[This “Revenue Recognition For Multiple Deliverables” post is adapted from: Emerging Issues Task Force (EITF) of GAAP Issue No. 00-21 (EITF 00-21), Revenue Arrangements with Multiple Deliverables]. Vendors may offer customers many related and unrelated products and services sold together (“bundled”) or separately. The prices assigned to the various elements of a particular transaction or series of transactions on the seller’s invoices and the timing of issuing those invoices are not always indicative of the actual earning of revenue on the various elements of these transactions. This post provides guidance on how to measure consideration received from complex, multi-element arrangements and how to allocate that consideration between the different deliverables contained in the arrangement.
A long-standing difficulty has been identifying authoritative guidance to the accounting for revenue arrangements (product or service sales) having more than one “deliverable”. Many instances of aggressive accounting came to light in the financial reporting abuses of the late 1990s and early 2000s, where all or most of the total revenue was recognized at the time of delivery of the first of multiple deliverables. EITF 00-21 comprehensively addressed these complex issues, and represents the only universally applicable guidance extant. (Staff Accounting Bulletin [SAB] 101, issued before EITF 00-21, contained a great deal of specific guidance, but this was substantially eliminated in replacement SAB 104, with EITF 00-21 gaining recognition as the premier set of requirements for these types of transactions).
Summarized EITF 00-21 Guidance
Arrangements between vendors and their customers often include the sale of multiple products and services (deliverables). A “multiple deliverable arrangement [MDA]” can be structured using fixed, variable, or contingent pricing or combinations thereof. Product delivery and service performance can occur at different times and in different locations, and customer acceptance can be subject to various return privileges or performance guarantees.
The consensuses in EITF 00-21 provide guidance on the following:
- How a vendor determines whether an MDA consists of a single unit of accounting or multiple units of accounting.
- Allocating MDA consideration to multiple units of accounting.
- Measuring MDA consideration
In applying this guidance, it is to be presumed that separate contracts executed at or near the same time with the same entity or related parties were negotiated as a package and are to be considered together in determining how many units of accounting are contained in an MDA. That presumption can be overcome by sufficient contradictory evidence.
The EITF collectively applies to all deliverables (i.e., products, services, and rights to use assets) covered by contractually binding written, oral, or implied arrangements. Excluded from the scope of the consensus are the following:
- Criteria for the timing of revenue recognition for a unit of accounting. Existing authoritative literature governs these determinations.
- Arrangements in which, conditioned upon the vendor’s revenue from the customer exceeding certain cumulative levels or the customer continuing its relationship with the vendor for a specified time period: (a). The vendor offers free or discounted products or services in the future, or (b). The vendor provides specified future cash rebates or refunds.
- Arrangements involving the sale of award credits by a “broadbased loyalty program operator” [presumably this exception refers to airline frequent-flyer or similar customer loyalty programs].
- Accounting for the direct costs incurred by a vendor relative to an MDA.
Basic Principles Established
EITF 00-21 set forth three basic principles, the application of which are the subject of the discussion that follows:
- MDAs are divided into separate units of accounting if the deliverables included in the arrangement meet all three of the criteria presented in the table below.
- Subject to certain limits regarding contingent amounts to be received under the MDA, relative fair values are used to allocate MDA proceeds to the separate units of accounting.
- The revenue recognition criteria to be applied are determined separately for each unit of accounting.
Units of Accounting
The following figure summarizes the criteria used in determining units of accounting for MDA within the scope of the EITF and is adapted from a decision diagram contained in the EITF abstract:
Criteria –Outcome -Result
1. Does the delivered item have -Yes -Go to criterion 2
stand-alone value to the customer? -No -Do not separate item
2. Does objective and reliable evidence -Yes -Go to criterion 3
exist regarding the fair value of the -No -Do not separate item
3. If the MDA includes a general right of -Yes or Not -Delivered item is a
return with respect to the delivered item, -Applicable separate unit of
is delivery of the undelivered items accounting
probable and substantially controlled by
the vendor? -No -Do not separate item
This separability evaluation is to be applied consistently to MDAs that arise under similar circumstances or that possess similar characteristics. The evaluation is to be performed at the inception of the MDA and upon delivery of each item.
If consideration is allocated to a deliverable that does not qualify as a separate unit of accounting, then the reporting entity is required to:
- Combine the amount allocated to the deliverable with the amounts allocated to all other undelivered items included in the MDA; and
- Determine revenue recognition for the combined items as a single unit of accounting.
Measurement and Allocation of MDA Consideration
The determination of whether total MDA consideration is fixed or determinable disregards the effects of refund rights or performance bonuses [if any].
After applying the criteria set forth in the decision diagram, the vendor may recognize an asset representing the cumulative difference, from inception of the MDA, between amounts recognized as revenue and amounts received or receivable from the customer [this is analogous to the asset “costs and estimated earnings in excess of billings”, which is used in long-term construction accounting]. The amount of such assets may not exceed the total amounts to which the vendor is legally entitled under the MDA, including fees that would be earned upon customer cancellation.
The amount recognized as an asset would be further limited if the vendor did not intend to enforce its contractual rights to obtain such cancellation fees from the customer.
In measuring fair value, it is presumed that a separately stated sales price included in the sales contract for a deliverable is not representative of that deliverable’s separate fair value. Rather, the best evidence of fair value is VSOE of the sales price of the deliverable on a stand-alone basis. Use of VSOE, when available, to determine fair value is always preferable. Otherwise, third-party evidence of fair value is an acceptable substitute.
