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2.8 Principal-Versus-Agent Considerations

For an entity, deciding whether the nature of its promise is to transfer goods or services to the customer

itself (as a principal) or to arrange for goods or services to be provided by another party (as an agent)

is an important determination because the conclusion the entity reaches can significantly affect the

amount of revenue recognized. Whereas a principal of a performance obligation will recognize revenue

at the gross amount it is entitled to from its customer, an agent will present revenue at the net amount

retained. An entity must use judgment when assessing whether it is acting as a principal or as an agent.

The revenue standard focuses on recognizing revenue as an entity transfers control of a good or service.

Therefore, an entity is a principal in a transaction if it controls the specified goods or services before

they are transferred to the customer. The revenue standard provides some indicators to help an entity

determine whether it controls the underlying goods or services before they are transferred to the

customer.

2.8.1 Identifying the Specified Goods or Services

ASC 606-10

55-36

When another party is involved in providing goods or services to a customer, the entity should determine

whether the nature of its promise is a performance obligation to provide the specified goods or services itself

(that is, the entity is a principal) or to arrange for those goods or services to be provided by the other party

(that is, the entity is an agent). An entity determines whether it is a principal or an agent for each specified

good or service promised to the customer. A specified good or service is a distinct good or service (or a distinct

bundle of goods or services) to be provided to the customer (see paragraphs 606-10-25-19 through 25-22). If

a contract with a customer includes more than one specified good or service, an entity could be a principal for

some specified goods or services and an agent for others.

55-36A

To determine the nature of its promise (as described in paragraph 606-10-55-36), the entity should:

a.

Identify the specified goods or services to be provided to the customer (which, for example, could be a

right to a good or service to be provided by another party [see paragraph 606-10-25-18])

b.

Assess whether it controls (as described in paragraph 606-10-25-25) each specified good or service

before that good or service is transferred to the customer.

The first step in the evaluation of whether an entity is acting as a principal or as an agent “[w]hen

another party is involved in providing goods or services to a customer” is to identify the goods or

services that will be transferred to the customer (i.e., the “specified goods or services” referred to in ASC

606-10-55-36A). In the amendments in

ASU 2016-08

, the FASB confirmed that the unit of account for

evaluating whether an entity is acting as a principal or as an agent is not at the contract level. Rather,

the principal-versus-agent analysis is performed for each specified distinct good or service (or distinct

bundle of goods or services) that will be transferred to the customer. Accordingly, an entity could be a

principal for certain aspects of a contract with a customer and an agent for others.

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The unit of account to be used in the first step of the principal-versus-agent analysis could be described

as being at the performance obligation level. Consequently, this part of the analysis could be performed

as part of step 2 of ASC 606’s revenue model. However, the revenue standard does not refer to the

analysis as being conducted at the performance obligation level because the performance obligation of

an agent is to arrange for another entity to transfer the specified goods or services to the customer. For

an entity to determine whether it controls promised goods or services before they are transferred to a

customer, it must first identify the specified goods or services that will be transferred to the customer.

However, the notion of aggregating goods or services that are not distinct into performance obligations

(i.e., a distinct bundle of goods or services) will apply to identifying the unit of account used in the

evaluation of whether an entity is acting as a principal or as an agent. That is, the same guidance that

an entity applies to identify performance obligations (ASC 606-10-25-19 through 25-22) will be used to

determine the specified goods or services.

2.8.2 Determining Whether the Entity Controls the Goods or Services Before

They Are Transferred to the Customer

An entity is a principal in providing a specified good or service if the entity controls that specified good

or service before it is transferred to the customer. The control principle used in the determination

of whether an entity is acting as a principal or as an agent is the same control principle used in the

evaluation of the timing of when a good or service (i.e., an asset) is transferred to a customer. ASC

606-10-25-25 states, in part, “Control of an asset refers to the ability to direct the use of, and obtain

substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other

entities from directing the use of, and obtaining the benefits from, an asset.” Paragraph BC120 of

ASU

2014-09

describes the components of control as follows:

a.

Ability — A customer must have the present right to direct the use of, and obtain substantially all of

the remaining benefits from, an asset for an entity to recognize revenue. For example, in a contract

that requires a manufacturer to produce an asset for a particular customer, it might be clear that the

customer will ultimately have the right to direct the use of, and obtain substantially all of the remaining

benefits from, the asset. However, the entity should not recognize revenue until the customer has

actually obtained that right (which, depending on the contract, might occur during production or

afterwards).

b.

Direct the use of — A customer’s ability to direct the use of an asset refers to the customer’s right to

deploy that asset in its activities, to allow another entity to deploy that asset in its activities, or to restrict

another entity from deploying that asset.

c.

Obtain the benefits from — The customer must have the ability to obtain substantially all of the

remaining benefits from an asset for the customer to obtain control of it. Conceptually, the benefits

from a good or service are potential cash flows (either an increase in cash inflows or a decrease in

cash outflows). A customer can obtain the benefits directly or indirectly in many ways, such as by using,

consuming, disposing of, selling, exchanging, pledging, or holding an asset.

In addition, ASC 606-10-55-39 provides indicators to support an entity’s evaluation of control.

Connecting the Dots

In the determination of whether an entity controls a specified good or service before the good

or service is transferred to a customer, the control principle should be considered before the

indicators of control are analyzed. As noted in paragraph BC16 of ASU 2016-08, “the indicators

in paragraph 606-10-55-39 were included to support an entity’s assessment of whether it

controls a specified good or service before it is transferred to the customer. The indicators

(a) do not override the assessment of control, (b) should not be viewed in isolation, (c) do not

constitute a separate or additional evaluation, and (d) should not be considered a checklist of

criteria to be met in all scenarios.” Further, paragraph BC18(e) of ASU 2016-08 states, in part,

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that “the indicators are not an exhaustive list and merely support the assessment of control.

They do not replace or override that assessment.”

At the 2021 AICPA & CIMA Conference on Current SEC and PCAOB Developments, Jonathan

Wiggins, then a senior associate chief accountant in the SEC’s OCA, cautioned that the indicators

of control in the principal-versus-agent analysis as outlined in ASC 606-10-55-39 are neither a

checklist nor a substitute for an entity’s assessment of control; rather, an entity should consider

whether these indicators support its control assessment.

2.8.3 Controlling a Good Before Transferring It to a Customer

Often, it will be clear that an entity controls a good before it is transferred to a customer because the

entity acquired the good (i.e., obtained control) from a third party before transfer of the good to the

customer. These situations will often involve an element of inventory risk that is assumed while the good

is in the entity’s control.

However, other scenarios may not be as clear. Consider a situation in which an online electronics retailer

holds some goods (inventory) in its warehouse but also has arrangements with some of its suppliers that

allow it to direct the supplier to ship certain goods directly from the supplier’s warehouse to the end

customer (i.e., it does not have inventory risk for all goods). This sort of an arrangement would have to

be evaluated more carefully, as illustrated below.

Example 2-132

An electronics retailer has physical locations but also sells goods to its customers through its Web site.

Customers can choose to purchase goods at the retailer’s physical location but can purchase the same goods

online. The retailer has full discretion in determining the price of the goods and generally offers the same price

in stores as it does online. Customers who choose to buy electronics online enter into a contract with the

retailer to purchase one or more specified goods. The retailer can satisfy its obligation to transfer a specified

good to a customer either by shipping the good from one of its physical locations or by directing its supplier to

ship the good from the supplier’s warehouse. If the retailer directs its supplier to ship the good directly to the

customer, the retailer will take title to the specific good only momentarily before title passes to the customer

upon shipment. The retailer is required to pay the supplier for the good even if it does not receive payment

from the customer. If the customer is not satisfied with the good or there is a defect, the customer can return

the good to one of the retailer’s physical locations.

In this case, because the retailer takes title to the good only momentarily before passing title on to the

customer, it may not be clear whether the retailer controls the specified good before the good is transferred to

the customer. That is, further consideration is required. However, the retailer may conclude that it controls the

good before the good is transferred to the customer because it has the ability to direct the use of, and obtain

substantially all of the remaining benefits from, the good (i.e., it directs the supplier to ship the good to the

retailer’s customer). In addition, after considering the control indicators discussed below, the retailer concludes

that it is the principal because it is primarily responsible for satisfying the performance obligation, it has some

inventory risk upon product return, and it has latitude to establish pricing — factors that further indicate that

it controls the good before the good is transferred to the customer. Therefore, the retailer concludes that it

should record revenue on a gross basis.

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Typically, the principal in a transaction to sell goods to its customer will have legal title to the goods

before they are transferred to the customer. However, ASC 606-10-55-37 states, in part, that “an

entity does not necessarily control a specified good if the entity obtains legal title to that good only

momentarily before legal title is transferred to a customer.” Nevertheless, we do not believe that having

legal title only momentarily (e.g., flash title) automatically precludes the entity from having control of

the goods before they are transferred to the customer. Accordingly, the entity will need to perform

a thorough analysis of the overall definition of control and the other indicators in ASC 606-10-25-30

and ASC 606-10-55-39 to determine whether it has the ability to control the goods before they are

transferred to the customer.

The example below considers whether an entity’s momentary legal title to goods that the entity sells to

an end customer automatically precludes a determination that the entity (1) has control of the goods

before selling them to the end customer and (2) is therefore the principal in the transaction.

Example 2-133

Company L, the owner and operator of retail stores that sell hardware to customers, enters into contracts

with hardware manufacturers to purchase hardware. Upon receiving a purchase order from L, a manufacturer

produces the hardware and ships it to L’s warehouse. Company L subsequently delivers the hardware to its

individual retail stores for sale to end consumers. At its own discretion, L will direct the use of the hardware by

specifying the stores to which the hardware is to be delivered.

The manufacturer retains legal title to the hardware until L sells the hardware to an end consumer. Upon

L’s sale of the hardware to the end consumer, legal title is transferred only momentarily to L and then is

immediately transferred from L to the end consumer (i.e., flash title transfer). Consequently, L has physical

possession of the hardware but has legal title to the hardware only momentarily before selling it to the end

consumer. However, L can obtain the economic benefits of the hardware because it has the unilateral ability

to sell the hardware to an end consumer despite having legal title to the hardware only momentarily before

the sale. In addition, the manufacturer does not have the ability to recall the hardware or direct it to another

retailer once it has been shipped to L. Further, L is not obligated to pay the manufacturer for any hardware

purchased until such hardware is sold to the end consumer.

We do not believe that having legal title to the hardware only momentarily automatically precludes L from

having control of the hardware. To be considered a principal in a transaction, an entity must have control of the

specified good or service before transferring that good or service to a customer, as stated in ASC 606-10-55-37.

Legal title is one of the indicators of control in ASC 606-10-25-30, but that indicator alone is not determinative

of whether an entity has control of an asset. As indicated in ASC 606-10-25-30(b), there are circumstances in

which control of an asset can be transferred to the customer even though the seller retains legal title to the

asset until the asset is sold to the end consumer. In the fact pattern outlined above, L must consider the overall

definition of control and the other indicators in ASC 606-10-25-30 and ASC 606-10-55-39 to determine whether

it obtains control of the hardware without taking legal title to the hardware.

ASC 606-10-25-25 states, in part:

Control of an asset refers to the ability to direct the use of, and obtain substantially all of the

remaining benefits from, the asset. Control includes the ability to prevent other entities from

directing the use of, and obtaining the benefits from, an asset.

Under the facts of this example, L has the ability to direct the use of the hardware by delivering the hardware

to L’s individual retail stores for resale to end consumers. Further, L can obtain the remaining benefits from the

hardware by selling it to end consumers. Although the manufacturer retains legal title to the hardware until it

is sold, the manufacturer does not have the ability to prevent L from directing the hardware to L’s retail stores

and selling the hardware to end consumers. Therefore, notwithstanding that L has legal title to the hardware

only momentarily and is not obligated to pay the manufacturer for the hardware until the hardware is sold to

the end consumer, L controls the hardware as the principal in the transaction in the absence of any indicators

under ASC 606-10-55-39 to the contrary.

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2.8.4 Controlling the Right to a Service

There may also be instances in which an entity controls a right to a service and passes it on to a

customer. In these instances, the entity is not providing the service, but the entity may control the right

to the service by controlling the service before it is transferred to the customer. Sometimes, the entity

can use the service itself, or it can transfer the right to the service to a customer. In addition, an entity

may control the right to a service if it directs the service provider to perform the service on the entity’s

behalf for any of the entity’s customers.

Example 2-134

Entity A enters into an online training service agreement with Customer B to provide training to B’s employees.

Entity A contracts with third-party service providers to provide online training courses that are branded as A’s

courses. Entity A and Customer B have agreed on a single price for the online training services.

Entity A separately enters into contracts with third-party service providers (i.e., instructors) and directs those

service providers to perform each aspect of the online training by providing specific instructions on the type of

content to be included. Once A enters into contracts with the third-party service providers, it can direct those

service providers to perform services on A’s behalf for any of its customers. The third-party service providers

do not have any contractual relationship or contact with A’s customers, and if there are any customer service

issues, A will resolve them directly with the customer. Therefore, A is primarily responsible for providing the

online training to B.

Even though A is not performing the services, it controls the right to the services by directing third-party service

providers to perform each aspect of the online training services. Because A controls the right to the services, A

concludes that it is acting as the principal.

Example 2-135

Assume the same facts as in

Example 2-134

, except that (1) Entity A has a lawn maintenance service platform

on which third-party service providers list their businesses and (2) customers use A’s platform to connect

to those providers. Customers enter A’s portal and see vendors’ Web pages that showcase their service

parameters, experience, reviews, and pricing. Each customer that wants lawn maintenance services then

selects a third-party service provider and enters into a contract separately with that provider for the provision

of lawn maintenance service. The provision of the lawn maintenance services is subject to the service provider’s

terms and conditions agreed to by the customer and the service provider, including pricing. The only contract

between A and the third-party service provider is one that governs the terms and conditions under which A will

provide platform listing services to that provider.

Customer B selects Service Provider C from A’s platform, at which point the lawn maintenance service contract

between B and C is agreed upon. Even though B uses A’s platform for lawn maintenance services, A does not

have a contract with C for lawn maintenance services. That is, A does not obtain a right to C’s lawn maintenance

services that allows it to direct C to perform the lawn maintenance services for any of A’s customers. Entity

A can neither transfer the right to the specified services (C’s lawn maintenance services) nor use that right

to direct C to provide the services on A’s behalf. Rather than controlling the right to the service, A arranges,

through its platform, for C to provide lawn maintenance services to B. Consequently, A concludes that it is

acting as an agent in arranging for the lawn maintenance services.

Example 2-134

has similarities to a fact pattern discussed by Lauren Alexander, then a professional

accounting fellow in the OCA, in a

speech

at the 2019 AICPA Conference on Current SEC and

PCAOB Developments. In her speech, Ms. Alexander made the following observations related to the

determination of whether an entity is a principal or an agent in a contract to provide specified services

to a customer:

Determining whether an entity is a principal or an agent in a revenue transaction can be particularly challenging

when two parties are involved in providing services to a customer, especially if some of the services can only be

provided by a specific service provider.

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In the consultation that I will discuss today, the registrant entered into contracts with customers to provide

several related services in exchange for a fee. The contracts acknowledged that another service provider would

provide some of the services, and the services were marketed to customers using the brand names of both the

registrant and the other service provider. The registrant sought the staff’s view on whether it was a principal or

an agent in the revenue transaction.

The registrant noted that some of the services promised in the contract were based on its proprietary content,

and that it was heavily involved in providing those services to the customer, with limited involvement from the

other service provider. However, due to certain regulatory restrictions, the registrant could not legally provide

some of the services promised in the contract and therefore had to rely entirely on the other service provider

to deliver those services.

The registrant concluded that it was the principal in the transaction for each of the specified services and

should record revenue on a gross basis because it controlled the services before transferring them to the

customer. In reaching this conclusion, the registrant stated that it had the contractual ability to direct the

other service provider to provide services to customers on its behalf, and customers did not have contractual

relationships with the other service provider. The registrant asserted that it was primarily responsible for

fulfilling the promise to provide the specified services.

However, the registrant noted that it only had the right to dictate certain general parameters about the services

to be provided by the other service provider, and that the other service provider had discretion in determining

exactly how to fulfill its obligation. The registrant said that it controlled when the other service provider

delivered the services, and that contractually the other service provider did not have the right to deny services

to customers. Finally, the registrant was responsible for handling most customer concerns that arose from the

services provided by the other service provider.

In this fact pattern, the staff did not object to the registrant’s conclusion that it was the principal in the

transaction and should record revenue on a gross basis. The staff observed that the registrant could control

the specified services by entering into a contract with another service provider in which the registrant defined

the scope of services to be performed on its behalf, even if the registrant could not fulfill the contract using its

own resources (that is, it could not legally provide certain of the services promised in the contract).

As discussed in previous staff speeches, we continue to observe that applying the principal versus agent

guidance may require significant judgment, especially in the case of emerging business models. We encourage

registrants to carefully consider their specific facts and circumstances and contractual terms, and any changes

to these terms over time, when applying this guidance. [Footnotes omitted]

The judgments Ms. Alexander described regarding certain service contracts can be particularly

challenging when those services are delivered by using a single end-user-facing platform and the end

user is accessing content or IP owned by multiple parties.

Example 2-136

Entity P offers paid subscriptions to stream content from its library of entertainment options. Entity P obtains

content licenses from content partners to build out its library to attract and retain subscribers. Entity P enters

into separate agreements with content partners that give P the right to use the content for a specified period

in connection with providing P’s streaming service to its customers. The contracts vary but typically contain a

fixed fee and variable fees based on usage. When a customer subscribes to P’s streaming service, the customer

has access to the entire library for the subscription period. Entity P has sole discretion in determining the terms

of its subscription service, including the right to (1) add or replace content from its library without obtaining

consent from the content partner and (2) establish the price of its subscription service. Entity P’s customers

may not be aware that P does not own the content, and P’s customers cannot access the content in any way

other than through P’s platform.

Although P does not own any of the IP rights to the content, the content licenses give P the right to use the IP

to provide a streaming service to its subscribers for a specified period. Since P provides content that is owned

by other content partners, P considers whether it controls the right to use the content before the content is

made available on its platform for streaming by its subscribers.

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Example 2-136 (continued)

Entity P concludes that the nature of its promise is to provide its subscribers access to content through its

streaming services as a principal. Entity P identifies the content as the specified good or service and concludes

that it obtains control of the content before it makes the content available to its subscribers. This is because P’s

contracts with the content providers allow P to direct the use of the content by deciding what content is made

available to its subscribers and when that content is made available to them.

Entity P also considers the indicators in ASC 606-10-55-39 and determines the following:

•

Entity P is primarily responsible for fulfilling the promise to provide a streaming service to its customers

since the content providers are not involved in the transactions between P and P’s customers after the

license agreements are executed.

•

Entity P has inventory risk since the consideration it pays to obtain each license includes a fixed fee. That

is, P commits to purchasing the content before it has a contract with a customer to provide access to the

content as part of its streaming service.

•

Entity P has full discretion to determine the price of the content subscriptions.

Consequently, P concludes that it controls the content before the content is delivered to its customers and that

it is therefore the principal for the subscription streaming service.

Example 2-137

Assume the same facts as in

Example 2-136

, except that rather than offering third-party content as part of

its subscription streaming service, Entity P resells a third-party streaming service. In this scenario, P has an

agreement with a third-party content provider (Provider D), which has its own library of content and makes

that content available as a streaming service. Provider D separately sells its streaming service to other third

parties. Entity P’s agreement with D allows P to include D’s streaming service as part of P’s streaming service.

Provider D determines what content is available as part of D’s streaming service, and subscribers who purchase

D’s streaming service through P will each create their own log-in with D and access D’s service either through

P or directly through D. Provider D is responsible for maintaining its own infrastructure to make the content

available as part of its subscription service and is the party that is primarily responsible for making its content

available to subscribers. Entity P’s contract with D requires P to pay D a fixed fee per subscription.

Entity P concludes that the nature of its promise in its contract with D is to arrange for D to provide D’s

subscription service to P’s customers. Entity P identifies D’s streaming service as the specified good or service

and concludes that it does not obtain control of D’s streaming service (or a right to D’s streaming service)

before the streaming service is transferred to P’s customers. This is because although P may be able to initially

sell access to D’s streaming service, P cannot control the content that D includes as part of its streaming

service. That is, D determines what content is made available. In addition, D is required to maintain its own

infrastructure to provide the streaming service and is the party that is primarily responsible for making its

content available to subscribers. Further, P’s customers can access D’s content directly through D’s platform.

Entity P also considers the indicators in ASC 606-10-55-39 and determines the following:

•

Provider D is the party that is primarily responsible for fulfilling the promise to provide the streaming

service to subscribers since the delivery mechanism is D’s infrastructure and subscribers can access

content directly through D’s platform.

•

Entity P does not have inventory risk. This is because P is paying a fee per subscription.

•

Although P can determine the price of its subscription service (which includes D’s streaming service), this

indicator is less relevant in P’s facts and circumstances than the other indicators of control.

Consequently, P concludes that it does not control D’s content and that it is therefore the agent in the provision

of D’s subscription streaming service.

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2.8.5 Integrating a Good or Service From a Third Party With a Good or Service

Controlled by the Entity

An entity would also be a principal when it integrates a good or service provided by a third party with

other goods or services controlled by the entity. The entity’s performance obligation may be to transfer

to the customer a distinct bundle of goods or services, a component of which is provided by the third

party. The entity would need to obtain control of the third party’s good or service to integrate the good

or service with the other goods or services promised to the customer.

Example 2-138

Entity A enters into a contract with Customer B to develop a customized solution composed of hardware and

software. Customer B requests that specific features and functionality be included in the finished solution.

Entity A determines the specifications of the hardware and software, buys hardware components from a

third party (either A is reimbursed by B or the contract price includes the price of the hardware components),

customizes the solution by using its proprietary software, completes the installation, and performs tests to

ensure that the solution is working as intended. That is, as part of its obligation to develop the customized

solution for the customer, A performs a significant service of integrating the hardware components into the

solution, which forms part of a single performance obligation. Entity A therefore concludes that it controls

the hardware components before the components are transferred to the customer as part of the completed

solution.

Connecting the Dots

We believe that an entity should evaluate the level of integration between the various inputs in

identifying its performance obligations when it uses third-party goods or services as inputs to

produce or deliver a combined output. In addition, the entity should consider whether it has

sufficient control over those inputs to significantly integrate them into its offering.

At the 2021 AICPA & CIMA Conference on Current SEC and PCAOB Developments, Mr. Wiggins

discussed situations in which an entity may conclude that it is a principal because it takes a

good or service from a third party and integrates that good or service into its own offering. In his

discussion of entities’ contracts with customers involving a good or service from a third party,

Mr. Wiggins highlighted the importance of determining (1) whether the entity is performing an

integration service, (2) the nature of the integration service, (3) the significance of the integration

service, and (4) whether the entity controls the third party’s good or service. He noted that if an

entity does not control a promised good or service from a third party, it would be unclear how

the entity can significantly integrate that promised good or service with its own offering.

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2.8.6 Indicators That an Entity Is Acting as a Principal

If an entity is acting as a principal, the entity controls specified goods or services before they are

transferred to the customer. This may be the case even if the entity does not fulfill the promise itself

but directs a third party to fulfill the obligation on its behalf. In other situations, however, it may not be

clear whether the entity does in fact obtain control of the goods or services provided by a third party

before they are transferred to the customer. In these circumstances, the entity will need to consider the

indicators in ASC 606-10-55-39 and 55-39A when evaluating whether it is acting as a principal. Those

indicators are listed and explained as follows:

ASC 606-10

55-39

Indicators that an entity controls the specified good or service before it is transferred to the customer

(and is therefore a principal [see paragraph 606-10-55-37]) include, but are not limited to, the following:

a.

The entity is primarily responsible for fulfilling the promise to provide the specified good or service.

This typically includes responsibility for the acceptability of the specified good or service (for example,

primary responsibility for the good or service meeting customer specifications). If the entity is primarily

responsible for fulfilling the promise to provide the specified good or service, this may indicate that the

other party involved in providing the specified good or service is acting on the entity’s behalf.

b.

The entity has inventory risk before the specified good or service has been transferred to a customer

or after transfer of control to the customer (for example, if the customer has a right of return). For

example, if the entity obtains, or commits to obtain, the specified good or service before obtaining

a contract with a customer, that may indicate that the entity has the ability to direct the use of, and

obtain substantially all of the remaining benefits from, the good or service before it is transferred to the

customer.

c.

The entity has discretion in establishing the price for the specified good or service. Establishing the price

that the customer pays for the specified good or service may indicate that the entity has the ability to

direct the use of that good or service and obtain substantially all of the remaining benefits. However, an

agent can have discretion in establishing prices in some cases. For example, an agent may have some

flexibility in setting prices in order to generate additional revenue from its service of arranging for goods

or services to be provided by other parties to customers.

d.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

e.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

55-39A

The indicators in paragraph 606-10-55-39 may be more or less relevant to the assessment of control

depending on the nature of the specified good or service and the terms and conditions of the contract. In

addition, different indicators may provide more persuasive evidence in different contracts.

We have observed that primary responsibility and inventory risk tend to be important indicators in

the overall principal-versus-agent analysis under the revenue standard. However, the relevance of

particular control indicators may vary depending on the fact pattern. Consequently, an entity will

need to determine whether it controls the underlying goods or services before they are transferred

to the customer by considering how the control indicators should be evaluated under the facts and

circumstances of the entity’s arrangements.

Each of the indicators specifically described in ASC 606-10-55-39 — primary responsibility, inventory risk,

and discretion in establishing pricing — is further discussed below.

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2.8.6.1 Primary Responsibility

The entity that has primary responsibility for fulfilling the obligation to the customer is often the entity

that is most visible to the customer and the entity from which the customer believes it is acquiring

goods or services. Often, the entity that has primary responsibility for fulfilling the promise to transfer

goods or services to the customer will assume fulfillment risk (i.e., risk that the performance obligation

will not be satisfied) and risks related to the acceptability of specified goods or services. That is, such an

entity will typically address customer questions and complaints, rectify service issues, accept product

returns, or be primarily responsible for exchanges or refunds. For example, when a customer purchases

a flight on a Web site operated by a company that aggregates flight information and facilitates payment

(e.g., a travel site), the airline rather than the travel site has the primary responsibility to provide the

transportation service to the customer. If the flight were to be canceled or if baggage were to be lost, the

customer would contact the airline to address the issue. Although the customer initially interacted with

the travel site to arrange for the flight, the airline is primarily responsible for fulfilling the obligation to

provide transportation services to the customer.

Similarly, in

Example 2-132

, when a customer purchases a good from an online retailer’s Web site that is

shipped directly to the customer from the supplier, the customer would contact the retailer if there are

quality issues or would return the good to the retailer if there is a defect. That is, even though the good

was actually shipped directly from the supplier to the customer, the customer views the retailer as being

primarily responsible for fulfilling the promise to transfer the specified good, and the retailer assumes

significant risk related to fulfillment of that promise.

In some cases, it can be difficult to establish whether an entity has primary responsibility for fulfilling

a promise to provide a specified good or service, and doing so may require significant judgment. For

example, when two parties are involved in providing a specified good or service to a customer, both

parties may have contact with the customer. Conversely, in other cases, it may be clear that an entity

has primary responsibility. If it is clear that an entity has primary responsibility for fulfilling a promise

to provide a specified good or service to a customer, we believe that this would typically mean that the

entity is deemed to be the principal. Although ASC 606-10-55-39 lists primary responsibility as only an

indicator, ASC 606-10-55-36 makes clear that when the principal-versus-agent analysis is performed, it

is key to identify which party is promising to provide the specified good or service to the customer. If an

entity has primary responsibility to the customer for providing a specified good or service, it will usually

follow that the entity is the party that is promising to provide the good or service to the customer (i.e.,

the entity is a principal, not an agent), even if the entity has engaged another party to satisfy some or all

of the performance obligation on its behalf.

2.8.6.2 Inventory Risk

When an entity has inventory risk, it is exposed to economic risk associated with either (1) holding the

inventory before a customer is identified or (2) accepting product returns and being required to mitigate

any resulting losses by reselling the product or negotiating returns with the supplier. Inventory risk is

a specific kind of risk that can result in an entity’s loss because the entity controls a specified product

(e.g., the entity holds the product before a customer is identified, or the entity takes the product back on

return and must resell or dispose of it). Inventory risk is not the same as general economic risk, which

can result in an entity’s loss even if the entity never controls a specified product (e.g., an entity acting as

an agent earns less commission because of a decline in demand, or an entity shares in price/demand

risk with a vendor without controlling the product).

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While holding the inventory, the entity bears the risk of loss as a result of obsolescence or destruction of

inventory. This risk is generally referred to as front-end inventory risk. In the case of a service, the entity

may commit to pay for a service before it identifies a customer for the service. This is also a form of

inventory risk.

Another type of inventory risk is back-end inventory risk, which is economic risk assumed upon product

return (when there is a general right of return). If an entity is willing to assume economic risk upon

product return (and there is a general right of return), it is assuming some risk that is assumed by a

principal in a transaction. However, in some instances, an entity may be willing to accept a return only if

it can return the product to the supplier, in which case back-end inventory risk may be mitigated. When

combined with other factors, the existence of back-end inventory risk may lead to a conclusion that the

entity controls the specified good or service before it is transferred to the customer even if another

party transfers the product or service directly to the customer. In

Example 2-132

, the online retailer

does not have inventory risk before entering into a contract with a customer because the online retailer

takes title to a good only momentarily before the supplier ships the good to a customer. However, if the

customer were to be dissatisfied with the good, the customer would return it to the online retailer rather

than the supplier. The online retailer would then have back-end inventory risk since it would have to

determine whether it can resell the good to another customer or return the good to the supplier.

2.8.6.3 Discretion in Establishing Pricing

When an entity has control over the establishment of pricing, it generally assumes substantial risks

and rewards related to the demand of the specified product or service, especially when the price it is

required to pay a third party for the specified good or service is fixed. In contrast, when an entity acts as

an agent in a transaction, the amount that the entity earns may be fixed (either in absolute dollars per

transaction or as a fixed percentage of the sales price).

When combined with other factors, pricing discretion could indicate that the entity controls the specified

good or service before it is transferred to the customer. However, ASC 606-10-55-39(c) states, in part,

that “an agent can have discretion in establishing prices in some cases. For example, an agent may have

some flexibility in setting prices in order to generate additional revenue from its service of arranging for

goods or services to be provided by other parties to customers.”

Example 2-139

A food delivery service offers delivery of meals from restaurants to customers within a certain radius from

a specific location in a city. Via its Web site or app, the food delivery service connects a customer with a

restaurant and also delivers ordered food from the restaurant to the customer. Each restaurant indicates its

prices on the food delivery service’s platform and has the ability to change those prices daily. The food delivery

service earns a 5 percent commission on sales from each restaurant order.

In this example, each restaurant has discretion in establishing pricing rather than the food delivery service. In

addition, the restaurant is responsible for fulfilling the food ordered. This would suggest that the restaurant

controls the specified good or service (i.e., the food ordered by the customer) at all times before the food is

transferred to the customer.

Note, however, that the food delivery service may be the principal for the delivery service, particularly if it is

primarily responsible for the delivery service, in which case it would be an agent for part of the transaction and

a principal for another part. See

Section 2.8.9

for further discussion of contracts in which an entity is both a

principal and an agent.

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2.8.7 Codification Examples of Promised Goods or Services for Which an

Entity Is a Principal (ASC 606-10-55-320 Through 55-329)

The following implementation guidance from the revenue standard will help an entity determine

whether it is acting as a principal in a contract:

ASC 606-10

Example 46 — Promise to Provide Goods or Services (Entity Is a Principal)

55-320

An entity enters into a contract with a customer for equipment with unique specifications. The entity

and the customer develop the specifications for the equipment, which the entity communicates to a supplier

that the entity contracts with to manufacture the equipment. The entity also arranges to have the supplier

deliver the equipment directly to the customer. Upon delivery of the equipment to the customer, the terms

of the contract require the entity to pay the supplier the price agreed to by the entity and the supplier for

manufacturing the equipment.

55-321

The entity and the customer negotiate the selling price, and the entity invoices the customer for the

agreed-upon price with 30-day payment terms. The entity’s profit is based on the difference between the sales

price negotiated with the customer and the price charged by the supplier.

55-322

The contract between the entity and the customer requires the customer to seek remedies for defects

in the equipment from the supplier under the supplier’s warranty. However, the entity is responsible for any

corrections to the equipment required resulting from errors in specifications.

55-323

To determine whether the entity’s performance obligation is to provide the specified goods or services

itself (that is, the entity is a principal) or to arrange for those goods or services to be provided by another

party (that is, the entity is an agent), the entity identifies the specified good or service to be provided to the

customer and assesses whether it controls that good or service before the good or service is transferred to the

customer.

a.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

b.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

c.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

d.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

e.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

55-323A

The entity concludes that it has promised to provide the customer with specialized equipment

designed by the entity. Although the entity has subcontracted the manufacturing of the equipment to the

supplier, the entity concludes that the design and manufacturing of the equipment are not distinct because

they are not separately identifiable (that is, there is a single performance obligation). The entity is responsible

for the overall management of the contract (for example, by ensuring that the manufacturing service conforms

to the specifications) and thus provides a significant service of integrating those items into the combined

output — the specialized equipment — for which the customer has contracted. In addition, those activities

are highly interrelated. If necessary modifications to the specifications are identified as the equipment is

manufactured, the entity is responsible for developing and communicating revisions to the supplier and for

ensuring that any associated rework required conforms with the revised specifications. Accordingly, the entity

identifies the specified good to be provided to the customer as the specialized equipment.

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ASC 606-10 (continued)

55-323B

The entity concludes that it controls the specialized equipment before that equipment is transferred

to the customer (see paragraph 606-10-55-37A(c)). The entity provides the significant integration service

necessary to produce the specialized equipment and, therefore, controls the specialized equipment before it

is transferred to the customer. The entity directs the use of the supplier’s manufacturing service as an input in

creating the combined output that is the specialized equipment. In reaching the conclusion that it controls the

specialized equipment before that equipment is transferred to the customer, the entity also observes that even

though the supplier delivers the specialized equipment to the customer, the supplier has no ability to direct its

use (that is, the terms of the contract between the entity and the supplier preclude the supplier from using the

specialized equipment for another purpose or directing that equipment to another customer). The entity also

obtains the remaining benefits from the specialized equipment by being entitled to the consideration in the

contract from the customer.

55-324

Thus, the entity concludes that it is a principal in the transaction. The entity does not consider the

indicators in paragraph 606-10-55-39 because the evaluation above is conclusive without consideration of the

indicators. The entity recognizes revenue in the gross amount of consideration to which it is entitled from the

customer in exchange for the specialized equipment.

Example 46A — Promise to Provide Goods or Services (Entity Is a Principal)

55-324A

An entity enters into a contract with a customer to provide office maintenance services. The entity and

the customer define and agree on the scope of the services and negotiate the price. The entity is responsible

for ensuring that the services are performed in accordance with the terms and conditions in the contract. The

entity invoices the customer for the agreed-upon price on a monthly basis with 10-day payment terms.

55-324B

The entity regularly engages third-party service providers to provide office maintenance services to its

customers. When the entity obtains a contract from a customer, the entity enters into a contract with one of

those service providers, directing the service provider to perform office maintenance services for the customer.

The payment terms in the contracts with the service providers generally are aligned with the payment terms

in the entity’s contracts with customers. However, the entity is obliged to pay the service provider even if the

customer fails to pay.

55-324C

To determine whether the entity is a principal or an agent, the entity identifies the specified good or

service to be provided to the customer and assesses whether it controls that good or service before the good

or service is transferred to the customer.

55-324D

The entity observes that the specified services to be provided to the customer are the office

maintenance services for which the customer contracted and that no other goods or services are promised

to the customer. While the entity obtains a right to office maintenance services from the service provider

after entering into the contract with the customer, that right is not transferred to the customer. That is, the

entity retains the ability to direct the use of, and obtain substantially all the remaining benefits from, that right.

For example, the entity can decide whether to direct the service provider to provide the office maintenance

services for that customer, or for another customer, or at its own facilities. The customer does not have a right

to direct the service provider to perform services that the entity has not agreed to provide. Therefore, the right

to office maintenance services obtained by the entity from the service provider is not the specified good or

service in its contract with the customer.

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ASC 606-10 (continued)

55-324E

The entity concludes that it controls the specified services before they are provided to the customer.

The entity obtains control of a right to office maintenance services after entering into the contract with the

customer but before those services are provided to the customer. The terms of the entity’s contract with the

service provider give the entity the ability to direct the service provider to provide the specified services on the

entity’s behalf (see paragraph 606-10-55-37A(b)). In addition, the entity concludes that the following indicators

in paragraph 606-10-55-39 provide further evidence that the entity controls the office maintenance services

before they are provided to the customer:

a.

The entity is primarily responsible for fulfilling the promise to provide office maintenance services.

Although the entity has hired a service provider to perform the services promised to the customer, it is

the entity itself that is responsible for ensuring that the services are performed and are acceptable to

the customer (that is, the entity is responsible for fulfilment of the promise in the contract, regardless of

whether the entity performs the services itself or engages a third-party service provider to perform the

services).

b.

The entity has discretion in setting the price for the services to the customer.

55-324F

The entity observes that it does not commit itself to obtain the services from the service provider

before obtaining the contract with the customer. Thus, the entity has mitigated its inventory risk with respect

to the office maintenance services. Nonetheless, the entity concludes that it controls the office maintenance

services before they are provided to the customer on the basis of the evidence in paragraph 606-10-55-324E.

55-324G

Thus, the entity is a principal in the transaction and recognizes revenue in the amount of

consideration to which it is entitled from the customer in exchange for the office maintenance services.

Example 47 — Promise to Provide Goods or Services (Entity Is a Principal)

55-325

An entity negotiates with major airlines to purchase tickets at reduced rates compared with the price of

tickets sold directly by the airlines to the public. The entity agrees to buy a specific number of tickets and must

pay for those tickets regardless of whether it is able to resell them. The reduced rate paid by the entity for each

ticket purchased is negotiated and agreed in advance.

55-326

The entity determines the prices at which the airline tickets will be sold to its customers. The entity sells

the tickets and collects the consideration from customers when the tickets are purchased.

55-327

The entity also assists the customers in resolving complaints with the service provided by the airlines.

However, each airline is responsible for fulfilling obligations associated with the ticket, including remedies to a

customer for dissatisfaction with the service.

55-328

To determine whether the entity’s performance obligation is to provide the specified goods or services

itself (that is, the entity is a principal) or to arrange for those goods or services to be provided by another

party (that is, the entity is an agent), the entity identifies the specified good or service to be provided to the

customer and assesses whether it controls that good or service before the good or service is transferred to the

customer.

a.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

b.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

c.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

d.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

55-328A

The entity concludes that with each ticket that it commits itself to purchase from the airline, it obtains

control of a right to fly on a specified flight (in the form of a ticket) that the entity then transfers to one of its

customers (see paragraph 606-10-55-37A(a)). Consequently, the entity determines that the specified good or

service to be provided to its customer is that right (to a seat on a specific flight) that the entity controls. The

entity observes that no other goods or services are promised to the customer.

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ASC 606-10 (continued)

55-328B

The entity controls the right to each flight before it transfers that specified right to one of its

customers because the entity has the ability to direct the use of that right by deciding whether to use the ticket

to fulfill a contract with a customer and, if so, which contract it will fulfill. The entity also has the ability to obtain

the remaining benefits from that right by either reselling the ticket and obtaining all of the proceeds from the

sale or, alternatively, using the ticket itself.

55-328C

The indicators in paragraph 606-10-55-39(b) through (c) also provide relevant evidence that the entity

controls each specified right (ticket) before it is transferred to the customer. The entity has inventory risk with

respect to the ticket because the entity committed itself to obtain the ticket from the airline before obtaining

a contract with a customer to purchase the ticket. This is because the entity is obliged to pay the airline for

that right regardless of whether it is able to obtain a customer to resell the ticket to or whether it can obtain a

favorable price for the ticket. The entity also establishes the price that the customer will pay for the specified

ticket.

