ABOUT ACCOUNTING CLUBS
Discover who we are and what we do
Expert Q&A’s
Read about various complex accounting concepts
PODCASTS
See the podcasts we offer to help in your respective areas
Chapter 6: Other considerations
Customer options to acquire additional goods or services include sales incentives, customer loyalty points, contract renewal options, and other discounts. Certain volume discounts could also be a form of customer options.
Non-cash and cash incentives and subsequent modification
Non-cash and cash incentives
Incentives offered in contracts can take various forms, including non-cash items like free products or services, such as a complimentary airline ticket given to a customer upon meeting a specified purchase threshold. When evaluating such incentives, management must assess whether they represent separate promises within the arrangement, akin to how customer loyalty points are treated. Additionally, management should determine its role as either principal or agent if the incentive is considered a separate performance obligation fulfilled by another party. Cash incentives, however, are not treated as performance obligations but are instead treated as reductions of the transaction price. Determining whether an incentive is cash or non-cash may require judgement in some cases. If an incentive essentially functions as a cash payment to the customer, it is treated as a reduction of the transaction price rather than a promise of future products or services. Furthermore, items like gift certificates or gift cards, which can be used similarly to cash, should be evaluated to determine if they are effectively cash payments in substance.
Incentives offered or modified after arrangement inception
An entity might introduce a different or supplementary incentive for items that have not sold as expected, especially when goods are sold through distributors to end customers and sales do not meet projections. Such changes can occur post-recording of revenue from the initial sale to the distributor. Management must discern whether altering or adding an incentive constitutes a contract modification. Any adjustment to an incentive involving cash (or additional cash) to the customer or their customer qualifies as a contract modification affecting the determination of the transaction price. Furthermore, additional goods or services provided post-initial contract completion, without extra compensation, may not constitute performance obligations if they were not part of the original contract terms, whether explicitly or implicitly based on customary business practices. Example 12, Case C, in the revenue standard provides an illustration of this scenario. In such cases, management should evaluate whether a business practice of offering complimentary goods or services has been established, determining if there is an implied commitment in future contracts.
Change in incentives offered to customer
Entity L initially provides a free Blu-ray player to a retailer to incentivize customers to purchase televisions. Revenue recognition occurs when the televisions and Blu-ray players are delivered to the retailer, signifying control transfer. Subsequently, Entity L introduces a C200 rebate for end customers to support the retailer in selling televisions from its inventory ahead of a popular sporting event. This promotion applies to all televisions sold during the week leading up to the event. Notably, Entity L did not anticipate offering a customer rebate at the time of selling the televisions to the retailer, nor had it done so previously.
Question
How should entity L account for the offer of the additional C200 rebate?
Answer
The introduction of the customer rebate represents a contract modification impacting solely the transaction price. Entity L should treat the C200 rebate as a deduction from the transaction price for the televisions held by the retailer, anticipated to be sold during the rebate period. This accounting treatment aligns with the guidance on contract modifications and variable consideration. Entity L must also assess whether similar rebates are planned for future transactions or expected by customers, as these factors may influence the transaction price at the time of the initial sale.
Management should assess each arrangement to determine if there are options embedded in the agreement, either explicit or implicit, and the accounting effect of any options identified. If the option provides a customer with a material right, the customer is purchasing two things in the arrangement – the good or service originally purchased, and the right to a free or discounted good or service in the future – and is effectively paying in advance for future goods or services.
Customer loyalty programmes
Customer loyalty programs play a pivotal role in nurturing brand loyalty and driving sales volume. These programs take on various forms, such as airlines offering complimentary air miles and retail stores providing future discounts after reaching a certain purchase threshold. Although individual incentives may appear negligible, the cumulative impact of loyalty programs can be significant, as demonstrated in practice.
A portion of the transaction price is allocated to the “material right” represented by the points earned through these programs. This allocation is determined based on the relative standalone selling price of the points, as per outlined guidance. Revenue recognition occurs when the entity fulfills its performance obligation related to the points or upon the expiration of points, as exemplified in Example 52 of the revenue standard.
Some loyalty programs allow customers to earn points that can be redeemed in various ways. For example, points earned from purchases might be redeemable for free or discounted goods/services or to offset outstanding balances. However, accounting for these programs can be intricate and typically falls into one of three categories:
- Points earned from purchases can only be redeemed for goods/services provided by the issuing entity.
- Points earned from purchases can be used to acquire goods/services from other entities but cannot be redeemed for goods/services sold by the issuer.