Example Of Multiple Deliverable Revenue Recognition
Lie Dharma Putra Company sells an mp3 player, which it calls the Liepod. Lie Dharma prefers to sell the Liepod with a bundled annual support package, which sells for $320. Without the service package, the Liepod retails for $250, and Lie Dharma sells the servicing package separately for $120 per year.
Lie Dharma splits apart the two revenue elements of the bundled annual support package by allocating revenue to the Liepod, based on the fair values of the Liepod and its support package, which it calculates as follows:
$250 product price
__________________________________ × $320 bundled price = $216.22
$250 product price + $120 servicing price
Lie Dharma Putra Company also allocates revenue to the support package in the same manner with the following calculation:
$120 servicing price
__________________________________ × $320 bundled price = $103.78
$250 product price + $120 servicing price
Based on these calculations, Lie Dharma can recognize $216.22 of revenue every time it sells the bundled Liepod support package. However, because Lie Dharma must provide one year of service under the support package, the remaining $103.78 of revenue associated with the servicing contract can only be incrementally recognized on a monthly basis over the 12-month life of the service contract, which is $8.65 per month.
Applicability Of The EITF Guidance
With regard to the guidance in EITF 00-21, the consensus holds that when higher-level accounting literature offers guidance to parts of the MDA, the following rules apply:
- Higher-level literature provides guidance regarding the determination of separate units of accounting and how to allocate arrangement consideration to those separate units of accounting, the arrangements or the deliverable(s) that is within the scope of that literature should be accounted for in accordance therewith, rather than the guidance in EITF 00-21.
- If higher-level literature provides guidance requiring separation of deliverables within the scope of higher-level literature from deliverables not within the scope of higher-level literature, but does not specify how to allocate total consideration to each separate unit of accounting, the allocation is to be performed according to relative fair values, using the reporting entity’s best estimate of the fair value of those deliverable(s) within the scope of higher-level literature and those not within its scope. Subsequent accounting (i.e., the identification of separate units of accounting and the allocation of values) for the value allocated to the deliverable(s) not subject to higher-level literature would be governed by the provisions of EITF 00-21.
- If higher-level literature provides no guidance regarding the separation of the deliverables within the scope of higher-level literature from those deliverables that are not or the allocation of arrangement consideration to deliverables within the scope of the higher level literature and to those that are not, then the guidance in EITF 00-21 should be followed for purposes of such separation and allocation.
In that case, it is possible that a deliverable subject to the guidance of higher-level literature does not meet the criteria set forth by EITF 00-21 to be considered a separate unit of accounting. If so, the arrangement consideration allocable to such deliverable should be combined with the amount allocable to the other applicable undelivered item(s) within the arrangement. The appropriate recognition of revenue would then be determined for those combined deliverables as a single unit of accounting.
Multiple Deliverable Disclosures
The financial statements of a vendor are to include the following disclosures, when applicable:
- The nature of the vendor’s MDAs including provisions relative to performance, cancellation, termination, or refund.
- The vendor’s accounting policy with respect to the recognition of revenue from MDAs (e.g., whether deliverables are separable into units of accounting).
An example of this disclosure requirement follows:
The company enters into multiple-element revenue arrangements, which may include any combination of services, software, hardware and/or financing.
A multiple-element arrangement is separated into more than one unit of accounting if all of the following criteria are met: (1) the delivered item has value to the client on a stand-alone basis; (2) there is objective and reliable evidence of the fair value of the undelivered item; and (3) if the arrangement includes a right of return relative to the delivered item, delivery is considered probable and is under the company’s control. If these criteria are met for each element and there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement consideration is allocated to the separate units of accounting based on each unit’s relative fair value.
There may be cases, however, in which there is objective and reliable evidence of fair value of the undelivered item but no such evidence for the delivered item. In those cases, the residual method is used to allocate the arrangement consideration. Under the residual method, the amount of consideration allocated to the delivered item equals the total arrangement consideration less the aggregate fair value of the undelivered item. The revenue policies described below are then applied to each unit of accounting, as applicable.
If the allocation of consideration in a profitable arrangement results in a loss on an element, that loss is recognized at the earlier of (1) delivery of that element, (2) when the first dollar of revenue is recognized on that element, or (3) when there are no remaining profitable elements in the arrangement to be delivered.
How To Make Sure the EITF 00-21 Is Followed?
A company can circumvent the EITF 00-21 rules by issuing separate contracts for each element of a sale that would normally be considered to have multiple deliverables. One way to spot this issue is to conduct a periodic audit that searches for clusters of contracts entered into with a single customer within a short period of time. The audit program should include a review of these contracts to determine if they are in fact associated with a single sale transaction.
If a company has multiple sale arrangements that include multiple deliverables, it is possible that it will not separate the various elements into separate units of accounting in a consistent manner. To guard against this issue, a periodic audit should compare the documentation of the various MDAs to locate any inconsistencies in the definition of units of accounting.
Another control problem arises when a company records a combination of revenue and “costs and estimated earnings in excess of billings” that exceed the total amount to which a customer has agreed to pay. A billing procedure should require the accounting staff to compare the combination of billings and unbilled costs to the customer’s contractual agreement to pay, and record a loss for any costs incurred that exceed this amount.