55-329

Thus, the entity concludes that it is a principal in the transactions with customers. The entity recognizes

revenue in the gross amount of consideration to which it is entitled in exchange for the tickets transferred to

the customers.

2.8.8 Determining Whether an Entity Is Acting as an Agent

If an entity concludes that it does not obtain control of a good or service before that good or service is

transferred to a customer, the entity is acting as an agent. That is, the entity’s performance obligation

is to arrange for another party to transfer the good or service to the customer. As an agent, the entity

will recognize as revenue the commission or fee it earns (i.e., the net amount of consideration retained)

when or as it satisfies its performance obligation of arranging for the specified goods or services to be

provided by another party. This guidance is articulated in ASC 606-10-55-38, which is included below.

ASC 606-10

55-38

An entity is an agent if the entity’s performance obligation is to arrange for the provision of the specified

good or service by another party. An entity that is an agent does not control the specified good or service

provided by another party before that good or service is transferred to the customer. When (or as) an entity

that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or

commission to which it expects to be entitled in exchange for arranging for the specified goods or services to

be provided by the other party. An entity’s fee or commission might be the net amount of consideration that

the entity retains after paying the other party the consideration received in exchange for the goods or services

to be provided by that party.

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2.8.8.1 Codification Examples of Promised Goods or Services for Which an Entity

Is an Agent (ASC 606-10-55-317 Through 55-319 and ASC 606-10-55-330 Through 55-

334)

The following implementation guidance from the revenue standard will help an entity determine

whether it is acting as an agent in a contract:

ASC 606-10

Example 45 — Arranging for the Provision of Goods or Services (Entity Is an Agent)

55-317

An entity operates a website that enables customers to purchase goods from a range of suppliers who

deliver the goods directly to the customers. Under the terms of the entity’s contracts with suppliers, when a

good is purchased via the website, the entity is entitled to a commission that is equal to 10 percent of the sales

price. The entity’s website facilitates payment between the supplier and the customer at prices that are set

by the supplier. The entity requires payment from customers before orders are processed, and all orders are

nonrefundable. The entity has no further obligations to the customer after arranging for the products to be

provided to the customer.

55-318

To determine whether the entity’s performance obligation is to provide the specified goods itself (that

is, the entity is a principal) or to arrange for those goods to be provided by the supplier (that is, the entity is an

agent), the entity identifies the specified good or service to be provided to the customer and assesses whether

it controls that good or service before the good or service is transferred to the customer.

a.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

b.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

c.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

d.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

e.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

55-318A

The website operated by the entity is a marketplace in which suppliers offer their goods and

customers purchase the goods that are offered by the suppliers. Accordingly, the entity observes that the

specified goods to be provided to customers that use the website are the goods provided by the suppliers, and

no other goods or services are promised to customers by the entity.

55-318B

The entity concludes that it does not control the specified goods before they are transferred to

customers that order goods using the website. The entity does not at any time have the ability to direct the

use of the goods transferred to customers. For example, it cannot direct the goods to parties other than the

customer or prevent the supplier from transferring those goods to the customer. The entity does not control

the suppliers’ inventory of goods used to fulfill the orders placed by customers using the website.

55-318C

As part of reaching that conclusion, the entity considers the following indicators in paragraph 606-10-

55-39. The entity concludes that these indicators provide further evidence that it does not control the specified

goods before they are transferred to the customers.

a.

The supplier is primarily responsible for fulfilling the promise to provide the goods to the customer. The

entity is neither obliged to provide the goods if the supplier fails to transfer the goods to the customer

nor responsible for the acceptability of the goods.

b.

The entity does not take inventory risk at any time before or after the goods are transferred to the

customer. The entity does not commit to obtain the goods from the supplier before the goods are

purchased by the customer and does not accept responsibility for any damaged or returned goods.

c.

The entity does not have discretion in establishing prices for the supplier’s goods. The sales price is set

by the supplier.

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ASC 606-10 (continued)

55-319

Consequently, the entity concludes that it is an agent and its performance obligation is to arrange

for the provision of goods by the supplier. When the entity satisfies its promise to arrange for the goods to

be provided by the supplier to the customer (which, in this example, is when goods are purchased by the

customer), the entity recognizes revenue in the amount of the commission to which it is entitled.

Example 48 — Arranging for the Provision of Goods or Services (Entity Is an Agent)

55-330

An entity sells vouchers that entitle customers to future meals at specified restaurants, and the sales

price of the voucher provides the customer with a significant discount when compared with the normal

selling prices of the meals (for example, a customer pays $100 for a voucher that entitles the customer to

a meal at a restaurant that would otherwise cost $200). The entity does not purchase or commit itself to

purchase vouchers in advance of the sale of a voucher to a customer; instead, it purchases vouchers only as

they are requested by the customers. The entity sells the vouchers through its website, and the vouchers are

nonrefundable.

55-331

The entity and the restaurants jointly determine the prices at which the vouchers will be sold to

customers. Under the terms of its contracts with the restaurants, the entity is entitled to 30 percent of the

voucher price when it sells the voucher.

55-332

The entity also assists the customers in resolving complaints about the meals and has a buyer

satisfaction program. However, the restaurant is responsible for fulfilling obligations associated with the

voucher, including remedies to a customer for dissatisfaction with the service.

55-333

To determine whether the entity is a principal or an agent, the entity identifies the specified good or

service to be provided to the customer and assesses whether it controls the specified good or service before

that good or service is transferred to the customer.

a.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

b.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

c.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

d.

Subparagraph superseded by Accounting Standards Update No. 2016-08.

55-333A

A customer obtains a voucher for the restaurant that it selects. The entity does not engage the

restaurants to provide meals to customers on the entity’s behalf as described in the indicator in paragraph

606-10-55-39(a). Therefore, the entity observes that the specified good or service to be provided to the

customer is the right to a meal (in the form of a voucher) at a specified restaurant or restaurants, which the

customer purchases and then can use itself or transfer to another person. The entity also observes that no

other goods or services (other than the vouchers) are promised to the customers.

55-333B

The entity concludes that it does not control the voucher (right to a meal) at any time. In reaching this

conclusion, the entity principally considers the following:

a.

The vouchers are created only at the time that they are transferred to the customers and, thus, do not

exist before that transfer. Therefore, the entity does not at any time have the ability to direct the use

of the vouchers or obtain substantially all of the remaining benefits from the vouchers before they are

transferred to customers.

b.

The entity neither purchases nor commits itself to purchase vouchers before they are sold to customers.

The entity also has no responsibility to accept any returned vouchers. Therefore, the entity does not

have inventory risk with respect to the vouchers as described in the indicator in paragraph 606-10-

55-39(b).

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ASC 606-10 (continued)

55-334

Thus, the entity concludes that it is an agent in the arrangement with respect to the vouchers. The

entity recognizes revenue in the net amount of consideration to which the entity will be entitled in exchange for

arranging for the restaurants to provide vouchers to customers for the restaurants’ meals, which is the

30 percent commission it is entitled to upon the sale of each voucher.

2.8.8.2 Timing of Revenue Recognition When the Entity Is an Agent

The timing of when an agent satisfies its performance obligation may not be the same as the timing

of when the principal in the arrangement transfers control of the specified good or service to the end

customer. ASC 606-10-25-23 states that (1) an entity should “recognize revenue when (or as) the entity

satisfies a performance obligation by transferring a promised good or service . . . to a customer” and

(2) an “asset is transferred when (or as) the customer obtains control of that asset.” Accordingly, when

an entity determines that it is acting as an agent with respect to the specified good or service, the entity

must use judgment and consider all of the relevant facts and circumstances to determine when it has

satisfied its performance obligation to arrange for the provision of a specified good or service by another

party.

When the nature of an entity’s promise is to arrange for goods or services to be provided by another

party, it is often important to determine whether the entity is an agent for the buyer, the seller, or

both to assess (1) to whom the entity is obligated to satisfy its performance obligation of arranging

for the provision of goods or services and (2) when the entity satisfies such performance obligation.

Further, if there is a difference in timing between when the agent arranges for goods or services to be

provided by a seller and when the specified goods or services are transferred from the seller to the

buyer, it is important to determine whether the entity’s promise of arranging for goods or services to

be transferred by the seller is satisfied when the arrangement is made or when the specified goods or

services are transferred by the seller to the buyer.

Example 2-140

Entity A operates a travel booking Web site that arranges for airlines to provide transportation services to end

customers. Entity A partners with various airlines and offers their flights on its platform. End customers will

purchase specific flights on A’s platform and pay A the nonrefundable airfare price at the time of purchase.

Flights can be sold up to 12 months before the scheduled departure date. Within seven days of an end

customer’s purchase, A remits to the airline the airfare price less A’s commission. After the initial booking on A’s

platform, any changes requested by the end customer are handled directly by the airline. Therefore, A has no

further involvement with the end customer or the airline related to the flight purchased after the initial booking.

Entity A concludes that the nature of its promise is to arrange for airlines to provide transportation services to

end customers. Entity A’s customer is the end customer, and A’s performance obligation is satisfied at the time

of the initial booking. This is because A has no further obligations after the initial booking. Specifically, A has no

further involvement with the end customer or the airline after the initial booking, any changes requested by the

end customer must be handled directly by the airline, and the amount A collects is nonrefundable. Accordingly,

A may conclude that it should recognize revenue at the point in time when the initial booking is successfully

made.

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Example 2-141

Entity B operates a travel booking Web site that arranges for various travel services (e.g., hotels, rental cars,

experiences) to be provided by third parties. Entity B partners with these third parties and offers their services

on its platform. End customers will reserve the travel services on B’s platform, but B does not collect payment

from end customers until the travel services are provided. This is because B allows end customers to change

or cancel their travel arrangements at any time before when the underlying travel services are scheduled to be

transferred to the end customers. Entity B also promises to provide assistance to end customers in modifying

or canceling the arranged travel services and to coordinate with the travel service providers until the underlying

services are provided. Within seven days of payment by the end customer, B remits to the travel service

provider the price of the travel service less B’s commission.

Entity B concludes that the nature of its promise is to identify paying end customers for its travel service

provider partners. Entity B’s customer is the travel service provider, and B’s performance obligation is not

satisfied until the travel service provider begins to provide travel services to the end customer. This is because

B remains obligated to identify paying end customers after booking and before the travel service provider

begins providing travel services. Specifically, end customers can cancel or modify their travel arrangements at

any time before when the underlying travel services are scheduled to be provided, B continues to be involved

with the end customers and the travel service providers by helping end customers modify or cancel their

arrangements until such services are provided, and end customers are not required to pay until the travel

services are provided. That is, a paying end customer is not identified for the travel service provider until the

travel services are provided. Accordingly, B may conclude that it should recognize revenue at the point in time

when the travel services provided to the end customer commence.

2.8.9 Contracts in Which the Entity Is a Principal and an Agent

An entity must determine whether it is a principal or an agent at what can effectively be described as

the performance obligation level (i.e., the specified good or service that is distinct), not the contract

level. Therefore, in some contracts, an entity could have both performance obligations to arrange for

goods or services to be provided by another entity (i.e., the entity is acting as an agent) and performance

obligations to transfer goods or services to the customer itself (i.e., the entity is acting as a principal).

2.8.9.1 Illustrative Examples of Contracts in Which an Entity Is Both a Principal

and an Agent

The following implementation guidance from the revenue standard illustrates a situation in which an

entity is a principal and an agent in the same contract:

ASC 606-10

Example 48A — Entity Is a Principal and an Agent in the Same Contract

55-334A

An entity sells services to assist its customers in more effectively targeting potential recruits for open

job positions. The entity performs several services itself, such as interviewing candidates and performing

background checks. As part of the contract with a customer, the customer agrees to obtain a license to access

a third party’s database of information on potential recruits. The entity arranges for this license with the

third party, but the customer contracts directly with the database provider for the license. The entity collects

payment on behalf of the third-party database provider as part of its overall invoicing to the customer. The

database provider sets the price charged to the customer for the license and is responsible for providing

technical support and credits to which the customer may be entitled for service down-time or other technical

issues.

55-334B

To determine whether the entity is a principal or an agent, the entity identifies the specified goods or

services to be provided to the customer and assesses whether it controls those goods or services before they

are transferred to the customer.

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ASC 606-10 (continued)

55-334C

For the purpose of this Example, it is assumed that the entity concludes that its recruitment services

and the database access license are each distinct on the basis of its assessment of the guidance in paragraphs

606-10-25-19 through 25-22. Accordingly, there are two specified goods or services to be provided to the

customer — access to the third-party’s database and recruitment services.

55-334D

The entity concludes that it does not control the access to the database before it is provided to

the customer. The entity does not at any time have the ability to direct the use of the license because the

customer contracts for the license directly with the database provider. The entity does not control access to the

provider’s database — it cannot, for example, grant access to the database to a party other than the customer

or prevent the database provider from providing access to the customer.

55-334E

As part of reaching that conclusion, the entity also considers the indicators in paragraph 606-10-

55-39. The entity concludes that these indicators provide further evidence that it does not control access to the

database before that access is provided to the customer.

a.

The entity is not responsible for fulfilling the promise to provide the database access service. The

customer contracts for the license directly with the third-party database provider, and the database

provider is responsible for the acceptability of the database access (for example, by providing technical

support or service credits).

b.

The entity does not have inventory risk because it does not purchase or commit to purchase the

database access before the customer contracts for database access directly with the database provider.

c.

The entity does not have discretion in setting the price for the database access with the customer

because the database provider sets that price.

55-334F

Thus, the entity concludes that it is an agent in relation to the third-party’s database service. In

contrast, the entity concludes that it is the principal in relation to the recruitment services because the entity

performs those services itself and no other party is involved in providing those services to the customer.

In the example above, an important part of the fact pattern is that the entity has no further obligations

to the customer after arranging for the database access to be provided to the customer. If this is not

the case (e.g., because the entity would be responsible for the acceptability of the database access), the

analysis could be different.

Example 2-142

Company X, a food delivery service, offers delivery of meals from restaurants to consumers within a certain

radius from a specific location in a city. Via its Web site and app, the food delivery service connects a consumer

with a restaurant, processes food orders, and provides a service of delivering food to the consumer. Each

restaurant has full discretion to establish the price for its food ordered through X. The food delivery service

earns a 5 percent commission on sales from each restaurant order and charges a flat delivery fee of $10 per

order. The restaurant is responsible for fulfilling the ordered food and addressing all consumer complaints

regarding the quality of the food or an incorrect order. If the food is compromised while in transit, X is liable.

Company X is responsible for delivering the food and can change the delivery fee at its discretion. Company X

takes custody of the food ordered from a restaurant, but it can deliver the food only to the consumer’s location.

Company X uses independent contractors (ICs) to perform the delivery service, and such ICs commit to being

available to provide the delivery service at set schedules. When an IC is presented with a delivery request, that

IC can decide whether to accept or reject the request. If an IC accepts a request, X will direct the IC to pick up

the food at a specific restaurant and deliver the good to a specific consumer. If, instead, an IC rejects a request,

X is still obligated to provide the delivery service and will attempt to find another IC to perform the delivery. In

some cases, X will take a loss on the delivery service by paying an IC a rate higher than the delivery fee to fulfill

the delivery.

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Example 2-142 (continued)

Assume that the food and the delivery service are each capable of being distinct and distinct within the context

of the contract.

In this example, X does not obtain control of the food (one of the specified goods or services) before it is

transferred to the consumer. Although X takes custody of the food, it cannot redirect the food to another

consumer or consume the good (the food) as a resource. Further, X is not responsible for fulfilling the food

order or addressing consumer complaints, does not purchase the food before the food is transferred to the

consumer, and does not have discretion to establish the price of the food. Company X is acting as an agent and

arranging for the restaurant to fulfill the promise to transfer food to the consumer.

However, X is primarily responsible for providing the service of delivering the food to the consumer. If the

food is compromised while in transit, X is liable to the customer. Although ICs are used to perform the delivery

service and an individual IC can reject a particular delivery, X is still obligated to provide the delivery service and

is required to identify another IC to complete the delivery service even if doing so results in a loss to X. Further,

X has full discretion to establish the price of the delivery service. Consequently, X is the principal for the delivery

service.

2.8.10 Estimating Gross Revenue as a Principal

An entity may be determined to be a principal in a contract with a customer when there is uncertainty in

the transaction price that is unlikely to be resolved. Such uncertainty may arise because the entity does

not have, and will not obtain, sufficient transparency into the intermediary’s pricing.

As noted in paragraph BC38 of

ASU 2016-08

, the FASB contemplated, but ultimately rejected,

amendments to ASC 606 to address these types of transactions. Rather, the Board found the guidance

in step 3 of the revenue model to be helpful in the determination of what amounts are variable

consideration and thus should be included in the transaction price. Specifically, paragraph BC38(c)

states, in part:

A key tenet of variable consideration is that at some point the uncertainty in the transaction price ultimately will

be resolved. When the uncertainty is not expected to ultimately be resolved, the guidance indicates that the

difference between the amount to which the entity is entitled from the intermediary and the amount charged

by the intermediary to the end customer is not variable consideration and, therefore, is not part of the entity’s

transaction price.

Accordingly, for the transactions contemplated above, the Board found it reasonable for the principal to

include in its transaction price the amounts known (i.e., the amounts to which the entity expects to be

entitled from the intermediary).

Example 2-143

Company L sells a SaaS solution for building developers and building managers (the “end users”) through

channel partners. Company L enters into a contract with Company R, a channel partner, that allows R to sell

L’s SaaS solution to end users on behalf of L. Entity X, an end user of the SaaS solution, enters into a contract

with R to purchase L’s SaaS solution. Entity X is not a party to the contract between R and L. In accordance with

R’s contract with X, R arranges for L to provide the SaaS solution to X and promises to provide implementation

services to X. The implementation services are distinct from the SaaS solution. While L is the principal for the

SaaS solution, R is the principal for the implementation services.

In accordance with L’s reseller arrangement with R, R has the discretion to sell L’s SaaS solution at any price

but is required to remit $150 to L for each 12-month subscription sold (irrespective of the price that R charges

the end user). Company R bills X for both the SaaS solution and the implementation services under the

terms of the contract between R and X. Company L does not have information, and is not expected to obtain

information, about the price that R charges X for the SaaS solution.

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Example 2-143 (continued)

Typically, as the principal, L would record the consideration to which it expects to be entitled from its customer

(i.e., X) for the sale of the SaaS solution as revenue. However, in this fact pattern, L does not know, and will

not know, the amount that the end user is paying R for the SaaS solution (and also does not know, and will

not know, the amount that R retains as its fee for the reselling services). Consequently, L should include in the

transaction price only the amount that is known, which is the amount to which L expects to be entitled from R

for the sale of the SaaS solution to X. It would not be appropriate for L to estimate the consideration that X pays

R for the SaaS solution because L will never know the actual amount that X pays R. Since the uncertainty about

the amount that X pays R will never be resolved, that amount does not represent variable consideration that

should be included in the transaction price of the SaaS solution.

2.8.11 Digital Advertising Industry

In a

speech

at the 2017 AICPA Conference on Current SEC and PCAOB Developments, Barry Kanczuker,

then an associate chief accountant in the OCA, provided the following guidance on determining whether

an entity is a principal or an agent for digital advertising space:

I have observed that applying [the guidance in ASC 606 on determining whether an entity is a principal or an

agent] can be challenging in some fact patterns. I believe that some of the challenges are amplified in certain

industries, such as the digital advertising industry or other industries in the technology space, where there are

often multiple parties involved in providing the good or service, and transactions often take place within the

blink of an eye.

Last year at this conference, [then OCA Professional Accounting Fellow] Ruth Uejio made remarks that principal

versus agent considerations in evolving business models may create “unique challenges that will require

sound judgment.” I would like to continue this discussion. For example, I believe determining whether an entity

controls a specified good or service immediately prior to the good or service being transferred to the customer

may be especially challenging in certain types of service transactions, such as when enforceable contracts only

exist among the parties once the service is being provided, or in transactions that take place in an instant.

Topic 606 does provide indicators to support an entity’s assessment of whether it controls a specified good or

service before it is transferred to the customer. However, these indicators of control should not be considered

a checklist of criteria. The indicators may be more or less relevant to the assessment of control depending

on the nature of the specified good or service and the terms and conditions of the contract. I believe that

determining the relevance of an indicator to the assessment of control in certain types of transactions will

require reasonable judgment.

As an example of the application of this guidance, I would like to share a recent pre-filing consultation that OCA

received in the digital advertising space. In this consultation, the registrant’s customer, an advertiser, provided

the registrant with specifications of the target audience it wished to reach through its digital advertising efforts.

The advertiser’s specifications also included limited pricing information, such as the total advertising budget

over a period of time. The registrant’s technology enabled it to identify and purchase advertising space that

met the advertiser’s specifications on a real-time basis, as internet users in the advertiser’s target audience

were browsing a website or viewing an app with available advertising space. The registrant had the ultimate

discretion, including pricing discretion, for individual purchases of advertising space. The advertiser held the

registrant responsible for reaching the advertiser’s target audience and otherwise meeting the advertiser’s

specifications, and typically did not receive any information from the registrant that identified the specific

websites or apps from which the registrant purchased the advertising space.

The registrant concluded that it was acting as a principal in the arrangement because it controlled the

specified good or service before it was transferred to the customer. As part of its assessment of control, the

registrant considered the indicators of control and noted that it was primarily responsible for fulfillment and

had discretion in establishing the price. The staff views principal versus agent considerations to be an area

that requires reasonable judgment — in this case, based on the facts and circumstances and the Topic 606

guidance, the staff did not object to the registrant’s conclusion that it was the principal in the transaction.

I want to be clear: an area of significant judgment does not mean that the standard permits optionality. In order

to make these reasonable judgments, I believe that registrants need to “roll up their sleeves” to understand

the nuances of the transactions and faithfully apply the Topic 606 model to their specific set of facts and

circumstances. [Footnotes omitted]

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As discussed in Mr. Kanczuker’s speech above, determining whether an entity is a principal or an agent

can be challenging in certain industries, particularly the digital advertising industry. In a

speech

at the

2020 AICPA Conference on Current SEC and PCAOB Developments, Geoff Griffin, then a professional

accounting fellow in the OCA, discussed another similar fact pattern. In his speech, Mr. Griffin made the

following observations related to the determination of whether an entity is a principal or an agent in a

contract to provide a customer with access to the entity’s advertising platform:

Significant judgment is often required when determining whether an entity is a principal or an agent in a

revenue transaction. As discussed in previous staff speeches, assessing whether an entity is a principal or agent

under the applicable revenue guidance can be particularly challenging in certain industries, such as the digital

advertising industry or other industries in the technology space, where arrangements often involve multiple

parties providing the good or service. I would like to share a fact pattern that illustrates such an arrangement.

In this fact pattern, the registrant operated a platform that facilitated an advertiser’s purchase of advertising

space from a publisher. The registrant identified a specific advertiser’s digital advertisement (“ad”) before

bidding on potential advertising space in an auction process. Upon winning an auction, the registrant obtained

an exclusive right to the potential advertising space and immediately pre-loaded the identified advertiser’s ad to

the publisher’s site. If a valid user reaches the stage in the publisher’s app where the potential advertising space

is to be displayed, the pre-loaded ad is displayed in the advertising space on the publisher’s site and a revenue

transaction occurs.

The registrant concluded it was an agent in the transaction, despite the fact that it obtained momentary title

to the advertising space, stating that it did not obtain control of the advertising space prior to transferring it to

the customer. That is, the registrant concluded that it did not have the ability to direct the use of, and obtain

substantially all the remaining benefits from, the publisher’s advertising space. Due to certain constraints, the

registrant concluded it was unable to direct the use of the potential advertising space to an ad other than

the predetermined ad in the seconds between winning the auction and the time the ad was displayed on the

publisher’s site.

As part of its assessment, the registrant considered the indicators of control set forth in the revenue

recognition guidance, determining that it was not primarily responsible for fulfillment and did not have

inventory risk; however, the registrant determined that it did have pricing discretion as the publisher had no

ability to set or influence the price charged to advertisers. In reaching its conclusion, the registrant stated

that it was not primarily responsible for fulfillment based on the terms and conditions of its contract with the

advertiser. The registrant believed that the terms and conditions of its contract only obligated it to provide

an advertiser with access to the platform that facilitated the customer’s purchase of advertising space from

publishers. Finally, the registrant stated that it did not promise its customer, explicitly or implicitly, the delivery

of advertising space, nor did the customer have recourse against the registrant if its ad was not properly

displayed in the advertising space or a valid user did not view the ad.

Based on the facts and circumstances presented to OCA staff, the staff did not object to the registrant’s

conclusion that it was an agent in the transaction and should recognize revenue on a net basis. [Footnotes

omitted]

2.8.11.1 Accounting Considerations Related to Adtech Entities’ Revenue

Arrangements — Programmatic Advertising

The adtech industry is characterized by a high degree of automation, data-driven behavioral targeting,

and a growing emphasis on user privacy. Programmatic advertising has become a key transaction

method, facilitated by demand-side platforms, sell-side platforms, and other adtech platforms that are

interconnected across a vast ecosystem of digital channels. Further, new digital channels and formats,

including mobile apps, connected television (CTV),

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social media, digital out-of-home media, podcasts,

video, audio, and gaming, have made cross-channel campaign management necessary for advertisers

to track their return on ad spending (ROAS)

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in real-time. In addition, AI and machine learning are being

leveraged throughout the programmatic advertising ecosystem to process vast amounts of data and

make real-time decisions about how ads are created, targeted, and optimized.

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CTV is a television that (1) is connected to the Internet via over-the-top devices (e.g., streaming box, gaming console) or has built-in Internet

capabilities (e.g., a smart TV) and (2) can access a variety of long-form and short-form Web-based content.

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ROAS is a key performance indicator in the adtech industry. It refers to the amount of revenue that is earned for every dollar spent.

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2.8.11.1.1 How Programmatic Advertising Transactions Are Executed

Programmatic advertising transactions are executed in various ways, including the following:

•

Open auctions

— Open auctions are where most programmatic advertising transactions occur

today. In an open auction, multiple adtech platforms leverage algorithms and data to bid on

ad space across multiple digital channels via a real-time bidding (RTB) auction, with the highest

bidder winning the auction. These transactions occur within milliseconds and allow for the

instantaneous buying and selling of ad space. Open auctions include hundreds of potential

buyers and sellers.

•

Private auctions

— Private auctions are exclusive “invitation-only” auctions in which publishers

offer their premium ad space to a select group of buyers. When the premium ad space becomes

available, a select group of buyers can bid on it via an RTB auction. If the ad space does not clear

the private auction, it is often offered next in an open auction.

•

Preferred deals

— Preferred deals are “first-look” opportunities that allow a buyer to purchase

ad space from a publisher at a fixed price before the ad space is made available in an auction.

The publisher and buyer directly negotiate the preferred deals, including the price, and use an

adtech platform to facilitate the transaction. However, the ad space is not reserved for a specific

advertiser, and the buyer is not committed to purchasing it. If the buyer does not purchase the

ad space, the publisher can sell the ad space in a private auction or an open auction.

•

Programmatic guaranteed deals

— Programmatic guaranteed deals require a publisher to

commit to delivering a specific amount of ad space to a specific buyer at a fixed price. The buyer

commits to purchasing the ad space in advance.

In programmatic advertising, ad space may be auctioned off under a “waterfall” approach or a “header

bidding” approach. Often, the adtech platform with which a publisher contracts to host the publisher’s

auctions will allow the publisher to determine which approach to use.

Under the waterfall approach, ad space is offered to demand sources sequentially. If the first buyer does

not want the ad space, it “falls down” to the next buyer, and so on.

Under the header bidding approach, a header bidding wrapper (e.g., a JavaScript code on the adtech

platform’s Web site) sends a request for bids on ad space to multiple demand sources simultaneously.

Upon receiving the bid request, each demand source conducts an auction and returns its highest

bid to the header bidding wrapper, which then compares all received bids and typically forwards the

highest one to the publisher for final decision-making. To select the winning bid, the publisher’s sell-side

platform evaluates the highest header bid alongside other demand sources (such as direct deals and

non-header-bidding programmatic bids) on the basis of parameters established by the publisher. If

the highest header bid is selected, the creative ad is displayed in the ad space. This entire sequence

transpires within a matter of milliseconds.

Although the term “header bidding” was coined after the use of code in a Web site’s header, the

principles underlying header bidding apply to other digital channels besides Web sites, potential

differences in technical implementation notwithstanding. For example, “in-app bidding” is the mobile app

equivalent of header bidding. Instead of using code in a Web site’s header, in-app bidding uses software

to allow multiple buyers to bid on ad space in a publisher’s mobile app. It follows the same logic: multiple

bidders get a chance to bid simultaneously.

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2.8.11.1.2 Key Players in Programmatic Advertising

The graphic below depicts many of the key players in the programmatic advertising ecosystem.

The roles and responsibilities of the key players depicted above may be described as follows:

•

Advertisers

— Advertisers are businesses or brands that invest in creative ads to reach their

target audiences. They may be represented by advertising agencies or in-house marketing

teams that plan and execute ad campaigns. In the adtech industry, advertisers (and their

agencies) are on the demand side, aiming to deliver the right creative ad to the right target

audience at the right time. Advertisers may compensate a publisher for the right to display their

creative ads on the publisher’s digital platform in various ways, including the following:

o

Cost per click

— An advertiser pays an agreed-upon amount each time a user clicks on the

advertiser’s creative ad.

o

Cost per mille

— An advertiser pays a specified price every thousand times its creative ad is

displayed and viewed.

o

Cost per acquisition

— An advertiser pays when a user completes a specific action, such as

purchasing or signing up, after interacting with the advertiser’s creative ad.

o

Cost per view

— An advertiser pays each time a user views the advertiser’s creative ad in the

form of a video.

o

Cost per installation

— An advertiser pays each time its creative ad leads to an installation

of its app or digital asset. For example, a gaming advertiser prices its bids on the basis of

installation rather than views because it expects the publisher’s digital platform to deliver

an installation. That is, the bid of a gaming advertiser represents the price the advertiser is

willing to pay if an installation is delivered.

Advertisers generally contract with operators of various adtech platforms, including demand-

side platforms, ad networks, and ad exchanges, to buy available ad space. Depending on the

business model of these adtech platforms, the advertisers may guide the adtech platforms’

algorithms by setting input parameters (e.g., who sees the creative ad, how much to bid, when to

bid). Often, they receive reports and data analytics that monitor campaign performance in near

real-time, allowing for immediate adjustments and optimization.

Ad Network

Operators

Data Aggregator

Operators

Publishers

Key Players in

the Programmatic

Advertising Ecosystem

Advertisers

Sell-Side Platform

Operators

Demand-Side

Platform Operators

Ad Exchange

Operators

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Advertisers also enter into arrangements with third-party operators of attribution platforms

that specialize in tracking, measuring, and analyzing the performance of the advertisers’ ad

campaigns. The attribution platforms are integrated with other adtech platforms to verify and

measure campaign performance and provide key performance indicators such as cost per

acquisition and ROAS. Advertisers may use these platforms to independently track performance

and corroborate the amounts due on the basis of the payment terms (e.g., clicks, views,

installations).

•

Demand-side platform operators

— Demand-side platforms are technology platforms that enable

advertisers (or other parties acting on behalf of the advertisers) to purchase ad space across

multiple publishers and digital channels. Demand-side platforms use sophisticated algorithms

to determine the right target audience, bid in real time, and optimize the advertisers’ ad

campaigns. Rather than contracting with dozens of publishers individually or using separate

ad networks, advertisers can use a demand-side platform to bid on available ad space from

multiple sources (e.g., ad exchanges, publishers, sell-side platforms). Demand-side platforms

connect to adtech platforms via an API

81

that allows the advertisers to bid on any available ad

space programmatically once it becomes available.

•

Publishers

— Publishers own digital platforms on which they offer ad space. Representing the

supply side of the programmatic advertising ecosystem, publishers operate across various digital

formats and platforms, including Web sites, mobile devices, CTV, apps, audio, and podcasts.

To earn revenue, a publisher will sell ad spaces (or ad impressions) that temporarily allow

advertisers to display their creative ads on the publisher’s digital platform. The publisher (or a

platform operator acting on the publisher’s behalf) will send a buyer a bid request containing

metadata that describe an available ad space and provide information about the consumer so

that the buyer can make a more informed decision about how much to bid on the ad space.

Publishers generally contract with multiple operators of adtech platforms, including operators

of sell-side platforms, ad exchanges, and ad networks, to sell available ad space. In a manner

similar to how advertisers do so, publishers may guide the algorithms of such platforms by

setting input parameters (e.g., who sees the creative ad, where the ad is displayed, the auction

type, the minimum bid price or floor price for the ad space, whether certain creative ads are

excluded from appearing on the platforms).

•

Sell-side platform operators

— Sell-side platforms are technology platforms that enable

publishers (or other parties acting on behalf of the publishers) to sell available ad space across

multiple demand-side platforms, ad exchanges, and ad networks. In a manner similar to how

demand-side platforms do so, sell-side platforms connect to adtech platforms via an API that

allows them to send requests for bids on any ad space programmatically once the ad space

becomes available.

•

Ad exchange operators

— Ad exchanges are digital marketplaces that facilitate programmatic

advertising. They can be thought of as a “central trading floor” for programmatic advertising, on

which bids from buyers are paired with bid requests from sellers.

Ad exchanges can support different auction types and facilitate private deals, such as auctions

with restricted buyers. They generally earn revenue by facilitating the exchange of ad space

between buyers and sellers, and they use advanced algorithms to match buyers and sellers.

In practice, the term “ad exchange” is sometimes used interchangeably with “sell-side platform”

or with the exchange functionality of a sell-side platform. Initially, however, ad exchanges were

independent platforms that sat between demand-side platforms and sell-side platforms.

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APIs enable different software systems to communicate and exchange data. In the adtech industry, APIs are used to connect platforms, automate

processes, and facilitate the flow of information between the different adtech platforms.

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•

Ad network operators

— Traditionally, ad network operators aggregated ad inventory from

multiple publishers and sold it to buyers, often as premium ad inventory. Today, ad networks

function in a manner similar to how ad exchanges operate, facilitating the programmatic buying

and selling of ad space.

•

Data aggregator operators

— Data aggregators are platforms that collect, organize, and manage

information to create audience profiles. The data are used for ad targeting, enabling advertisers

to reach specific demographics, interests, and behaviors. Platforms such as data management

platforms, customer data platforms, and data curators manage first-party, second-party,

and third-party data and integrate this information into the broad programmatic advertising

ecosystem to inform targeting strategies.

The graphic below illustrates a simplified programmatic advertising ecosystem that involves advertisers,

demand-side platforms, publishers, sell-side platforms, ad exchanges, ad networks, and data

aggregators.

Notwithstanding the platforms highlighted above, it is important to note that the adtech industry

encompasses a variety of other platforms, including those of entities that independently measure the

effectiveness of advertisers’ campaigns and provide prebid and postbid verification solutions to both

advertisers and publishers. In response to the constantly evolving digital landscape, the adtech industry

is also continually seeing the emergence of new platforms to support innovative digital channels and

technologies. Further, a significant trend within the programmatic advertising ecosystem is vertical

integration, by which entities manage multiple stages of the advertising supply chain from ad creation

and media buying to ad serving and data analytics. This trend is driven by the desire for greater control

over the entire advertising process and the ability to leverage data across different stages, reflecting the

ongoing evolution of the adtech landscape.

2.8.11.1.3 Illustrative Example of a Programmatic Advertising Transaction

The example below illustrates a simplified programmatic advertising transaction.

RTB Auctions

Supply Side

Ad Exchange

Ad Exchange

Ad Exchange

Demand Side

Ad Network

(Working for Buyers)

Advertisers

Demand-Side

Platforms

(Bidder Services)

Data Aggregators

Sell-Side Platforms

(Auction Services)

Ad Network

(Working for Sellers)

Publishers

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Example 2-144

An automobile manufacturer (the advertiser) wishes to launch a digital advertising campaign to promote a

new high-performance vehicle. The advertiser uses a demand-side platform to define its target audience (e.g.,

consumers interested in high-performance vehicles, residing in specific geographic locations). The demand-

side platform programmatically connects to various ad space sources, including ad exchanges and sell-side

platforms, on which publishers offer their ad space for sale programmatically.

When a consumer visits a publisher’s digital platform (e.g., a Web site), the publisher decides what to do next on

the basis of what it knows about the user and the available ad space. For example, the publisher may choose

to serve the ad space to an open auction, private auction, preferred deal, or programmatic guaranteed deal (or

some combination thereof). Information about consumers that informs the publisher may be obtained from

multiple sources, including code embedded in the publisher’s Web site and third-party sources such as data

aggregators.

On the basis of information about the consumer and the available ad space, the publisher’s adtech platform

serves the ad space to an open auction and sends a bid request to multiple ad exchanges. The bid request

includes metadata about the ad space and the consumer accessing the publisher’s digital platform, which allow

the buyers to make informed decisions on how much to bid on the ad space.

The automobile manufacturer’s demand-side platform submits a bid for ad space in which the automobile

manufacturer’s creative ad can be displayed to the target audience. The demand-side platform uses algorithms

and machine learning to evaluate the amount to bid on the available ad space on the basis of metadata that it

obtains from the ad exchange and third-party data aggregators, coupled with the automobile manufacturer’s

ad campaign objectives and input parameters.

The automobile manufacturer’s demand-side platform submits the highest bid and wins the open auction. The

demand-side platform provides instructions to the ad exchange on retrieving the automobile manufacturer’s

creative ad. This information is passed on to the publisher, which retrieves the creative ad from the advertiser.

The automobile manufacturer’s ad for its high-performance vehicle is displayed on the publisher’s digital

platform.

This entire process, from the bid request to the auction process to the display of the creative ad, occurs within

milliseconds.

2.8.11.1.4 How the Complex Programmatic Advertising Ecosystem Affects

Revenue Recognition

In accordance with ASC 606, entities that provide goods and services to customers in the programmatic

advertising ecosystem must evaluate their contracts to determine when, and how much, revenue

should be recognized. Typically, an adtech transaction begins with the publisher and concludes with the

advertiser, ultimately resulting in the transfer of ad space from the publisher to the advertiser. However,

since multiple intermediaries are involved in the facilitation of adtech transactions, it is essential to

assess each party’s role as either a principal or an agent and to determine whether each party obtains

control of the ad space before it is transferred to the advertiser. The rapid, often millisecond-level

execution of these transactions further complicates this evaluation.

For the operator of an adtech platform that facilitates the programmatic buying and selling of ad space,

a key consideration is whether the entity acts as a principal or as an agent. That is, the entity must

determine whether (1) the nature of its performance obligation is a promise to buy or sell ad space as

either the buyer’s agent or the seller’s agent or (2) it is acting as the principal for the obligation to deliver

the ad space to the buyer (or the buyer’s agent). As discussed in ASC 606-10-55-36A, for an entity to

determine the nature of its promise, it should identify the specified goods or services that are being

provided to the customer and then assess whether it controls each specified good or service before that

good or service is transferred to the customer. Regardless of an entity’s position in the programmatic

advertising ecosystem, applying the guidance in ASC 606-10-55-36A is essential for accurately identifying

the entity’s customer, which may directly affect the amount of revenue recognized.

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Because the principal-versus-agent analysis is performed for each specified distinct good or service (or

distinct bundle of goods or services) that will be transferred to the customer, the same guidance that

an entity applies to identify performance obligations (ASC 606-10-25-19 through 25-22) will be applied

to determine the unit of account (i.e., the specified goods or services) used in the evaluation of whether

an entity is acting as a principal or as an agent. In addition, because an adtech entity may bundle the

ad space (or a right to the ad space) with other distinct performance obligations, such as access to its

adtech platform or campaign management services, such an entity may be a principal for certain aspects

of a contract with a customer and an agent for others.

2.8.11.1.4.1 Evaluating Control in a Programmatic Advertising Ecosystem

When the operator of an adtech platform that facilitates programmatic advertising performs the

principal-versus-agent analysis, the specified good or service is typically the publisher’s ad space.

Accordingly, the entity should consider whether it obtains control of the publisher’s ad space (or a right

to the publisher’s ad space) before the ad space is transferred to the customer.

