Telecommunications entities may need to change certain revenue recognition methods when adopting the new revenue recognition standard issued in May 2014. Under US GAAP this standard was issued as Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606).
There are several items in the new revenue standard that might be a change such as:
- Allocation of transaction price to performance obligations
- Nonrefundable upfront fees
- Indirect sales channel
- Significant financing component
- Contract costs
Allocate transaction price to performance obligations
Existing revenue recognition guidance in ASC 605-25 limits the recognition of contingent consideration (i.e., the contingent revenue cap). Historically, this guidance has limited the amount of revenue recognized by wireless companies upon the delivery of a subsidized device to the amount collected at the time of sale. This is because the remaining transaction consideration is contingent upon the wireless entity providing the monthly voice/data service and, therefore, cannot be allocated to the previously delivered item (device).
Under the new revenue standard, the transaction price is allocated to the identified performance obligations based on their relative standalone selling prices with revenue is being recognized as each performance obligation is satisfied based on transfer of control to the customer. This will likely result more of the transaction price being allocated to a device than under existing US GAAP revenue recognition requirements. This will in turn result in accelerated revenue recognition before the consideration is actually due and payable from the customer. This will result in a contract asset being recognized.
Below is an example that will illustrate the difference in accounting under both existing and the new revenue requirements.
An entity offering wireless services enters into a 2 year contact with a customer to provide voice and data services for $70 per month with an early termination penalty with a standalone selling price of $1,680 ($70 a month X 24 months). The customer selects a device that is fully subsidized (no cash is due at time of purchase) with a standalone selling price of $300. As such, the total transaction price is $1,680.
Existing US GAAP Revenue Treatment: Revenue recognized on the delivery of the device is limited to the amount not contingent on delivering the future voice/data services to the customer. In this case, the amount is capped at zero due to not collecting any of the consideration at the time of purchase. As such, the entire transaction price is allocated to the voice/data services and recognized on a ratable basis over the 2 year contract term.
New Revenue Recognition Standard: The device and the voice/data services are deemed to be distinct performance obligations. There is not contingent revenue cap under the new revenue recognition standard and, as such, the total transaction price of $1,680 is allocated on a relative selling price basis to the device and the voice/data services as shown below:
An entity offering wireless services enters into a 2 year contact with a customer to provide voice and data services for $85 per month with an early termination penalty with a standalone selling price of $1,680 ($70 a month * 24 months). The customer selects a device that is partially subsidized for a price of $150 with a standalone selling price of $500. As such, the total transaction price is $1,830.
Existing US GAAP Revenue Treatment: Revenue recognized on the delivery of the device is limited to the amount not contingent on delivering the future voice/data services to the customer. In this case, the amount related to the device is capped at the cash collected of $150 at the time of purchase. The remaining transaction price of $1,680 is allocated to the voice/data services and recognized on a ratable basis over the 2 year contract term.
New Revenue Recognition Standard: The device and the voice/data services are deemed to be distinct performance obligations. There is no contingent revenue cap under the new revenue recognition standard and, as such, the total transaction price of $1,830 is allocated on a relative selling price basis to the device and the voice/data services as shown below:
Nonrefundable upfront fees
In certain circumstances, entities may receive payments from customers before they provide the contracted service or deliver a good. Up-front fees generally relate to the initiation, activation or setup of a good to be used, or a service to be provided, in the future. In many cases, the up-front amounts paid by the customer are nonrefundable. Entities must evaluate whether nonrefundable up-front fees relate to the transfer of a good or service. In addition, the existence of a nonrefundable up-front fee may indicate that the arrangement includes a renewal option for future goods and services at a reduced price.
An example for wireless companies is charging an activation fee upon initiation of the contract and no such fee being charged in subsequent renewal periods. The entity would likely conclude that there are no performance obligations transferred to the customer in exchange for this fee. Essentially, the entity may conclude it is offering discounted prices on future services for the renewal periods. This may be deemed a material right not to pay another upfront fee and a separate performance obligation in which a portion of the transaction price should be allocated.
Due to the fact that this is a contract renewal, there are two ways to account for this material right according to ASC 606-10-55.