- Points earned from purchases can be redeemed either with the issuer or with other entities.
In each scenario, management must carefully assess the nature of its performance obligation to determine the appropriate accounting treatment for the loyalty program. Specifically, in cases where points can only be redeemed with the issuer, revenue recognition occurs upon point redemption or expiration, with the entity typically acting as the principal for both the sale of goods/services and the fulfillment of the loyalty points performance obligation.
Points redeemed solely by others
In a loyalty program where points are exclusively redeemable with a third party, the entity must first determine its role as either a principal or an agent in the transaction involving points redeemed by others. This assessment dictates the timing of revenue recognition. If deemed an agent, the entity recognizes revenue for the net fee or commission retained in the transaction. The revenue is recognized when the entity fulfills its performance obligation related to the points and records a liability for the anticipated payment to the party redeeming the points. The boards, in the revenue standard’s basis for conclusions, highlighted that an entity acting as an agent might satisfy its obligation when transferring the points to the customer, rather than upon point redemption by the customer with the third party.
For points redeemable by either the issuer or third parties, management must evaluate the nature of the entity’s performance obligation. The entity fulfills its obligation concerning the points upon transferring goods or services to the customer, transferring the obligation to a third party, or when the points expire. If the customer chooses to redeem points with another party, management must assess whether the entity acts as a principal or an agent in the subsequent transaction. As with the prior scenario, if acting as an agent, the entity recognizes revenue for the net fee or commission retained in the exchange
Loyalty points redeemable by another party
The retailer, engaged in a customer loyalty program with an airline, awards one air travel point per currency unit spent by customers on goods purchased from the retailer. These points can solely be redeemed for air travel with the airline. Each point’s transaction price is determined at C0.01 based on its estimated stand-alone selling price. For each point redeemed, the retailer pays the airline C0.009. During the period, the retailer sells goods amounting to C1 million and issues 1 million points. Allocating C10,000 of the transaction price to the points, calculated by multiplying the number of points issued (1 million) by the allocated transaction price per point (C0.01), the retailer concludes its obligation is to facilitate the provision of loyalty points by the airline to customers, functioning as an agent in the transaction.
Question
How should the retailer account for points issued to its customers?
Answer
The retailer, acting as an agent in the transaction, determines its revenue as the commission retained for each point redeemed. This commission amounts to C1,000, calculated as the difference between the transaction price allocated to the points (C10,000) and the C9,000 paid to the airline. The retailer recognizes this commission upon transferring the points to the customer (at the time of purchasing goods from the retailer), as it has fulfilled its commitment to facilitate the provision of loyalty points by the airline to the customer.
Loyalty points redeemable by multiple parties
The retailer operates a customer loyalty program in collaboration with a hotel, where customers earn one loyalty point for each currency unit spent on goods from the retailer. These points can be redeemed for hotel accommodations or discounts on future purchases from the retailer. Each loyalty point is allocated a transaction price of C0.01 based on its estimated stand-alone selling price. During the period, the retailer sells goods worth C1 million and grants 1 million points. Allocating C10,000 of the transaction price to the points, calculated as 1 million points multiplied by C0.01 per point, the retailer determines that it has not fulfilled its performance obligation. This is because it must remain prepared to transfer goods or services if customers choose not to redeem points with the hotel.
Question
How should the retailer account for points issued to its customers?
Answer
The retailer should refrain from recognizing revenue for the C10,000 allocated to the points at the time of issuance, as its performance obligation remains unsatisfied. Revenue recognition should occur when customers redeem the points with the retailer, when the obligation transfers to the hotel, or when the points expire. Additionally, the retailer must evaluate whether it acts as the principal or an agent if customers choose to redeem points with the hotel.
Loyalty points redeemable solely by issuer
Airline A has a frequent flyer program that rewards customers with frequent flyer miles based on amounts paid for flights. A customer purchases a ticket for C500 (the stand-alone selling price) and earns 2,500 miles based on the price of the ticket. Miles are redeemable at a rate of 50 miles for C1 (C0.02 per mile). The miles can only be redeemed for flights with airline
Question
Ignoring breakage, how should the consideration be allocated between the miles (accumulating material right) and the flight?
Answer
The transaction price of C500 should be allocated between the flight and miles based on the relative stand-alone selling prices of C500 for the flight and C50 (2,500 points x C0.02) for the miles as follows:
Airline A would recognise revenue of C455 when the flight occurs. It would defer revenue of C45 and recognise it upon redemption or expiration of the miles.