As stated in ASC 606-10-55-37, an entity is a principal in providing a specified good or service “if it

controls the specified good or service before that good or service is transferred to a customer.” The

control principle used in the determination of whether an entity is acting as a principal or as an agent is

the same control principle used in the evaluation of when a good or service (i.e., an asset) is transferred

to the customer.

ASC 606-10-25-25 states, in part, “Control of an asset refers to the ability to direct the use of, and obtain

substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other

entities from directing the use of, and obtaining the benefits from, an asset.”

However, it may not be clear whether an entity does in fact obtain control of the goods or services

provided by a third party before they are transferred to a customer. In these circumstances, the entity

will need to consider the indicators in ASC 606-10-55-39 when evaluating whether it is acting as a

principal. Those indicators are summarized below.

There are three key indicators

to help the entity make this

assessment:

•

“The entity is primarily responsible for fulfilling the

promise to provide the specified good or service.”

•

“The entity has inventory risk before the specified good

or service has been transferred to a customer or after

transfer of control to the customer (for example, if the

customer has a right of return).”

•

“The entity has discretion in establishing the price for

the specified good or service. . . . However, an agent

can have discretion in establishing prices in some

cases.”

As noted in paragraph BC16 of

ASU 2016-08

, “the indicators in paragraph 606-10-55-39 were included

to support an entity’s assessment of whether it controls a specified good or service before it is

transferred to the customer. The indicators (a) do not override the assessment of control, (b) should not

be viewed in isolation, (c) do not constitute a separate or additional evaluation, and (d) should not be

considered a checklist of criteria to be met in all scenarios.” Further, paragraph BC18(e) of ASU 2016-08

states, in part, that “the indicators are not an exhaustive list and merely support the assessment of

control. They do not replace or override that assessment.”

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It is common in a principal-versus-agent analysis to place greater weight on certain indicators of control

than on others. While there is no default indicator that is more important than others, certain indicators

may be more relevant in some circumstances than others. How each indicator is factored into the

analysis may also be influenced by how clearly the indicator is met.

The operator of an adtech platform that facilitates programmatic advertising may consider the following

when evaluating whether it controls the publisher’s ad space (or a right to the publisher’s ad space)

before the ad space is transferred to the customer:

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•

Does the adtech platform operator obtain legal title to the ad space before transferring the ad

space to the customer? While programmatic advertising occurs within milliseconds, the adtech

platform operator may momentarily obtain legal title to the ad space before the ad space is

transferred from the publisher to the buyer. The entity should consider whether obtaining

legal title allows it to control the ad space through its ability to (1) redirect the ad space to a

different buyer or (2) use the ad space itself. In performing this evaluation, the entity should

consider technological and practical limitations to rerouting or reassigning the ad space to a

different buyer, along with the terms and conditions of its contractual agreements. Although

an adtech platform operator may momentarily obtain legal title to ad space during an auction

or immediately before a creative ad is displayed, ASC 606-10-55-37 states, in part, that “an

entity does not necessarily control a specified good if the entity obtains legal title to that good

only momentarily before legal title is transferred to a customer.” Thus, an adtech platform

operator’s legal ownership or other legal rights to ad space are not necessarily conclusive in the

determination of whether the entity controls the ad space.

Connecting the Dots

At the 2020 AICPA Conference on Current SEC and PCAOB Developments, Mr. Griffin

discussed a fact pattern in which a registrant operated a platform that facilitated an

advertiser’s purchase of ad space from publishers. In that fact pattern, the registrant

concluded that it was an agent despite momentarily obtaining legal title to the ad space

before the ad space was transferred to the customer. The registrant determined that

because of certain constraints, it could not direct the use of the potential ad space to

advertisers other than the winning bidder.

•

Does the adtech platform operator have exclusive rights to the publisher’s specified ad space

regardless of whether it identifies a buyer? If so, do these contractual rights give the adtech

platform operator the exclusive right to monetize the publisher’s ad space, including identifying

the creative ads, deciding placement on the publisher’s digital property, and redirecting the ad

space between different buyers? Exclusivity may indicate that the adtech platform operator can

prevent other entities, including the publisher, from directing the use of the ad space, which may

suggest that the entity obtains control of the publisher’s ad space.

•

Which party is responsible for the acceptability of the ad space? Is the adtech platform operator

responsible if the publisher fails to serve a creative ad as the result of technical error or latency

issues, or if the creative ad is displayed on an ad space that is inconsistent with the advertiser’s

campaign input parameters? Responsibility for the acceptability of the ad space is an indicator of

control.

•

Who sets the key input parameters in the adtech platform? Does the adtech platform operator

have ultimate discretion over all key decisions related to buying or selling ad space, including

the parameters used by the platform to buy and sell the ad space? Alternatively, is the adtech

platform marketed as a self-service model in which all decisions are made by the buyers and

82

This list is not all-inclusive, and entities should consider their facts and circumstances when performing the assessment.

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sellers who are provided with access to the platform? In a self-service model, buyers and sellers

typically control the input parameters, suggesting that the adtech platform operator does not

have the ability to direct the use of the ad space. Conversely, if the adtech platform operator is

responsible for setting and changing the key parameters for purchasing and selling ad space,

this may indicate that the adtech platform operator has the ability to direct the use of the ad

space.

Connecting the Dots

At the 2017 AICPA Conference on Current SEC and PCAOB Developments, Mr.

Kanczuker discussed a fact pattern in which a registrant used its technology to identify

and purchase advertising space that met the advertiser’s specification on a real-time

basis. The registrant had the ultimate discretion, including over pricing, for individual

purchases of advertising space, and the advertiser held the registrant responsible

for reaching the advertiser’s target audience and otherwise meeting the advertiser’s

specifications. In addition, the advertiser did not specify the Web sites or apps for

which the registrant purchased the advertising space. In that fact pattern, the registrant

concluded that it was the principal because it controlled the advertising space before

the space was transferred to the advertiser, noting as part of its control assessment that

it was primarily responsible for fulfillment and had discretion in establishing the price.

•

Does the adtech platform operator provide a significant service of integrating the publisher’s ad

space with other services, including access to the adtech platform? While adtech platforms are

technologically integrated with publishers’ ad space and the broader programmatic advertising

ecosystem, this integration is often solely to participate in programmatic advertising and is not

viewed as a “significant” level of integration that would support a conclusion that the promises

are not distinct. Rather, this level of integration is to ensure that the matchmaking is transparent,

automated, and efficient.

2.8.11.1.4.2 Illustrative Examples of the Evaluation of Control Over Ad Space

The examples below illustrate how an entity may evaluate control over ad space. Each example

illustrates whether an entity acts as a principal or an agent when it facilitates programmatic advertising.

Entities will need to exercise judgment when evaluating their facts and circumstances, and they may

reach different conclusions depending on their unique facts and circumstances.

Example 2-145

Company A, an adtech company, offers a self-service, cloud-based, sell-side platform (the “S-Platform”) that

enables Web site publishers (and entities acting on their behalf) to monetize their available ad space. The

S-Platform allows Web site publishers to submit bid requests so that they can sell ad space programmatically

via different auction types (e.g., open, private, preferred, or guaranteed). Further, the S-Platform includes

enhanced features, such as data analytics, pricing strategies, and real-time monitoring.

Company A enters into nonexclusive licensing agreements with Web site publishers that give the publishers the

right to access the S-Platform for a specific period so that they can sell ad space programmatically to buyers

(i.e., advertisers, entities acting on behalf of advertisers, or both). The Web site publishers are responsible for

setting the key parameters in the S-Platform that guide the platform’s algorithms, such as the minimum bid

price or floor price, the type of acceptable ads, the method of auction, and preferred buyers.

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Example 2-145 (continued)

Company A does not promise the Web site publishers a specified number of sales or otherwise run campaigns

for them. Company A also does not prepurchase ad space for resale or commit to a certain number of

purchases. Further, A does not have exclusive rights to a Web site publisher’s ad space. Thus, a Web site

publisher can make its ad space available on the S-Platform and other unrelated platforms.

While buyers enter into nonexclusive licensing agreements that govern the use of the S-Platform, these

agreements do not contain any terms and conditions that affect the amount of consideration that A or a Web

site publisher will ultimately receive. Company A does not promise a good or service to a buyer in exchange for

consideration; instead, it provides the buyer with access to the S-Platform to enhance the Web site publisher’s

access.

Company A’s standard terms and conditions indicate that the Web site publishers are solely responsible for

providing the ad space purchased and any necessary refunds. These standard terms and conditions are agreed

to by the buyers that transact with the S-Platform. In addition, A is not liable for any creative ads that are not

displayed by the Web site publishers, including any obligations by the publishers to provide refunds for issues

with purchased ad space.

Once a buyer wins an auction, A collects payment from the buyer and remits an amount, net of its commission,

to the Web site publisher. Company A has the discretion to adjust the minimum price established by the Web

site publisher to ensure that the price generates sufficient commission for A’s services. Company A has an

enforceable right to charge back any refunds, for example, if the creative ad does not successfully load as the

result of an error with the Web site publisher’s platform.

When a buyer wins an auction, A cannot legally redirect the ad space to another buyer. While the S-Platform is

technologically integrated with a Web site publisher’s available ad space, this integration is solely to ensure that

matchmaking is effective and is not viewed as A’s providing a significant service of integrating the S-Platform

with the ad space.

Revenue Recognition

Company A concludes that its contracts with the Web site publishers are within the scope of ASC 606 and that

the Web site publishers are its customers. Company A identifies two promises in each contract with a Web

site publisher: (1) provision of access to the S-Platform and (2) the ad space. In accordance with ASC 606, the

ad space is evaluated as a specified good or service because it is the asset that is ultimately transferred to the

buyer. If A concludes that it obtains control of the publisher’s ad space, it would most likely identify the buyer as

its customer, which would affect the amount of revenue recognized by A. In addition, since A is the only party

that provides access to the S-Platform and has sole control over providing the S-Platform, A is the principal for

the S-Platform and therefore presents revenue related to the access to the S-Platform on a gross basis.

Because the S-Platform facilitates the sale of a Web site publisher’s ad space to potential buyers, A also

needs to determine whether it controls (1) the ad space from the Web site publisher before the ad space is

transferred to a buyer or (2) a right to the Web site publisher’s ad space that gives A the ability to direct the

Web site publisher to provide the ad space to a buyer on A’s behalf. To make this determination, A considers

the definition of control under ASC 606-10-25-25 and whether it has the ability to direct the use of, and obtain

substantially all of the remaining benefits from, the ad space.

Under A’s standard terms and conditions, A has no legal ability to redirect the ad space to a different party

other than the winning bidder or to prevent the Web site publisher from transferring the ad space to the

winning bidder. Further, the Web site publisher controls what ad space is available on the S-Platform and sets

the key parameters the S-Platform uses, such as minimum prices for ad spaces, type of acceptable ads, method

of auction, and preferred advertisers. Lastly, A does not control when the ad space is available or where the

creative ad is displayed; rather, the Web site publisher ultimately decides whether to make the ad space

available for bid on the S-Platform and where the creative ad is displayed. Because of these considerations, A

does not believe that it controls the ad space or the right to the ad space under ASC 606-10-25-25.

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Example 2-145 (continued)

In addition, A considers the control indicators in ASC 606-10-55-39, which support its control assessment

under ASC 606-10-25-25. Company A provides a platform that facilitates programmatic advertising to Web site

publishers and buyers and collects a commission for facilitating transactions between these parties. Company

A does so in a manner consistent with its standard terms and conditions, which indicate that the Web site

publishers are solely responsible for satisfying the ad space purchased. Company A is not liable for any ad

space not delivered by a Web site publisher. Moreover, A does not have front-end inventory risk (since it does

not prepurchase ad space for resale or commit to a certain number of purchases) or back-end inventory

risk. Lastly, although A has some discretion to adjust the amounts above the minimum price established by

a Web site publisher to ensure that the price generates a commission on the transaction, this level of pricing

discretion would not preclude a conclusion that A is an agent in the transaction.

On the basis of the discussion above, A concludes that it is a seller’s agent in the sale of ad space and should

present revenue related to such a sale on a net basis.

Example 2-146

Company B, an adtech company, offers a self-service, cloud-based, buy-side platform (the “D-Platform”)

that enables buyers to programmatically bid on ad space offered by mobile app publishers. The D-Platform

leverages its predictive technology and algorithms to identify ad space on the basis of a buyer’s selected

bidding parameters. Company B is not engaged in creating or designing ads or in advising buyers regarding

creative ad campaigns; however, B provides services limited to presenting creative ads (e.g., resizing creative

ads to fit the ad space).

Company B enters into nonexclusive licensing agreements with buyers that give the buyers the right to

access the D-Platform for a specific period so that they can programmatically bid on available ad space. The

buyers have full transparency and control over which parameters they input into the D-Platform, and they

are responsible for managing their own ad campaigns and determining how much they spend on a cost-per-

installation basis. Once a buyer’s budget is exhausted, the buyer must authorize any additional spending. On

the basis of the parameters inputted by the buyers, the D-Platform bids for available ad space that generates

the highest commission for B.

Company B does not promise any amount of ad space, and the determination of whether a buyer purchases

ad space through the D-Platform is based on the parameters the buyer selects. Under the terms of the

agreements, B is not responsible if a mobile app publisher fails to serve a creative ad as the result of technical

error or latency issues, or if a creative ad is inconsistent with a buyer’s campaign parameters. Further, B does

not provide “returns” given the nature of the transactions and the timing of B’s entitlement to consideration.

Company B contracts directly with mobile app publishers to enable buyers to place creative ads in their

available ad space. Publishers download B’s software and integrate the software tools with their mobile apps so

that B can transfer and display creative ads on the publishers’ apps. Although the D-Platform is technologically

integrated with a publisher’s available ad space, this integration is solely to ensure that matchmaking is effective

and is not viewed as B’s providing a significant service of integrating the D-Platform with the ad space. Further,

B is not subject to any minimum purchase requirements under its contracts with the mobile app publishers,

and it pays the mobile app publishers on a cost-per-mille basis.

If the D-Platform wins a buyer’s bid for ad space, B momentarily has legal title to the ad space, which gives B the

right to place any creative ad from any buyer in that ad space provided that the ad space meets the parameters

established by the buyer and the parameters established by the publisher. Company B concludes that this legal

right is not substantive because B does not have the practical or technological capabilities to redirect the ad

space after the platform has submitted a bid associated with a specific buyer. From a technological capability

standpoint, once a buyer has won the bid, the ad cannot be retrieved, redirected to a different buyer, or used

by B. Further, redirecting a won bid to a different buyer would be inconsistent with B’s standard terms and

conditions.

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Example 2-146 (continued)

Revenue Recognition

Company B concludes that its contracts with the buyers are within the scope of ASC 606 and that the buyers

are its customers. Company B identifies two promises in each contract with a buyer: (1) provision of access to

the D-Platform and (2) ad space. Since B is the only party that provides access to the D-Platform and has sole

control over providing the D-Platform, B is the principal for the D-Platform and therefore presents revenue

related to the access to the D-Platform on a gross basis.

Since the ad space involves a third party (a mobile app publisher), B needs to determine whether it controls

(1) the ad space from the mobile app publisher before the ad space is transferred to the buyer or (2) a right

to the mobile app publisher’s ad space that gives B the ability to direct the publisher to provide the ad space

to the buyer. To make this determination, B considers the definition of control under ASC 606-10-25-25 and

whether it can direct the use of, and obtain substantially all of the remaining benefits from, the ad space.

Company B concludes that it does not control the ad space because its promise to the buyer is to provide

access to the D-Platform, which gives the buyer the right to programmatically bid on available ad space. The

buyer is ultimately responsible for setting the parameters on the D-Platform and managing all aspects of its ad

campaigns. Further, B does not control when the ad space is made available because the mobile app publisher

decides whether to make the ad space available for bid on the D-platform. Although B momentarily has the

ability to place any creative ad in an ad space when the D-Platform wins a bid, B has concluded that this right

is not substantive because B does not have the practical or technological capabilities to redirect the ad space

after the platform has submitted a bid associated with a specific buyer. Lastly, redirecting a won bid to another

buyer would be inconsistent with B’s standard terms and conditions. On the basis of these considerations, B

does not believe that it controls the ad space or the right to the ad space under ASC 606-10-25-25.

In addition, B considers the control indicators in ASC 606-10-55-39, which support its control assessment

under ASC 606-10-25-25. Company B’s promise to its customers is to provide them with access to the

D-Platform to facilitate the purchase of ad spaces from mobile app publishers, which is consistent with B’s

standard terms and conditions. Company B has not promised its customers a specified number of ad spaces,

and it has no fulfillment risk since it is not responsible for the acceptability of the ad space. Further, the

buyers are responsible for all inputs into the D-Platform and therefore control the target audience, all related

specifications associated with the ad space, and the amount that they wish to pay for the ad space. Moreover,

B does not have front-end inventory risk (since it does not prepurchase ad space for resale or commit to a

certain number of purchases) or back-end inventory risk. Lastly, although B has some discretion over the price

of the ad space because the D-Platform will only allow bids that generate the highest commission for B to

proceed, this level of pricing discretion would not preclude a conclusion that B is an agent in the transaction.

On the basis of the discussion above, B concludes that it is a buyer’s agent in the purchase of ad space and

should present revenue related to such a purchase on a net basis.

Example 2-147

Company C is an adtech company that provides services to advertisers. It engages directly with advertisers that

seek to advertise on different digital platforms. However, C is not involved in creating or designing creative ads.

Company C enters into agreements with advertisers that specify the maximum amount that the advertisers are

willing to spend over a specified period. Spending is based on a cost-per-mille model in which C is entitled to a

fixed amount of consideration based on how many times the creative ad of an advertiser is viewed. Company

C leverages its proprietary platform to place advertisers’ creative ads in available ad space programmatically

through various digital platforms and auction types. Company C markets itself as being able to maximize the

ROAS for advertisers by using its proprietary technology. Although C provides advertisers with reports that

enable them to assess the performance of their ad campaigns, it does not provide them with access to its

proprietary platform.

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Example 2-147 (continued)

Company C is responsible for all customer satisfaction related to the ad campaigns, ensuring that the creative

ads are placed on relevant digital channels and that impressions are not from invalid bots or fraudulent

transactions. Company C’s terms and conditions provide it with ultimate discretion to determine the publishers’

digital platforms on which to place the creative ads and the parameters to be used on its proprietary platform.

The advertisers have certain protective rights that limit the types of publishers that can display their ads.

In addition to entering into agreements with advertisers, C enters into separate agreements with certain

publishers that provide C with exclusive access to the publishers’ premium ad spaces on their digital platforms.

Each publisher’s premium ad space is available solely for C’s use; it cannot be used by another entity, including

the publisher. The publisher connects its platform to C’s platform, thereby enabling C to programmatically place

creative ads in the publisher’s premium ad space within a matter of milliseconds. Company C has the ability

and right to change any creative ad placed in the premium ad space at its sole discretion and is not required

to discuss the change with the advertiser or the publisher. Although the publisher may have some contractual

ability to deny specific ads, or the ads of specific advertisers, from being placed in its premium ad space, this

provision is a protective right to avoid having inappropriate creative ads placed on the publisher’s platform.

To determine which creative ads are placed in available ad space to which C holds exclusive rights, C’s

proprietary platform uses algorithms that C exclusively controls. The algorithms are designed to maximize

revenue by considering both the expected views and the billing rates that C can charge advertisers. Advertisers

do not have the ability to control C’s platform or direct C to place a specific creative ad on a particular

publisher’s digital platform. In addition, if C determines that it would benefit from the ad space, it can push its

own creative ad rather than that of an advertiser.

Revenue Recognition

Company C concludes that its contracts with the advertisers are within the scope of ASC 606 and that the

advertisers are its customers. Company C identifies one promise in each contract with an advertiser: to fulfill

the advertiser’s ad campaign by using C’s proprietary platform. Company C does not provide the customer with

access to C’s platform.

Because C’s promise to fulfill the advertiser’s ad campaign involves ad space from a third party (a publisher),

C needs to determine whether it controls (1) the ad space or (2) a right to the publisher’s ad space that gives

C the ability to direct the publisher to provide the ad space to the advertiser. To make this determination, C

considers the definition of control under ASC 606-10-25-25 and whether it can direct the use of, and obtain

substantially all of the remaining benefits from, the ad space.

Company C concludes that it controls the ad space (or a right to the publisher’s ad space). Under C’s terms

and conditions, C has the ultimate discretion in deciding when and where to place the advertiser’s creative ads,

with the goal of maximizing the advertiser’s ROAS. When C’s proprietary platform wins a bid for ad space, C has

the ability to redirect the ad space to any advertiser, including itself. Regarding the exclusive ad space, C has

obtained the right to decide the placement of the creative ads and can prevent others from benefiting from the

ad space (e.g., by choosing not to monetize the ad space). On the basis of these considerations, C believes that

it controls the ad space and the right to the ad space under ASC 606-10-25-25.

In addition, C considers the control indicators in ASC 606-10-55-39, which support its control assessment

under ASC 606-10-25-25. Although C does not have front-end inventory risk and has only limited back-end

inventory risk, it has discretion over pricing and presents itself to the customer as the party responsible for the

acceptability of the ad space and for appropriately identifying ad space that maximizes the advertiser’s ROAS.

Company C is also responsible for all customer satisfaction issues, including ensuring that all creative ads are

placed on relevant digital channels and identifying and preventing fraudulent impressions. Further, C provides

specific reporting to the customer so that the customer can monitor the performance of the ad campaigns.

On the basis of the discussion above, C concludes that it is a principal in transactions to acquire ad space and

should present revenue related to those transactions on a gross basis.

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2.8.12 Payment Processors and Facilitators

Entities have grappled with the issue of how to present revenue and the various fees related to payment

processing in a manner consistent with the revenue standard. A careful evaluation of the relevant

guidance is critical since the payments ecosystem — as well as the players — continues to evolve.

Consideration must be given to a delivery model of the services, the parties involved in the payment

transactions, and the various components in each fee arrangement. Whether an offering is integrated or

independent can have a significant effect on the accounting analysis.

ASC 606-10-55-36 states, in part, that “[i]f a contract with a customer includes more than one specified

good or service, an entity could be a principal for some specified goods or services and an agent for

others.” Accordingly, for each specified good or service identified, an entity must determine whether

it controls the specified good or service before transferring that good or service to the customer.

Therefore, an entity in a payment processing arrangement must determine whether it has the ability to

direct the use of, and to obtain substantially all the benefits from, the services provided by other parties

in the payment processing ecosystem before those services are transferred to the customer.

Determining which party controls the services provided by the other parties in the payment processing

ecosystem requires significant judgment. Therefore, an entity may also evaluate the control indicators in

ASC 606 to support its conclusion.

Factors to consider as part of this determination may include:

•

The nature of the entity’s contractual arrangements, relationships, and promises with the

customer and other parties and the entity’s potential risks of loss (e.g., chargebacks, fees due

to other parties) arising from the transaction. As part of this analysis, the entity may consider

whether it acts as the “merchant of record” for the transactions that it processes.

•

Any contractual arrangements or relationships between the customer and the other parties in

the payment processing ecosystem.

•

The ability of the entity to direct other parties in the payment processing ecosystem to provide

payment processing services on its behalf. As part of this analysis, the entity may consider

whether it establishes underwriting guidelines, has the ability to decline transactions or withhold

funds, approves customer contracts, provides customer support, and has responsibility over the

resolution of customer service issues.

•

Whether the customer views the entity to be primarily responsible for the payment processing

services, including their acceptability.

•

The ability of the entity to enhance, modify, or discontinue payment processing services.

•

The ability of the entity to determine and subsequently change the parties that will be used to

perform the various payment processing services.

•

The ability to set the overall price paid by the customer.

•

Whether the entity provides a significant service of integrating all of the services transferred to

the customer.

•

The entity’s obligation to maintain payment processing information on behalf of the merchant,

perform preauthorization services, and determine what payment processing information is

provided to the other parties in the payment processing ecosystem.

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2.8.13 SaaS Resellers’ Arrangements

2.8.13.1 Overview

Arrangements for the resale of cloud-based or hosted software solutions (e.g., SaaS) vary in complexity,

and a reseller’s accounting for a particular arrangement will depend on its specific facts and

circumstances. SaaS resellers need to carefully evaluate each arrangement to identify the goods or

services that will be transferred to the customers (i.e., the “specified goods or services” referred to in

ASC 606-10-55-36A). Because third parties are often involved in providing services to the end customer,

SaaS resellers need to perform a principal-versus-agent analysis for each specified distinct good or

service (or distinct bundle of goods or services) that will be transferred to the customer. In certain

circumstances, a SaaS reseller may be a principal for certain aspects of a contract with a customer and

an agent for others.

In many instances, SaaS resellers do not obtain control of the SaaS service before it is transferred to

the customer because the SaaS vendor controls substantially all aspects of the service without direction

from the reseller. However, there may be scenarios in which an entity provides a significant service of

integrating a third party’s service or services into its own service or services (i.e., the third party’s service

or services are an input) and the nature of the entity’s promise is to transfer a combined service to an

end customer as a principal.

2.8.13.2 Background

SaaS resellers play a crucial role in the software ecosystem by connecting SaaS vendors with end

customers. Some resellers primarily focus on generating leads for SaaS vendors in exchange for a

commission. These resellers do not directly handle the sales process; instead, they act as referral

agents, linking potential customers with the SaaS vendor. More commonly, however, SaaS resellers

operate as value-added resellers. These resellers bundle one or more of the SaaS vendor’s services with

additional products or services, which may include professional services such as consulting, customized

integration, implementation, training, and ongoing technical support. Value-added resellers often

possess industry-specific expertise and technical skills, helping customers navigate the vendor selection

and procurement processes.

The diagram below illustrates a typical arrangement involving a SaaS reseller, a SaaS vendor, and an end

customer.

SaaS Reseller

SaaS Vendor

End Customer

Cash collected from the

end customer is remitted

to the SaaS vendor net

of the SaaS reseller’s

commission.

The SaaS reseller and the end

customer execute a purchase

order. The SaaS reseller

provides additional value-

added service and collects

cash from the end customer.

The SaaS vendor is

responsible for delivering

the SaaS to the end

customer over the

contract term.

The end customer agrees

to the SaaS end user

license agreement.

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2.8.13.3 Identifying the SaaS Reseller’s Customer

When the nature of a SaaS reseller’s performance obligation is a promise to arrange for a SaaS vendor’s

goods or services to be provided directly to the end customer, it is often important to determine

whether the SaaS reseller is an agent for the end customer, the SaaS vendor, or both to assess (1) to

whom the SaaS reseller is obligated to satisfy its performance obligation of arranging for the provision of

goods or services and (2) when the SaaS reseller satisfies the performance obligation. Depending on the

facts and circumstances, the SaaS reseller’s customer may be the SaaS vendor if the substance of the

arrangement is that of a sales agent. Alternatively, the SaaS reseller may view the end customer as its

customer if it is acting in the role of a purchasing agent.

It is also possible that the SaaS vendor and the end customer can each be considered the SaaS

reseller’s customer if the SaaS reseller is providing goods or services to both parties either explicitly

or implicitly. This scenario often occurs when the SaaS reseller bundles the SaaS vendor’s service with

additional services, such as implementation and professional services, and delivers the bundle to the

end customer. As illustrated in

Example 2-150

, the accounting in such circumstances can affect how

much consideration is allocated to each performance obligation, especially when a SaaS reseller is the

principal for some, but not all, of the specified goods or services that are transferred to a customer.

2.8.13.4 Evaluating the SaaS Reseller’s Promise to the Customer

In accordance with ASC 606, SaaS resellers must carefully evaluate their contracts to determine how and

when to recognize revenue. The key consideration for performing this assessment is the determination

of whether the SaaS reseller is acting as a principal or as an agent. That is, a SaaS reseller must

determine whether the nature of its performance obligation is a promise to provide the SaaS directly

to the end customer (in which case, the SaaS reseller is acting as a principal) or a promise to arrange

for the SaaS vendor to provide the SaaS directly to the end customer (in which case, the SaaS reseller

is acting as an agent). As discussed in ASC 606-10-55-36A, for an entity to determine the nature of its

promise, it should identify the specified goods or services that are being provided to the customer and

then assess whether it controls each specified good or service before that good or service is transferred

to the customer.

Because the principal-versus-agent analysis is performed for each specified distinct good or service (or

distinct bundle of goods or services) that will be transferred to the customer, the same guidance that an

entity applies to identify performance obligations (ASC 606-10-25-19 through 25-22) will be applied to

determine the unit of account (i.e., the specified goods or services) used in the evaluation of whether an

entity is acting as a principal or as an agent. In addition, because SaaS resellers may bundle the vendor’s

SaaS with other distinct performance obligations, a reseller may be a principal for certain aspects of a

contract with a customer and an agent for others.

The specified service for a SaaS reseller when it performs the principal-versus-agent analysis is typically

the vendor’s SaaS. Accordingly, a reseller should consider whether it obtains control of the vendor’s

SaaS (or a right to the vendor’s SaaS) before the SaaS is transferred to an end customer. A reseller may

conclude that it does not obtain control of the vendor’s SaaS before the SaaS is transferred to an end

customer because the reseller (1) does not provide the SaaS itself, (2) cannot change or modify the

SaaS, and (3) is promising when it sells the SaaS to the end customer that a specified service will be

provided by a specified vendor in the future (e.g., if the end customer purchased a one-year subscription

to “Vendor U’s SaaS,” the reseller cannot fulfill that promise by delivering a one-year subscription from

another SaaS provider).

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Further, ASC 606-10-25-55-37A discusses how an entity controls a good or service provided by a third

party (and is therefore a principal) if it integrates goods or services (ASC 606-10-25-21(a)) provided by

the third party into another good or service that the entity provides to the end customer. Therefore,

there may be limited circumstances in which a SaaS reseller directs the use of the vendor’s SaaS

platform as an input that is combined with other goods or services provided directly by the reseller

to create an output that would constitute the specified good or service promised to the customer.

Such circumstances may occur when the SaaS reseller is also a software developer that integrates the

vendor’s SaaS platform into its own product offering, as illustrated in

Example 2-149

.

See

Section 2.8.5

for considerations, as discussed by Mr. Wiggins at the 2021 AICPA & CIMA Conference

on Current SEC and PCAOB Developments, related to whether an entity may conclude that it is a

principal because it integrates a good or service from a third party into its own offering.

SaaS resellers often provide implementation services that may include system setup and configuration,

data migration, integration services (e.g., connecting the SaaS with other tools or systems), system

testing, training, and postimplementation support. Typically, these types of value-added services do not

represent a significant integration service.

2.8.13.5 Evaluating Control

As stated in ASC 606-10-55-37, an entity is a principal in providing a specified good or service “if it

controls the specified good or service before that good or service is transferred to a customer.” The

control principle used in the determination of whether an entity is acting as a principal or as an agent is

the same control principle used in the evaluation of when a good or service (i.e., an asset) is transferred

to a customer.

ASC 606-10-25-25 states, in part, “Control of an asset refers to the ability to direct the use of, and obtain

substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other

entities from directing the use of, and obtaining the benefits from, an asset.”

However, it may not be clear whether an entity does in fact obtain control of the goods or services

provided by a third party before they are transferred to a customer. In these circumstances, the entity

will need to consider the indicators in ASC 606-10-55-39 and 55-39A — including primary responsibility,

inventory risk, and discretion in establishing pricing, which are specifically described in ASC 606-10-55-39

and discussed in

Section 2.8.6

,

Section 2.8.13.5.1

,

Section 2.8.13.5.2

, and

Section 2.8.13.5.3

— when

evaluating whether it is acting as a principal. As noted in

Section 2.8.2

, the indicators in ASC 606-10-

55-39 are intended to support, rather than replace or override, an entity’s assessment of whether it

controls a specified good or service before that good or service is transferred to the customer.

2.8.13.5.1 Primary Responsibility

In the context of SaaS reseller arrangements, the SaaS vendor is generally visible to the end customer

because the end customer has contracted to purchase access to a specific SaaS vendor through a

reseller. Further, the end customer is subject to standard terms and conditions that include the SaaS

vendor’s terms, since all end customers must sign the end user license agreement (EULA) with the

SaaS vendor to gain access to and use the service. The EULA typically outlines the terms and conditions

governing the customer’s access to and use of the SaaS. These aspects make the end customer aware of

the party from which it is acquiring the SaaS.

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Regarding fulfillment risk, a SaaS reseller is generally responsible for initially providing the end customer

with access to the vendor’s SaaS platform (which represents initial fulfillment risk) and ensuring that

the end customer receives the specific service it has ordered (which indicates initial acceptability risk).

However, these risks are less relevant in the control analysis because the end customer cannot fully

benefit from the vendor’s SaaS platform by merely receiving initial access. The end customer derives

benefits only if the SaaS vendor continuously provides the service throughout the entire subscription

period. The vendor is obligated to provide the service only after the order has been approved and the

end customer has agreed to the vendor’s terms and conditions.

Moreover, the fact that SaaS resellers often do not offer warranties or guarantees regarding the SaaS

suggests that the resellers are not primarily responsible for providing the service. If an arrangement

between a SaaS reseller and an end customer is terminated — regardless of whether as a result of

cancellation or expiration — the SaaS vendor typically continues to deliver the service to all existing

customer subscriptions on the same terms and conditions until the subscription period expires or is

canceled. Further, the agreement between the SaaS reseller and the end customer may explicitly state

or imply that the reseller does not provide the SaaS platform itself and that its role is limited to assisting

in the initial selection of a vendor and managing initial fulfillment and acceptability risk.

2.8.13.5.2 Inventory Risk

As noted above, inventory risk may be relevant to the determination of whether an entity obtains control

of a good or service before the good or service is transferred to a customer. Specifically, an entity’s

commitment to acquiring a specified good or service before a customer has been identified may indicate

that the entity has the ability to direct the use of the good or service and obtain substantially all of the

benefits from it.

For example, a value-added SaaS reseller might agree to certain guarantees that require it to make

a shortfall payment to the SaaS vendor if the reseller’s sales targets are not met. While this type of

arrangement could suggest that the reseller has committed to obtaining the SaaS before it is transferred

to the customer — effectively creating a form of inventory risk — it is typically viewed as similar to a

variable-based commission structure rather than as an arrangement that poses true inventory risk.

Further, the reseller’s guarantee to make a shortfall payment is tied to its own future performance and

would be outside the scope of ASC 460.

The conclusion that guarantees to make shortfall payments do not suggest that the reseller controls

the vendor’s SaaS before it is transferred to the end customer stems from the fact that the additional

control indicators outlined in the principal-versus-agent guidance are not intended to override the

principle of control itself. A commitment to resell a specific volume of a vendor’s SaaS does not, by itself,

demonstrate that the reseller has control of the SaaS or any rights to it before it is transferred to the

end customer.

2.8.13.5.3 Discretion in Establishing Pricing

A SaaS reseller may have discretion in establishing the price that end customers pay for the vendor’s

SaaS. As noted in

Section 2.8.6.3

, pricing discretion in combination with other factors could indicate

that the entity controls the specified good or service before it is transferred to the customer. However,

as also noted in Section 2.8.6.3, ASC 606-10-55-39(c) states, in part, that “an agent can have discretion

in establishing prices in some cases. For example, an agent may have some flexibility in setting prices in

order to generate additional revenue from its service of arranging for goods or services to be provided

by other parties to customers.”

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2.8.13.6 Other Channel Partners

Many SaaS resellers and vendors establish formal reseller agreements that outline where the resellers

are permitted to sell the vendor’s solution. Some SaaS resellers may sell through online marketplace

platforms on which SaaS resellers can market various vendors’ SaaS solutions. These platforms may

offer automated billing, subscription management, and enhanced onboarding tools that simplify the

process for end customers to access and use the SaaS product. Resellers may also use the platforms to

sell additional value-added services, such as implementation support and consulting.

Generally, these marketplace platforms do not obtain control of the SaaS products before they are sold

and transferred to end customers; instead, they provide services to the SaaS reseller, the SaaS vendor,

or both. When a SaaS reseller leverages an online marketplace, the above considerations related to

identifying the specified goods or services and evaluating whether the entity is a principal or an agent for

each performance obligation remain applicable.

2.8.13.7 Illustrative Examples

Determining whether a SaaS reseller controls the service before its transfer to the customer — and is

therefore considered the principal in the arrangement — can be straightforward in some situations

but may require considerable judgment in others.

Example 2-148

and

Example 2-149

illustrate how a

SaaS reseller may evaluate whether it acts as a principal or an agent for SaaS provided by a third-party

vendor.

Example 2-150

demonstrates how a value-added reseller allocates the transaction price when

the SaaS reseller is a principal for certain performance obligations and an agent for others.

Example 2-148

Company A is a reseller of a wide range of technology solutions, including SaaS platforms. The marketing

materials of A primarily emphasize its ability to add value to the purchasing process of end customers by

helping them select and procure the most appropriate SaaS solution. Although A provides advice and support

to end customers in choosing SaaS platforms, the final decision on which platform to purchase rests with an

end customer. Once a decision is made, the end customer issues a purchase order to A to buy access to the

SaaS platform for a specified period. This purchase order constitutes an agreement directly between A and

the end customer; the SaaS vendor is not a party to this agreement. Company A is responsible for collecting

payment from the end customer in accordance with the terms of the purchase order, and its obligation to pay

the SaaS vendor under its own purchase order is not contingent on successfully collecting payment from the

end customer.

Company A has a reseller agreement with Company B that allows A to resell B’s SaaS platform as a

subscription-based service. In addition, A enters into contracts with end customers that allow the end

customers to access and use software hosted by B for a defined period. Company A has full discretion in

setting the price for B’s SaaS platform. For each sale, A earns a commission of 20 percent of the total sales

price. All sales of B’s SaaS platform are subject to B’s EULA. The contract with the end customer specifies

that A does not make any warranties or guarantees regarding the performance or integrity of the service. If

A’s reseller agreement with B is terminated, B will continue to provide services to all existing end customer

subscriptions under the same terms and conditions until the expiration or cancellation of the respective

subscription periods.

In 20X1, an end customer enters into a purchase order with A to purchase access to B’s SaaS platform for a

one-year subscription period. The end customer pays A an up-front fee of $2 million for this access. Company A

then remits $1.6 million to B and retains $400,000 as its commission. Company A facilitates initial access to B’s

SaaS through an electronic online portal hosted by B. Although the online portal is hosted by B, A is responsible

for ensuring that the end customer gains access to the SaaS through the portal.

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Example 2-148 (continued)

Company A identifies the specified service as B’s SaaS and thus evaluates whether it obtains control of B’s SaaS

before the SaaS is transferred to the end customer. Although A has a contract with B to resell B’s SaaS, A does

not obtain a right from B that allows it to control B’s SaaS before the service is delivered to an end customer.

Company A evaluates the definition of control under ASC 606-10-25-25 and notes that it can neither direct

the use of B’s SaaS platform nor prevent B from directing such use. Although A can instruct B to deliver initial

access to the end customer, the end customer cannot benefit from initial access unless B continues to provide

the SaaS for the duration of the one-year subscription. Therefore, delivery of the specified service is contingent

on B’s ongoing actions, which A cannot direct (e.g., A cannot prevent B from ceasing to provide the customer

with the service). Although A is regarded as the party that invoices the end customer for B’s SaaS platform,

this factor alone does not determine whether A is acting as the principal or the agent in the transaction. In this

situation, the end customer enters into a contractual relationship with B by agreeing to its EULA.

In addition, A considers the control indicators outlined in ASC 606-10-55-39, which it believes supports its

control assessment under ASC 606-10-25-25. Company A is responsible for arranging access to B’s service

(indicating that A bears initial fulfillment risk) and confirming that the end customer can successfully access

the service (indicating that A has initial acceptability risk). However, A concludes that these initial fulfillment

and acceptability risks are less relevant to determining whether it controls B’s SaaS. This is because the end

customer cannot fully benefit from B’s SaaS simply by being granted initial access. The end customer can

only gain the benefits of the service if B continuously provides it throughout the one-year subscription (i.e.,

interaction with B’s SaaS platform must be ongoing for the end customer to use the service). Further, B is

responsible for any service-related issues tied to its SaaS, such as reliability and downtime. Thus, even though

the end customer initially interacts with A to obtain access to B’s service, the end customer understands that B

primarily fulfills this obligation.