- Value the option itself – According to ASC 606-10-55-44 the option would be estimated as (1) the discount that the customer could receive without exercising the option and (2) the likelihood that the option will be exercised. Under this scenario the option would be valued and deferred until the option is exercised or expires. Also, the entity would need to estimate the number of renewal periods. For example, if an entity determines that its customers typical renew their contracts two times, it would recognize the option at each renewal date.
- Alternative method to assume option is exercised – According to ASC 606-10-55-45: If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate, the transaction price to the optional goods or services by reference to the goods or, services expected to be provided and the corresponding expected consideration. Typically, those types of options are for contract renewals such as the fact pattern described above for the activation fee. This is the so called “look through” method where there is a not a separate performance obligation identified for the option due to the entity assuming the option is exercised. Under this method, the entity would need to estimate the number of renewal periods and allocate the total consideration (including the activation fee) for the total expected term (original term plus any renewal periods). Essentially, the activation fee would be spread over both the original and any expected renewal periods.
On the other hand, if the wireless entity determines that the fee is not a material right, the up-front fee is included in the transaction price and allocated on a standalone selling price basis to the separate performance obligations for the device and the voice/data services and recognized over the initial contract period.
Indirect Sales Channel
Telecommunications entities often use indirect sales channels, such as dealers or distributors, to sell voice/data services to customers. Typically, in the indirect sales channel, the dealer may purchase the device from the manufacturer or the wireless company and then sell the device to the end customer, who concurrently signs up for voice/data services with the wireless company. The wireless company will typically make a payment to the dealer to compensate them for selling the device at a subsidized price (similar to the direct channel outlined above). Wireless entities will need to evaluate payments made to the dealers to determine whether they represent a commission (costs to obtain a contract) or a subsidy that on the device that is being paid to the dealer on behalf of the end customer (consideration payable to the customer).
Under existing standards, wireless entities may have waited to recognize revenue from device sales to dealers until the device was subsequently sold to the end customer (sell-through method) due to the price not being fixed and determinable. This may have been the case due to price concessions or returns. Under the new revenue recognition standard, these items represent variable consideration that is required to be estimated and included in the transaction price subject to a constraint that ensures that a significant amount of revenue is not reversed in subsequent periods. In other words, it is no longer acceptable to defer revenue due solely to the price being variable.
Significant financing component
For certain transactions, the receipt of consideration does not match the timing of the transfer of goods or services to the customer (e.g., the consideration is prepaid or is paid well after the services are provided). When the customer pays in arrears, the entity is effectively providing financing to the customer. Conversely, when the customer pays in advance, the entity has effectively received financing from the customer. An entity is not required to assess whether the arrangement contains a significant financing component unless the period between the customer’s payment and the entity’s transfer of the goods or services is greater than one year.
When telecom entities offer arrangements in which a good or service is provided up-front, but paid for over time, telecom entities will need to consider whether there is a significant financing component in the arrangement. Entities offering wireless services will need to evaluate whether there is a significant financing component to the arrangement when they offer subsidized devices in conjunction with a multiple year voice/data services contract or when an entity offers the customer a device installment plan.
Under the new revenue recognition standard, the incremental costs of obtaining a contract (i.e., costs that would not have been incurred if the contract had not been obtained) will be recognized as an asset if the entity expects to recover them. Expensing these costs as they are incurred is not permitted unless they qualify for the practical expedient. This practical expedient that permits an entity to expense the costs to obtain a contract as incurred when the expected amortization period is one year or less. Anticipated contract renewals, amendments, and follow-on contracts with the same customer must be considered when determining the period of benefit, and therefore the period of amortization, is one year of less.
For wireless entities, an example is the payment of commissions. Wireless entities may need to consider the impact of this guidance on their current cost capitalization practices. Many contracts in the industry may not qualify for the practical expedient because of their duration, including expected renewals. Further, when capitalizing such costs, entities must use judgment in determining (1) the period over which capitalized costs will be amortized (i.e., periods of expected contract renewals would be included) and (2) the approach to monitoring the resulting assets for impairment on an ongoing basis (this may be challenging when there is a large volume of underlying contracts). This likely will be a significant change for entities that currently make a policy election to expense these costs today.