or over time. For services or long-term contracts, determining whether control transfers over time can significantly impact the timing of revenue recognition. Companies must also ensure that their systems are capable of tracking progress toward completion in real time.

4. Bundling of Goods and Services

Contracts that bundle goods and services often involve highly interdependent deliverables, making it difficult to assess whether each component is distinct. For example, a telecommunications company might bundle equipment, installation, and services, and separating these components may not be straightforward or may take more work.

Conclusion

Multi-element arrangements present unique challenges and opportunities for companies under ASC 606. By understanding the principles of the five-step revenue recognition model, companies can effectively navigate the complexities of identifying distinct performance obligations, estimating standalone selling prices, and recognizing revenue accurately. Please contact a Solaris consultant for assistance with managing multi-element arrangements during contract review at your organization.  

References

1. Financial Accounting Standards Board (FASB), ASC 606 – Revenue from Contracts with Customers.

2. Deloitte, A Roadmap to Applying the New Revenue Recognition Standard – Multiple Deliverable Arrangements.

3. Ernst & Young, Revenue Recognition: Accounting for Multi-Element Arrangements under ASC 606.

4. PricewaterhouseCoopers (PwC), Applying the Revenue Recognition Standard to Multi-Element Arrangements.

5. KPMG, ASC 606: Revenue Recognition, Understanding Multi-Element Arrangements.

6. Grant Thornton, Navigating Multi-Element Arrangements under ASC 606.

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