Lastly, A notes that it does not have substantive inventory risk. Although A has the sole discretion to establish

pricing for the end customer (an indicator that A may be acting as a principal), this factor alone is not definitive

in the analysis.

On the basis of the above assessment, A concludes that it is acting as an agent that is responsible for arranging

for B to provide B’s SaaS to the end customer.

Example 2-149

Company X is a developer, seller, and reseller of SaaS. The company specializes in implementing cybersecurity

solutions and provides outsourced monitoring and management of security devices and systems.

Company S, an independent third party, develops a specialized cybersecurity software and sells it as a service.

Company X, in contrast, does not develop the same specialized cybersecurity software on its own. Rather,

X enters into an MSA with S that enables X to include S’s cybersecurity SaaS platform as part of X’s suite of

products to end customers. The MSA is solely between X and S (i.e., the end customers are not a party to the

MSA, and those customers are not aware of S’s involvement with X). In addition, the MSA outlines that (1) S is

providing technology and services to X and (2) X will include such technology and services as part of services

sold to end customers. Company X does not need approval from S to enter into contracts with end customers,

and end customers do not contract with S. That is, end customers contract only with X for its suite of products

that include S’s SaaS platform.

Company X has designed a software platform that integrates with S’s SaaS platform, creating combined

functionality that brings together X’s integrated managed cybersecurity solution and S’s cybersecurity SaaS

into a single integrated service. Company X’s contracts with end customers do not identify S as the provider of

the specialized cybersecurity software service, and X alone is responsible for the fulfillment of the promise to

transfer an integrated managed cybersecurity solution. If the end customers have any issues with respect to

the platform and related services, X is responsible for customer satisfaction and resolving disputes.

From the end customers’ perspective, X is the provider of the service. That is, X is responsible for the

fulfillment of the integrated managed cybersecurity solution to its customers, including ensuring the solution’s

acceptability.

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Example 2-149 (continued)

In accordance with the MSA, X pays S a fixed monthly fee per end user irrespective of what X charges end users

for the integrated managed cybersecurity solution.

Although X is reselling S’s SaaS platform by integrating the service with its own services, the nature of X’s

promise is to transfer a single managed cybersecurity solution (which includes S’s SaaS platform as an input)

as a principal. In a manner consistent with the type of control considered in ASC 606-10-55-37A, X obtains

control of S’s SaaS platform, which is evidenced by X’s significant integration of S’s service with X’s own software

and services before X transfers a combined output to X’s customers. Specifically, X’s software is designed and

coded to function with S’s SaaS platform so that it integrates into X’s managed cybersecurity solution. That is,

X provides a significant service of integrating S’s SaaS platform with its own software and services to provide a

single output to its customers.

Because X obtains control of S’s SaaS platform and directs the use of the service as an input in creating the

combined output that is transferred to the end customers, X is a principal in the arrangement with those

customers and should record revenue in the gross amount to which it expects to be entitled. Amounts paid to

S would be recorded as an expense.

Example 2-150

Company P is a value-added reseller that bundles Company U’s SaaS platform with additional value-added

services.

During the current year, P invoices an end customer a total of $1 million for a bundle of services. The services

include implementation services, training, Tier 1 technical support, and a one-year subscription to U’s SaaS

platform. Company P determines that it is the principal for the implementation services, training, and Tier 1

technical support since no other party is involved in delivering these services to the end customer. In addition,

P concludes that each of these services represents a performance obligation to the end customer. However,

P concludes that it is an agent for U’s SaaS platform because U does not control the service before it is

transferred to the end customer. Therefore, P is providing services to the end customer as the principal while

acting as a reseller agent for U’s services.

Company P concludes that the stand-alone selling prices of the performance obligations are as follows:

Performance Obligation

SSP

Implementation services

$

200,000

Training

10,000

Tier 1 technical support

100,000

Company U’s SaaS platform

940,000

Total

$

1,250,000

Company P agrees to sell U’s SaaS for $940,000 on behalf of U for a 20 percent commission and bundles the

service with its other services. Thus, $752,000 is remitted to U, and P retains a $188,000 commission. Assume

that the criteria for allocating a discount to one or more, but not all, performance obligations in accordance

with ASC 606-10-32-37 are not met.

In practice, we believe that there are two acceptable models (“Alternative A” and “Alternative B”) for allocating

a contract transaction price when the entity is a principal for some performance obligations and an agent for

other performance obligations.

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Example 2-150 (continued)

Alternative A

Company P determines that the stand-alone selling price of the service provided as an agent is $188,000 (and

that therefore, the total stand-alone price of the performance obligations is $498,000). Because P must remit

$752,000 back to U and retains only a $188,000 commission, P determines that the total consideration it is

entitled to receive is $248,000 rather than the contract price of $1 million. Therefore, P allocates the $248,000

transaction price to identified performance obligations on a relative stand-alone selling price basis, as shown in

the table below.

Performance Obligation

Allocated Transaction Price

Implementation services

$99,598, or ($200,000 ÷ $498,000 total

stand-alone selling price) × $248,000

Training

$4,980, or ($10,000 ÷ $498,000 total

stand-alone selling price) × $248,000

Tier 1 technical support

$49,799, or ($100,000 ÷ $498,000 total

stand-alone selling price) × $248,000

Reseller service

$93,623, or ($188,000 ÷ $498,000 total

stand-alone selling price) × $248,000

Alternative B

The facts and circumstances in this example may suggest that P has performance obligations to two separate

customers. Specifically, the obligations for which P acts as a principal — namely, implementation services,

training, and Tier 1 technical support — are transferred to the end customer. In contrast, the performance

obligation for which P acts as a reseller agent (facilitating the delivery of the SaaS platform to the end customer)

is performed on behalf of U. Therefore, it is reasonable to view the arrangement as consisting of two separate

contracts.

The contract with U includes a single promise to provide reseller services, while the contract with the end

customer encompasses multiple promises: implementation services, training, and Tier 1 technical support.

Company P would allocate the commission of $188,000 received from U directly to the reseller services. The

remaining consideration of $60,000 ($1 million less the $940,000 stand-alone selling price of U’s SaaS platform)

would be allocated to the performance obligations for which P acts as a principal with respect to the end

customer on the basis of relative stand-alone fair value.

The allocations are shown in the tables below.

Contract With Company U

Performance Obligation

Allocated Transaction Price

Reseller service

$188,000

Contract With the End Customer

Performance Obligation

Allocated Transaction Price

Implementation services

$38,710, or ($200,000 ÷ $310,000 total

stand-alone selling price) × $60,000

Training

$1,935, or ($10,000 ÷ $310,000 total

stand-alone selling price) × $60,000

Tier 1 technical support

$19,355, or ($100,000 ÷ $310,000 total

stand-alone selling price) × $60,000

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Example 2-150 (continued)

Choosing Between the Alternatives

While both alternatives described in this example are acceptable, we believe that for an entity to fairly depict

the substance of the transaction, one alternative may be preferable to the other depending on the facts

and circumstances of the particular arrangement. To determine which alternative is preferable, an entity

should understand and evaluate the relationship of all of the parties involved in the particular arrangement.

Specifically, Alternative A would most likely be preferable if (1) the facts and circumstances indicate that the

entity has only one customer in the arrangement or (2) the economic substance of the arrangement is such

that there is a single bundled discount provided to the end customer. In contrast, Alternative B would most

likely be preferable if the facts and circumstances indicate that (1) the entity’s performance obligations in the

contract (or contracts) are provided to two separate customers (i.e., those performance obligations for which

the entity acts as a principal are transferred to the end customer, and those performance obligations for which

the entity acts as an agent are performed on behalf of a third party) and (2) the pricing of the performance

obligations provided to the separate customers is not interdependent. Judgment is often needed in these types

of arrangements to assess whether an entity has one customer or two customers.

2.8.14 Software License Reseller Arrangements

Many software license resellers are also IT solutions providers that support customers in defining,

building, implementing, and managing technology solutions. In the software channel ecosystem,

resellers connect software publishers (and their distributors) with end customers through two common

commercial models: (1) a referral/agency arrangement, in which the reseller is not a party to the

publisher-customer contract and earns a referral fee or commission from the publisher, and (2) a

buy-sell/resale arrangement, in which the reseller purchases licenses from the publisher/distributor and

separately contracts with the end customer to resell those licenses (often alongside implementation or

support services).

In buy-sell/resale arrangements, resellers frequently perform presale consultative activities — helping

customers select a publisher/product, determine license quantities, understand permitted use,

and optimize usage to meet technical and financial objectives. Those activities may be bundled with

other services commercially; however, for revenue recognition purposes, a reseller first identifies the

specified goods or services promised to a customer and then performs a principal-versus-agent (gross-

versus-net) analysis for each specified distinct good or service (or distinct bundle) that will be transferred

to the customer.

In typical software license reseller arrangements, the specified goods or services for which a principal-

versus-agent (gross-versus-net) analysis is performed are often (1) the software license (a right to use

the publisher’s IP) and (2) PCS associated with that license.

2.8.14.1 Buy-Sell/Resale Arrangements — How Fulfillment Typically Works

In buy-sell/resale arrangements, the reseller’s right to resell the publisher’s licenses is commonly

governed by a channel partner agreement with the publisher (or distributor). This agreement typically

grants the reseller a present contractual right to sell and/or cause the issuance of the publisher’s

licenses to end customers. Importantly, the reseller may not hold a “master” copy of the software or a

prepurchased pool of licenses; instead, the ability to fulfill a promise to transfer a license arises from the

executed channel partner agreement and the operational process by which the publisher/distributor

issues activation keys or provides access on the basis of the reseller’s order details.

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Channel partner agreements sometimes provide the publisher with rejection rights that are

designed to address legal or compliance constraints (e.g., export controls, sanctions, antipiracy, or

anticounterfeiting). In practice, some rejection rights are narrowly framed while others are broader. Such

rights are often described as protective and may be exercised infrequently.

Separately, end customers are often required to accept a publisher’s EULA after contracting with

the reseller but before receiving an activation key or license grant. The EULA typically consists of

standardized click-through terms that establish privity between the publisher and the end user and

establish use restrictions and the publisher’s protective rights. It generally does not include the key

commercial terms of the reseller’s sale (e.g., pricing, returns, contract term), and the reseller is usually

not a party to the EULA.

Once the reseller executes the customer contract, it is often responsible for ensuring delivery of the

purchased license and may provide first-line support for activation/download issues, escalating product

defects and bug fixes to the publisher (which typically stands behind product performance/defects

under its own terms). Commercially, the customer’s payment obligation is usually to the reseller under

the reseller-customer contract; resellers often have discretion over end-customer pricing, may share

limited pricing detail with publishers, and handle returns only as an exception (often driven by reseller-

side ordering/advice errors or nonconformance with purchase specifications).

2.8.14.2 Principal-Versus-Agent Analysis Under ASC 606 — Framing and Key

Judgments

A software license reseller should (1) identify the specified goods or services that will be transferred

to its customer and then (2) perform a principal-versus-agent analysis for each specified distinct good

or service (or distinct bundle) that will be transferred to the customer. Considerations for the reseller

related to the performance of this analysis include the following:

•

Software license (right to use IP)

— In software license reseller arrangements, the principal-versus-

agent analysis for the license often focuses on whether the reseller controls the right to the

license before that right is transferred to the customer — in other words, whether the reseller

(1) has an enforceable right to grant the license or to direct that the license be issued and

(2) can compel fulfillment by the publisher (subject only to limited exceptions). A channel partner

agreement may be informative when it grants the reseller a present right to distribute or issue

licenses and the reseller has legal recourse if the publisher fails to issue licenses for reasons

not permitted by the agreement. The reseller’s lack of either physical possession of software

or a prepurchased “pool” of licenses is generally not determinative if the reseller controls the

right to the license and can direct another party to provide the key or access needed to fulfill its

promise.

•

PCS

— The principal-versus-agent analysis for PCS often turns on whether the reseller obtains

control of PCS before it is delivered. If the publisher/vendor must continuously provide PCS (e.g.,

technical support, patches, and bug fixes) over the coverage period and the reseller cannot

direct that ongoing performance or prevent the publisher/vendor from directing it, the reseller

may be viewed as arranging for the publisher/vendor to provide PCS.

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•

Rejection rights and EULA

— Rejection rights of the publisher in partner agreements and the

customer’s acceptance of a publisher’s EULA require specific evaluation because they can affect

whether the reseller controls the specified license before transfer:

o

Rejection rights

— If rejection rights are substantively limited to legal/compliance constraints

(e.g., sanctions, export controls, antipiracy) and are expected to be remote in practice for

valid orders, they may be viewed as protective rights rather than a substantive constraint that

prevents the reseller from fulfilling its promise with a high degree of certainty. Conversely, if

rejection rights are broad and meaningfully exercised such that the reseller cannot reliably

obtain license issuance for reasons unrelated to compliance, those facts may weigh toward

an agent conclusion for the license.

o

EULA

— Similarly, a standardized click-through EULA that primarily establishes protective

use restrictions and publisher remedies — and does not set the key commercial terms of

the reseller’s sale (price, returns, contract term) or otherwise reframe customer recourse —

may be viewed as protective and not, on its own, inconsistent with a principal conclusion

for the license. Conversely, if the EULA effectively dictates core commercial terms and

customer recourse in a way that makes the reseller’s promise more akin to arranging for the

publisher’s performance, those facts may weigh toward an agent conclusion.

Example 2-151

Background

Company A is a reseller of a wide range of technology solutions. The marketing materials of A primarily

emphasize its ability to add value to the purchasing process of end customers by helping them select and

procure the most appropriate technology solution, including advising customers about what products to

procure, permitted use, user counts, and how to optimize the product to achieve technical and financial goals.

Company A enters into reseller agreements with vendors. Each of these agreements allows A to resell a

vendor’s on-premise software licenses and related PCS. Company A has the ability to choose from which

vendor it will purchase the products needed to fulfill the end customers’ orders.

Licenses

A customer purchases an on-premise software license by executing a purchase order with A. Company A then

purchases the license from a vendor by executing a purchase order with that vendor. Company A’s contract

with the vendor allows A to sell the vendor’s license to any customer that A identifies (i.e., the vendor cannot

reject a customer order except for protective reasons, and scenarios in which rejection of a customer order is

permissible are expected to be remote). Company A is responsible for collecting payment from the customer,

and A’s obligation to pay the vendor is not contingent on successfully collecting payment from the customer.

Company A has full discretion in setting the price for the license that it resells. All sales of the vendor’s software

license are subject to the vendor’s EULA.

The vendor delivers a license directly to an end customer through an electronic key on the basis of information

specified in the purchase order between A and the vendor. Company A is responsible for (1) assisting the

customer if the customer encounters issues downloading and installing the software (all software is provided

electronically) and (2) processing returns if the license does not conform to the specifications identified in the

customer’s purchase order.

PCS

Company A also enters into contracts with end customers to sell PCS related to the vendor’s on-premise

software license for a defined period. PCS is delivered by the vendor directly to the end customer and typically

includes technical support and rights to patches and bug fixes (and, if applicable under the PCS terms,

unspecified updates/upgrades). All sales of PCS are subject to the vendor’s PCS terms and the vendor’s EULA.

Each of A’s contracts with an end customer specifies that A does not warrant the performance of PCS and does

not make warranties or guarantees regarding the vendor’s PCS. If A’s reseller agreement with the vendor is

terminated, the vendor will continue to provide PCS to all existing end customers under the same terms and

conditions until the expiration of the respective PCS periods.

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Example 2-151 (continued)

Vendor B’s On-Premise Software License and PCS

An end customer enters into a purchase order with A to purchase Vendor B’s on-premise software license for

a multiyear term and PCS for the same period. Company A remits consideration to B for both the on-premise

software license and PCS in accordance with the purchase order executed between A and B, and A retains a

stated amount related to the sale. Company A directs B to provide the end customer with an activation key to

enable the end customer to download the on-premise software license, and B provides PCS directly to the end

customer.

Company A identifies B’s on-premise software license and PCS as specified distinct goods and services and thus

evaluates whether it obtains control of each of those specified goods and services before they are transferred

to the end customer.

Principal-Versus-Agent Analysis for PCS

Although A has a contract with B to resell B’s PCS, A does not obtain a right from B that allows it to control B’s

PCS before the service is delivered to an end customer. Company A evaluates the definition of control under

ASC 606-10-25-25 and notes that it can neither direct the performance of B’s PCS nor prevent B from directing

such performance. While A can facilitate the customer’s initial connection to B’s support process, the end

customer cannot benefit from PCS unless B continues to provide PCS throughout the PCS period. Therefore,

delivery of the specified service is contingent on B’s ongoing actions, which A cannot direct. Although A invoices

the end customer for PCS, this factor alone does not determine whether A is acting as the principal or the

agent in the transaction.

In addition, A considers the control indicators outlined in ASC 606-10-55-39, which it believes support its

control assessment under ASC 606-10-25-25. Company A is responsible for arranging for the customer to

obtain PCS coverage and may help route requests; however, B is responsible for fulfilling PCS, including

resolving support issues and providing patches and bug fixes, and the end customer understands that B

primarily fulfills this obligation. In addition, A notes that it does not have substantive inventory risk related to

PCS and that its retained amount is structured as a commission or margin.

On the basis of the above assessment, A concludes that it is acting as an agent that is responsible for arranging

for B to provide PCS to the end customer.

Principal-Versus-Agent Analysis for License

Company A concludes that it controls a right to B’s software license in accordance with ASC 606-10-25-25

before the software license is transferred to the end customer. In assessing control in the context of a software

licensing arrangement, A notes that a software license is a contractual legal right to use an entity’s IP that, by

its nature, does not exist until the right is granted. However, because an unlimited number of software licenses

can generally be created and granted, A believes that the relevant question in the evaluation of control is

whether A has an enforceable right to grant (or cause the issuance of) licenses that exists before the customer

obtains control of the license.

Company A believes that it has a legally enforceable right to issue (or direct the issuance of) licenses as a result

of the reseller agreement, which grants A a nonexclusive right to distribute the vendor’s software products to

customers and is not cancelable in a manner that would prevent A from obtaining issuance for valid orders. In

addition, A believes that it would have legal recourse against the vendor for breach of contract if the vendor

failed to issue the license for reasons other than those permitted under the agreement.

Company A also considers whether the rejection clause in the reseller agreement affects its conclusion.

Because the vendor cannot reject customer orders except for protective reasons and such rejection is

expected to be remote, A concludes that this rejection clause is protective and does not affect A’s conclusion

that A controls the right to issue licenses.

Similarly, A considers whether the EULA between the vendor and the end customer affects A’s conclusion that

A controls the right to issue licenses. Company A concludes that the EULA is a protective right intended to

ensure legal usage of the vendor’s IP by the end user and does not limit or modify A’s right under the reseller

agreement to cause the license to be issued.

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Example 2-151 (continued)

Company A further assesses whether its lack of possession of a master copy of the software indicates that it

lacks control of the license. Company A considers that the lack of possession is not determinative and that the

evaluation should focus instead on whether A controls the right to the license before that right is transferred

to the customer. Company A concludes that it does control the right to the license before transfer because

A’s enforceable right under the reseller agreement enables A to direct the vendor to provide the access key or

software copy necessary to fulfill the promise.

Because the nature of the entity’s promise may not always be readily apparent for licenses, A considers the

control indicators in ASC 606-10-55-39 as confirmatory evidence (rather than determinative on their own).

Company A concludes that it is primarily responsible for fulfillment because the revenue contract for the

license is between A and the customer, the vendor is not a party to that sales arrangement, and the customer

looks to A to ensure that the specified license is delivered and acceptable (including troubleshooting activation/

download issues and coordinating with the vendor if key delivery is delayed). Company A also concludes that it

has discretion in establishing pricing because A sets the prices charged to customers and the vendor does not

participate in those pricing terms. In addition, A notes that it (1) does not have front-end inventory risk because

it does not prepurchase a pool of licenses and (2) has only an immaterial amount of back-end exposure when it

accepts returns in limited circumstances.

On the basis of the above assessment, A concludes that (1) it controls the right to issue B’s software license

before the license is transferred to the end customer and (2) the indicators in ASC 606-10-55-39 provide

confirmatory evidence of that control conclusion. Accordingly, A concludes that it is the principal for the

promise to provide B’s software license to the end customer.

Revenue Presentation and Allocation

In this example, since A is acting as an agent for arranging for B to provide PCS to the end customer and is

acting as a principal for the provision of B’s software license to the end customer in the same contract, A would

allocate the transaction price to all of the performance obligations on a relative stand-alone selling price basis.

Further, in a manner consistent with its principal-versus-agent conclusions, A would (1) present revenue for the

license on a gross basis and (2) present revenue for PCS on a net basis (i.e., the amount retained).

2.9 Presentation

A contract with a customer creates legal rights and obligations. The rights under the contract will

generally give rise to contract assets as the entity performs (or accounts receivable, if an unconditional

right to consideration exists); and contract liabilities are created when consideration is received (or

receivable) in advance of performance. Each reporting period, an entity is required to assess its financial

position related to its contracts with customers. Depending on the extent to which an entity has

performed and the amount of consideration received (or receivable) by the entity under a contract, the

entity could record a contract asset or a contract liability. Contract assets and contract liabilities that

arise in the same contract should be presented net.

Paragraph BC317 of

ASU 2014-09

indicates that an entity should present its remaining rights and

obligations under a contract on a net basis. The reasoning behind this is that neither party to the

contract would continue to fulfill its obligations if it knew that the other party would not perform.

Because the rights and obligations in a contract are interdependent, contract assets and contract

liabilities that arise in the same contract should be presented net.

Receivables should be recorded separately from contract assets since only the passage of time is

required before consideration is due. That is, receivables are only subject to credit risk. In contrast,

contract assets are subject to more than just credit risk (i.e., they are also subject to performance risk).

As discussed in paragraph BC323 of ASU 2014-09, the FASB and IASB believed that making a distinction

between contract assets and receivables was important to financial statement users. Consequently,

only contract assets and contract liabilities are reported net. Accounts receivable should be reported

separately.

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ASC 606-10-45-5 addresses the use of alternative descriptions for contract assets and contract liabilities

as follows:

ASC 606-10

45-5

This guidance uses the terms

contract asset

and

contract liability

but does not prohibit an entity from using

alternative descriptions in the statement of financial position for those items. If an entity uses an alternative

description for a contract asset, the entity shall provide sufficient information for a user of the financial

statements to distinguish between receivables and contract assets.

Paragraph BC321 of ASU 2014-09 notes the FASB’s and IASB’s observation that “some industries have

historically used different labels to describe contract assets and contract liabilities or may recognize

them in more than one line item either in the financial statements or in the notes.” The ASU does not

prohibit an entity from using alternative terms or from using additional line items to present the assets

and liabilities, but it requires an entity to provide appropriate disclosures that adequately describe the

assets and liabilities.

Terms that are commonly used in practice to describe contract assets and contract liabilities include, but

are not limited to, the following:

•

Contract assets

— Unbilled receivables, progress payments to be billed.

•

Contract liabilities

— Deferred revenue, unearned revenue.

2.9.1 Contract Liabilities

ASC 606-10

45-2

If a customer pays consideration, or an entity has a right to an amount of consideration that is

unconditional (that is, a receivable), before the entity transfers a good or service to the customer, the entity

shall present the contract as a contract liability when the payment is made or the payment is due (whichever

is earlier). A contract liability is an entity’s obligation to transfer goods or services to a customer for which the

entity has received consideration (or an amount of consideration is due) from the customer.

A contract liability would exist when an entity has received consideration but has not transferred the

related goods or services to the customer. This is commonly referred to as deferred revenue. An entity

may also have an unconditional right to consideration (i.e., a receivable) before it transfers goods or

services to a customer.

The example below, which is reproduced from ASC 606, illustrates how an entity would account for a

contract liability and receivable. (For further discussion about receivables, see

Section 2.9.4

.)

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ASC 606-10

Example 38 — Contract Liability and Receivable

Case A — Cancellable Contract

55-284

On January 1, 20X9, an entity enters into a cancellable contract to transfer a product to a customer on

March 31, 20X9. The contract requires the customer to pay consideration of $1,000 in advance on January 31,

20X9. The customer pays the consideration on March 1, 20X9. The entity transfers the product on March 31,

20X9. The following journal entries illustrate how the entity accounts for the contract:

a.

The entity receives cash of $1,000 on March 1, 20X9 (cash is received in advance of performance).

Cash

$1,000

Contract liability

$1,000

b. The entity satisfies the performance obligation on March 31, 20X9.

Contract liability

$1,000

Revenue

$1,000

Case B — Noncancellable Contract

55-285

The same facts as in Case A apply to Case B except that the contract becomes noncancellable on

January 31, 20X9. The following journal entries illustrate how the entity accounts for the contract:

a.

January 31, 20X9 is the date at which the entity recognizes a receivable because it has an unconditional

right to consideration.

Receivable

$1,000

Contract liability

$1,000

b.

The entity receives the cash on March 1, 20X9.

Cash

$1,000

Receivable

$1,000

c.

The entity satisfies the performance obligation on March 31, 20X9.

Contract liability

$1,000

Revenue

$1,000

55-286

If the entity issued the invoice before January 31, 20X9, the entity would not recognize the receivable

and the contract liability in the statement of financial position because the entity does not yet have a right to

consideration that is unconditional (the contract is cancellable before January 31, 20X9).

2.9.2 Refund Liabilities

Some contracts with customers may result in refund liabilities owed to customers. The most common

of such refund liabilities are return provisions in sales contracts that permit the customer to return the

product if certain circumstances arise. These liabilities may also arise when an entity receives cash in

advance, but the agreement is cancelable because of certain termination provisions in the agreement.

When these provisions are present in a contract, the seller would recognize a liability to reflect its

obligation to return amounts paid or payable by the customer (i.e., a refund liability).

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An agreement that includes a provision for termination without penalty may not be a contract under

step 1 of ASC 606 (i.e., a contract may not exist for the cancelable term). Such a provision may therefore

affect the presentation of these arrangements on the balance sheet. For a cancelable contract (with

a termination right without penalty), funds received in advance should not be classified as a contract

liability. Funds received in advance that are associated with a cancelable term (with a termination right

without penalty) should be presented separately from any contract liability as a refund liability, or similar

liability.

A refund liability should not be presented together with contract liabilities that arise under the same

contract. A contract liability is defined in ASC 606-10-45-2 as “an entity’s obligation to transfer goods or

services to a customer for which the entity has received consideration (or an amount of consideration

is due) from the customer.” A refund liability, however, represents the customer’s conditional right to

consideration from the seller (as opposed to consideration receivable from the customer) and does

not represent a performance obligation. Consequently, we believe that the refund liability should be

presented separately from the contract liability. Note that as a result, the refund liability would not be

netted with any contract assets the entity may recognize.

2.9.3 Contract Assets

ASC 606-10

45-3

If an entity performs by transferring goods or services to a customer before the customer pays

consideration or before payment is due, the entity shall present the contract as a contract asset, excluding

any amounts presented as a receivable. A contract asset is an entity’s right to consideration in exchange for

goods or services that the entity has transferred to a customer. An entity shall assess a contract asset for credit

losses in accordance with Subtopic 326-20 on financial instruments measured at amortized cost. A credit loss

of a contract asset shall be measured, presented, and disclosed in accordance with Subtopic 326-20 (see also

paragraph 606-10-50-4(b)).

A contract asset would exist when an entity has a contract with a customer for which revenue has been

recognized (i.e., goods or services have been transferred to the customer) but customer payment is

contingent on a future event (e.g., satisfaction of additional performance obligations). Such an amount is

commonly referred to as an unbilled receivable.

The following example from the revenue standard illustrates the recording of a contract asset for

performance completed under a contract before an unconditional right to consideration exists:

ASC 606-10

Example 39 — Contract Asset Recognized for the Entity’s Performance

55-287

On January 1, 20X8, an entity enters into a contract to transfer Products A and B to a customer in

exchange for $1,000. The contract requires Product A to be delivered first and states that payment for the

delivery of Product A is conditional on the delivery of Product B. In other words, the consideration of $1,000 is

due only after the entity has transferred both Products A and B to the customer. Consequently, the entity does

not have a right to consideration that is unconditional (a receivable) until both Products A and B are transferred

to the customer.

55-288

The entity identifies the promises to transfer Products A and B as performance obligations and

allocates $400 to the performance obligation to transfer Product A and $600 to the performance obligation

to transfer Product B on the basis of their relative standalone selling prices. The entity recognizes revenue for

each respective performance obligation when control of the product transfers to the customer.

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ASC 606-10 (continued)

55-289

The entity satisfies the performance obligation to transfer Product A.

Contract asset

$400

Revenue

$400

55-290

The entity satisfies the performance obligation to transfer Product B and to recognize the unconditional

right to consideration.

Receivable

$1,000

Contract asset

$400

Revenue

$600

The FASB issued guidance in

ASU 2025-07

(effective for annual reporting periods beginning after

December 15, 2026, including interim reporting periods within those annual reporting periods) that

clarifies that an entity’s right to receive a share-based noncash payment from a customer is accounted

for under ASC 606 unless and until the entity’s right to receive or retain the share-based noncash

consideration is unconditional under ASC 606. If an entity has a right to receive share-based noncash

consideration (e.g., shares) in a contract with a customer, but such right is conditional and based on the

entity’s performance under the contract (e.g., delivering a quantity of goods), the entity would record

a contract asset (based on the fair value of the share-based noncash payment at contract inception)

when or as the entity satisfies its performance obligation. As described in ASC 606-10-32-21, noncash

consideration is measured at contract inception. If the value of the noncash consideration changes as

a result of the form of the consideration (e.g., a decline in the share price since contract inception), the

transaction price (and the initial measurement of any contract asset recorded when or as the entity

satisfies its performance obligation) is not adjusted. However, as noted in ASC 606-10-55-250, the

contract asset recorded would need to be assessed for impairment. Regardless of any impairment

assessment, the revenue recognized should be based on the fair value of the asset at contract inception;

any impairment losses would be recognized separately from the revenue recognized (i.e., revenue would

not be reduced as a result of any impairment losses).

Entities will need to carefully evaluate what impairment model is appropriate for contract assets when

impairment could result from changes in conditions other than counterparty credit or nonperformance

risk. The impairment model selected should be applied consistently to similar facts and circumstances,

and appropriate disclosure should be provided if material.

2.9.4 Receivables

ASC 606-10

45-4

A receivable is an entity’s right to consideration that is unconditional. A right to consideration is

unconditional if only the passage of time is required before payment of that consideration is due. For example,

an entity would recognize a receivable if it has a present right to payment even though that amount may

be subject to refund in the future. An entity shall account for a receivable in accordance with Topic 310 and

Subtopic 326-20. Upon initial recognition of a receivable from a contract with a customer, any difference

between the measurement of the receivable in accordance with Subtopic 326-20 and the corresponding

amount of revenue recognized shall be presented as a credit loss expense.

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The revenue standard was not intended to change either the timing of receivable recognition or the

subsequent accounting for receivables. While both contract assets and receivables are similar in that

they represent an entity’s right to consideration, the risks associated with each differ. Receivables

are only exposed to credit risk since only the passage of time is required before receivables are due.

However, contract assets are exposed to both credit risk and other risks (e.g., performance risk).

An entity could have a present and unconditional right to payment, and therefore a receivable, even if

there is a refund obligation that may require the entity to pay consideration to a customer in the future

(e.g., when a product is returned, or when rebates are earned on a specified volume of purchases). Since

refund obligations give rise to variable consideration, they could affect the transaction price and the

amount of revenue recognized. However, an entity’s present right to consideration may not be affected

by the potential need to refund consideration in the future. Consequently, in certain circumstances, a

gross receivable could be recorded along with a liability. This is discussed further in paragraph BC326 of

ASU 2014-09 and is illustrated in the following example from ASC 606:

ASC 606-10

Example 40 — Receivable Recognized for the Entity’s Performance

55-291

An entity enters into a contract with a customer on January 1, 20X9, to transfer products to the

customer for $150 per product. If the customer purchases more than 1 million products in a calendar year, the

contract indicates that the price per unit is retrospectively reduced to $125 per product.

55-292

Consideration is due when control of the products transfer to the customer. Therefore, the entity has

an unconditional right to consideration (that is, a receivable) for $150 per product until the retrospective price

reduction applies (that is, after 1 million products are shipped).

55-293

In determining the transaction price, the entity concludes at contract inception that the customer will

meet the 1 million products threshold and therefore estimates that the transaction price is $125 per product.

Consequently, upon the first shipment to the customer of 100 products the entity recognizes the following.

Receivable

$15,000

(a)

Revenue

$12,500

(b)

Refund liability

$2,500

(a)

$150 per product × 100 products

(b)

$125 transaction price per product × 100 products

55-294

The refund liability (see paragraph 606-10-32-10) represents a refund of $25 per product, which is

expected to be provided to the customer for the volume-based rebate (that is, the difference between the

$150 price stated in the contract that the entity has an unconditional right to receive and the $125 estimated

transaction price).

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Connecting the Dots

At the April 2016 FASB-only TRG meeting, the FASB staff noted that it has received questions

about the point in time at which a receivable should be recorded under a contract with a

customer (including when contract assets would be reclassified as accounts receivable). The

FASB staff agreed that some confusion could have resulted from the wording in Example 38,

Case B, of the revenue standard, which some believed was not aligned with the guidance that

identifies a receivable as a right to consideration that is unconditional other than for the passage

of time. Partly in response to stakeholders’ concerns acknowledged at the meeting, the FASB

later issued

ASU 2016-20

, which contains guidance aimed at clarifying the timing of revenue

recognition related to receivables (referred to in ASU 2016-20 as “Issue 9”).

At the TRG meeting, the staff also noted that it has received other questions, including inquiries

about situations in which performance occurs over time and whether receivables should be

recorded as performance occurs or when amounts are invoiced and due. The staff observed

that there is diversity in practice today regarding how and when receivables are recorded and

that such diversity is not likely to be eliminated under the revenue standard. However, the

staff reiterated that these questions do not affect revenue recognition; rather, they affect the

presentation of assets on an entity’s balance sheet.

The example below illustrates how an entity that satisfies its sole performance obligation in a contract

with a customer and plans to invoice the customer in multiple annual installments should reflect the

transaction on its balance sheet.

Example 2-152

On March 1, 20X1, Entity A enters into a contract with one performance obligation (software license that is

determined to be satisfied at a point in time on March 1, 20X1) for $3,600. Entity A delivers the software license

on March 1, 20X1, and will invoice the customer in three equal and annual installments of $1,200 on March 1 of

20X1, 20X2, and 20X3. Payment is due by April 1 of each year.

Entity A should record a receivable for the full contract amount ($3,600) when it satisfies the performance

obligation on March 1, 20X1. That is, the $3,600 should be recorded as a receivable in accordance with

ASC 606-10-45-4, which states that a “receivable is an entity’s right to consideration that is unconditional”

and a “right to consideration is unconditional if only the passage of time is required before payment of that

consideration is due.” As noted in paragraph BC323 of ASU 2014-09, “making the distinction between a

contract asset and a receivable is important because doing so provides users of financial statements with

relevant information about the risks associated with the entity’s rights in a contract. That is because although

both would be subject to credit risk, a contract asset also is subject to other risks, for example, performance

risk.” In this scenario, A’s rights are only subject to credit risk because the sole performance obligation has been

satisfied as of March 1, 20X1 (i.e., A has an unconditional right to cash for the full contract amount).

The example below illustrates how an entity that satisfies its performance obligation over time in its

contracts with customers and plans to invoice each customer with different payment terms should

reflect the transactions on its balance sheet.

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Example 2-153

On March 1, 20X1, Entity A enters into two identical (other than payment terms) noncancelable contracts with

two different customers, Customer Y and Customer Z. The contracts each contain the same single performance

obligation (i.e., SaaS) that is satisfied over time. The transaction price is $2,400. Each customer is issued an

invoice on March 1, 20X1, and A provides continuous service from March 1, 20X1, through February 28, 20X2.

Customer Y’s payment is due on March 31, 20X1, but is received by A on April 15, 20X1. Customer Z’s payment

is due on April 15, 20X1. There are multiple views on how A should reflect these transactions on its balance

sheet as of March 31, 20X1:

•

Alternative A

— Entity A should record a receivable when it issues an invoice to its customer

and

begins

satisfying the performance obligation. The right to consideration is unconditional because only the

passage of time up to the due date is required (since A has already begun performing the services).

Accordingly, A’s transactions with Y and Z would be reflected in the financial statements as follows:

Customer Y

Receivable

2,400

Contract liability

2,200

Revenue

200

Customer Z

Receivable

2,400

Contract liability 

2,200

Revenue

200

•

Alternative B

— Until the invoice is due, A should build up its receivable balance incrementally as it

satisfies its performance obligation. For Y, since payment is due on March 31, 20X1, the full receivable

balance is recorded. For Z, the full receivable balance would be recorded once payment is due on April

15, 20X1. Accordingly, A’s transactions with Y and Z would be reflected in the financial statements as

follows:

Customer Y

Receivable

2,400

Contract liability

2,200

Revenue

200

Customer Z

Receivable

200

Contract asset

2,200*

Contract liability 

2,200*

Revenue

200

*

Contract asset and contract liability would be netted on the face of the balance sheet.

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Discussions with the FASB staff confirmed that the Board did not intend to change practice related to

when receivable balances are recorded. Depending on an entity’s existing accounting policies, either

Alternative A or Alternative B could be acceptable.

Connecting the Dots

Contract assets and contract liabilities should be determined at the contract level (i.e., not at the

performance obligation level), and only a net contract asset or net contract liability should be

presented for a particular contract. Receivables, however, would be presented separately from

contract assets and contract liabilities.

Implementation Q&A 34

discusses the difficulty of determining when a customer paid for

a particular good or service under a contract involving multiple promised goods or services

because of the fungible nature of cash. Since receivables are presented separately from contract

assets and contract liabilities, the allocation of cash to performance obligations in a contract

involving multiple performance obligations could also affect the recognition of receivables,

contract assets, and contract liabilities. Consider the example below.

Example 2-154

On January 1, 20X1, Entity A enters into a noncancelable contract with a customer that contains two

performance obligations: a software license (satisfied at a point in time) and PCS (satisfied over time from

January 1, 20X1, through December 31, 20X3). Entity A issues an invoice on January 1, 20X1, for the first year

(due on February 1, 20X1) and subsequently issues an invoice on each anniversary for the next two years. The

transaction price of the contract is $6,000 (invoiced at $2,000 per year). As a result of allocating the transaction

price to each performance obligation on a relative stand-alone selling price basis, 60 percent of revenue

($3,600) is allocated to the license and 40 percent of revenue ($2,400) is allocated to PCS. Contractually, each

$2,000 invoice provides the right to receive PCS for one year ($800) and applies to one-third of the total license

fee of $3,600 ($1,200). Entity A has the contractual right to bill and collect payment for the remaining license fee

independently of providing any future PCS.

On January 1, 20X1, the software license is transferred to the customer and PCS commences. The customer

pays the $2,000 invoice in full on February 1, 20X1. Entity A has an accounting policy of recording the receivable

when amounts are invoiced and the associated performance obligation has been satisfied or has commenced.

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Example 2-154 (continued)

There are multiple views on how this transaction should be presented as of and for the period ended March

31, 20X1:

•

Alternative A

— To identify the receivable amount in this contract, A must first allocate the payment

made on February 1, 20X1, to the performance obligations contractually tied to the payment. Entity A

would then determine the remaining receivable for performance obligations satisfied when payment is

unconditional. Accordingly, the transaction would be reflected in the financial statements as follows:

License:

Cash (60% × $2,000)

1,200

Receivable

2,400*

Revenue

3,600

PCS:

Cash (40% × $2,000)

800

Contract asset**

1,600***

Contract liability** [($2,400 ÷ 36) × 33]

2,200

Revenue [($2,400 ÷ 36) × 3]

200

Consolidated:

Cash

2,000

Receivable

2,400

Contract asset**

1,600

Contract liability**

2,200

Revenue

3,800

*

The $2,400 represents the entity’s unconditional right to payment in years 2 and 3.