Volume discount: pricing of optional purchases provides a material right
The manufacturer engages in a three-year contract with a customer to supply high-performance plastics, with the contract specifying a decrease in price per container as sales volume increases throughout the calendar year.
Although management anticipates a total sales volume of 2.5 million containers for the year, based on past contracts and forecasted sales to the customer, there’s no commitment from the customer to purchase any minimum volume of containers. Management has determined that the volume discount offers a material right to the customer.
Question
How should the manufacturer account for the prospective volume discount?
Answer
The manufacturer should treat the anticipated volume discount as a distinct performance obligation, representing a material right for the customer to purchase additional products at a reduced rate. Transaction price allocation would then be based on the relative stand-alone selling prices of the goods (the high-performance plastics) and the option. Assuming the manufacturer opts for the practical alternative provided in IFRS 15, given that the discounted goods to be purchased later are the same as the initial goods being bought, the allocation of transaction price for the additional goods would be as follows:
For the first 1,000,000 containers, revenue recognition would amount to C94 each, with the remaining C6 (the excess of the C100 price paid by the customer over the allocated C94 per container) deferred as a contract liability for the yet-to-be-fulfilled material right. This contract liability would accrue until the discounted containers (purchased by the customer for C90) are delivered, at which point it would be recognized as revenue upon container delivery. Adjustments to cumulative revenue and the contract liability’s value would be made at each reporting date to reflect updates to the total sales volume estimate.
A material right is a promise embedded in a current contract that should be accounted for as a separate performance obligation if that option provides a material right to the customer that it would not receive without entering into that contract. The evaluation of whether an option provides a material right to a customer requires judgment. Management should consider both quantitative and qualitative factors, including whether the right accumulates (for example, loyalty points). Management should consider relevant transactions, including the cumulative value of rights received in the current transaction, rights that have accumulated from past transactions, and additional rights expected from future transactions with the customer.
Option that provides a material right
The retailer operates a loyalty program where customers earn one loyalty point for every C10 spent in the store. These points can be redeemed for free products offered by the retailer. Historical data indicates that customers often accumulate enough points to claim free products. For instance, a customer makes a C50 purchase and earns five loyalty points as a result. The retailer estimates the stand-alone selling price of each point to be C0.20, totaling C1 for the five points earned, based on the probability of redemption.
Question
Do the loyalty points provide a material right?
Answer
Indeed, the loyalty points offer a material right to customers. While the five points earned in a single transaction may not seem significant on their own, they contribute to the accumulation of points, eventually granting the customer the right to claim a free product. It’s essential to allocate a portion of the transaction revenue to these loyalty points and recognize it when the points are redeemed or expire.
Accounting for the exercise of a customer option
When a customer chooses to exercise an option, they typically pay any remaining consideration for the associated good or service. In handling this situation, there are two viable approaches:
Firstly, one can treat the option exercise as a contract modification. This method involves referring to paragraph 11.44 onwards for a detailed discussion on contract modifications.
Alternatively, the option exercise can be regarded as a continuation of the existing contract. Under this approach, any additional consideration received is attributed to the goods or services linked to the material right. Revenue is then recognized upon the transfer of control. It’s important to apply consistent treatment to similar transactions. Interestingly, in many scenarios, both methods yield the same financial reporting outcome.
Activity
Entity M, in its contract with a customer, offers two years of Service A for C200, along with an option for the customer to buy one year of Service B for C100. Service A is valued at C200, and Service B at C160 as stand-alone selling prices. Recognizing the option to purchase Service B at a discount as a material right, Entity M estimates its stand-alone selling price at C50, factoring in the likelihood of the option being exercised. Allocating the C200 transaction price, Entity M assigns C160 to Service A and C40 to the option for Service B. Revenue from Service A is recognized over the two-year service period, while the revenue allocated to the Service B option is deferred until the service is transferred or the option expires. After three months, the customer exercises the option to purchase Service B for C100. Since Service B is distinct from Service A, it constitutes a separate performance obligation.
Question
How should entity M account for the exercise of the option to purchase service B?
Answer
Entity M has the option to handle the customer’s exercise of its option either as a continuation of the existing contract or as a contract modification. If Entity M chooses the former, it would allocate the additional C100 paid by the customer upon exercising the option entirely to Service B. This would result in recognizing a total of C140 (C100 plus the C40 originally allocated to the option) over the period during which Service B is provided to the customer. Alternatively, under the contract modification approach, Entity M would evaluate whether the additional consideration reflects the stand-alone selling price of the additional service B and adjust revenue recognition accordingly.