**

Contract asset and contract liability would be netted, and net contract liability of $600 related to PCS paid

in advance would be recorded.

***

The $1,600 represents the entity’s right to payment in years 2 and 3 that is conditional on providing future

PCS.

•

Alternative B

— Entity A would allocate cash entirely to the satisfied performance obligations (i.e., the

software license and the satisfied portion of PCS) and record the remaining consideration due that is

associated with the satisfied performance obligations as a receivable. Consequently, as illustrated below,

A would not present any contract liability for PCS paid for by the customer before performance.

Cash

2,000

Receivable*

1,800

Contract asset** [($2,400 ÷ 36) × 33]

2,200

Contract liability** [($2,400 ÷ 36) × 33]

2,200

Revenue {$3,600 + [($2,400 ÷ 36) × 3]}

3,800

*

Since revenue related to fulfilling the PCS obligation is recognized under Alternative B, the entity would also

record a receivable throughout the year before issuing an invoice. In year 3, the entity would present a net

contract liability since payment would have been received in advance for year 3 PCS.

** Contract asset and contract liability would be netted to $0.

Because cash is fungible and can be allocated at either the contract level or the performance obligation level,

either Alternative A or Alternative B could be acceptable. Entities should apply a consistent approach for similar

contracts and in similar circumstances.

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2.9.5 Classification as Current or Noncurrent

If an entity presents a classified balance sheet, it should determine whether certain revenue-related

balances should be presented as current or noncurrent (or bifurcated between the two).

2.9.5.1 Contract Assets and Contract Liabilities

In a manner similar to the treatment of assets and liabilities related to the receipt or use of cash (e.g.,

receivables, prepaid assets, or debt), contract assets and contract liabilities should be bifurcated

between current and noncurrent when presented in a classified balance sheet.

Note that the contract asset or contract liability determined at the contract level (i.e., after the contract

assets and contract liabilities for each performance obligation within a single contract have been netted)

is the contract asset or contract liability that should be bifurcated between current and noncurrent

when presented in a classified balance sheet, as illustrated in the example below.

Example 2-155

Entity X enters into two noncancelable contracts with two different customers (“Contract A” and “Contract

B”). Entity X promises to sell each customer (1) a subscription to a cloud-based service running diagnostics

of the customer’s facility and (2) certain equipment. For purposes of this example, the cloud-based service

subscription and each piece of equipment represent distinct performance obligations. Assume that there is no

significant financing component.

The stand-alone selling price and the expected pattern and timing of satisfaction of each of the performance

obligations are as follows:

Performance Obligation

SSP

Timing of Satisfaction of the

Performance Obligation

Subscription to cloud-based service

$ 1,000 per month

Service is delivered throughout the contract

term

Equipment C

$ 3,000

January 31, 20X0

Equipment D

$ 1,000

April 30, 20X1

Equipment E

$ 2,000

September 30, 20X0

The terms of each contract are described below. 

Contract A 

Entity X’s performance obligations and the payment terms under Contract A are as follows:

•

Three-year subscription to the cloud-based service

— A payment of $36,000 is due up front (on January 1,

20X0). 

•

Equipment C

— A payment of $3,000 is due upon delivery on January 31, 20X0. 

•

Equipment D

— A payment of $1,000 is due upon delivery on April 30, 20X1. 

The total transaction price of $40,000 is allocated to the performance obligations on the basis of their relative

stand-alone selling prices as follows:

•

$36,000 is allocated to the three-year subscription to the cloud-based service.

•

$3,000 is allocated to Equipment C.

•

$1,000 is allocated to Equipment D.

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Example 2-155 (continued)

The table below shows the transactions that have occurred as of March 31, 20X0, and the resulting impacts.

Cash

Contract

Liability

Revenue

Receipt of consideration due

on January 1, 20X0

$

36,000

$

(36,000)

$

—

Receipt of consideration due

upon delivery of Equipment

C on January 31, 20X0

3,000

—

3,000

Delivery of three months of

the cloud-based service

(January 1 through March

31, 20X0)

—

3,000

3,000

Quarter-end amounts

$

39,000

$

(33,000)

$

6,000

The contract asset and contract liabilities within a single contract must first be netted before bifurcation

between current and noncurrent presentation on the balance sheet. Accordingly, X determines that it has

a net contract liability balance of $33,000 as of March 31, 20X0. In addition, X has a remaining performance

obligation of $34,000 ($33,000 for the cloud-based service and $1,000 for Equipment D). Entity X determines

that it is appropriate to present a current liability ($12,000) and a noncurrent liability ($21,000). This is because

X expects to deliver 12 months of the cloud-based service within the next 12 months, which would result in

$12,000 of revenue recognition. The remaining deferred revenue balance is related to promised goods or

services that will be transferred to the customer beyond 12 months and would therefore be classified as

noncurrent.

The following journal entry illustrates how X accounts for Contract A as of March 31, 20X0:

Cash

39,000

Contract liability (current)

12,000

Contract liability (noncurrent)

21,000

Revenue

6,000

Contract B 

Entity X’s performance obligations and the payment terms under Contract B are as follows:

•

One-year subscription to the cloud-based service commencing on January 1, 20X0

— A payment of $12,000 is

due on December 31, 20X0.

•

Equipment C

— A payment of $5,000 is due upon delivery on January 31, 20X0. 

•

Equipment E

— No payment is due upon delivery on September 30, 20X0.

The total transaction price of $17,000 is allocated to the performance obligations on the basis of their relative

stand-alone selling prices as follows:

•

$12,000 is allocated to the one-year subscription to the cloud-based service.

•

$3,000 is allocated to Equipment C.

•

$2,000 is allocated to Equipment E.

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Example 2-155 (continued)

The table below shows the transactions that have occurred as of March 31, 20X0, and the resulting impacts.

Cash

Contract

Liability

Contract

Asset

Revenue

Receipt of consideration due

upon delivery of Equipment

C on January 31, 20X0

$

5,000

$

(2,000)

$

—

$

3,000

Delivery of three months

of the cloud-based service

(January 1 through March

31, 20X0)

—

—

3,000

3,000

Quarter-end amounts

$

5,000

$

(2,000)

$

3,000

$

6,000

There is a net contract asset of $1,000, which is the difference between the contract asset of $3,000 and the

contract liability of $2,000 as of March 31, 20X0.

The contract asset and contract liabilities within a single contract must first be netted before bifurcation

between current and noncurrent presentation on the balance sheet. ASC 606 does not prescribe how

consideration received should be applied in a contract that includes multiple performance obligations. There is

a difference between the $5,000 of consideration received and the $3,000 of revenue allocated to Equipment

C. Since X has transferred 3 months of the cloud-based service to the customer, X has a $3,000 contract asset

related to the cloud-based service (current because payment is expected to be received within 12 months).

Note that as of March 31, 20X0, on the basis of the payment terms, X does not have a right to the $12,000

consideration that is unconditional (a receivable) until 12 months of the cloud-based service are transferred to

the customer. Hence, when X recognizes revenue for the 3 months of cloud-based service delivered to date, it

recognizes a contract asset rather than a receivable.

Some may consider the $2,000 additional consideration to be partial payment related to the cloud-based

service subscription transferred to date, while others may argue that the $2,000 is a prepayment for Equipment

E. In either case, the determination of the amount of the net contract asset (or net contract liability) would be

the same. That is, X has either of the following:

•

A $1,000 contract asset related to the 3-month subscription to date for which there is no unconditional

right to payment.

•

A net $1,000 contract asset (a $3,000 contract asset related to the cloud-based service less a $2,000

contract liability for Equipment E).

In this fact pattern, since it is expected that all performance obligations will be satisfied within one year of the

reporting date (March 31, 20X0), the $1,000 contract asset would be classified as a current asset.

The following journal entry illustrates how X accounts for Contract B on March 31, 20X0: 

Cash

5,000

Contract asset (current)

1,000

Revenue

6,000

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Example 2-155 (continued)

Consolidated Contract Asset and Contract Liability (Reflecting Both Contract A and Contract B)

As of March 31, 20X0, under the assumption that Contract A and Contract B were the only arrangements that X

accounted for, X would report the consolidated contract asset and contract liability on its financial statements

related to Contract A and Contract B as follows:

Cash

44,000*

Contract asset (current)

1,000**

Contract liability (current)

12,000**

Contract liability (noncurrent)

21,000**

Revenue

12,000***

*

That is, the sum of $39,000 received from Contract A and $5,000 received from Contract B.

**

Contract A and Contract B are separate contracts. Consequently, it would be inappropriate to net the contract

asset and contract liability arising from the two contracts.

***

That is, the sum of $6,000 in revenue from Contract A and $6,000 in revenue from Contract B.

As illustrated in the example above, the contract position, either as a contract asset or as a contract

liability within a single contract, must first be netted before bifurcation between current and noncurrent

presentation on the balance sheet. Therefore, it is possible at a consolidated level of the financial

statement to present all four categories (i.e., current and noncurrent contract assets and current and

noncurrent contract liabilities). A reporting entity should apply judgment in bifurcating between current

and noncurrent presentation by considering the nature of the contract, including the payment schedule

and the timing of satisfaction of future performance obligations.

2.9.5.2 Refund Liabilities

The example below considers whether it is appropriate for an entity to classify refund liabilities (or

similar liabilities) as a noncurrent liability in a classified balance sheet.

Example 2-156

Entity P, an entity with an operating cycle of less than 12 months, expects to return proceeds related to refund

liabilities (or similar liabilities) more than 12 months after the reporting date. However, the counterparty can

demand a refund of amounts previously paid at any time.

Entity P should not classify the portion that it expects to repay more than 12 months after the reporting date as

a noncurrent liability in a classified balance sheet. All amounts related to such liabilities should be recorded as a

current liability because the counterparty can demand a refund at any time.

On a classified balance sheet, the refund liability should not be presented as noncurrent if the customer

can cancel the contract at any point or within 12 months or less. Rather, all amounts should be recorded

as a current liability. The refund liability is excluded from contract liabilities because the customer must,

in effect, make a separate purchase decision when the noncancelable term ends, at which point it could

demand a refund of funds previously paid.

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Chapter 2 — Revenue Recognition

ASC 470-10-45-10, which specifies that loans due on demand should be presented as a current liability,

supports this view.

ASC 470-10

45-10

The current liability classification shall include obligations that, by their terms, are due on demand or

will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though

liquidation may not be expected within that period. The demand provision is not a subjective acceleration

clause as discussed in paragraph 470-10-45-2.

2.9.5.3 Capitalized Contract Costs

It is acceptable for costs of obtaining or fulfilling a contract to be bifurcated between current and

noncurrent in a classified balance sheet. Alternatively, in a manner similar to the treatment of

(1) intangible assets, (2) inventory, or (3) property, plant, and equipment, capitalized costs of obtaining or

fulfilling a contract may be presented as a single asset and neither bifurcated nor reclassified between

current and noncurrent assets. That is, the assets would be classified as long-term unless they had an

original amortization period of one year or less.

2.9.6 Other Presentation Matters

2.9.6.1 Unit of Account for Presentation

Under ASC 606, a contract asset can arise when the amount of revenue recognized by an entity

exceeds

the amount that has already been paid by the customer together with any unpaid amounts

recognized as receivables. Conversely, a contract liability can arise when the amount of revenue

recognized by an entity is

less

than the amount that has already been paid by the customer together

with any unpaid amounts recognized as receivables.

When there are multiple performance obligations in a contract (or in multiple contracts accounted for as

a single combined contract in accordance with ASC 606-10-25-9), it is possible that revenue recognized

is in excess of amounts paid or receivable for some performance obligations but less than amounts paid

or receivable for other performance obligations. In such circumstances, the appropriate unit of account

for presenting contract assets and contract liabilities is the contract. Accordingly, it is not appropriate

to present both contract assets and contract liabilities for a single contract; instead, a single net figure

should be presented.

ASC 606-10-45-1 states that “[w]hen either party to a contract has performed, an entity shall present the

contract in the statement of financial position as a contract asset or a contract liability, depending on the

relationship between the entity’s performance and the customer’s payment. An entity shall present any

unconditional rights to consideration separately as a receivable.”

This also applies to circumstances in which multiple contracts are combined and are accounted for as a

single contract in accordance with the requirements for combination in ASC 606-10-25-9.

Paragraph BC317 of ASU 2014-09 explains that the “Boards decided that the remaining rights and

performance obligations

in a contract

should be accounted for

and presented on a net basis

, as

either a contract asset or a contract liability. . . . The Boards decided that those interdependencies are

best reflected by

accounting and presenting

on a net basis the remaining rights and obligations in the

statement of financial position” (emphasis added).

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Connecting the Dots

Variability due to changes in the foreign currency exchange is not variable consideration.

Questions have been raised about the accounting for receivables, contract assets, and

contract liabilities in contracts that include consideration denominated in a foreign currency.

Specifically, stakeholders have asked how an entity should apply the guidance in ASC 830 on

foreign currency matters to the recognized assets and liabilities in a customer contract with the

expectation that more contract assets may arise in contracts under ASC 606.

ASC 606 requires an entity to recognize (1) a contract asset if the entity performs by transferring

goods or services to a customer before the customer pays consideration or before payment

is due or (2) a contract liability if the entity receives (or has an unconditional right to receive)

consideration before it transfers goods or services to the customer.

Contract liabilities are nonmonetary liabilities because they require an entity to perform a

service in the future. Contract assets are monetary assets because they will ultimately be settled

for a fixed amount of cash.

A separate issue arises if a single contract with a customer contains a performance obligation

that is in a contract asset position and another performance obligation that is in a contract

liability position. ASC 606 requires an entity to present contract assets and contract liabilities on

a net basis in the balance sheet. Therefore, questions have arisen about whether the guidance

in ASC 830 should be applied to the gross contract asset and liability balances separately or only

to the net contract asset or liability for a single contract. We believe that the guidance in ASC 830

should be applied on a gross basis. For a complete discussion of this issue, see

Section 4.8

of

Deloitte’s Roadmap

Foreign Currency Matters

.

2.9.6.2 Balance Sheet Offsetting

2.9.6.2.1 Offsetting Contract Assets and Contract Liabilities Against Other Assets

and Liabilities

ASC 606 uses the terms “contract asset” and “contract liability” (defined in ASC 606-10-20) in the context

of revenue arising from contracts with customers and provides guidance on the presentation of contract

assets and contract liabilities in the statement of financial position (see ASC 606-10-45-1 through 45-5).

Entities may also recognize other types of assets or liabilities as a result of revenue or other transactions

related to customers. Examples might include costs of obtaining a contract capitalized in accordance

with ASC 340-40-25-1, financial assets or liabilities as defined in ASC 825-10-20 (e.g., receivables), and

provisions as defined in ASC 460.

In practice, it will not be possible for entities to offset contract assets and contract liabilities against other

assets and liabilities given that the contract assets and contract liabilities do not represent determinable

amounts owed by each party. ASC 210-20 prohibits offsetting of assets and liabilities unless required or

permitted by another Codification subtopic, and neither ASC 606-10 nor any other Codification subtopic

includes such a requirement or permission with respect to contract assets and contract liabilities.

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Chapter 2 — Revenue Recognition

2.9.6.2.2 Offsetting Refund Liabilities Against Accounts Receivable

For an entity to offset refund liabilities against accounts receivable, all of the following criteria in ASC

210-20-45-1 must be met:

a.

Each of two parties owes the other determinable amounts.

b.

The reporting party has the right to set off the amount owed with the amount owed by the other party.

c.

The reporting party intends to set off.

d.

The right of setoff is enforceable at law.

If an entity has a legally enforceable contract and amounts have been billed (i.e., there is an

unconditional right to payment for amounts billed), but because of a termination right a contract has not

been identified under step 1 of ASC 606, the entity will generally recognize a refund liability (or similar

liability) and accounts receivable.

If the contract is legally enforceable and the recognition of accounts receivable is appropriate,

presenting the amounts net would generally be inappropriate. ASC 210-20 provides guidance on

evaluating whether an asset and a liability may be netted. For example, ASC 210-20-45-1 outlines the

criteria used to determine whether a right of setoff exists, including the requirement that the reporting

party have both the legal right and the intent to set off. If the reporting entity does not expect the

customer to terminate, it effectively believes that the customer will pay in the normal course and that

the entity will provide goods or services. In such a case, the criteria related to the right of setoff would

not be met and the entity should not net the amounts.

However, when the criteria related to the right of offset are met, a reporting entity is not required to net

the amounts. An entity’s decision to offset when the criteria in ASC 210-20-45-1 are met is an accounting

policy election that should be applied consistently to all similar types of transactions.

The example below illustrates how to determine whether it is permissible to offset a refund liability

against accounts receivable.

Example 2-157

Company P manufactures hardware and sells it to various retailers, which ultimately sell the hardware to end

customers. Company P has concluded that the retailers are its customers and that control of the hardware

is transferred to the retailers upon delivery to them. Upon receipt of the hardware, retailers have 90 days to

return any unsold hardware to P. If a retailer exercises its right to return hardware, P provides a credit against

the retailer’s accounts receivable balance. That is, P does not pay cash to settle the refund liability; rather, it

offsets the refund liability against any currently outstanding accounts receivable.

83

In accordance with ASC

606-10-32-10, P estimates a refund liability for hardware that it expects retailers to return.

Company P must evaluate the criteria in ASC 210-20 to determine whether it is permitted to offset the refund

liability against accounts receivable in P’s balance sheet.

In practice, P may not have the legal right to offset the refund liability against amounts receivable from a

retailer. Further, the estimated refund liability may not represent a determinable amount because P estimated

the refund liability by using a portfolio of information.

The notion that an entity should apply ASC 210-20 to determine whether offsetting is appropriate is

consistent with the considerations related to offsetting contract assets and contract liabilities against

other assets and liabilities.

83

Company P would pay cash to settle the refund liability only if the customer did not have an outstanding accounts receivable balance.

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2.9.6.3 Income Statement Classification of Amortized Contract Costs

Generally, the amortization of any incremental costs of obtaining a contract that are capitalized under

ASC 340-40 should be classified in the income statement as selling, general, and administrative (SG&A)

expense.

Under ASC 340-40, an entity is required to recognize the incremental costs of obtaining a contract (i.e.,

those costs that would not have been incurred if the contract had not been obtained) as an asset if

the entity expects to recover them.

84

When capitalized, the costs are “amortized on a systematic basis

that is consistent with the transfer to the customer of the goods or services to which the asset relates.”

However, ASC 340-40 does not include guidance on the presentation of amortized contract costs in the

income statement.

In addition, the Codification does not contain guidance on the types of expenses that represent SG&A

expense or cost of sales. SEC Regulation S-X, Rule 5-03(b), provides limited guidance by indicating the

various line items that should appear on the face of the income statement (if applicable). Rule 5-03(b)

indicates that the cost of any tangible goods sold and the cost of any services sold are “[c]osts and

expenses applicable to sales and revenues.” Further, Rule 5-03(b) requires a separate line item for SG&A

expenses.

Despite the limited authoritative guidance, we believe that SG&A expense in the income statement

would be the preferred classification of the amortization of incremental costs of obtaining a contract

that are capitalized under ASC 340-40. This is because such costs represent costs of acquiring a contract

(e.g., selling costs), as opposed to costs of fulfilling a contract that generally would be included in cost of

goods sold (or a similar line item).

2.9.6.4 Interaction Between ASC 606 and SEC Regulation S-X, Rule 5-03(b)

SEC Regulation S-X, Rule 5-03(b)

§ 210.5-03 Statements of comprehensive income. . . .

(b) If income is derived from more than one of the subcaptions described under § 210.5-03.1, each class

which is not more than 10 percent of the sum of the items may be combined with another class. If these

items are combined, related costs and expenses as described under § 210.5-03.2 shall be combined in

the same manner.

1.

Net sales and gross revenues

. State separately:

(a) Net sales of tangible products (gross sales less discounts, returns and allowances), (b) operating

revenues of public utilities or others; (c) income from rentals; (d) revenues from services; and

(e) other revenues. Amounts earned from transactions with related parties shall be disclosed as

required under § 210.4-08(k). A public utility company using a uniform system of accounts or a

form for annual report prescribed by federal or state authorities, or a similar system or report,

shall follow the general segregation of operating revenues and operating expenses reported

under § 210.5-03.2 prescribed by such system or report. If the total of sales and revenues

reported under this caption includes excise taxes in an amount equal to 1 percent or more

of such total, the amount of such excise taxes shall be shown on the face of the statement

parenthetically or otherwise.

84

ASC 340-40-25-4 provides a practical expedient under which “an entity may recognize the incremental costs of obtaining a contract as an expense

when incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less.”

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SEC Regulation S-X, Rule 5-03(b), indicates the various line items that should appear on the face of the

income statement. Specifically, a registrant should separately present any amounts that represent 10

percent of the sum of income derived from net sales of tangible products, operating revenues of public

utilities or others, income from rentals, revenues from services, and other revenues. Aside from minor

revisions, no updates have been made to Rule 5-03(b) since the issuance of

ASU 2014-09

. Further, there

is limited guidance on interpreting the requirements of Rule 5-03(b) — for example, the terms “income

from rentals,” “revenues from services,” “products,” and “services” are not specifically defined. Despite

the long-standing need for registrants to use judgment when applying Rule 5-03(b), stakeholders have

raised concerns about the interplay between Rule 5-03(b) and new accounting standards, including the

revenue standard.

The interaction between ASC 606 and Rule 5-03(b) was discussed at the March 2018 CAQ SEC

Regulations Committee joint meeting with the SEC staff. As indicated in the

highlights

of that

meeting, the SEC staff noted that it is encouraging registrants to submit real-life examples of potential

inconsistencies in income statement classification that may arise between ASC 606 and Rule 5-03(b). For

additional information, see Deloitte’s May 22, 2018,

journal entry

.

Entities may need to apply judgment when aligning their revenue streams with the presentation

requirements of Rule 5-03(b) and consider how they are disaggregating revenue in the footnotes. The

SEC staff has asked registrants questions related to inconsistencies between disaggregation of revenue

in the footnotes to the financial statements (or the discussion of disaggregation of revenue outside of

the financial statements) and the presentation of revenue from products and services on the face of

the income statement. For additional information and examples of SEC comments issued to registrants

on this topic, see

Section 2.18.4

of Deloitte’s Roadmap

SEC Comment Letter Considerations, Including

Industry Insights

. For considerations related to the disaggregation of revenue in accordance with the

disclosure requirements of ASC 606, see

Section 15.2.2

of Deloitte’s Roadmap

Revenue Recognition

.

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2.10 Disclosure Requirements

The table below summarizes the revenue standard’s disclosure requirements, including elections for

nonpublic entities and interim requirements.

Category

Disclosure Requirements

Election

Available to

Nonpublic

Entities

Interim

Requirement

(ASC 270)

85

Disaggregation of

revenue

Disaggregate revenue into categories that depict

how revenue and cash flows are affected by

economic factors.

Yes

86

Yes

Sufficient information to understand the

relationship between disaggregated revenue and

each disclosed segment’s revenue information.

Yes

Yes

Contract balances

Opening and closing balances (receivable,

contract assets, and contract liabilities).

No

Yes

Amount of revenue recognized from beginning

contract liability balance.

Yes

Yes

Explanation of significant changes in contract

balances (using qualitative and quantitative

information).

Yes

No

Performance

obligations

(including remaining

performance

obligations)

Qualitative information about (1) when

performance obligations are typically satisfied,

(2) significant payment terms, (3) the nature of

goods or services promised, (4) obligations for

returns of refunds, and (5) warranties.

No

No

Amount of revenue recognized from performance

obligations satisfied in prior periods (e.g., changes

in transaction price estimates).

Yes

Yes

Transaction price allocated to the remaining

performance obligations:

•

Disclosure of quantitative amounts.

Yes

Yes

•

Quantitative or qualitative explanation of

when remaining performance obligation

amounts will be recognized as revenue.

Yes

Yes

85

This column represents the interim disclosure requirements in years after the year of adoption of the revenue standard.

86

At a minimum, a nonpublic entity must disclose revenue that is disaggregated in accordance with the timing of transfer of goods or services (e.g.,

goods transferred at a point in time and services transferred over time) and qualitative information about how economic factors affect revenue

and cash flows.

311

Chapter 2 — Revenue Recognition

(Table continued)

Category

Disclosure Requirements

Election

Available to

Nonpublic

Entities

Interim

Requirement

(ASC 270)

Significant judgments

and estimates

Qualitative information about determining the

timing of:

•

Performance obligations satisfied over

time (e.g., methods of measuring progress,

why methods are representative of the

transfer of goods or services, judgments

used in the evaluation of when a customer

obtains control of goods or services).

Yes

87

No

•

Performance obligations satisfied at a

point in time — specifically, the significant

judgments used in the evaluation of when

a customer obtains control.

Yes

No

Qualitative and quantitative information

88

about:

•

Determining the transaction price

(e.g., estimating variable consideration,

adjusting for the time value of money,

noncash consideration).

Yes

No

•

Constraining estimates of variable

consideration.

No

No

•

Allocating the transaction price, including

estimating stand-alone selling prices

and allocating discounts and variable

consideration.

Yes

No

•

Measuring obligations for returns, refunds,

and other similar obligations.

Yes

No

87

The election available to nonpublic entities applies only to the requirement to disclose information about why the methods used to recognize

revenue over time provide a faithful depiction of the transfer of goods or services to a customer. Nonpublic entities are still required to disclose

the information about the methods used to recognize revenue over time in accordance with ASC 606-10-50-18(a).

88

This includes the methods, inputs, and assumptions used in an entity’s assessment.

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(Table continued)

Category

Disclosure Requirements

Election

Available to

Nonpublic

Entities

Interim

Requirement

(ASC 270)

Contract costs

Qualitative information about:

•

Judgments made in determining the

amount of the costs incurred to obtain or

fulfill a contract.

Yes

No

•

The method the entity uses to determine

the amortization for each reporting period.

Yes

No

Quantitative information about:

•

The closing balances of assets recognized

from the costs incurred to obtain or fulfill a

contract, by main category of asset.

Yes

No

•

The amount of amortization and any

impairment losses recognized in the

reporting period.

Yes

No

Practical expedients

Disclosure of practical expedients used.

Yes

89

No

For more information, see

Chapter 15

of Deloitte’s Roadmap

Revenue Recognition

.

2.10.1 Impact of Termination Provisions on Disclosure

Termination provisions may significantly affect revenue recognition for technology entities. In addition,

contracts with termination provisions may affect an entity’s financial statement disclosures.

2.10.1.1 Effect of Termination Provisions on Disclosures Related to Remaining

Performance Obligations

In an arrangement with a termination provision, an entity should not include amounts that are subject

to termination without penalty in its required disclosures related to remaining performance obligations.

Under the requirements outlined in ASC 606-10-50-13, an entity must disclose the “aggregate amount

of the transaction price allocated to the performance obligations that are unsatisfied . . . as of the end of

the reporting period.”

When arrangements include provisions for termination without penalty, the amounts excluded from

the assessment under step 1 of ASC 606 are, in effect, optional purchases. Any amounts that are

paid or due are thus accounted for as a refund liability (or similar liability) and not a contract liability.

Because these amounts are related to a cancelable arrangement for which a contract does not exist (as

determined under step 1), they do not represent any part of the transaction price (as determined under

step 3) related to unsatisfied performance obligations (which would be identified as part of step 2).

89

However, nonpublic entities that have elected the practical expedient or policy election in

ASU 2021-02

are required to disclose the practical

expedient or policy election used.

313

Chapter 2 — Revenue Recognition

2.10.1.2 Supplemental Disclosures Related to Termination Provisions

An entity is not necessarily precluded from separately disclosing the amounts of refund liability within

the financial statement notes that discuss remaining performance obligations. An entity must not

indicate that the refund liabilities are part of the transaction price related to its remaining performance

obligations. However, the entity generally would not be precluded from specifying the refund liability in

its financial statement notes if it properly describes this GAAP amount.

For example, an entity might provide the disclosure below.

Illustrative Disclosure — Transaction Price Allocated to Remaining Performance Obligations

As of December 31, 20X7, approximately $4.5 million of revenue is expected to be recognized from remaining

performance obligations. The Company expects to recognize revenue on approximately 65 percent of these

amounts over the next 12 months, with the remaining balance recognized thereafter.

In addition, approximately $0.8 million is recorded as a refund liability in the Company’s consolidated balance

sheet that is not included in the above remaining performance obligations. This liability is generally related to

amounts received from customers but is associated with termination provisions for arrangements that are

cancelable at the customer’s discretion (and the Company would be required to refund such amounts).

2.10.1.3 Effect of Termination Provisions on Contract Balance Disclosures

When some of an entity’s arrangements contain termination provisions, any amounts received that

are not associated with contracts identified under step 1 of ASC 606 should be recorded as a separate

liability apart from the contract liability. Therefore, the entity would not be permitted to include the

refund liability in its contract liability balance disclosures required by ASC 606-10-50-8. However, if the

entity chooses to present a full rollforward of its contract liability, one approach may be to reclassify

the refund liability as a contract liability when the termination right lapses (i.e., when the contract is no

longer cancelable without penalty and the amounts are recharacterized as deferred revenue). Under

this approach, the reclassification of the refund liability as a contract liability would be presented in a

manner consistent with the illustrative disclosure below.

Illustrative Disclosure — Contract Liability Balance Rollforward

Changes in the contract liability balance were as follows for the years ended December 31, 20X8, and

December 31, 20X7:

December 31, 20X8

December 31, 20X7

Balance, beginning of period

$

XX

$

XX

Deferral of revenue

[*]

XX

XX

Reclassification of separate liabilities

(e.g., refund liability)

XX

XX

Recognition of unearned revenue

[**]

(XX)

(XX)

Balance, end of period

$

XX

$

XX

*

Represents consideration received from a customer, or an unconditional right to consideration

(i.e., a receivable) that is related to goods or services to be transferred to the customer in the

future.

**

Represents previously recognized contract liabilities for which the entity has transferred the

related goods or services to the customer and recognized the related revenue in the current

period.

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2.11 SEC Comment Letter Trends

Themes associated with SEC staff comments related to the revenue standard’s application include the

following:

•

Significant judgments, including those related to:

o

The identification of performance obligations (e.g., whether specified software upgrades

are separate performance obligations, why software and a related service such as PCS or

a cloud-based service have been combined as a single performance obligation, whether a

material right exists when an up-front payment is made for a SaaS arrangement, whether

implementation services provided in software or SaaS arrangements are distinct).

o

The determination of the transaction price (e.g., how estimates of variable consideration

were determined; whether variable consideration was constrained and, if so, the significant

judgments that went into the determination of the constraint and when the constraint

will be removed; whether certain incentives should be accounted for as a reduction of the

transaction price).

o

The allocation of the transaction price (e.g., how variable consideration is allocated to a

distinct service within a series for which the performance obligation is a SaaS; whether it

is appropriate to use a residual approach to estimate the stand-alone selling price of a

software license; the methods, inputs, and assumptions used to determine the stand-alone

selling price).

o

The identification of the measure of progress (e.g., why a particular method used to

recognize revenue over time provides a faithful depiction of the transfer of goods or

services).

•

Performance obligation disclosures, including those related to:

o

Timing of revenue recognition (e.g., point in time versus over time, when a customer obtains

control over a software license, method of measuring progress for services).

o

Significant payment terms (e.g., when payment is typically due, whether a significant financing

component exists, whether the amount of consideration is variable, whether the estimate of

variable consideration is typically constrained).

o

Significant financing components (e.g., if a registrant elected the practical expedient in ASC

606-10-32-18 that permits an entity not to recognize a significant financing component if the

time between the transfer of a good or service and payment is one year or less).

o

The nature of goods or services promised, including principal-versus-agent considerations

(e.g., whether the nature of a SaaS arrangement is a promise to provide access to the SaaS

or a promise to provide a specified amount of services, whether revenue is presented on

a gross or net basis, how an entity determined that it is a principal in providing payment

processing services).

•

Contract costs, including their capitalization and the related amortization period (e.g., the

method being used to amortize the capitalized costs, how the selected amortization period

correlates with the period of benefit, whether additional commissions paid upon renewal are

commensurate with the initial commissions and how such renewals are considered in the

amortization period).

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Chapter 2 — Revenue Recognition

•

Disaggregation of revenue disclosures, including those related to:

o

The determination of the categories in which to present disaggregated revenue information

(e.g., whether the categories are appropriate given an entity’s business model, whether the

categories depict how revenue and cash flows are affected by economic factors).

o

Consideration of information disclosed outside the financial statements (e.g., earnings calls,

investor presentations).

o

How to derive the product and service categories presented on the face of the statements of

operations from what has been disclosed in the footnotes.

•

Contract balance disclosures, including those associated with how the timing of satisfaction of

performance obligations is related to the timing of payment and the corresponding effects on

the contract asset and contract liability balances.

•

Remaining performance obligation disclosures, including those related to any optional

exemptions applied and when amounts are expected to be recognized.

Connecting the Dots

In the technology industry, contracts with customers typically have multiple performance

obligations. Consequently, when the SEC staff reviews the filings of registrants in the technology

industry, it may comment on the manner in which revenue is measured and recognized in such

arrangements as well as on the related disclosures. Historically, registrants have been asked to

clarify the descriptions of promised goods or services in an arrangement, how they determined

the stand-alone selling prices of those promised goods or services, and the timing of each

element’s delivery or performance.

For more information, see

Section 2.18

and

Section 6.5.1.3

of Deloitte’s Roadmap

SEC Comment Letter

Considerations, Including Industry Insights

.

316

Chapter 3 — Contract Costs

3.1 Costs of Obtaining a Contract

ASC 340-40 provides the following guidance on recognizing the incremental costs of obtaining a contract

with a customer:

ASC 340-40

25-1

An entity shall recognize as an asset the incremental costs of obtaining a contract with a customer if the

entity expects to recover those costs.

25-2

The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract

with a customer that it would not have incurred if the contract had not been obtained (for example, a sales

commission).

25-3

Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained

shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer

regardless of whether the contract is obtained.

3.1.1 Considerations for Identifying Incremental Costs of Obtaining a

Contract With a Customer

ASC 340-40-25-2 states that the “incremental costs of obtaining a contract are those costs that an entity

incurs to obtain a contract with a customer that it would not have incurred if the contract had not been

obtained (for example, a sales commission).” Application of this guidance requires an entity to identify

those costs that are incurred (i.e., accrued) as a direct result of obtaining a contract with a customer. An

entity should apply existing guidance outside of the revenue standard to determine whether a liability

should be recognized as a result of obtaining a contract with a customer. Upon determining that a

liability needs to be recorded, the entity should determine whether the related costs were incurred

because, and only because, a contract with a customer was obtained.

In many circumstances, it may be clear whether particular costs are costs that an entity incurs to

obtain a contract. For example, if an entity incurs a commission liability solely as a result of obtaining a

contract with a customer, the commission would be an incremental cost incurred to obtain a contract

with a customer. However, in other circumstances, an entity may need to exercise judgment and

consider existing accounting policies for liability accruals when determining whether a cost is incurred in

connection with obtaining a contract with a customer. If the determination of whether a cost has been

incurred is affected by other factors (i.e., factors in addition to obtaining a contract with a customer),

an entity will need to take additional considerations into account when assessing whether a cost is an

incremental cost associated with obtaining a contract with a customer.

317

Chapter 3 — Contract Costs

The FASB staff noted the following:

•

An entity should consider whether costs would have been incurred if the customer (or the

entity) decided that it would not enter into the contract just as the parties were about to sign

the contract. If the costs (e.g., the legal costs of drafting the contract) would have been incurred

even though the contract was not executed, the costs would not be incremental costs of

obtaining a contract.

•

When an entity is identifying incremental costs incurred to obtain a contract, it may be important

for the entity to first consider guidance outside of the revenue standard on determining whether

and, if so, when a liability has been incurred. That is, other guidance will generally determine

when a cost has been incurred, while ASC 340-40 provides guidance on determining whether

costs should be capitalized or expensed.

•

When sales commissions are paid to different levels of employees, the revenue standard does

not differentiate among the commissions on the basis of the employees’ respective functions

or titles. For example, if an entity’s commission policy on new contracts was to pay 10 percent

sales commission to the sales employee, 5 percent to the sales manager, and 3 percent to

the regional sales manager, all of the commissions are viewed as incremental because the

commissions would not have been incurred if the contract had not been obtained.

Entities should continue to refer to existing U.S. GAAP on liability recognition to determine whether and,

if so, when a liability needs to be recorded in connection with a contract with a customer. Therefore, an

entity should initially apply the specific guidance on determining the recognition and measurement of

the liability (e.g., commissions, payroll taxes, 401(k) match). If the entity recognizes a liability, only then

should the entity determine whether to record the related debit as an asset or as an expense.

3.1.2 Sales Commissions and Compensation Structures

Commissions are often cited as an example of an incremental cost incurred to obtain a contract. The

table below outlines the views related to whether commissions should be capitalized as detailed in

TRG Agenda Paper 57

and broadly summarized in

Implementation Q&A 78

. Quoted text is from TRG

Agenda Paper 57.

Topic

Example/Question

Views Discussed

View Selected by FASB Staff

Fixed

employee

salaries

“

Example 1:

An entity pays

an employee an annual

salary of $100,000. The

employee’s salary is based

upon the employee’s prior-

year signed contracts and

the employee’s projected

signed contracts for the

current year. The employee’s

salary will not change based

on the current year’s actual

signed contracts; however,

salary in future years likely

will be impacted by the

current year’s actual signed

contracts. What amount, if

any, should the entity record

as an asset for incremental

costs to obtain a contract

during the year?”

View A:

“Determine what

portion of the employee’s

salary is related to sales

projections and allocate that

portion of the salary as an

incremental cost to obtain a

contract.”

View B:

“Do not capitalize

any portion of the

employee’s salary as an

incremental cost to obtain a

contract. The costs are not

incremental costs to any

contract because the costs

would have been incurred

regardless of the employee’s

signed contracts in the

current year.”

View B.

“[N]one of the

employee’s salary should be

capitalized as an incremental

cost to obtain a contract. . . .

Whether the employee sells 100

contracts, 10 contracts, or no

contracts, the employee is still

only entitled to a fixed salary.”

“[T]he objective of the

requirements in [ASC] 340-40-

25-1 is not to allocate costs that

are associated in some manner

with an entity’s marketing and

sales activity. The objective is to

identify the incremental costs

that an entity would not have

incurred if the contract had not

been obtained.”

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(Table continued)

Topic

Example/Question

Views Discussed

View Selected by FASB Staff

Some, but

not all,

costs are

incremental

“

Example 2:

An entity pays

a 5% sales commission to its

employees when they obtain

a contract with a customer.

An employee begins

negotiating a contract with

a prospective customer and

the entity incurs $5,000 of

legal and travel costs in the

process of trying to obtain

the contract. The customer

ultimately enters into a

$500,000 contract and, as a

result, the employee receives

a $25,000 sales commission.

What amount should the

entity capitalize as an

incremental cost to obtain

the contract?”

View A:

“The entity should

capitalize only $25,000

for the sales commission.

Those costs are the only

costs that are incremental

costs to obtain the contract

because the entity would

not have incurred the costs

if the contract had not been

obtained.”

View B:

“The entity

should capitalize $30,000,

which includes the sales

commission, legal expenses,

and travel expenses. The

entity would not have been

able to obtain the contract

without incurring those

expenses.”

View A.

“[T]he sales commission

is the only cost that the entity

would not have incurred if the

contract had not been obtained.

While the entity incurs other

costs that are necessary to

facilitate a sale (such as legal,

travel and many others), those

costs would have been incurred

even if the customer decided at

the last moment not to execute

the contract.”

Consider a similar situation in

which an entity “incurs the same

type of legal and travel expenses

to negotiate a contract, but the

customer decides not to enter

into the contract right before

the contract was to be signed

by both parties. [T]he travel and

legal expenses would still have

been incurred even though

the contract was not obtained.

However, the commission would

not have been incurred.”