An option to purchase additional goods or services at their stand-alone selling prices is a marketing offer and therefore not a material right. This is true regardless of whether the customer obtained the option only as a result of entering into the current transaction. Example 50 of the revenue standard illustrates this concept. If a customer has the option to purchase additional goods or services in the future at current stand-alone prices, and prices are expected to increase, the option could be a material right. The customer is being offered a discount on future goods, compared to what others will have to pay, as a result of entering into the current transaction. Volume discounts take various forms and management might need to apply judgment to determine whether discounted pricing for optional future purchases provides a material right.
Future discount
Management should also evaluate whether a forthcoming discount extended to a customer constitutes an addition to the array of discounts typically offered to the same category of customer. Discounts in the future are not considered material rights if the customer could access the same discount without engaging in the current transaction. In this evaluation, the term “class of customer” encompasses similar customers, such as those in the same geographic area or market, who did not make similar previous purchases.
For instance, if a retailer provides a 50% discount on a future purchase to customers who buy a television, management must ascertain whether this discount is an incremental addition to the discounts provided to customers who did not buy a television.
Option that does not provide a material right (1)
The manufacturer enters into an agreement with a retailer, offering machinery and 200 hours of consulting services for C300,000. Each component is separately priced, with the machinery valued at C275,000 and the consulting services at C250 per hour. Both are treated as distinct performance obligations. Additionally, the manufacturer grants the retailer an option to buy ten extra hours of consulting services at a reduced rate of C225 per hour within the following 14 days, reflecting a 10% discount from the stand-alone selling price. Interestingly, the manufacturer extends a similar 10% discount on consulting services as part of a concurrent promotional campaign within the same timeframe.
Question
Does the option to purchase additional consulting services provide a material right to the customer?
Answer
No, the option doesn’t offer a material right. The discount it presents isn’t additional to the discount available to a comparable class of customers. This is because it aligns with the stand-alone selling price of hours offered to similar customers who didn’t engage in the current transaction to buy the machinery. The option is essentially a marketing incentive separate from the current contract. Its accounting treatment would occur when the customer decides to exercise it.
Option that does not provide a material right (2)
The entity engages in a contract to supply unlimited telecom services through a multi-line ‘family’ plan on a monthly basis. Customers possess the flexibility to incorporate extra lines into the plan each month for a predefined package rate, which corresponds to a reduction in the monthly service fee per line as more lines are added. Whenever customers choose to add or remove lines from the plan, they are essentially deciding on a month-to-month basis which family plan to acquire for that specific month, such as opting for a three-line plan over a four-line plan.
Question
Does the option to add an additional line to the plan provide the customer with a material right?
Answer
No, the option does not confer upon the customer a material right. The pricing structure for the family plan depends on the number of lines acquired in a given month and remains consistent across all customers, irrespective of the plan they may have purchased in previous months. Thus, the customer does not receive a discount based on their prior purchases.
An entity allocates the transaction price to performance obligations on a relative stand-alone selling price basis. If the stand-alone selling price of the option is not directly observable, an entity can estimate it.
Significant financing component considerations
Options for acquiring additional goods and services are frequently valid for durations exceeding one year, such as point and loyalty programs. When the timing of redemption is at the customer’s discretion, management is not obliged to assess whether a significant financing component exists in association with these options. However, if the timing of redemption is not under the customer’s control, such as when the option can only be exercised on specific dates one year or more after receiving the cash, a significant financing component may be present.
Determining the stand-alone selling price of customer options
The estimated stand-alone selling price reflects the discount that the customer would be entitled to, adjusted for any discount that the customer could receive without exercising the option (that is, any discount available to any other customer), and the likelihood that the option will be exercised. Example 49 of the revenue standard illustrates this concept.
How to estimate the stand-alone selling price of an option?
When evaluating its ability to estimate the number of options that won’t be exercised, management should take into account various indicators outlined in paragraph 11.77 onwards, particularly focusing on variable consideration. Additionally, considering both the entity’s historical data and the experience of similar arrangements can provide valuable insights. Reduction for breakage should only be recognized if it’s highly probable that such recognition won’t lead to significant reversals of previously recognized revenue. Estimating the stand-alone selling price of options requires judgment, as no specific method is mandated. Option-pricing models could be utilized by management for this purpose, incorporating intrinsic value—the option’s value if exercised immediately. While option-pricing models often include time value, the revenue standard doesn’t mandate its inclusion in estimating the stand-alone selling price. For options like customer loyalty points, which aren’t typically sold separately, management should assess whether the price charged in such instances aligns with the stand-alone selling price within a multi-goods or services arrangement.