319

Chapter 3 — Contract Costs

(Table continued)

Topic

Example/Question

Views Discussed

View Selected by FASB Staff

Timing of

commission

payments

“

Example 3:

An entity pays

an employee a 4% sales

commission on all of the

employee’s signed contracts

with customers. For cash

flow management, the entity

pays the employee half of

the commission (2% of the

total contract value) upon

completion of the sale, and

the remaining half of the

commission (2% of the total

contract value) in six months.

The employee is entitled

to the unpaid commission,

even if the employee is no

longer employed by the

entity when payment is due.

An employee makes a sale

of $50,000 at the beginning

of year one. What amount

should the entity capitalize

as an incremental cost to

obtain the contract?”

View A:

“Capitalize half of

the commission ($1,000) and

expense the other half of the

commission ($1,000).”

View B:

“Capitalize the entire

commission ($2,000).”

View B.

“The commission

is an incremental cost that

relates specifically to the signed

contract and the employee

is entitled to the unpaid

commission.

[T]he timing of payment does

not impact whether the costs

would have been incurred if

the contract had not been

obtained.”

“In this fact pattern, only the

passage of time needs to

occur for the entity to pay the

second half of the commission.

However, . . . there could be

other fact patterns in which

additional factors might impact

the payment of a commission

to an employee.” For example,

an entity could make the

second half of the commission

contingent upon the employee’s

selling additional services to

the customer or upon the

customer’s “completing a

favorable satisfaction survey

about its first six months

of working with the entity.”

Therefore, an “entity will need to

assess its specific compensation

plans to determine the

appropriate accounting for

incremental costs of obtaining a

contract.”

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(Table continued)

Topic

Example/Question

Views Discussed

View Selected by FASB Staff

Commissions

paid to

different

levels of

employees

“

Example 4:

An entity’s

salesperson receives a

10% sales commission on

each contract that he or

she obtains. In addition,

the following employees

of the entity receive sales

commissions on each

signed contract negotiated

by the salesperson: 5%

to the manager and 3%

to the regional manager.

Which commissions are

incremental costs of

obtaining a contract?”

View A:

“Only the

commission paid to the

salesperson is considered

incremental because the

salesperson obtained the

contract.”

View B:

“Only the

commissions paid to

the salesperson and the

manager are considered

incremental because the

other employee likely would

have had no direct contact

with the customer.”

View C:

“All of the

commissions are

incremental because the

commissions would not have

been incurred if the contract

had not been obtained.”

View C.

“The new revenue

standard does not make a

differentiation based on the

function or title of the employee

that receives the commission. It

is the entity that decides which

employee(s) are entitled to a

commission directly as a result

of entering into a contract.”

“[I]t is possible that several

commissions payments are

incremental costs of obtaining

the same contract. However,

[stakeholders are encouraged]

to ensure that each of the

commissions are incremental

costs of obtaining a contract

with a customer, rather than

variable compensation (for

example, a bonus)” that would

not be incremental because it

also relies on factors other than

sales.

Commission

payments

subject to a

threshold

“

Example 5:

An entity has

a commission program that

increases the amount of

commission a salesperson

receives based on how many

contracts the salesperson

has obtained during

an annual period. The

breakdown is as follows:

•

0-9 contracts . . . 0%

commission

•

10-19 contracts . . .

2% of value of

contracts 1-19

•

20+ contracts . . . 5%

of value of contracts

1-20+

Which commissions are

incremental costs of

obtaining a contract?”

View A:

“No amounts should

be capitalized because the

commission is not directly

attributable to a specific

contract.”

View B:

“The costs are

incremental costs of

obtaining a contract with a

customer and, therefore, the

costs should be capitalized.”

View B.

Both the 2 percent

commission and the 5 percent

commission are incremental

costs of obtaining a contract.

“The entity would apply other

GAAP to determine whether

a liability for the commission

payments should be recognized.

When a liability is recognized,

the entity would recognize

a corresponding asset for

the commissions. This is

because the commissions are

incremental costs of obtaining

a contract with a customer.

The entity has an obligation to

pay commissions as a direct

result of entering into contracts

with customers. The fact that

the entity’s program is based

on a pool of contracts (versus

a program in which the entity

pays 3% for all contracts) does

not change the fact that the

commissions would not have

been incurred if the entity did

not obtain the contracts with

those customers.”

321

Chapter 3 — Contract Costs

Some commission plans include substantive service conditions that need to be met before a

commission associated with a contract (or group of contracts) is actually earned by the salesperson.

In such cases, some or all of the sales commission may not be incremental costs incurred to obtain

a contract with the customer since the costs were not actually incurred solely as a result of obtaining

a contract with a customer. Rather, the costs were incurred as a result of obtaining a contract with a

customer

and

the salesperson’s providing ongoing services to the entity for a substantive period.

A commission structure could have a service condition that is determined to be nonsubstantive. In such

a case, the commission is likely to be an incremental cost incurred to obtain a contract with a customer

if no other conditions need to be met for the salesperson to earn the commission. In other cases, a

commission plan could include a service condition, but the reporting entity determines on the basis of

the amount and structure of the commission payments that part of the entity’s commission obligation is

an incremental cost incurred to obtain a contract with a customer (because it is

not

tied to a substantive

service condition) while the rest of the commission is associated with ongoing services provided by the

salesperson (because it is tied to a substantive service condition).

Sometimes, there may be other factors that affect the commission obligation, but the ultimate costs

are still incremental costs incurred to obtain the contract. For example, a commission may be payable

to a salesperson if a customer’s total purchases exceed a certain threshold regardless of whether the

salesperson is employed when the threshold is met (i.e., there is no service condition). In these cases,

although no liability may be recorded when the contract with the customer is obtained (because of the

entity’s assessment of the customer’s likely purchases), if the customer’s purchases ultimately exceed

the threshold and the commission is paid, the commission is an incremental cost of obtaining the

contract. That is, the commission is a cost that the entity would not have incurred if the contract had not

been obtained. This situation is economically similar to one involving a paid commission that is subject

to clawback if the customer does not purchase a minimum quantity of goods or services.

Entities will need to carefully evaluate the facts and circumstances when factors other than just

obtaining a contract with a customer affect the amount of a commission or other incurred costs. Entities

should consider their existing policies on accruing costs when determining which costs are incremental

costs incurred to obtain a contract with a customer.

Example 3-1

Entity A’s internal salespeople earn a commission based on a fixed percentage (4 percent) of sales invoiced to

a customer. Half of the commission is paid when a contract with a customer is signed; the other half is paid

after 12 months, but only if the salesperson is still employed by A. Entity A concludes that there is a substantive

service period associated with the second commission payment, and A’s accounting policy is to accrue the

remaining commission obligation ratably as the salesperson provides ongoing services to A.

Entity A enters into a three-year noncancelable service contract with a customer on January 1, 20X7. The total

transaction price of $3 million is invoiced on January 1, 20X7. The salesperson receives a commission payment

of 2 percent of the invoice amount ($60,000) when the contract is signed; the other 2 percent commission

payment will be made after 12 months if the salesperson continues to be employed by A at that time. That

is, if the salesperson is not employed by A on January 1, 20X8, the second commission payment will not be

made. Entity A records a commission liability of $60,000 on January 1, 20X7, and accrues the second $60,000

commission obligation ratably over the 12-month period from January 1, 20X7, through December 31, 20X7.

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Example 3-1 (continued)

Entity A concludes that only the first $60,000 is an incremental cost incurred to obtain a contract with a

customer and would be capitalized in accordance with ASC 340-40-25-1. Because there is a substantive

service condition associated with the second $60,000 commission, A concludes that the additional cost is a

compensation cost incurred in connection with the salesperson’s ongoing service to A. That is, the second

$60,000 commission obligation was not incurred solely to obtain a contract with a customer but was incurred

in connection with ongoing services provided by the salesperson.

If the salesperson would be paid the commission even if no longer employed, or if A otherwise concluded

that the service condition was not substantive, the entire $120,000 would be an incremental cost incurred to

obtain a contract and would be capitalized in accordance with ASC 340-40-25-1. Entities will need to exercise

professional judgment when determining whether a service condition is substantive.

Because commission and compensation structures can vary significantly between entities, an entity

should evaluate its specific facts and circumstances when determining which costs are incremental costs

incurred to obtain a contract with a customer. Since many entities pay sales commissions to obtain

contracts with customers, questions have arisen regarding how to apply the revenue standard’s cost

guidance to such commissions, including:

•

Whether certain commissions (e.g., commissions on contract renewals or modifications,

commission payments that are contingent on future events, and commission payments that are

subject to clawback or thresholds) qualify as assets.

•

The types of costs to capitalize (e.g., whether and, if so, how an entity should consider fringe

benefits such as payroll taxes, pension, or 401(k) match) in determining the amount of

commissions to record as incremental costs.

•

The pattern of amortization for assets related to multiple performance obligations (e.g., for

contract cost assets related to multiple performance obligations that are satisfied over disparate

points or periods of time).

Entities should continue to first refer to existing U.S. GAAP on liability recognition to determine whether

and, if so, when a liability from a contract with a customer needs to be recorded. For example, an entity

would apply the specific U.S. GAAP on liability recognition (e.g., commissions, payroll taxes, 401(k) match)

and then determine whether to record the related debit as an asset or expense.

In addition, the revenue standard is clear that (1) an entity should amortize the asset on a systematic

basis and (2) the method should reflect the pattern of transfer of goods or services to a customer to

which the asset is related. That is, the asset should be amortized in a manner that reflects the benefit

(i.e., revenue) generated from the asset.

3.1.2.1 Tiered Commissions

Commission plans for a specific employee that involve initial contracts and contract renewals might

be established in such a way that (1) the commission is subject to a cumulative contract threshold and

(2) commission rates change depending on the number (or cumulative value) of contracts signed. For

instance, fixed or percentage commissions may commence or change once a specified threshold is

achieved for the cumulative number or value of contracts. The examples below, which are adapted from

examples considered by the FASB staff in

TRG Agenda Paper 23

, illustrate various cumulative threshold

scenarios.

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Example 3-2

Once a cumulative threshold

number

of contracts is reached, the entity pays commissions on individual

contracts as a percentage of the value of

each

contract in the manner shown in the table below.

Number of Contracts Signed

Commission Rate

1–5

0% commission

6–10

3% of each individual contract price

11 or more

5% of each individual contract price

Example 3-3

Once a cumulative threshold

value

of contracts is reached, the entity pays commissions on individual contracts

as a percentage of the value of

each

contract in the manner shown in the table below.

Value of Contracts Signed

Commission Rate

First $1 million

0% commission

Next $4 million

3% of each individual contract price

More than $5 million

5% of each individual contract price

Example 3-4

Once a cumulative threshold number of contracts is reached, the entity pays commissions on the last contract

as a percentage of the

cumulative value of that contract and the preceding contracts

in the manner

shown in the table below, taking into account any commission already paid.

Number of Contracts Signed

Commission Rate

1–5

0% commission

6

3% of the total contract price of contracts 1–6

7–10

0% commission

11 or more

5% of the total contract price of all contracts

(including commission already paid on

contracts 1–6)

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Example 3-5

As shown in the table below, the entity pays the first commission when the first contract is signed.

Subsequently, once a cumulative threshold number of contracts is reached, the entity pays a commission on

the threshold contract that is greater than the commission paid on the initial contract and takes into account

any commissions previously paid. In this example, it is assumed that the entity has no history of its sales

employees’ closing more than 15 new contracts in a period.

Number of Contracts Signed

Commission Amount

1

$

3,000

10

$

5,000

cumulative commission

(including $3,000 already paid)

15

$

10,000

cumulative commission

(including $5,000 already paid)

Assume that the commissions in all of the examples above are incremental costs incurred to obtain a

contract that should be capitalized in accordance with ASC 340-40-25-1.

There are at least two acceptable approaches to determining which commissions are incremental

to obtaining a contract in the scenarios described above. One approach (“Approach A”) would be

to specifically attribute the incremental costs of each contract to that contract. For example, if no

commission is paid until the fifth contract is signed, the commission would be attributed to only the fifth

contract. Another approach (“Approach B”) would be to accrue commission for each contract on the

basis of the average commission rate expected to be paid under the commission plan. For example,

although a commission is paid only once the fifth contract is signed, the commission is earned, and

would be accrued, as contracts 1 through 5 are signed. Entities should consider their historical policies

for recording commission liabilities when determining which approach to apply.

Under the two alternative approaches, the entity in each of the illustrative examples above should

account for the tiered commissions as follows:

•

Example 3-2

:

o

Approach A

— When the 6th contract is signed, the entity should capitalize 3 percent of the

price of that contract and successive contracts as an incremental cost of obtaining a contract

until the 11th contract is signed, at which point the entity should capitalize 5 percent of the

price of that contract and successive contracts.

o

Approach B

— The entity should estimate the total amount of commission to be earned for

the period and capitalize a ratable amount of commission costs upon the signing of each

contract. For example, if the entity estimates that seven contracts, each valued at $10,000,

will be signed and therefore the total estimated price of the 6th and 7th contract is $20,000,

it estimates the total commission to be capitalized as $600 ($20,000 × 3% commission). Upon

the signing of each $10,000 contract, the entity may capitalize $86 of commission ($600 total

estimated commission ÷ the 7 expected contracts signed = $86 estimated commission per

contract).

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•

Example 3-3

:

o

Approach A

— Upon the signing of the specific contract that results in the aggregate value

of over $1 million in contract value, the entity should capitalize 3 percent of the price of that

contract and successive contracts as an incremental cost of obtaining a contract until the $5

million aggregate value is reached, at which point the entity should capitalize 5 percent of the

price of that contract and successive contracts.

o

Approach B

— The entity should estimate the total amount of commission to be earned for

the period and capitalize a ratable amount of commission costs upon the signing of each

contract. For example, if the entity estimates that three contracts will be signed with an

aggregate of $4 million in contract value (contract 1 is $1 million, contract 2 is $1 million, and

contract 3 is $2 million), the entity will estimate $90,000 in commissions to be capitalized,

or ($4 million − $1 million) × 3% commission. The entity may capitalize the relative value for

each contract:

▪

Contract 1: ($1 million ÷ $4 million) × $90,000 = $22,500.

▪

Contract 2: ($1 million ÷ $4 million) × $90,000 = $22,500.

▪

Contract 3: ($2 million ÷ $4 million) × $90,000 = $45,000.

•

Example 3-4

:

o

Approach A

— When the 6th contract is signed, the entity should capitalize 3 percent of

the cumulative prices of contracts 1 through 6 as an incremental cost of obtaining the 6th

contract. Similarly, when the 11th contract is signed, the entity should capitalize 5 percent

of the cumulative prices of contracts 1 through 11 (less the 3 percent previously paid on

contracts 1 through 6) as an incremental cost of obtaining the 11th contract. Further, the

entity should capitalize 5 percent of the price of each successive contract (beyond the 11th

contract) as an incremental cost of obtaining a contract.

o

Approach B

— The entity should estimate the total amount of commission to be earned for

the period and capitalize a ratable amount of commission costs upon the signing of each

contract. For example, if the entity estimates that eight contracts will be signed and the

estimated cumulative prices of contracts 1 through 6 will be $32,000, it will estimate $960

in commissions to be capitalized ($32,000 × 3% commission = $960). If the price of each

contract is the same, the entity may capitalize $120 upon the signing of each contract ($960

total estimated commission ÷ the 8 expected contracts signed = $120 estimated commission

per contract).

•

Example 3-5

:

o

Approach A

— Once the initial contract is signed, the entity should capitalize $3,000 as an

incremental cost of obtaining that contract. The entity would not capitalize any additional

amounts when contracts 2 through 9 are signed because the next commission “tier” has not

been met. Once the 10th contract is signed, the entity should capitalize an additional $2,000.

Similarly, the entity would not capitalize any additional amounts when contracts 11 through

14 are signed and should capitalize an additional $5,000 once the 15th contract is signed.

o

Approach B

— The entity should estimate the total amount of commission to be earned for

the period and capitalize a ratable amount of commission costs upon the signing of each

contract. For example, if the entity estimates that 11 contracts will be signed and the price

of each contract is the same, it may capitalize $455 when each contract is signed ($5,000 ÷

the 11 expected contracts signed = $455 to be capitalized as the commission amount per

contract).

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3.1.2.2 Fringe Benefits

The example below illustrates the determination of whether fringe benefits such as 401(k) match

contributions associated with sales commissions should be capitalized as incremental costs of obtaining

contracts with customers.

Example 3-6

Entity C has a policy to match 401(k) contributions based on salaries paid to sales representatives, including

sales commissions. These sales commissions are determined to meet the definition of incremental costs of

obtaining contracts with customers in ASC 340-40-25-2 and are therefore capitalized in accordance with ASC

340-40-25-1.

When 401(k) match contributions (along with other fringe benefits) are attributed directly to sales commissions

that are determined to be incremental costs of obtaining contracts with customers, the 401(k) match

contributions also qualify as incremental costs of obtaining the contracts since such costs would not have

been incurred if the contracts had not been obtained. However, incremental costs of obtaining contracts with

customers would not include fringe benefits constituting an allocation of costs that would have been incurred

regardless of whether a contract with a customer had been obtained.

3.1.3 Practical Expedient in ASC 340-40-25-4 for Expensing Contract

Acquisition Costs

If an entity elects the practical expedient of expensing incremental costs of obtaining a contract when

incurred because the amortization period of the asset would have been one year or less, the entity is

also required, under ASC 606-10-50-22, to disclose such election. In addition, the practical expedient

should be applied consistently to contracts with similar characteristics and in similar circumstances.

The identification of contracts with similar characteristics and the evaluation of similar circumstances

should be performed as an entity-wide assessment. An entity with multiple subsidiaries or business

units that operate in multiple jurisdictions might determine that different subsidiaries or business units

have contracts with dissimilar characteristics or circumstances.

However, it is not permitted to apply the practical expedient selectively on a contract-by-contract basis.

Further, an entity is not permitted to apply the practical expedient in ASC 340-40-25-4 to some costs

attributable to performance obligations in a contract but not others. The incremental costs of obtaining

a contract, which are required to be capitalized in accordance with ASC 340-40-25-1, are related to

the contract as a whole. These capitalized costs of obtaining a contract form a single asset regardless

of whether the contract contains more than one performance obligation. The practical expedient

is available only if the amortization period of the entire asset that the entity otherwise would have

recognized is one year or less.

Example 3-7 below illustrates a situation in which the practical expedient in ASC 340-40-25-4 would not

be available.

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Chapter 3 — Contract Costs

Example 3-7

Entity B enters into a contract with a customer to provide the following:

•

Product X delivered at a point in time.

•

Maintenance of Product X for one year.

•

An extended warranty on Product X that covers years 2 and 3 (Product X comes with a one-year

statutory warranty).

Each of the elements is determined to be a separate performance obligation.

A sales commission of $200 is earned by the salesperson. This represents $120 for the sale of Product X

(payable irrespective of whether the customer purchases the maintenance or extended warranty) and an

additional $40 each for the sale of the maintenance contract and the sale of the extended warranty ($80

commission for the sale of both).

The commission is determined to meet the definition of an incremental cost of obtaining the contract in ASC

340-40-25-2 and is therefore capitalized in accordance with ASC 340-40-25-1.

In this fact pattern, the entity cannot elect the practical expedient in ASC 340-40-25-4 to expense costs as

incurred because the amortization period of the asset that the entity would recognize is more than one

year (i.e., the extended warranty performance obligation included in the contract is for years 2 and 3). The

entity may, however, determine that it is appropriate to attribute the asset created by the commission to the

individual performance obligations and record amortization of the asset in an amount that corresponds to the

revenue recognized as each good or service is transferred to the customer.

As previously noted, an entity is precluded from using the practical expedient in ASC 340-40-25-4 if the

amortization period of the asset that the entity otherwise would have recognized is greater than one

year. This restriction applies even if the amortization period is only slightly greater than one year.

Example 3-8

Entity A enters into a noncancelable contract with a customer to provide marketing services for 13 months.

A commission of $100 is earned by the salesperson in connection with A’s entering into the contract with

the customer. The commission is determined to meet the definition of an incremental cost of obtaining

the contract in ASC 340-30-25-2 and is therefore capitalized in accordance with ASC 340-40-25-1. Entity A

concludes that the asset is related to the entire contract to provide 13 months of marketing services.

In this fact pattern, the entity cannot elect the practical expedient in ASC 340-40-25-4 to expense costs as

incurred since the amortization period of the asset that the entity would otherwise recognize is more than one

year (i.e., the 13 months in which marketing services are being performed).

3.1.4 Using the Portfolio Approach When Accounting for Contract Costs

ASC 340-40-05-1 expressly indicates that ASC 340-40 is aligned with ASC 606, stating that “[t]his

Subtopic provides accounting guidance for the following costs related to a contract with a customer

within the scope of Topic 606 on revenue from contracts with customers.” ASC 606 is applied at the

individual contract level (or to a combination of contracts accounted for under ASC 606-10-25-9). In

addition, ASC 606-10-10-4 allows an entity to apply, as a practical expedient, the revenue recognition

guidance to a portfolio of contracts rather than an individual contract. The practical expedient can only

be used “if the entity reasonably expects that the effects on the financial statements of applying [the

revenue recognition guidance] to the portfolio would not differ materially from applying [the revenue

recognition guidance] to the individual contracts (or performance obligations) within that portfolio.”

In addition, ASC 606-10-10-3 states that an “entity shall apply this guidance, including the use of any

practical expedients, consistently to contracts with similar characteristics and in similar circumstances.”

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If an entity reasonably expects that contract costs recorded under a portfolio approach would not differ

materially from contract costs that would be recorded individually, it may apply a portfolio approach

to account for the costs. The entity would use judgment in determining the characteristics of the

portfolio in a manner similar to its assessment of whether a portfolio satisfies the requirements in ASC

606-10-10-4.

In applying the portfolio approach, an entity should consider paragraph BC69 of

ASU 2014-09

, which

states that the FASB and IASB “did not intend for an entity to quantitatively evaluate each outcome

and, instead, the entity should be able to take a reasonable approach to determine the portfolios that

would be appropriate for its types of contracts.” In determining the characteristics and composition

of the portfolio, an entity should consider the nature and timing of costs incurred and the pattern of

transferring control of the related good or service to the customer (e.g., amortization of the capitalized

costs).

3.1.5 Determining When to Recognize and How to Measure Incremental

Costs

Arrangements for the payment of some incremental costs of obtaining a contract may be complex.

For example, payment of a sales commission may be (1) contingent on a future event, (2) subject to

clawback, or (3) based on achieving cumulative targets.

The revenue standard does not address when to initially recognize the incremental costs of obtaining

a contract. Rather, ASC 340-40 only addresses which costs to capitalize and subsequent recognition of

amortization or impairment expense. Therefore, other Codification topics (e.g., ASC 275, ASC 710, ASC

712, ASC 715, and ASC 718) specify when a liability for costs should be recognized and how that liability

should be measured.

If an entity concludes that a liability for incremental costs of obtaining a contract should be recognized

under the relevant Codification topic, the guidance in ASC 340-40-25-1 should be applied to determine

whether those recognized costs should be capitalized as an asset or recognized immediately as an

expense.

3.2 Costs of Fulfilling a Contract

ASC 340-40 provides the following guidance on recognizing the costs incurred in fulfilling a contract with

a customer:

ASC 340-40

15-3

The guidance in this Subtopic applies to the costs incurred in fulfilling a contract with a customer within

the scope of Topic 606 on revenue from contracts with customers, unless the costs are within the scope of

another Topic or Subtopic, including, but not limited to, any of the following:

a.

Topic 330 on inventory

b. Paragraphs 340-10-25-1 through 25-4 on preproduction costs related to long-term supply

arrangements

c.

Subtopic 350-40 on internal-use software

d. Topic 360 on property, plant, and equipment

e. Subtopic 985-20 on costs of software to be sold, leased, or otherwise marketed.

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ASC 340-40 (continued)

25-5

An entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet all of

the following criteria:

a. The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify

(for example, costs relating to services to be provided under renewal of an existing contract or costs of

designing an asset to be transferred under a specific contract that has not yet been approved).

b. The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to

satisfy) performance obligations in the future.

c.

The costs are expected to be recovered.

25-6

For costs incurred in fulfilling a contract with a customer that are within the scope of another Topic (for

example, Topic 330 on inventory; paragraphs 340-10-25-1 through 25-4 on preproduction costs related to

long-term supply arrangements; Subtopic 350-40 on internal-use software; Topic 360 on property, plant, and

equipment; or Subtopic 985-20 on costs of software to be sold, leased, or otherwise marketed), an entity shall

account for those costs in accordance with those other Topics or Subtopics.

25-7

Costs that relate directly to a contract (or a specific anticipated contract) include any of the following:

a. Direct labor (for example, salaries and wages of employees who provide the promised services directly

to the customer)

b. Direct materials (for example, supplies used in providing the promised services to a customer)

c.

Allocations of costs that relate directly to the contract or to contract activities (for example, costs of

contract management and supervision, insurance, and depreciation of tools and equipment used in

fulfilling the contract)

d. Costs that are explicitly chargeable to the customer under the contract

e. Other costs that are incurred only because an entity entered into the contract (for example, payments

to subcontractors).

25-8

An entity shall recognize the following costs as expenses when incurred:

a. General and administrative costs (unless those costs are explicitly chargeable to the customer under the

contract, in which case an entity shall evaluate those costs in accordance with paragraph 340-40-25-7)

b. Costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the

price of the contract

c.

Costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in

the contract (that is, costs that relate to past performance)

d. Costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance

obligations or to satisfied performance obligations (or partially satisfied performance obligations).

Because the FASB and IASB did not intend to reconsider cost guidance altogether, the revenue standard

focuses on costs of fulfilling a contract that is not within the scope of another standard. Accordingly,

if costs are within the scope of another standard and that standard requires them to be expensed,

it is not possible to argue that they should be capitalized in accordance with ASC 340-40. In addition,

only costs directly related to a contract or anticipated contract with a customer are within the scope

of ASC 340-40. Costs not directly related to a contract or anticipated (specified) contract should not be

evaluated for capitalization under ASC 340-40. Further, when determining whether fulfillment costs are

within the scope of ASC 340-40, the reporting entity should also consider its relationship with the other

entity in the arrangement. That is, if the reporting entity incurs costs and transfers consideration to

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another entity, and that other entity also transfers consideration to the reporting entity in exchange for

goods or services, the reporting entity should consider whether the consideration exchanged between

the two parties should be accounted for as (1) consideration payable to a customer under ASC 606 or

(2) consideration received from a vendor under ASC 705-20.

Connecting the Dots

Stakeholders have questioned whether costs incurred for an anticipated contract (e.g., costs

for design and development or nonrecurring engineering) (1) would be within the scope of

ASC 340 and therefore could be capitalized or (2) should be expensed in accordance with

ASC 730. The costs incurred for an anticipated contract would pertain to a contract that is

not yet obtained and whose terms might not yet be known. Factors for an entity to consider

in determining whether the costs should be capitalized include, but are not limited to, (1) the

likelihood or certainty that the entity will obtain the contract, (2) the likelihood that the costs will

be recovered under the specific anticipated contract, (3) whether the costs create or enhance

an asset that will be transferred to the customer once the entity obtains the contract (such costs

could be capitalizable under other guidance), and (4) whether the costs are considered to be

costs associated with research and development (R&D) and would therefore be within the scope

of ASC 730 and expensed as incurred. An entity will need to carefully consider the facts and

circumstances of the arrangement in determining the appropriate treatment of costs incurred

before a contract is obtained.

Example 2 in ASC 340-40 illustrates how to account for costs of fulfilling a contract.

ASC 340-40

Example 2 — Costs That Give Rise to an Asset

55-5

An entity enters into a service contract to manage a customer’s information technology data center for five

years. The contract is renewable for subsequent one-year periods. The average customer term is seven years.

The entity pays an employee a $10,000 sales commission upon the customer signing the contract. Before

providing the services, the entity designs and builds a technology platform for the entity’s internal use that

interfaces with the customer’s systems. That platform is not transferred to the customer but will be used to

deliver services to the customer.

Costs to Fulfill a Contract

55-7

The initial costs incurred to set up the technology platform are as follows:

Design services

$

40,000

Hardware

120,000

Software

90,000

Migration and testing of data center

100,000

Total costs

$

350,000

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ASC 340-40

55-8

The initial setup costs relate primarily to activities to fulfill the contract but do not transfer goods or

services to the customer. The entity accounts for the initial setup costs as follows:

a.

Hardware costs — accounted for in accordance with Topic 360 on property, plant, and equipment

b.

Software costs — accounted for in accordance with Subtopic 350-40 on internal-use software

c.

Costs of the design, migration, and testing of the data center — assessed in accordance with paragraph

340-40-25-5 to determine whether an asset can be recognized for the costs to fulfill the contract. Any

resulting asset would be amortized on a systematic basis over the seven-year period (that is, the five-

year contract term and two anticipated one-year renewal periods) that the entity expects to provide

services related to the data center.

55-9

In addition to the initial costs to set up the technology platform, the entity also assigns two employees who

are primarily responsible for providing the service to the customer. Although the costs for these two employees

are incurred as part of providing the service to the customer, the entity concludes that the costs do not

generate or enhance resources of the entity (see paragraph 340-40-25-5(b)). Therefore, the costs do not meet

the criteria in paragraph 340-40-25-5 and cannot be recognized as an asset using this Topic. In accordance

with paragraph 340-40-25-8, the entity recognizes the payroll expense for these two employees when incurred.

3.2.1 Variable Consideration and Uncertain Transaction Price

As noted above, an entity would need to be able to demonstrate whether any capitalized costs are

recoverable. That is, the entity’s contract with a customer needs to generate sufficient profit to recover

any capitalized costs. Otherwise, no asset should be recorded or a recorded asset would be impaired.

Determining whether capitalized costs are recoverable may be challenging when the contract contains

variable consideration rather than fixed consideration.

When an entity enters into a contract with a customer to provide goods or services for variable

consideration and the transaction price is fully or partially constrained at the time the customer obtains

control of the goods or services, the entity may incur an up-front loss until the uncertainty associated

with the variable consideration is resolved. That is, the amount of the asset(s) derecognized or fulfillment

costs recognized exceeds the amount of revenue to be recognized on the date the entity satisfies its

performance obligation(s) because of the application of the constraint on variable consideration.

An entity should not defer costs associated with transferred goods or services in a contract when

variable consideration is fully or partially constrained. Rather, an entity should expense costs that are

not eligible for capitalization under other authoritative literature (e.g., ASC 330 on inventory; ASC 360

on property, plant, and equipment; or ASC 985-20 on costs of software to be sold, leased, or otherwise

marketed) unless (1) such costs meet the criteria to be capitalized in accordance with ASC 340-40

1

or

(2) the resolution of uncertainty giving rise to the constraint on variable consideration will result in the

entity’s recovery of an asset (e.g., a sales return).

1

ASC 340-40-25-6 indicates that when costs incurred to fulfill a contract with a customer are within the scope of any other Codification topics or

subtopics, such costs should be accounted for in accordance with those other topics or subtopics.

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Example 3-9

Entity A, a manufacturer, sells hardware and related components to Customer B, a distributor, for resale to

B’s customers. The manufacturer is required to recognize revenue when, after consideration of the indicators

of control in ASC 606-10-25-30, it determines that control of hardware and related components has been

transferred to the distributor.

Entity A enters into a contract with B to sell hardware and related components with a cost basis of $180,000 for

consideration of $200,000. However, the hardware and related components have a high risk of obsolescence,

which may cause A to provide rebates or price concessions to B in the future (i.e., the transaction price is

variable). The contract does not include a provision for product returns, and A does not expect to accept any

return of obsolete goods.

Entity A adjusts (i.e., constrains) the transaction price and concludes that it is probable that $170,000 is the

amount of consideration that will not be subject to a significant revenue reversal. When control of the hardware

and related components is transferred to B, A recognizes revenue of $170,000 (the constrained transaction

price) and costs of $180,000.

2

As a result, A incurs a loss of $10,000.

3.2.2 Initial Losses and Expected Future Profits

Questions arise about whether losses incurred on an initially satisfied performance obligation can be

capitalized when an entity is expected to generate profits on the sale of optional goods or services to a

customer. This scenario is illustrated in the example below.

Example 3-10

Entity E’s business model includes the sale of (1) hardware and (2) parts needed to operate that hardware. It

is possible for customers to source parts from other suppliers, but customers will almost always choose to

purchase parts from E (the OEM). The parts are needed for the hardware to properly function for its expected

economic life.

Entity E’s business model is to sell the hardware at a significantly discounted price (less than the cost to

manufacture the hardware) when E believes that doing so is likely to secure a profitable stream of parts sales.

This initial contract is only for the hardware; it does not give E any contractual right to require that customers

subsequently purchase any parts. However, E’s historical experience indicates that (1) customers will virtually

always subsequently purchase parts and (2) the profits on the parts sales will more than compensate for the

discount given on the hardware.

The hardware has a cost of $200 and would usually be sold for a profit. However, the equipment is sold at a

discounted price of $150 if subsequent parts sales are expected.

When the hardware is sold for $150, E is

not

permitted to defer an element of the cost of $200 to reflect its

expectation that this sale will generate further, profitable sales in the future.

In accordance with ASC 340-40-25-6, when the costs of fulfilling a contract are within the scope of another

standard, they should be accounted for in accordance with that standard. In the circumstances described,

the cost of $200 is within the scope of ASC 330 and must be expensed when the hardware is sold. Further,

ASC 340-40-25-8(c) requires “[c]osts that relate to satisfied performance obligations (or partially satisfied

performance obligations) in the contract (that is, costs that relate to past performance)” to be expensed when

incurred.

Although E expects customers to purchase additional parts that will give rise to future profits, those additional

purchases are at the customer’s option and are not part of the contract to sell the hardware. Since E has

satisfied its obligation to deliver the hardware, it is required to recognize revenue of $150 and the $200 cost in

full.

Consequently, a loss of $50 arises on the initial sale of the hardware.

2

The entity may need to consider applying the impairment guidance in ASC 330 to similar hardware and related components held in inventory.

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3.2.3 Contracts Satisfied Over Time

ASC 340-40-25-8(c) requires fulfillment costs attributed to satisfied (or partially satisfied) performance

obligations to be expensed as incurred. In addition, the revenue standard requires fulfillment costs to be

evaluated for expense or deferral independently of the recording of the associated revenue.

3.2.3.1 Recognition of Fulfillment Costs Incurred Before the Transfer of Goods or

Services When Revenue Is Recognized Over Time

ASC 340-40-25-7 provides various examples of contract fulfillment costs, including direct labor, direct

materials, and allocations of costs that are directly related to the contract (e.g., insurance, depreciation

of tools and equipment used). In some contracts, fulfillment costs (e.g., implementation or other set-up

costs) may be incurred before an entity begins satisfying its performance obligation. Further, in some

cases, the costs incurred will enhance a resource of the entity that the entity will use in satisfying its

performance obligation(s) to the customer.

An entity may need to exercise significant professional judgment when determining whether fulfillment

costs incurred enhance a resource of the entity that the entity will use in satisfying its performance

obligation(s) to the customer. To evaluate whether fulfillment costs meet the criterion in ASC 340-40-

25-5(b) for capitalization, an entity should consider whether the costs (1) generate or enhance a

resource (i.e., an asset, including a service) that will be transferred to the customer or (2) will be

used by the entity in connection with transferring goods or services to the customer. The following

considerations may be helpful in the evaluation:

•

Is the customer’s ability to benefit from the fulfillment activities limited to the use of the entity’s

service? If the customer cannot benefit from the entity’s fulfillment activities other than from the

use of the entity’s service, the fulfillment costs may be enhancing the entity’s resources.

•

Do the fulfillment activities expand the entity’s service capabilities? If the fulfillment activities are

required before the entity can begin transferring services to the customer and they expand the

entity’s service capacity, the related fulfillment costs would most likely enhance a resource of the

entity that the entity will use in satisfying its performance obligation(s) to the customer.

We do not believe that an entity needs to have physical custody of an enhanced resource for fulfillment

costs to qualify for capitalization under ASC 340-40-25-5(b). For example, the criterion in ASC 340-40-

25-5(b) could be met if the enhancements are made at the customer’s location but will be used by the

entity in connection with satisfying the performance obligation(s).

If the costs generate or enhance a resource that will be transferred to the customer, they may not

enhance a resource

of the entity

that the entity will use in satisfying its performance obligation(s) to the

customer. Such costs may still initially meet the criteria for capitalization (under either ASC 340-40 or

other U.S. GAAP), but such costs would typically be recognized as an expense once the related asset is

transferred to the customer.

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Example 3-11

Entity P enters into a four-year contract with a customer to provide hosted software services. Before the

hosted software services can begin, P is required to perform implementation services, which create interfaces

between the customer’s infrastructure and P’s hosted software. The implementation services will not transfer

to the customer a good or service that is distinct because the customer can only benefit from the interface

connection through the use of the hosted software services. For the implementation services, P charges the

customer $600, which is included in the overall transaction price that is allocated to the performance obligation

to provide hosted software services. Entity P incurs fulfillment costs of $500 to perform the implementation

services.

Because the implementation services do not transfer a distinct good or service to the customer, the fulfillment

costs of $500 do not enhance a resource that will be controlled by the customer. Rather, the fulfillment costs

enhance a resource that P will use to satisfy its performance obligation. Therefore, the fulfillment costs of $500

meet the criterion in ASC 340-40-25-5(b) for capitalization.

3.2.3.2 Costs Incurred to Fulfill a Combined Performance Obligation Satisfied

Over Time

ASC 340-40-25-8(c) indicates that an entity should not capitalize costs related to completely or partially

satisfied performance obligations. Further, ASC 340-40-25-8(d) requires an entity to expense costs when

incurred if the entity cannot determine whether the costs are related to past performance or to future

performance. Accordingly, if an entity incurs costs related to past performance or cannot determine

whether the costs are related to past performance or to future performance, the entity should expense

the costs when incurred rather than capitalize them.

In some arrangements, costs (other than set-up costs) are incurred at or around the time an entity

begins to satisfy a performance obligation. For example, an entity may physically deliver hardware

used as part of a combined performance obligation to provide services (e.g., an integrated security

monitoring solution) to a customer over time. That is, the hardware is not distinct; rather, it forms

part of a combined performance obligation that is satisfied over time. The hardware may be recorded

by the entity as inventory before it is physically transferred to the customer and would typically be

derecognized by the entity once it is physically delivered to the customer since it would most likely be a

fulfillment cost.

Depending on the facts and circumstances, it may or may not be acceptable under ASC 340-40 for an

entity to capitalize initial fulfillment costs incurred when the costs are related to part of a combined

performance obligation that will be satisfied over time. Generally, before delivery, the asset to which

the fulfillment costs are related (e.g., hardware) is held in the entity’s inventory and is therefore within

the scope of the inventory accounting guidance of ASC 330. However, once the asset is physically

transferred to the customer, the asset may no longer be within the scope of ASC 330.

We observe that when the guidance in ASC 330 is applicable, ASC 330-10-10-1 and ASC 330-10-35-2 are

particularly relevant to the determination of when to recognize the cost (i.e., expense) of the asset. ASC

330-10-10-1 states:

A major objective of accounting for inventories is the proper determination of income through the process of

matching appropriate costs against revenues.

ASC 330-10-35-2 states, in part:

The cost basis of recording inventory ordinarily achieves the objective of a proper matching of costs and

revenues.

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Because the cost should be recognized with the related revenue, we believe that it may sometimes be

acceptable to defer the cost.

In addition, we believe that in some cases, the asset may no longer be within the scope of ASC 330

once it is deployed in a specific customer contract (i.e., once it is shipped to a customer). At this point,

the costs related to the asset could be evaluated as contract fulfillment costs in accordance with ASC

340-40.

If ASC 340-40 is applicable, an entity should consider the three criteria in ASC 340-40-25-5 to determine

whether capitalization of the costs is appropriate. Generally, the asset to which the costs are related

is physically delivered to the customer as part of a specific contract with that customer; therefore,

criterion (a) is met. Further, if the entity expects to recover the costs of the delivered asset through the

transaction price, the entity would conclude that criterion (c) is met.