The estimated stand-alone selling price is reduced for expected ‘breakage’. Breakage is the extent to which future performance is not expected to be required because the customer does not redeem the option (see para 11.204 ). The transaction price is therefore only allocated to obligations that are expected to be satisfied.
Renewal and cancellation options
Entities might allow customers to renew their existing contracts. A cancellation option that allows a customer to cancel a multiyear contract after each year might effectively be the same as a renewal option because a decision is made annually whether to continue under the contract. Management should assess a renewal or cancellation option to determine if it provides a material right similar to other types of customer options. The amount of the transaction price for the original contract that is allocated to the material right associated with a contract renewal is initially deferred. When the customer renews the contract, the deferred amount, as well as the additional transaction price resulting from the renewal, is allocated to the goods or services transferred during the renewal period
How to determine the stand-alone selling price of a renewal option that provides a material right?
Determining the stand-alone selling price involves exercising judgment, considering various factors. Management may rely on historical data, adjusted to reflect current conditions, to gauge pricing. Additionally, expected renewal rates, budgetary constraints, marketing research, and negotiation discussions with customers about pricing terms play pivotal roles. Industry-wide data, especially for homogeneous services, can provide valuable benchmarks in this assessment.
Contracts that include multiple renewal options (identified as a material right) introduce complexity. Management would theoretically need to assess the stand-alone selling price of each option. (As an alternative to estimating the stand-alone selling price of the option, if the future goods or services are similar to the original goods or services and are provided by the terms of the original contract, an entity could include the optional goods or services that it expects to provide (and corresponding expected customer consideration) in the initial measurement of the transaction price. Typically, those types of options are for contract renewals, whereby an entity would view the contract with renewal options as a contract for its expected term (that is, including the expected renewals)
Arrangements involving customer loyalty points or discount vouchers are unlikely to qualify for the practical alternative associated with contract renewals. The goods or services provided under such arrangements might differ from those provided in the initial contract or they might be provided under different pricing terms. For example, if an airline offers flights to customers in exchange for points from its frequent flyer program, the airline is not restricted, because it can subsequently determine the number of points that are required to be redeemed for any particular flightt.
Unexercised rights (breakage)
Customers might not exercise all of their rights or options in an arrangement. These unexercised rights are referred to as ‘breakage’ or forfeiture. Breakage applies not only to sales incentive programs, but also to any situations where an entity receives prepayments for future goods or services.
An entity should consider the guidance on constraining variable consideration to determine whether or not it expects to be entitled to a breakage amount. If the entity expects to be entitled to a breakage amount, it recognizes the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer. If the entity does not expect to be entitled to a breakage amount, it recognizes the expected breakage amount as revenue when the likelihood of the customer exercising its rights becomes remote. The assessment of estimated breakage should be updated at each reporting period. Changes in estimated breakage should be accounted for by adjusting the contract liability to reflect the remaining rights expected to be redeemed.
Sale of gift cards
Entity O ought to account for the gift cards redeemed during 20X2 by recognizing revenue amounting to C25,000. This sum is derived from the value of the gift cards redeemed, totaling C22,500, along with the breakage proportionate to the total rights exercised, equating to C2,500. This calculation involves multiplying the total expected breakage, which is C5,000, by the proportion of gift cards redeemed, calculated as C22,500 redeemed out of C45,000 expected to be redeemed.
Receipt of a non-refundable prepayment creates an obligation for an entity to stand ready to perform under the arrangement by transferring goods or services when requested. An entity recognizes a contract liability in the amount of the prepayment for the performance obligation to be satisfied. The entity de-recognizes the liability when it transfers the goods or services and satisfies its performance obligation.
Legal requirements for unexercised rights vary among jurisdictions. Certain jurisdictions require entities to remit payments received from customers for rights that remain unexercised to a governmental entity (for example, unclaimed property or ‘escheat’ laws). An entity should not recognize estimated breakage as revenue related to the consideration received from a customer that it is required to remit to a governmental entity if the customer never demands performance. Management should understand its legal rights and obligations when determining the accounting model to follow.