Unlike the evaluations of criteria (a) and (c), respectively, which are relatively straightforward, the

evaluation of whether criterion (b) is met (i.e., whether the costs generate or enhance a resource of the

entity that the entity will use to satisfy its performance obligation in the future) generally requires more

judgment. An entity should consider the following factors to determine whether the asset delivered

to the customer generates or enhances a resource of the entity that the entity will use to satisfy its

performance obligation in the future (e.g., to provide the ongoing service):

•

Is the customer’s ability to benefit from the fulfillment activities limited to the use of the entity’s

service? If the customer cannot benefit from the entity’s fulfillment activities other than from the

use of the entity’s service, the fulfillment costs may be enhancing the entity’s resources.

•

Do the fulfillment activities expand the entity’s service capabilities? If the fulfillment activities are

required before the entity can begin transferring services to the customer and they expand the

entity’s service capacity, the related fulfillment costs would most likely enhance a resource of the

entity that the entity will use in satisfying its performance obligation(s) to the customer.

We also believe that the following additional factors are relevant to the determination of whether

capitalization of the fulfillment costs is appropriate:

•

Does the activity that results in the delivery of the asset to the customer factor into the entity’s

measure of progress toward complete satisfaction of the performance obligation? For example,

the entity may demonstrate that the fulfillment costs enhance a resource that will be used to

satisfy the entity’s performance obligation in the future if the entity does not begin satisfying its

performance obligation until the asset is delivered to the customer.

•

Does the entity still have some level of control or influence over the asset once the asset

is physically delivered to the customer? Although the asset is physically delivered to the

customer, the entity may be providing a service that requires the entity to integrate the asset

and the service to deliver a combined output (e.g., because the asset and service are highly

interdependent or highly interrelated). The entity may conclude that by transferring a combined

service to the customer (e.g., a service that the entity delivers by using both hardware and the

service), it continues to maintain some level of control or influence over the asset that is being

used as an input to deliver a combined output. That is, the entity’s service continues to dictate

how the customer uses the asset even if the customer has physical possession. This analysis is

consistent with the evaluation of whether an entity controls a good or service before the good

or service is transferred to an end customer and therefore is a principal, as discussed in ASC

606-10-55-37A(c).

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On the basis of the above factors, an entity should evaluate whether the fulfillment costs enhance the

entity’s resources that the entity will use to satisfy (or continue to satisfy) its performance obligation in

the future. If the entity determines that capitalization of the related costs is appropriate in accordance

with ASC 340-40-25-5, it should subsequently amortize the costs related to the asset as it transfers the

related services.

Because of the level of judgment necessary to evaluate whether capitalization is appropriate —

specifically, whether the asset generates or enhances a resource of the entity that the entity will use

to satisfy its remaining performance obligation — we would encourage entities with similar types of

arrangements to consult with their accounting advisers. Further, it may be appropriate in some cases to

evaluate whether the arrangement contains a lease when the performance of the contract relies on a

specified asset; see Deloitte’s Roadmap

Leases

for more information on determining whether a contract

is or contains a lease.

3.2.3.3 Labor Costs Incurred to Fulfill a Contract for Goods or Services When

Revenue Is Recognized Over Time

ASC 340-40-25-7 provides guidance on the types of costs that constitute fulfillment costs within the

scope of ASC 340-40 if they are outside the scope of other Codification topics. Costs incurred to

produce goods for which revenue is recognized at a point in time would typically be treated as inventory

costs within the scope of ASC 330. However, costs incurred to provide goods or services for which

revenue is recognized over time would typically not be within the scope of ASC 330 since control over

those goods or services is transferred to the customer as the entity performs.

Questions have arisen regarding the amounts to be included in fulfillment costs related to labor.

While “salaries and wages of employees who provide the promised services directly to the customer”

are the only examples of direct labor costs that are cited in ASC 340-40-25-7(a), direct labor costs also

include fringe benefits and other labor-related costs incurred in compensating an employee whose

primary employment efforts are directly related to a contract with a customer. In addition, ASC 340-40-

25-7(c) indicates that fulfillment costs include certain allocated labor costs (i.e., indirect labor costs)

related to overhead, such as those incurred for contract management and supervision.

We believe that costs that would have been capitalizable as inventory had they been within the scope

of ASC 330 would typically also represent fulfillment costs directly related to a contract in accordance

with ASC 340-40. ASC 330-10-30-1 provides the following guidance on determining the amounts to be

included in inventory:

As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly

or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean

acquisition and production cost, and its determination involves many considerations.

In authoritative literature, specific references to the composition of labor costs are limited. However,

the ASC master glossary’s definition of direct loan origination costs includes a reference to ASC 310-20-

55, which includes examples of forms of employee compensation that would be considered direct

labor costs associated with originating a loan. Although the concepts discussed in the examples are

specifically related to direct costs incurred in connection with loan origination activities, we believe that

it is appropriate for an entity to consider the implementation guidance in ASC 310-20 by analogy to

identify forms of employee compensation that should be included in the composition of labor costs.

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The example in ASC 310-20-55-12 states:

Payroll-related fringe benefits include any costs incurred for employees as part of the total compensation and

benefits program. Examples of such benefits include all of the following:

a.

Payroll taxes

b.

Dental and medical insurance

c.

Group life insurance

d.

Retirement plans

e.

401(k) plans

f.

Stock compensation plans, such as stock options and stock appreciation rights

g.

Overtime meal allowances.

Further, ASC 310-20-25-6 states, in part:

Bonuses are part of an employee’s total compensation. The portion of the employee’s total compensation

that may be deferred as direct loan origination costs is the portion that is directly related to time spent on the

activities contemplated in the definition of that term and results in the origination of a loan.

We believe that in a manner consistent with the above guidance, labor costs include base pay, overtime

pay, vacation and holiday pay, illness pay, shift differential, payroll taxes, and contributions to a

supplemental unemployment benefit plan. Further, other employee benefit costs such as cash bonuses,

profit sharing, stock bonus plans, insurance benefits, retirement benefits, and other miscellaneous

benefits (both discretionary and nondiscretionary) are among the labor costs that are eligible for

inclusion in fulfillment costs directly related to a contract.

3.2.4 Determining Whether ASC 985-20 or ASC 340-40 Applies

ASC 985-20-15-3 states, in part, that the guidance in ASC 985-20 does not apply to “[a]rrangements to

deliver software or a software system, either alone or together with other products or services, requiring

significant production, modification, or customization of software.” ASC 985-20 generally applies to

the costs of computer software that is being developed for general release to the market as opposed

to being developed solely to meet a specific customer’s needs. Nevertheless, some costs may be

incurred for software that (1) will be delivered to a specific customer under a contract and (2) also will

be marketed to others. As illustrated in the example below, the vendor should determine which costs

are incurred for software that is being developed for general release and which costs are incurred for

software that is being developed for specific contracts.

A vendor may be required to apply the guidance in ASC 985-20 when accounting for software costs it

incurred before entering into a contract if the costs were incurred for a product that will be marketed

to multiple customers. However, a vendor must use judgment to determine whether costs incurred

to develop software before a contract is signed are costs associated with fulfilling the contract and

therefore subject to the guidance in ASC 340-40 or costs subject to the requirements of ASC 985-20,

particularly when there is a very limited market for the product and the product will require additional

customization under contracts with future customers.

Example 3-12

Entity L has existing software that it has used on a previous contract for which it maintains the proprietary

rights. It had begun to reconfigure the software into an open architecture format when it signed a contract for

delivery of a strategic air defense system that will use at least some of the modules of the open architecture

software. Entity L anticipates that it will be able to use the open architecture software on several future

contracts.

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Example 3-12 (continued)

Under ASC 985-20, L may be required to capitalize some of the software development costs associated with

the reconfigured open architecture software if those costs meet the criteria for capitalization. However, the

costs associated with developing the modules in accordance with the terms of the defense contract should not

be accounted for under ASC 985-20 if significant production, modification, or customization of the software

would be required; instead, such costs should be accounted for under ASC 340-40.

As noted above, ASC 985-20 does not apply to costs incurred for computer software that requires significant

production, modification, or customization under a contractual agreement. Although L retains the rights to

the software, at least some portion of the development effort must be used to satisfy the requirements of the

defense contract. The costs associated with developing modules that are promised goods or services under

that contract are costs incurred to fulfill the contract and thus within the scope of ASC 340-40; accordingly, they

should not be accounted for under ASC 985-20.

If the ultimate product will include functionalities that are distinct and separable and are not promised

goods or services under the current defense contract (i.e., they will be used only for future contracts), the

development costs of such functionalities might be subject to the guidance in ASC 985-20 depending on the

market for the software. That is, if the additional modules have a broad customer base and are not limited to

one or a few contracts, ASC 985-20 would apply since the costs for these additional modules would be incurred

in the absence of a specific contract.

3.3 Amortization and Impairment of Contract Costs

3.3.1 Amortization

ASC 340-40 does not provide specific guidance on the method an entity should use to amortize contract

costs recognized as assets. Rather, ASC 340-40-35-1 requires an entity to amortize such costs “on a

systematic basis that is consistent with the transfer to the customer of the goods or services to which

the asset relates.” Entities will therefore have to determine an appropriate method for amortizing costs

capitalized in accordance with ASC 340-40-25-1 or ASC 340-40-25-5.

Amortization of capitalized costs on a “systematic basis” should take into account the expected timing

of transfer of the goods and services related to the asset, which typically corresponds to the period and

pattern in which revenue will be recognized in the financial statements. The pattern in which the related

revenue is recognized could be significantly front-loaded, back-loaded, or seasonal, and costs should be

amortized accordingly.

To determine the pattern of transfer, entities may need to analyze the specific terms of each

arrangement. In determining the appropriate amortization method, they should consider all relevant

factors, including (1) their experience with, and ability to reasonably estimate, the pattern of transfer

and (2) the timing of the transfer of control of the goods or services to the customer. In some situations,

more than one amortization method may be acceptable if it reasonably approximates the expected

period and pattern of transfer of goods and services. However, certain amortization methods may

be unacceptable if they are not expected to reflect the period and pattern of such transfer. When

entities select a method, they should apply it consistently to similar contracts. If there is no evidence to

suggest that a specific pattern of transfer can be expected, a straight-line amortization method may be

appropriate.

If the pattern in which the contractual goods or services are transferred over the contract term varies

significantly each period, it may be appropriate to use an amortization model that more closely aligns

with the transfer pattern’s variations. For example, amortization could be allocated to the periods on

the basis of the proportion of the total goods or services that are transferred each period. If the cost

is related to goods or services that are transferred at a point in time, the amortized cost would be

recognized at the same point in time.

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When the contractual goods or services are transferred over a period of uncertain duration, entities

should consider whether the relationship with the customer is expected to extend beyond the initial

term of a “specific anticipated contract” (as referred to in ASC 340-40-35-1 and described in ASC 340-40-

25-5(a)). For example, if an entity enters into a four-year contract with a customer but the customer is

expected to renew that contract for two years, the appropriate amortization period may be six years (i.e.,

the expected duration of the period in which the customer will purchase the related goods or services,

which could be the expected life of the customer relationship).

When an entity’s customer has been granted a material right to acquire future goods or services and

revenue related to the material right is being deferred, it would typically be reasonable for the entity to

consider the amount allocated to that right when determining the amortization method for the costs

that are capitalized in accordance with ASC 340-40-25-1 or ASC 340-40-25-5.

3.3.1.1 Allocation Among Performance Obligations

When an asset is recognized for the incremental costs of obtaining a contract, ASC 340-40-35-1 requires

the asset to be amortized in a manner that is “consistent with the transfer to the customer of the

goods

or services to which the asset relates

” (emphasis added). When the pattern of transfer differs for

separate performance obligations in a contract, it may be appropriate to allocate the costs among the

performance obligations and to amortize the capitalized costs accordingly. For example, the costs could

be allocated on the basis of the stand-alone selling prices of the performance obligations.

The FASB staff has noted that an entity could satisfy the requirement in ASC 340-40-35-1 in accordance

with either of the following two views:

3

(a) View A — Allocate the asset to the individual performance obligations on a relative basis (in proportion

to the transaction price allocated to each performance obligation) and amortize the respective portion

of the asset based on the pattern of performance for the underlying performance obligation . . . .

(b) View B — Amortize the single asset using one measure of performance considering all of the

performance obligations in the contract. Use a measure that best reflects the “use” of the asset as

the goods and services are transferred. Note that this approach may result in a similar pattern of

amortization as View A, but without any specific allocation of the contract cost asset to individual

performance obligations.

Note that an entity is not permitted to apply the practical expedient in ASC 340-40-25-4 (recognizing

the “costs of obtaining a contract as an expense when incurred if the amortization period of the asset

that the entity otherwise would have recognized is one year or less”) to some performance obligations

in a contract but not others. Therefore, when the costs of obtaining a contract are allocated to different

performance obligations so that they are amortized over different periods, the practical expedient in

ASC 340-40-25-4 can only be applied if all of the amortization periods are one year or less.

The example below illustrates an allocation of the costs of obtaining a contract among different

performance obligations.

3

Quoted from

Implementation Q&A 75

.

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Example 3-13

Entity B enters into a contract with a customer to provide the following:

•

Product X delivered at a point in time.

•

Maintenance of Product X for one year.

•

An extended warranty on Product X that covers years 2 and 3 (Product X comes with a one-year

statutory warranty).

Each of the elements is determined to be a separate performance obligation.

A sales commission of $200 is earned by the salesperson. This represents $120 for the sale of Product X

(payable irrespective of whether the customer purchases the maintenance or extended warranty) and an

additional $40 each for the sale of the maintenance contract and the sale of the extended warranty ($80

commission for the sale of both).

The commission is determined to meet the definition of an incremental cost of obtaining the contract in ASC

340-40-25-2 and is therefore capitalized in accordance with ASC 340-40-25-1.

As discussed above, incremental costs of obtaining a contract that are capitalized in accordance with ASC

340-40-25-1 can be allocated to specific performance obligations for amortization purposes. Therefore, it

would be acceptable in the circumstances under consideration to attribute the $200 commission asset in the

following manner:

•

$120 to Product X

— To be expensed upon delivery of Product X to the customer.

•

$40 to the maintenance contract

— To be expensed over the one-year period of maintenance.

•

$40 to the extended warranty

— To be expensed over the two-year period of the warranty (i.e., years 2

and 3).

The asset will therefore be amortized as follows:

Delivery

(Day 1)

Year 1

Year 2

Year 3

Product X

$

120

Maintenance

—

$

40

Extended warranty

—

—

$

20

$

20

Total amortization expense

$

120

$

40

$

20

$

20

Note that in this fact pattern, the entity cannot apply the practical expedient in ASC 340-40-25-4 to expense

the sales commission when incurred because the total amortization period for the asset exceeds one year.

Neither can the expedient be applied specifically to the commission allocated to the maintenance contract

(notwithstanding that it is amortized over a period of one year) because if the practical expedient is applied, it

must be applied to the contract as a whole.

3.3.1.2 Determining the Amortization Period of an Asset Recognized for the

Incremental Costs of Obtaining a Contract With a Customer

Stakeholders have raised questions about determining the amortization period of an asset recognized

for the incurred incremental costs of obtaining a contract with a customer, including how to determine

whether a commission paid on renewal is commensurate with an initial commission and under what

circumstances it would be appropriate to amortize the asset over the expected customer life. The FASB

staff has noted that the amortization guidance in ASC 340-40 is conceptually consistent with that on

estimating the useful lives of long-lived assets. Since entities already use judgment to estimate useful

lives of long-lived assets, the staff believes that entities would also do so in determining amortization

periods for assets related to incremental costs of obtaining a contract.

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An entity should use judgment in determining the contract(s) to which a commission is related. The

staff has noted that if an entity pays a commission on the basis of only the initial contract without an

expectation that the contract will be renewed (given the entity’s past experience or other relevant

information), amortizing the asset over the initial contract term would be an appropriate application of

the revenue standard. However, if the entity’s past experience indicates that a contract renewal is likely,

the amortization period could be longer than the initial contract term if the asset is related to goods or

services to be provided during the contract renewal term.

When estimating the amortization period of an asset arising from incremental costs of obtaining

a contract, entities should (1) identify the contract(s) to which the cost (i.e., commission) is related,

(2) determine whether the commission on a renewal contract is commensurate with the commission

on the initial contract, and (3) evaluate the facts and circumstances to determine an appropriate

amortization period that would extend beyond the contract period if there are anticipated renewals

associated with the costs of obtaining the contract.

The FASB staff has confirmed that the amortization period of an asset recognized for the incremental

incurred costs of obtaining a contract might be, but should not be presumed to be, the entire customer

life. The staff has suggested that facts and circumstances may clearly indicate that amortizing the asset

over the average customer term is inconsistent with the amortization guidance in ASC 340-40-35-1. An

entity should use judgment in assessing the goods or services to which the asset is related.

In estimating the amortization period for an asset recognized in accordance with ASC 340-40-25-1

(“customer acquisition asset”), an entity will need to use judgment to identify “the goods or services

to which the asset relates” in accordance with ASC 340-40-35-1. The estimated amortization period

could range from the initial contract term on the low end to the average customer life on the high

end depending on the specific facts and circumstances. When determining the life of the customer

acquisition asset, the entity will need to make judgments similar to those it makes when determining the

amortization or depreciation period for other long-lived assets.

An entity should first identify the contract(s) related to the customer acquisition asset (e.g., commission

payment). That is, an entity will need to consider whether the asset is related only to the initial contract

with the customer or also to specific anticipated contracts (e.g., renewals) with the customer. For

example, if a commission is paid on contract renewals and the commission is commensurate with the

initial commission paid, the customer acquisition asset originally recorded may be related only to the

initial contract.

However, if an entity’s past experience indicates that a contract renewal is likely, the amortization period

could be longer than the initial contract term if the asset is related to goods or services to be provided

under a contract renewal. An entity will need to use judgment to determine whether the asset is related

to goods or services to be provided under the contract renewal term. Amortizing an asset over a period

longer than the initial contract period would not be appropriate when the entity pays a commission on a

contract renewal that is commensurate with the commission paid on the initial contract.

If no commissions are incurred in connection with a contract renewal, or if the commission paid is

not commensurate with the initial commission, an entity will need to use judgment when determining

whether the customer acquisition asset is related to (1) all future contracts with the customer (i.e., the

customer life) or (2) one or more, but not all, future contracts with the customer. The revenue standard

does not require an entity to amortize a customer acquisition asset over the expected customer life.

Rather, under ASC 340-40-35-1, the asset should “be amortized on a systematic basis that is consistent

with the transfer to the customer of the goods or services to which the asset relates.” An entity will need

to determine the appropriate amortization period on the basis of all relevant facts and circumstances.

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Since the capitalized asset is similar to an intangible asset, an entity might consider the guidance in ASC

350-30 on determining the useful life of intangible assets. Specifically, ASC 350-30-35-3 states, in part:

The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent

factors, in particular, all of the following factors with no one factor being more presumptive than the other: . . .

f.

The level of maintenance expenditures required to obtain the expected future cash flows from the asset

(for example, a material level of required maintenance in relation to the carrying amount of the asset

may suggest a very limited useful life). As in determining the useful life of depreciable tangible assets,

regular maintenance may be assumed but enhancements may not.

Entities may perform various activities geared toward maintaining customer relationships. In some

instances, there may be significant barriers to a customer’s changing service providers or suppliers so

that once a contractual relationship is formed between an entity and a customer, little effort may be

needed for the entity to retain the customer. However, in other circumstances, entities may operate in a

highly competitive environment in which there are only limited barriers, if any, to a customer’s switching

service providers or suppliers. In these circumstances, entities may need to make additional investments

or incur other costs to maintain customer relationships (e.g., invest in innovative products or services,

or provide customer incentives). The additional investments may be akin to “maintenance expenditures”

that may affect the useful life of a customer acquisition asset.

While an entity will need to use judgment to determine the amortization period of the customer

acquisition asset, the entity might consider the following factors:

•

Incremental costs of obtaining a sale (e.g., commissions) relative to ongoing contract value

— A small

commission relative to the value of the contract could suggest that the customer acquisition

asset has limited value and that the asset life is relatively short. In contrast, a higher commission

payment relative to the contract value (1) could suggest that the entity believes the asset to be

of greater value or (2) may be related to anticipated contracts with the customer.

•

Degree of difficulty in switching service providers or suppliers

— If it is difficult for a customer to

switch service providers or suppliers, the customer acquisition asset may have a longer life.

Accordingly, the entity may expect that the efforts it performed to acquire the customer will

provide it with value over a longer period (i.e., over some or all contract renewals). In contrast,

if there are only limited barriers to a customer’s switching service providers or suppliers

(and there are other service providers or suppliers available to the customer), the customer

acquisition asset may have a shorter life.

•

Extent to which the product or service changes over the customer life

— Significant changes in the

underlying product or service over the customer life may suggest that the life of the customer

acquisition asset is shorter than the customer life. That is, the asset may be related to some,

but not all, anticipated contracts with the customer. For example, if a customer’s decision about

whether to renew a contract is influenced by enhancements made to products or services, the

activities required to initially obtain the customer may not be related to all anticipated contract

renewals with the customer. In contrast, if the same service or product is provided in each

renewal period, the customer acquisition asset may be attributed to all anticipated contract

renewals.

•

Other customer maintenance activities

— If the entity incurs significant costs (relative to the initial

incremental cost incurred) to maintain a customer relationship, the useful life of the customer

acquisition asset could be short. However, if only limited costs are required to maintain a

customer relationship, the useful life of the customer acquisition asset could extend to all

anticipated contracts with the customer (i.e., the customer life). Fulfillment costs would not be

considered customer maintenance costs. Only costs that are incremental to transferring the

specified goods or services to the customer should be evaluated as maintenance costs.

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Chapter 3 — Contract Costs

The above factors are not all-inclusive, and none of them are determinative. Accordingly, an entity

should consider all relevant facts and circumstances when determining the amortization period for

customer acquisition assets. In addition, an entity should adequately disclose the method it uses to

determine the amortization for each reporting period in accordance with ASC 340-40-50-2(b).

3.3.1.2.1 Specific Anticipated Contract Not Limited to Contract Renewals

The reference to a “specific anticipated contract” in ASC 340-40-35-1 is

not

limited to contract renewals.

Although the guidance in ASC 340-40-35-1 will often be relevant in the context of contract renewals, it

is not limited to contract renewals for purposes of determining the amortization period for capitalized

incremental costs incurred to obtain a contract.

For example, an entity may incur incremental costs of obtaining a contract to deliver one part of an

overall project for a customer. The entity may have been informed that if it successfully fulfills its

performance obligations under the initial contract, the customer will award the entity an additional

contract to deliver other parts of the project. If the entity will not incur any further incremental costs

to obtain the additional contract, it may be appropriate to regard the additional contract as a “specific

anticipated contract” under ASC 340-40-35-1.

3.3.1.2.2 Evaluating Whether Commissions Paid on a Contract Renewal Are

Commensurate With Commissions Paid on the Initial Contract

Paragraph BC309 of ASU 2014-09 states that amortization of an asset over a period longer than the

initial contract period would not be appropriate when a commission paid on a contract renewal is

commensurate with the commission paid on the initial contract.

The FASB staff has confirmed that when commissions are paid on contract renewals, an entity

should evaluate whether the commission on renewal is commensurate with the initial commission by

considering the amount of the commissions relative to the contracts’ value. It has specifically noted that

“assessing whether a renewal commission is commensurate with an initial commission solely on the

basis of the level of effort to obtain the contract would not be consistent with the guidance in Subtopic

340-40.”

4

In addition, the FASB staff has clarified that it holds the following views

5

irrespective of the relative level

of effort involved with obtaining the original contract and the renewal contract:

•

“[I]n general, it would be reasonable for an entity to conclude that a renewal commission is

‘commensurate with’ an initial commission if the two commissions are reasonably proportional

to the respective contract value (for example, 5% of the contract value is paid for both the initial

and the renewal contract).”

•

“Similarly, [it] would be reasonable for an entity to conclude that a renewal commission is not

‘commensurate with’ an initial commission if it is disproportionate to the initial commission (for

example, 2% renewal commission as compared to a 6% initial contract commission).”

4

Quoted from

Implementation Q&A 72

.

5

See footnote 4.

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3.3.1.2.3 Determining the Appropriate Amortization Period of Commissions

When a Commission Paid Upon Renewal Is Not Commensurate With the Initial

Commission

Stakeholders have also raised questions about the appropriate amortization period for a commission

paid to an employee for obtaining an initial contract that has a high likelihood of renewal. That is, should

the commission be amortized over the initial contract term, or should the amortization period include

the expected renewal period? The amortization period will depend on many factors, including whether a

commission is paid on contract renewals and, if so, whether the commission paid is commensurate with

the initial commission.

Example 3-14

Entity X enters into a two-year contract with a customer. On signing the initial contract, X pays its salesperson

$200 for obtaining the contract. An additional commission of $120 is paid each time the customer renews the

contract for another two years. Assume that the $120 renewal commission is not commensurate with the $200

initial commission, which means that some of the commission paid for the initial contract should be attributed

to the contract renewal as well. On the basis of historical experience, 98 percent of X’s customers are expected

to renew their contract for at least two more years (i.e., the contract renewal is a specific anticipated contract),

and the average customer life is four years.

In this example, we believe that there are at least two acceptable approaches to amortizing the initial $200

commission and the $120 renewal commission:

•

Approach 1

— Amortize the initial commission amount of $200 over the contract period that includes

the anticipated renewal (i.e., four years). When the contract is renewed, the additional $120 commission

would be combined with the remaining asset and amortized over the remaining two-year period, as

shown in the following table:

Initial Contract

Renewal Contract

Year 1

Year 2

Year 3

Year 4

Total

Initial commission

$

50

$

50

$

50

$

50

$

200

Renewal commission

60

60

120

Total expense recognized

$

50

$

50

$

110

$

110

$

320

•

Approach 2

— Bifurcate the initial commission into two parts: (1) $120, the amount that is commensurate

with the renewal commission and that pertains to obtaining a two-year contract, and (2) $80, the amount

that is considered to be paid for obtaining the initial contract plus the anticipated renewal (i.e., the

customer relationship). The $120 would then be amortized over the initial two-year contract term, and

the $80 would be amortized over the entire four-year period, as shown in the following table:

Initial Contract

Renewal Contract

Year 1

Year 2

Year 3

Year 4

Total

Initial commission —

Part 1 ($120)

$

60

$

60

$

120

Initial commission —

Part 2 ($80 remainder)

20

20

$

20

$

20

80

Renewal commission

60

60

120

Total expense recognized

$

80

$

80

$

80

$

80

$

320

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Chapter 3 — Contract Costs

As noted in the example above, we believe that there are multiple acceptable approaches to amortizing

costs of obtaining contract assets when commissions paid upon renewal are not commensurate with

the initial commission paid. The example below illustrates how the alternatives may be applied when

a good or service is transferred at the inception of an arrangement and another good or service is

transferred over time.

Example 3-15

Company A enters into a software arrangement with a customer in exchange for consideration of $1,300.

Under the arrangement, A provides a software license ($1,000) and three years of PCS ($100 per year). In

addition, the arrangement includes two years of optional PCS renewals for which the customer is able to renew

at $100 per year. At contract inception, A expects that the customer will renew the PCS for both years. The

corresponding commission rates for the software license and PCS (including renewals) are as follows:

Goods and Services

Price

Commission

Rate

Commission

Software license

$

1,000

10%

$

100

Year 1 PCS

100

10%

10

Year 2 PCS

100

5%

5

Year 3 PCS

100

5%

5

Initial contract value

1,300

Initial commission

120

Year 4 PCS (expected)

100

1%

1

Year 5 PCS (expected)

100

1%

1

Total value

1,500

Total commission

$

122

Initial contract commission

120

Total consideration

1,500

Percentage 1

8.0%

Total commission

122

Total consideration

$

1,500

Percentage 2

8.1%

For purposes of this example, assume that revenue is recognized as follows:

Year 1

Year 2

Year 3

Year 4

Year 5

Software license

$

1,000

PCS

100

$

100

$

100

$

100

$

100

Total revenue

$

1,100

$

100

$

100

$

100

$

100

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Example 3-15 (continued)

As illustrated above, the commission paid upon PCS renewal in years 4 and 5 is not commensurate with

the commission paid on PCS in the initial contract; therefore, the initial commission is related to both the

original contract and the renewal periods. We believe that in this example, there are at least two acceptable

approaches to amortizing the initial $120 commission and the $2 renewal commission:

•

Approach 1

— Amortize the initial commission amount of $120 proportionately over the contract period

that includes the anticipated renewals (e.g., five years) by multiplying the annual revenue amount in each

year by Percentage 1. The incremental commission from years 4 and 5 would be amortized over the

remaining two-year period, as shown in the following table:

Initial Contract

Renewal Contract

Year 1

Year 2

Year 3

Year 4

Year 5

Total

Initial commission

$

88

$

8

$

8

$

8

$

8

$

120

Renewal commission

1

1

2

Total expense

recognized

$

88

$

8

$

8

$

9

$

9

$

122

•

Approach 2

— Amortize the total expected commission amount of $122 over the contract period

that includes the anticipated renewals (e.g., five years) by multiplying the annual revenue amount by

Percentage 2, as shown in the following table:

Initial Contract

Renewal Contract

Year 1

Year 2

Year 3

Year 4

Year 5

Total

Total commission

$

90

$

8

$

8

$

8

$

8

$

122

Total expense

recognized

$

90

$

8

$

8

$

8

$

8

$

122

3.3.1.3 Accounting for Unamortized Contract Costs Upon Modification

ASC 606-10-25-13(a) provides that when specified criteria are met, an entity should account for a

contract modification “as if it were a termination of the existing contract, and the creation of a new

contract.” Although the contract modification is accounted for

as if

it were a termination of the existing

contract and the creation of a new contract, the original contract was not in fact terminated. Therefore,

any unamortized contract costs that existed immediately before the contract modification should not

be written off unless those costs are no longer

related

to the remaining goods or services. Rather,

those unamortized contract costs should be carried forward into the new contract and amortized on

a systematic and rational basis that is consistent with the transfer of goods or services related to the

asset.

An entity will need to use judgment when determining which remaining goods or services to be

transferred under the modified contract are related to the asset. Further, the entity should consider

whether the asset is impaired by applying the guidance in ASC 340-40-35-3 through 35-5.

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Chapter 3 — Contract Costs

3.3.2 Impairment

ASC 340-40

35-3

An entity shall recognize an impairment loss in profit or loss to the extent that the carrying amount of an

asset recognized in accordance with paragraph 340-40-25-1 or 340-40-25-5 exceeds:

a.

The amount of consideration that the entity expects to receive in the future and that the entity has

received but has not recognized as revenue, in exchange for the goods or services to which the asset

relates (“the consideration”), less

b.

The costs that relate directly to providing those goods or services and that have not been recognized as

expenses (see paragraphs 340-40-25-2 and 340-40-25-7).

35-4

For the purposes of applying paragraph 340-40-35-3 to determine the consideration, an entity shall use

the principles for determining the transaction price (except for the guidance in paragraphs 606-10-32-11

through 32-13 on constraining estimates of variable consideration) and adjust that amount to reflect the effects

of the customer’s credit risk. When determining the consideration for the purposes of paragraph 340-40-35-3,

an entity also shall consider expected contract renewals and extensions (with the same customer).

35-5

Before an entity recognizes an impairment loss for an asset recognized in accordance with paragraph

340-40-25-1 or 340-40-25-5, the entity shall recognize any impairment loss for assets related to the contract

that are recognized in accordance with another Topic other than Topic 340 on other assets and deferred

costs, Topic 350 on goodwill and other intangible assets, or Topic 360 on property, plant, and equipment (for

example, Topic 330 on inventory and Subtopic 985-20 on costs of software to be sold, leased, or otherwise

marketed). After applying the impairment test in paragraph 340-40-35-3, an entity shall include the resulting

carrying amount of the asset recognized in accordance with paragraph 340-40-25-1 or 340-40-25-5 in the

carrying amount of the asset group or reporting unit to which it belongs for the purpose of applying the

guidance in Topics 360 and 350.

35-6

An entity shall not recognize a reversal of an impairment loss previously recognized.

The objective of impairment is to determine whether the carrying amount of the contract acquisition

and fulfillment costs asset is recoverable. This is consistent with other impairment methods under

U.S. GAAP and IFRS Accounting Standards that include an assessment of customer credit risk and

expectations of whether variable consideration will be received.

Further, the FASB decided that it would not be appropriate to reverse an impairment charge when the

reasons for impairment are no longer present. In contrast, the IASB decided to allow a reversal of the

impairment charge in these circumstances. The boards decided to diverge on this matter to maintain

consistency with their respective existing impairment models for other types of assets.

To test a contract cost asset for impairment, an entity must consider the total period over which

it expects to receive an economic benefit from the asset. Accordingly, to estimate the amount of

remaining consideration that it expects to receive, the entity would also need to consider goods or

services under a specific anticipated contract (e.g., a contract renewal).

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The FASB issued

ASU 2016-20

, which includes certain technical corrections that amend ASC 340-40 to

clarify that for impairment testing, an entity should:

•

Consider contract renewals and extensions when measuring the remaining amount of

consideration the entity expects to receive.

•

Include in the amount of consideration the entity expects to receive both (1) the amount of cash

expected to be received and (2) the amount of cash already received but not yet recognized as

revenue.

•

Test for and recognize impairment in the following order: (1) assets outside the scope of ASC

340-40 (such as inventory under ASC 330), (2) assets accounted for under ASC 340-40, and

(3) reporting units and asset groups under ASC 350 and ASC 360.

3.4 Onerous Performance Obligations

Both U.S. GAAP and IFRS Accounting Standards include guidance on accounting for certain types of

onerous contracts. A contract is considered onerous if the aggregate cost required to fulfill it is greater

than the expected economic benefit to be obtained from the contract. When this condition is met, the

guidance may require an entity to recognize the expected future loss before actually incurring the loss.

As indicated in ASC 605-10-05-4, existing guidance under U.S. GAAP addresses the recognition of losses

on the following specific transactions (not all-inclusive):

•

Separately priced extended warranty and product maintenance contracts (ASC 605-20).

•

Construction- and production-type contracts (ASC 605-35).

•

Certain software arrangements (ASC 985-605).

In addition, ASC 450-20 provides overall guidance on accounting for loss contingencies. Such guidance

requires an entity to recognize an expected loss if the contingency is probable and the amount is reliably

estimable. Further, ASC 330-10-35-17 and 35-18 provide guidance on the recognition of losses on firm

purchase commitments related to inventory.

The FASB decided not to include specific guidance on accounting for onerous contracts in the revenue

standard, but rather to retain existing onerous contract guidance. Accordingly, contracts within the

scope of the guidance referred to above may need to be evaluated as onerous contracts.

3.4.1 Separately Priced Extended Warranty Contracts and Product

Maintenance Contracts

The guidance in ASC 605-20 on recognizing losses on separately priced extended warranty and product

maintenance contracts may be applicable to technology entities that provide maintenance for hardware

products in contracts accounted for under ASC 606. Specifically, ASC 605-20-25-6 states the following:

ASC 605-20

25-6

A loss shall be recognized on extended warranty or product maintenance contracts if the sum of the

expected costs of providing services under the contracts and any asset recognized for the incremental cost of

obtaining a contract exceeds the related unearned revenue (contract liability). Extended warranty or product

maintenance contracts shall be grouped in a consistent manner to determine if a loss exists. A loss shall be

recognized first by charging to expense any recognized asset for the incremental costs of obtaining a contract,

determined in accordance with the guidance in paragraphs 340-40-25-1 through 25-4 for contracts within

scope of Topic 606 on revenue from contracts with customers. If the loss is greater than the recognized asset

for the incremental costs of obtaining a contract, a liability shall be recognized for the excess.

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Chapter 3 — Contract Costs

3.4.2 Construction- and Production-Type Contracts

Technology entities may enter into revenue contracts to sell customized software products that are

subject to the guidance in ASC 605-35. The existing guidance in ASC 605-35-25 on provision for loss

contracts was retained; however, the technical corrections of ASU 2016-20 include an update to ASC

605-35-25 that allows an entity to determine the provision for losses on contracts within the scope of

ASC 605-35 at the performance obligation level or the contract level as an accounting policy election.

3.4.3 Certain Software Arrangements

Software arrangements subject to the guidance in ASC 985-605 may require a loss provision. Specifically,

ASC 985-605-25-7 states the following:

ASC 985-605

25-7

If it becomes probable that the amount of the transaction price allocated to an unsatisfied or partially

unsatisfied performance obligation in accordance with Topic 606 on revenue from contracts with customers

will result in a loss on that performance obligation, the loss shall be recognized pursuant to Topic 450.

3.5 SEC Comment Letter Trends

The SEC staff frequently comments on the accounting for and disclosure of contract costs, including

(1) the method being used to amortize the capitalized costs and (2) how the selected amortization

period correlates with the period of benefit. Further, when additional commissions are paid upon

renewal, the staff has questioned (1) whether such commissions are commensurate with the initial

commissions and (2) how such renewals are considered in the amortization period.

For example, the SEC staff may question the nature of any employee service requirement when sales

commissions are expensed. In addition, when sales commissions are paid upon renewal of a contract,

the SEC staff may question whether commissions paid upon renewal are commensurate with initial

commissions and how the renewals are considered in the amortization period.

For more information, see

Section 2.18.3

and

Section 6.5.1.2

of Deloitte’s Roadmap

SEC Comment Letter

Considerations, Including Industry Insights

.

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Chapter 4 — Software and Software-

Related Costs

4.1 Background

As technology evolves, entities typically incur myriad costs related to software. For example, cloud-based

arrangements have revolutionized the business and technology landscape, offering more flexible and

often lower-cost IT solutions that allow businesses to outsource their traditional enterprise resource

planning (ERP) systems or any other on-site application to an off-site, on-demand solution. In addition,

an increasing number of processes are managed by using automated solutions, such as CRM, human

resources, payroll, finance, and collaboration and communication tools. This has resulted in entities’

incurring increasing amounts of software-related costs as they either purchase licenses to on-premise

software products or contract with vendors to access and use software solutions over the Internet (e.g.,

cloud computing or SaaS). Entities also frequently use hybrid deployments, in which they purchase or

develop on-premise software (some of which may be deployed in a private cloud environment) and use

that software in conjunction with another cloud-based third-party platform (i.e., a public cloud). Further,

entities may incur costs to develop software for their own internal use as well as for external sales to

customers. Entities incurring such costs will need to determine whether they represent assets that can

be capitalized under the applicable accounting guidance. Different accounting guidance exists for costs

related to software that is (1) sold, leased, or marketed; (2) obtained or developed for internal use; and

(3) accessed in a cloud-based (or hosting) arrangement that is a service contract.

It is important to determine whether software costs incurred are within the scope of ASC 985-20 or

ASC 350-40 because the requirements for capitalization vary between the two Codification subtopics.

For example, ASC 985-20-25-1 states, in part, that “[a]ll costs incurred to establish the technological

feasibility of a computer software product to be sold, leased, or otherwise marketed are research

and development costs.” Once technological feasibility is established, the costs of producing product

masters, including coding and testing, are generally capitalized until the product is available for general

use.

1

Because technological feasibility is often established shortly before the software product reaches

the general availability stage, many software entities do not have material costs capitalized under ASC

985-20.

By contrast, ASC 350-40 does not require the establishment of technological feasibility for capitalization

but does have other requirements for capitalization depending on the stage of development. Generally,

development costs incurred during the application development stage are capitalized, while costs

incurred during the preliminary project stage and the postimplementation-operation stage are

expensed as incurred. Costs incurred for internal-use software will typically meet the capitalization

requirements earlier in the development cycle than costs incurred for software licensed externally. As a

result, more costs typically qualify for capitalization when software is obtained or developed for internal

use than those for software that is licensed externally.

1

Production costs for software that is to be used as an integral part of a product or process cannot be capitalized until both (1) technological

feasibility has been established and (2) all R&D activities for the other components of the product or process have been completed.

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Chapter 4 — Software and Software-Related Costs

Further, ASC 350-40 also applies to implementation costs incurred for cloud-based (or hosting)

arrangements that are service contracts. Generally, implementation costs incurred for such

arrangements during the application development stage are deferred and presented in prepaid

expenses, while other costs (e.g., cloud computing and hosting costs) are expensed as incurred (unless

they are related to other capitalizable assets such as hardware and on-premise software). Within ASC

350-40, guidance differs for cloud-based (or hosting) arrangements versus internal-use software (e.g.,

only implementation costs for cloud-based [or hosting] arrangements are eligible for deferral, and there

are different presentation requirements).

Because of the above differences in capitalization requirements, the application of the incorrect

guidance could have material accounting implications. In addition, complexities may arise when entities

evaluate the appropriate scope as technology evolves and business models shift. For example, entities

may transition from using software solutions internally to selling and marketing them. Similarly, entities

may shift their business model from selling on-premise licensed solutions to SaaS arrangements.

It is therefore important to understand the scope guidance and regularly reassess previous scope

conclusions in a dynamic environment.

Changing Lanes

In September 2025, FASB issued

ASU 2025-06

to amend certain aspects of the accounting for

and disclosure of software costs under ASC 350-40. The ASU removes all references to the

“preliminary project stage,” the “application development stage,” and the “postimplementation-

operation stage” (collectively referred to hereinafter as “development stages”). Under the ASU,

only the following criteria in amended ASC 350-40-25-12(b) and added ASC 350-40-25-12(c),

which are the same as the criteria in existing ASC 350-40-25-12(b), must be met for entities to

begin capitalizing software costs:

•

“Management, with the relevant authority, implicitly or explicitly authorizes and commits to

funding a computer software project.”

•

“It is probable that the project will be completed and the software will be used to perform

the function intended (referred to as the ‘probable-to-complete recognition threshold’).”

Originally, the project that culminated in the issuance of ASU 2025-06 was intended to explore

convergence of the accounting model for software sold as a service and that for software sold

as a license. Although the Board ultimately decided not to pursue such convergence, paragraph

BC57 of the ASU indicates that the ASU’s amendments to ASC 350-40 may result in a SaaS

project’s meeting the probable-to-complete recognition threshold later in its life cycle and,

therefore, in the expensing (as opposed to capitalization) of more costs in a manner similar to

the treatment of software costs under ASC 985-20.

Because ASU 2025-06 is not effective until fiscal years beginning after December 15, 2027

(although early adoption is permitted), the effects of its adoption remain to be seen. See

Section

4.4

for further discussion of the ASU. Various amendments in the ASU are highlighted in other

sections below as applicable.

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4.2 Scope Considerations

4.2.1 On-Premise Licensed Software

ASC 985-20-15-2 states that ASC 985-20 applies to the costs of “computer software to be sold, leased,

or otherwise marketed as a separate product or as part of a product or process, whether internally

developed and produced or purchased.” Typically, software within the scope of ASC 985-20 is licensed

on a nonexclusive on-premise basis, either as a perpetual or term-based (i.e., subscription-based)

license, with the sale of such software accounted for under ASC 606.

In assessing how software development costs should be accounted for, entities must determine

whether there is a substantive plan to market the software externally or whether one will be created

during the software’s development period. If either is the case, the software development costs will be

subject to ASC 985-20 (see

Section 4.2.2.2

).

Connecting the Dots

Some on-premise software applications, such as mobile applications (apps), may not be

licensed for consideration. In those circumstances, an entity must carefully evaluate whether

the software is considered “sold, leased, or otherwise marketed as a separate product or

as part of a product or process” under ASC 985-20. For example, an entity may sell gaming

apps for consideration, and such apps would therefore be within the scope of ASC 985-20.

However, gaming apps may also be offered on a “freemium” basis, with in-app sales (e.g.,

consideration paid to play a game without viewing ads or for virtual items that enhance the

gaming experience). Even though a gaming app itself is free for download, we believe that it

would still be considered “marketed as a separate product,” particularly since there could be

in-app sales for consideration. Further, apps may be sold as part of a product or process (see

Section 4.2.1.2

). For example, a thin-client app may be sold as part of a cloud-based service, but

if its sole function is to enable connection to the cloud-based service, it may not be substantive

enough to be considered “sold, leased, or otherwise marketed.” Therefore, an entity may need

to use judgment to determine whether apps that are free for download or part of a product or

process are within the scope of ASC 985-20. If they are not within the scope of ASC 985-20, they

could be within the scope of ASC 350-40 (see

Section 4.2.2

).

4.2.1.1 Software Product

A software product is defined by ASC 985-20-55-1 as having the following qualities:

•

“As a product, it is complete and has exchange value.”

•

“As software, it is a set of programs that interact with each other. A program is further defined as

a series of instructions or statements that cause a computer to do work.”

A software product is a set of programs (e.g., software code) that has been packaged in such a way that

it can be marketed to third parties. The software product may be sold to either end users or distributors.

A software product also consists of the appropriate documentation and training materials. Determining

whether a set of programs consists of a single software product or multiple software products requires

judgment since ASC 985-20 does not provide specific guidance on the unit of accounting.

When determining separate software products, an entity should consider how programs are marketed.

A set of programs that is separately priced and marketed would most likely be treated as a separate

software product. For example, programs may be packaged and priced differently depending on the

market (e.g., different geographic areas or industries). In that circumstance, each set of packaged

programs may be a separate software product, with costs identified and allocated through the use of a

reasonable method.

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Chapter 4 — Software and Software-Related Costs

An entity could also consider the functionality and interdependence of its programs. For example, two

sets of technically independent programs, for which costs can be separately identified and a basis for

allocating revenue can be established, may be two separate software products. A set of programs is

technically independent if other programs are not essential to the set’s functionality. Therefore, the

entity might be able to market that set as a separate software product because customers will be

able to effectively use it without any other programs. By contrast, sets of programs that are technically

interdependent may not be marketed separately. For example, if a set of programs has been developed

but has no stand-alone functionality without the development of additional programs, it most likely

would not be a separate software product.

A newly developed set of programs could be combined with an existing separate software product if it

is integrated with and intended to replace that product. In addition, modules or add-ons with different

features and functions can be developed for an existing separate software product. If a set of programs

associated with a module or add-on is separately priced, it may be treated as its own separate software

product. However, if that set of programs is not priced separately and revenue cannot be reasonably

allocated to it, it should be treated as part of the existing software product.

A software product can either be developed by an entity’s own employees or by third parties. A

developer also can acquire an existing software product from a third party. Because there is no specific

ownership requirement in ASC 985-20, an entity may obtain the marketing rights to licensed software

(e.g., as a reseller or distributor), and the amount paid to obtain those rights would be a cost of a

separate software product (or part of another software product) as though the entity had acquired or

developed the program itself (i.e., as though it owned the IP outright).

4.2.1.2 Software That Is Part of a Product or Process

While software often is sold as a product that has stand-alone functionality (e.g., software used to

process tax returns), software may also be embedded as part of another product that is sold, such as

firmware that is embedded in smart devices (e.g., smartphones, tablets, gaming consoles, and other

devices associated with the IoT).

Further, software could be sold as part of a process. While not specifically defined in ASC 985-20, a

process is described in ASC 730-10-15-3 as “a system whose output is to be sold, leased, or otherwise

marketed to others. A process also may be used internally as a part of a manufacturing activity or a

service activity where the service itself is marketed.” Therefore, if on-premise software is sold as part of

a service, it would be subject to ASC 985-20. For example, an entity could sell a customer on-premise

payroll software that enables the entity to provide payroll and tax services to that customer (i.e., the

customer uses the on-premise software in connection with the payroll and tax services it receives from

the entity).

Connecting the Dots

Determining whether software is sold as part of a product or process could require judgment. If

software is used in the design, development, or manufacturing of a separate product or service,

the software would not be within the scope of ASC 985-20 unless that software is included in the

product or service sold. For example, if software is used to produce an architectural blueprint

but only the output associated with the blueprint is sold to a customer, that software would not

be within the scope of ASC 985-20. On the other hand, if the software is also provided with the

architectural blueprint sold to the customer so that the customer can modify the architectural

blueprint, that software would be within the scope of ASC 985-20.

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4.2.1.3 Software Sold as Part of a Hosting Arrangement

Sometimes, software may be sold as part of a hosting arrangement,

2

such as SaaS that is accessed via

an online portal. If so, the software is subject to ASC 985-20 only if both of the following criteria in ASC

985-20-15-5 are met:

a.

The customer has the contractual right to take possession of the software at any time during the

hosting period without significant penalty.

b.

It is feasible for the customer to either run the software on its own hardware or contract with another

party unrelated to the vendor to host the software.

Connecting the Dots

Some may question whether “at any time” during the hosting period means

at every point of

time

during the hosting period. We do not believe that to be the case. For example, an entity’s

arrangements may specify that the customer will automatically obtain the software at the end of

the hosting period. We believe that as long as the customer can take possession of the software

at that point without significant penalty and it is feasible for the customer to run the software

(either on its own or with a third-party vendor), the software license is a separate promise in the

hosting arrangement and would therefore meet the criteria in ASC 985-20-15-5(a) and (b).

If the above criteria are met, an entity (i.e., the vendor) would account for only the software costs under

ASC 985-20. It would account for costs associated with hosting the software separately under other U.S.

GAAP. For example, if the entity purchases servers to provide the hosting service, it would account for

those servers as long-lived assets under ASC 360.

ASC 985-20-15-6 states that the term “significant penalty” as used in ASC 985-20-15-5(a) contains the

following two distinct concepts:

a.

The ability to take delivery of the software without incurring significant cost

b.

The ability to use the software separately without a significant diminution in utility or value.

The analysis for determining whether either or both of these conditions are met (i.e., a significant penalty

exists), depends on the facts and circumstances of the arrangement and requires judgment. An entity

may consider the following factors (not all-inclusive) in making this assessment:

•

Contractual cancellation fees associated with the hosting arrangement.

•

Other contractual penalties for taking possession of the software (e.g., the requirement that the

customer continue to pay the hosting fees for the remainder of the hosting term even though

hosting services are terminated).

•

Costs of transitioning to (1) use of the software on the customer’s own servers or (2) hosting of

the software by the customer’s third-party vendor.

•

Whether the utility and value of the software can be maintained upon transition (e.g., whether

(1) the customer will continue to receive updates, upgrades, and enhancements and (2) the

software will be capable of providing the same functionality in another environment).

•

Whether the software (1) has stand-alone functionality (on its own or with readily available

resources) or (2) is significantly tied to other products or services that can be provided only by

the entity and will no longer be provided if the customer takes possession of the software.

2

A hosting arrangement is defined in the ASC master glossary as being “[i]n connection with accessing and using software products, an

arrangement in which the customer of the software does not currently have possession of the software; rather, the customer accesses and uses

the software on an as-needed basis.”

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Significance can be evaluated both quantitatively and qualitatively. The accounting literature does not

contain specific guidance on (1) which elements of the contract should be included in the measurement

of the amount of the penalty or (2) the benchmark against which the entity should measure the amount

of the penalty when determining whether the penalty is quantitatively significant. An entity may have

an established policy for determining whether the penalty is significant. For example, in a manner

consistent with other Codification subtopics, the entity may reasonably conclude that amounts above 10

percent of a given benchmark are significant. Establishing a method of determining both the elements of

the contract to include in the measurement of the penalty and the benchmark against which to measure

the penalty is an accounting policy decision that the entity should apply consistently. See

Section 2.4.4.1

for illustrative examples of how an entity might evaluate the existence of a significant penalty.

If the criteria in ASC 985-20-15-5 are not met (i.e., the customer does not receive on-premise software),

the entity accounts for the software costs under ASC 350-40 as internal-use software. However, the

entity must evaluate all its arrangements. If it has other substantive arrangements in which the same

software is sold, leased, or marketed (i.e., sold as on-premise software), the entity must account for the

software costs under ASC 985-20 (see

Section 4.2.3

).

4.2.2 Internal-Use Software

ASC 350-40-15-2A describes internal-use software as having both of the following characteristics:

a.

The software is acquired, internally developed, or modified solely to meet the entity’s internal needs.

b.

During the software’s development or modification, no substantive plan exists or is being developed to

market the software externally.

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ASC 350-40-55-1 and 55-2 contain the following examples of fact patterns in which software is for

internal use or not for internal use:

ASC 350-40

55-1

The following is a list of examples illustrating when computer software is for internal use:

a.

A manufacturing entity purchases robots and customizes the software that the robots use to function.

The robots are used in a manufacturing process that results in finished goods.

b.

An entity develops software that helps it improve its cash management, which may allow the entity to

earn more revenue.

c.

An entity purchases or develops software to process payroll, accounts payable, and accounts receivable.

d.

An entity purchases software related to the installation of an online system used to keep membership

data.

e.

A travel agency purchases a software system to price vacation packages and obtain airfares.

f.

A bank develops software that allows a customer to withdraw cash, inquire about balances, make loan

payments, and execute wire transfers.

g.

A mortgage loan servicing entity develops or purchases computer software to enhance the speed of

services provided to customers.

h.

A telecommunications entity develops software to run its switches that are necessary for various

telephone services such as voice mail and call forwarding.

i.

An entity is in the process of developing an accounts receivable system. The software specifications

meet the entity’s internal needs and the entity did not have a marketing plan before or during the

development of the software. In addition, the entity has not sold any of its internal-use software in the

past. Two years after completion of the project, the entity decided to market the product to recoup

some or all of its costs.

j.

A broker-dealer entity develops a software database and charges for financial information distributed

through the database.

k.

An entity develops software to be used to create components of music videos (for example, the software

used to blend and change the faces of models in music videos). The entity then sells the final music

videos, which do not contain the software, to another entity.

l.

An entity purchases software to computerize a manual catalog and then sells the manual catalog to the

public.

m. A law firm develops an intranet research tool that allows firm members to locate and search the firm’s

databases for information relevant to their cases. The system provides users with the ability to print

cases, search for related topics, and annotate their personal copies of the database.

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ASC 350-40 (continued)

55-2

The following list provides examples of computer software that is not for internal use:

a.

An entity sells software required to operate its products, such as robots, electronic game systems, video

cassette recorders, automobiles, voice-mail systems, satellites, and cash registers.

b.

A pharmaceutical entity buys machines and writes all of the software that allows the machines to

function. The pharmaceutical entity then sells the machines, which help control the dispensation of

medication to patients and help control inventory, to hospitals.

c.

A semiconductor entity develops software embedded in a microcomputer chip used in automobile

electronic systems.

d.

An entity purchases software to computerize a manual catalog and then sells the computer version and

the related software to the public.

e.

A software entity develops an operating system for sale and for internal use. Though the specifications

of the software meet the entity’s internal needs, the entity had a marketing plan before the project was

complete. In addition, the entity has a history of selling software that it also uses internally and the plan

has a reasonable possibility of being implemented.

f.

An entity is developing software for a point-of-sale system. The system is for internal use; however,

a marketing plan is being developed concurrently with the software development. The plan has a

reasonable possibility of being implemented.

g.

A telecommunications entity purchases computer software to be used in research and development

activities.

h.

An entity incurs costs to develop computer software for another entity under a contract with that other

entity.

In many cases, it will be obvious that software is obtained or developed solely to meet an entity’s internal

needs (e.g., ERP software purchased from a third-party vendor and used solely by the entity to process

business transactions). In other circumstances, entities will need to carefully evaluate the manner in

which the software is or will be used to determine whether it is subject to ASC 350-40.

In addition, the guidance in ASC 350-40 must be applied at the individual component or module level.

While there is no specific guidance on what an individual component or module might be, an entity

could consider the level of functionality each component or module provides as well as the level of

interdependence between the components or modules.

Connecting the Dots

ASC 350-40-15-2 provides an example of an accounting software system that contains separate

components or modules, including a general ledger, an accounts payable subledger, and

an accounts receivable subledger. Determining the appropriate components or modules

is important because the assessment of amortization and impairment for abandonments

is performed at the component or module level. In addition, components or modules of a

particular software system may be at different stages of development, and costs would need to

be separately tracked, particularly in agile development environments.

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4.2.2.1 Software Is Purchased for Internal Use as Part of a Hosting Arrangement

An entity may obtain internal-use software as part of a hosting arrangement with a vendor. If so, the

software costs are subject to ASC 350-40 if both of the following criteria in ASC 350-40-15-4A are met:

a.

The customer has the contractual right to take possession of the software at any time during the

hosting period without significant penalty.

b.

It is feasible for the customer to either run the software on its own hardware or contract with another

party unrelated to the vendor to host the software.

The criteria above are the same as those in ASC 985-20-15-5 (see

Section 4.2.1.3

). If the criteria are

met, the costs associated with the purchase or license of the software are subject to ASC 350-40. If the

criteria are not met, the arrangement is a service contract (see

Section 4.2.5

).

Connecting the Dots

It is common for software to be hosted on a third-party platform or infrastructure (i.e., not the

vendor’s or customer’s on-site platform or infrastructure). In these circumstances, it is important

to determine who has the contract with that third party (i.e., whether it is the vendor’s or

customer’s cloud instance of the third-party platform or infrastructure). If the software is hosted

on an entity’s (i.e., a customer’s) cloud instance and the entity has possession of the software,

the costs associated with it are subject to ASC 350-40. By contrast, if the software is hosted

on the vendor’s cloud instance and the entity (i.e., the customer) cannot otherwise obtain

possession of the software without significant penalty, the costs associated with that software

are accounted for as a service arrangement and only the implementation costs are subject to

ASC 350-40.

4.2.2.2 No Substantive Plan to Market the Software Externally

If the software is or will be marketed externally (i.e., marketed to be sold or licensed on an on-premise

basis), the costs will be within the scope of ASC 985-20. Therefore, if a substantive plan to market the

software externally exists or is being developed during the software development period, regardless of

whether the software is also intended to meet an internal need, the costs will be subject to ASC 985-20.

The software must be intended solely for internal use to be subject to ASC 350-40.

To be considered “substantive,” a marketing plan needs to be sufficiently detailed, and its

implementation should be reasonably possible.

3

ASC 350-40-15-2B states that a substantive plan “could

include the selection of a marketing channel or channels with identified promotional, delivery, billing,

and support activities.” It also states that “routine market feasibility studies are not substantive plans to

market software.”

Connecting the Dots

When an entity is determining whether it has a substantive plan to market software externally,

it must under ASC 350-40 evaluate its past practices and patterns. For example, if the entity

has a past practice or pattern of both using software internally and selling that same software

externally (or deciding to market internal-use software externally during development), a

rebuttable presumption is created that any software developed by the entity is intended for sale,

lease, or marketing (i.e., the software costs are subject to ASC 985-20).

4

3

The ASC master glossary defines reasonably possible as “[t]he chance of the future event or events occurring is more than remote but less than

likely.”

4

See ASC 350-40-15-2C and ASC 350-40-35-10.

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Example 4-1

Company A, a recording and music distribution company, is developing software that would enable users to

listen to, edit, and record music files. Company A plans to use the software to create music albums that it will

then sell to customers. Company A is also negotiating with four software resellers to sell them the new product.

Company A’s marketing department is compiling a detailed plan and designing promotional material for the

new product, and implementation of the marketing plan is considered at least reasonably possible. Therefore,

A has a substantive marketing plan and should account for the costs of the new software product under ASC

985-20.

Example 4-2

Company B is developing software that would enable it to better manage its advertising campaigns. Company

B has engaged a market research firm to conduct a market survey to determine whether a market for the

new software product exists. The market survey conducted by the market research firm is a routine market

feasibility study and not a substantive plan to market the product. Therefore, unless and until there is a

substantive plan being developed to market the software to others, B should account for the costs of the

software product under ASC 350-40.

Example 4-3

Company C is developing a data management software platform that will be sold only as a cloud-based

arrangement (i.e., as internal-use software; see

Section 4.2.2.3

). It does not have a marketing plan or intent to

sell the software on an on-premise basis (i.e., customers will not have the contractual ability to take possession

of the software). However, C has a past practice of selling other software products to customers on both a

hosted basis and on an on-premise basis, depending on the customer’s request. Therefore, while C has neither

a marketing plan nor the intent to sell the data management software on an on-premise basis, its past practice

creates a rebuttable presumption that the data management software is intended for sale, lease, or marketing.

Company C considers that recently, it either has transitioned or is in the process of transitioning its customers

to using all of its software products on a hosted basis. In addition, for any new or modified arrangements,

customers will no longer have the contractual ability to take possession of any of C’s software products.

Therefore, C concludes that it can overcome the rebuttable presumption that the data management software is

intended for sale, lease, or marketing and the data management software is therefore subject to ASC 350-40.

4.2.2.3 Software Is Marketed or Sold Only as a Cloud-Based (or Hosting)

Arrangement

If software is being marketed or sold only as a cloud-based (or hosting) arrangement, that software

would be considered internal-use software. To determine whether the product is considered software to

be sold, leased, or marketed, and therefore accounted for under ASC 985-20, see

Section 4.2.1

.

Many cloud-based or hosting arrangements include a “license” to software but allow the customer to use

the software only in an entity’s (rather than the customer’s) hosted environment (because of contractual

or practical limitations, or both, to taking possession of the software). The entity’s hosted environment

could include its cloud instance on a third party’s platform or infrastructure (i.e., the entity has a contract

with a third party to host its software). Although these arrangements may include a contractual license,

if the customer is unable to take possession of the software subject to the license without significant

penalty, the software is for the entity’s internal use in providing a service to its customers. These

transactions are accounted for as service arrangements (rather than licensing arrangements) since the

entity is providing the functionality of the software through a hosting arrangement (service) rather than

through an actual on-premise software license that is controlled by the customer. Therefore, the costs

to develop or acquire such software should be accounted for under ASC 350-40.

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Connecting the Dots

ASC 350-40-15-5 specifies that software is for internal use (vs. sold as on-premise software) if it

is used to develop a product or provide a service sold to a customer but the customer does not

actually acquire the software or a future right to use it.

Example 4-4

Company D offers its office productivity software solution as a SaaS whereby its customers access the solution

through an online portal and store data on D’s secure servers. The software will always be maintained at the

most up-to-date version available, and customers have rights to online and telephone support. Customers do

not have the ability to take possession of the software.

Because customers are not permitted to take possession of the software and may use only D’s cloud-based

service, D concludes that the costs associated with its office productivity software should be accounted for

under ASC 350-40.

Example 4-5

Company E is developing a CRM software solution to be marketed and sold to customers. Company E also

intends to use the software internally to manage its communications and relationships with customers and

potential customers.

A detailed marketing plan has already been developed for the software. The software will be provided to

customers on a hosted basis (i.e., the software will be accessed by using an Internet connection) and will

connect to E’s proprietary data analytics platform, which has already been developed and is housed on E’s

own servers (i.e., it is a SaaS solution that is accessed only online). Company E’s data analytics platform will be

a significant part of the overall solution sold to its customers and will be significantly integrated with the CRM

software solution being developed. Company E plans to provide its customers with the contractual ability to

take possession of the CRM software on an on-premise basis, when requested at any point during the hosting

period, without paying E a penalty or cancellation fee. However, customers will not have the contractual ability

to take possession of E’s data analytics platform. In addition, cancellation of the hosting service for the CRM

software will also result in the cancellation of the SaaS for E’s data analytics platform, which cannot be easily

replicated by the customer or third-party vendors. Further, customers would incur significant costs to integrate

the CRM software with other third-party data analytics platforms.

While a customer will have the “contractual right to take possession of the software at any time during the

hosting period” without paying E a penalty or cancellation fee, it cannot do so without incurring a significant

penalty (i.e., significant diminution in utility or value of the CRM software without E’s data analytics platform).

Therefore, E concludes that the software costs incurred to develop the CRM software should be accounted for

under ASC 350-40.

4.2.3 Transition Between Internal-Use Software and On-Premise Licensed

Software

4.2.3.1 Transition to Licensing Software Externally

After the development of internal-use software, an entity may decide to license the software externally

on an on-premise basis. If so, the entity must first account for any proceeds received from the license

of the software, net of any direct incremental costs (e.g., commissions, software reproduction costs,

warranty and service obligations, and installation costs), as a reduction of the carrying amount of

any costs for that software that were capitalized under ASC 350-40. It cannot recognize profit on the

software until it has reduced the carrying amount to zero. When the entity has reduced the carrying

amount to zero (inclusive of any amortization of the software), it can then recognize subsequent

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proceeds as revenue under ASC 606 (or a gain under ASC 610-20 if the contract is not with a customer).

5

Any subsequent software development costs for that software product are then subject to ASC 985-20.

If the decision to market the software externally happens during its development, any software costs

incurred prospectively are accounted for under ASC 985-20. As indicated above, this decision should be

supported by a substantive plan before the entity switches to ASC 985-20. In addition, amortization and

impairment assessments should likewise be subject to ASC 985-20.

6

4.2.3.2 Transition to Providing Software Through a Cloud-Based Arrangement

Because there have been significant shifts over time to migrate software solutions to the cloud, it is

common for software entities to sell software on both an on-premise licensed basis and a cloud basis. In

those circumstances, any software costs are subject to ASC 985-20.

However, scope-related questions have arisen in situations in which an entity predominantly sells

and provides a software solution through cloud-based arrangements. As long as there continue to

be substantive external sales of on-premise software, we believe that the software costs should still

be subject to ASC 985-20. If, instead, an entity no longer has substantive external sales of on-premise

software, neither ASC 985-20 nor ASC 350-40 provides transition guidance. In that circumstance, we

believe that it is reasonable to account for any future software development costs in accordance with

ASC 350-40 and to account for the aggregate amount of capitalized software costs for the software

prospectively under ASC 350-40 (e.g., amortization and impairment). We believe that an entity may apply

judgment in determining whether there are any substantive external sales of on-premise software.

4.2.4 Hybrid Cloud-Based Software Solutions

Many entities sell hybrid cloud-based software solutions, in which on-premise licensed software is sold

with cloud-based software. Often, the on-premise licensed software interacts with the cloud-based

software, and in some circumstances, the on-premise licensed software may be significantly integrated,

interdependent, or interrelated with the cloud-based software.

In these situations, an entity must carefully track its software costs to determine which are (1) subject to

ASC 985-20 (because there are substantive sales of on-premise licensed software) or (2) subject to ASC

350-40 (because the software is sold only as a service). Even if the on-premise software is significantly

integrated, interdependent, or interrelated with the cloud-based software, it generally would not be

appropriate to account for all software costs under ASC 985-20 if the software that is sold only as a

service is substantive. Likewise, it generally would not be appropriate to account for all software costs

under ASC 350-40 if the software sold on an on-premise licensed basis is substantive.

Example 4-6

Company F has a database management system, which is software that it uses in delivering its information

services to customers through an online portal. The system collects data from real-time feeds, news sources,

and contributed data sources. Company F also sells an on-premise license to its data analytics and machine

learning software product, which includes an interface to F’s database management system and is downloaded

on a customer’s servers.

The costs incurred in connection with the database management system are within the scope of ASC 350-40.

However, the costs of the data analytics and machine learning software product, which resides on a customer’s

servers, are accounted for under ASC 985-20. Therefore, F should separately track its software costs for each

software solution.

5

See ASC 350-40-35-7 and 35-8.

6

See ASC 350-40-35-9.

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4.2.5 Cloud-Based (or Hosting) Service Arrangements

An entity may enter into a cloud-based (or hosting) arrangement with a vendor (typically for internal

use). In determining whether it has purchased a software license or a service arrangement, the entity

must evaluate the same considerations as described in

Section 4.2.2.1

. If the entity (1) does not

have “the contractual right to take possession of the software at any time during the hosting period

without significant penalty” or (2) it is not “feasible for the [entity] to either run the software on its own

hardware or contract with another party unrelated to the vendor to host the software,” the entity has

entered into a service contract.

7

In this circumstance, only implementation costs incurred would be

subject to ASC 350-40. An entity may need to use judgment in determining which costs are related

to implementation — “implementation cost” is not a defined term because, as paragraph BC14 of

ASU 2018-15

states, “[ASC] 350-40 already has appropriate guidance that entities currently apply in

practice.” While the term is not defined in ASC 350-40, the EITF and members of the FASB board and

staff discussed the following examples of implementation activities during the October 12, 2017, EITF

meeting

:

8

•

“Integration (developing interfaces between the hosted software and the entity’s other systems).”

•

“Customization, either of the entity’s other systems or of the hosted software.”

•

“Configuration, either of the entity’s other systems or of the hosted software.”

•

“Data conversion or migration.”

•

“Installation.”

•

“Architecture and design.”

•

“Coding.”

•

“Testing.”

•

“Training.”

•

“Business process reengineering.”

Connecting the Dots

When an entity incurs implementation costs for a cloud-based (or hosting) service arrangement,

it may also purchase or develop internal-use software as part of that implementation. In that

circumstance, the entity should separately account for the costs incurred for that internal-use

software under ASC 350-40.

In accordance with ASC 350-40, capitalized implementation costs related to cloud-based service

arrangements are deferred and presented in the statement of financial position as prepaid expenses.

Further, when such costs are amortized, they are (1) presented in the income statement as an operating

expense with the associated hosting fees and (2) classified in the statement of cash flows as an

operating activity.

7

See ASC 350-40-15-4A through 15-4C.

8

Quoted text is from

Issue Summary No. 1, Supplement No. 1

, which the FASB staff released on September 28, 2017, to facilitate discussion of

EITF Issue 17-A at the October 12, 2017, EITF meeting.

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4.2.6 Multiple-Element Arrangements

Entities that purchase internal-use software or cloud-based services often purchase multiple elements in

the same arrangement (e.g., on-premise software licenses, PCS, cloud-based services, and professional

services). ASC 350-40-30-4 requires entities to allocate the cost to all individual elements on the basis of

their stand-alone prices.

9

Example 4-7

Company G purchases a three-year noncancelable software subscription from Vendor H that enables G to

manage its data center (e.g., manage various IT workloads). The software can operate (1) on different types

of commodity hardware that G can purchase and use on its own premises or (2) through cloud computing

arrangements (both the hardware and cloud computing services can be purchased from various third-party

vendors and are not part of the arrangement between G and H). The subscription arrangement includes a

three-year term-based license that is delivered digitally (it can be downloaded on G’s own servers or third-

party servers if G chooses to access it through its vendor’s cloud computing platform), as well as support and

maintenance over the three-year term. Company G also purchases professional services, including training

and business process reengineering services, from H in the same subscription arrangement. Company G

determines that there are three elements in the arrangement and allocates the total consideration payable to

H to those elements on the basis of their relative stand-alone prices. The three elements are accounted for as

follows:

•

Because G takes possession of the on-premise term-based software license, the amount allocated to it

is capitalized as internal-use software under ASC 350-40. The capitalized software cost is then amortized

on a straight-line basis over the three-year term and is subject to the impairment guidance in ASC 360.

•

The amount allocated to the support and maintenance is expensed over the three-year term. If G

prepays for the support and maintenance, it is initially recognized as a prepaid expense.

•

The amount allocated to the professional services is expensed as incurred. If G prepays for the

professional services, it is initially recognized as a prepaid expense.

4.2.7 Other Guidance to Consider

Software-related costs may be subject to U.S. GAAP other than ASC 985-20 or ASC 350-40. The

discussion below describes other guidance that may apply to such costs.

4.2.7.1 Web Site Development Costs

Web site development costs are subject to ASC 350-50. The guidance is similar to that in ASC 350-40.

For example, under ASC 350-50-25-6, if software for a Web site is purchased or developed for an entity’s

internal needs, costs incurred for (1) purchased software tools or (2) internally developed software

tools during the application development stage are generally capitalized. In addition, certain software

acquired or developed for internal use related to Web site operation or graphics is directly within the

scope of ASC 350-40.

While ASC 350-50 refers to Web site content, it does not address the accounting for such content.

Therefore, Web site content is accounted for under other U.S. GAAP. For example, if an entity is a

licensee in the record and music industry and relicenses music content, it would apply the guidance in

ASC 928-340.

9

A stand-alone price is defined in ASC 350-40-20 as the “price at which a customer would purchase a component of a contract separately.”

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Changing Lanes

ASU 2025-06 amends the guidance in ASC 350-50 on Web site development costs and moves

it to ASC 350-40. Example 4 in ASC 350-40-55-18 through 55-21, as amended, illustrates the

application of ASC 350-40 to Web site development costs.

4.2.7.2 Software Used for Research and Development Activities

If software is used in R&D activities and does not have alternative future uses, it is subject to ASC 730-10.

In addition, the following software costs are accounted for as R&D costs:

•

For software subject to ASC 985-20, all costs incurred before the establishment of technological

feasibility.

10

•

For software subject to ASC 350-40, all costs for pilot projects (i.e., “[d]esign, construction,

and operation of a pilot [project] that is not of a scale economically feasible to the entity for

commercial production”).

11

•

For software subject to ASC 350-40, all costs associated with a particular R&D project,

“regardless of whether the software has alternative future uses.”

12

Example 4-8

Company J is trying to implement a supply management system by using blockchain technology but is not

certain that the supply management system can be designed to meet J’s internal requirements. Company J has

decided to implement its system at one of its smaller facilities for 90 days to determine whether the system will

function as intended.

A project of this nature would be considered a pilot project and accounted for as R&D because J is

implementing a software system, intended for company-wide implementation, on a small scale. Often these

pilot projects are implemented at locations at which the risk of loss is very low or the cost to run parallel

systems is not significant.

Software associated with R&D assets may be acquired in a business combination. If the software will be

used for R&D activities, they are subject to the guidance in ASC 805-20 and ASC 350-30. In accordance

with ASC 805-20, they are recognized as an asset and measured at fair value.

4.2.7.3 Significant Production, Modification, or Customization of Software

Software sold to customers in arrangements that require significant production, modification, or

customization is accounted for under ASC 606. If the software is being produced, modified, or

customized for a specific customer contract, the costs for such software represent fulfillment costs that

are subject to ASC 340-40.

4.2.7.4 Business Process Reengineering Activities

An entity may incur costs associated with business process reengineering activities as part of developing

software or implementing cloud-based solutions. Those costs are subject to ASC 720-45 and are

expensed as incurred.

10

See ASC 985-20-25-1.

11

See ASC 350-40-15-7(b)(1) and ASC 730-10-55-1(h).

12

See ASC 350-40-15-7(b)(2).

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Chapter 4 — Software and Software-Related Costs

4.2.8 Flowchart for Determining the Appropriate Guidance

The flowchart below illustrates how an entity determines the appropriate guidance to apply to software-

related costs.

Apply ASC 350-50.

Apply ASC 340-40.

Apply ASC 805-20 and

ASC 350-30.

Apply ASC 730-10.

Apply ASC 350-40.

Apply ASC 985-20.

A service arrangement

exists. Apply ASC 350-40

only to implementation

costs.

Is the

software being

produced, modified,

or customized for a specific

customer contract that

is subject to ASC

606?

Is the

software

being

purchased (1)

as part of a hosting

arrangement or (2)

exclusively on an

on-premise

basis?

Are the costs

related to (1)

software acquisition

or (2) software

development?

Are

both

of

the criteria in

ASC 350-40-15-4A met

(i.e., (1) the entity “has

the contractual right to take

possession of the software at any

time during the hosting period without

significant penalty”

and

(2) it “is feasible

for the [entity] to either run the

software on its own hardware

or contract with another

party unrelated to the

vendor to host the

software”)?

Will the

entity’s

customers acquire

the software (1) on an

on-premise basis or (2)

as part of a hosting

arrangement?

(1) Is the

software being

acquired, developed, or

modified solely to meet the

entity’s internal needs, or (2) does

a substantive plan exist (or is

one being developed) to

market the software

externally?

Are the costs

associated

with Web site

development?

Is the software

acquired in a

business combination,

and will the software

be used for R&D

activities?

Are the costs associated

with software that (1) will

be used in R&D activities

and

does not have alternative future uses

or (2) will be solely for internal use

and

associated with a particular

R&D project, including pilot

projects?

Yes

Yes

Yes

Yes

No

No

No

No

Acquisition

Hosting arrangement

Development

Exclusively on-premise

Yes

No

Solely for

internal needs

Substantive

plan to market

externally

On-premise basis

Hosting

arrangement

No

Yes

Are

both

of

the criteria in

ASC 985-20-15-5 met

(i.e., (1) the “customer has

the contractual right to take

possession of the software at any

time during the hosting period without

significant penalty”

and

(2) it “is feasible

for the customer to either run the

software on its own hardware

or contract with another

party unrelated to the

vendor to host the

software”)?

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4.2.9 Importance of Ongoing Reassessment of Software Costs

As described above, there are various ways in which an entity’s evolving business models may affect

which guidance applies when accounting for costs to develop or acquire software. These include

changes in the manner in which entities are (1) developing or acquiring software solutions from their

vendors for internal use and (2) marketing and delivering software solutions to their customers. In the

rapidly evolving technology ecosystem, it is important for an entity to have sufficient internal controls in

place to periodically reassess and document how these changes in facts and circumstances may affect

the guidance the entity should apply and the related accounting.

4.3 Accounting for the Development of Generative AI Software Products

4.3.1 Overview

More and more companies are considering purchasing or developing software that uses or leverages

AI to enhance internal productivity or are incorporating generative AI into their revenue-generating

products. Although developing or enhancing generative AI applications may involve more traditional

software development costs (e.g., internal or external labor), some generative AI developments may

be more advanced and may incur additional costs. For example, large amounts of data are typically

necessary to train generative AI applications. Businesses that invest in generative AI will need to consider

the accounting impacts of the software or software-related costs associated with generative AI.

The software costs incurred for generative AI could include fees paid to use third-party foundation

models or LLMs as well as fine-tuning and other training costs. Entities developing generative AI

applications will need to consider whether the developed software will be used internally or whether

it will be sold as a hosting arrangement, an on-premise software license, or a hybrid software offering.

Depending on the nature of the generative AI software, the software costs related to the project may

be subject to the guidance in ASC 985-20 or ASC 350-40 while other costs incurred to support the

generative AI software may be subject to other U.S. GAAP.

The sections below discuss accounting considerations for entities developing generative AI technology

(whether for their own use or external marketing). Specific topics addressed include (1) whether costs

related to generative AI technology should be accounted for under ASC 350-30, ASC 350-40, ASC

985-20, or other U.S. GAAP and (2) how such costs should be evaluated under the applicable accounting

literature.

4.3.2 Background

Generative AI is a subset of AI that focuses on the ability of machines to take in inputs (e.g., text,

images) and create outputs in various formats (e.g., text, images, audio, code, voice, video). Generative

AI applications serve as interfaces for end users. These applications are powered by significant

infrastructure (e.g., cloud-based AI foundation models or LLMs) and generate content on the basis of

how the underlying models were trained as well as the end user’s inputs. Foundation models typically

use neural networks to learn patterns from huge amounts of data and predict outcomes on the basis

of historical data patterns. Like traditional AI, foundation models predict outputs by making inferences

related to the inputs they receive. However, through fine-tuning, prompt engineering, and adversarial

training (discussed further below), these models produce outputs on the basis of their understanding of

human-generated inputs.

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4.3.2.1 Generative AI Foundation Model

Generative AI applications are powered by foundation models, LLMs that use deep learning to process

huge amounts of data. A foundation model can perform a wide range of tasks in natural language

processing (NLP), a subfield of AI that enables computers to interpret input prompts and generate

outputs such as text, translation, summarization, and answers to questions. With a foundation model,

the software can predict outputs on the basis of statistical inferences it makes from the inputs received.

The quality, accuracy, and relevancy of a generative AI application’s outputs depend on the training the

underlying foundation model receives.

The development of AI infrastructure foundation models is based on machine learning algorithms that

consider linguistic rules and statistical models so that a computer can “understand” the natural language

of a user’s input prompt.

Entities that intend to develop a foundation model may incur the following costs:

•

Software developer costs

— Internal and external labor costs related to the development of the AI

infrastructure code, time-intensive training, validation of outputs, and optimization activities.

•

Data acquisition costs

— Foundation model developers might incur costs to acquire the vast

amount of data they need to develop foundation models that perform various NLP tasks and

produce a wide range of responses.

•

Computation resources

— High-performance hardware must be used to train a foundation

model. An entity could choose to purchase either specific hardware (e.g., computers with

powerful CPUs, GPUs, or RAM) or platform or infrastructure services from third parties (i.e.,

cloud services) that offer the same computational scalability.

•

Storage costs

— Because of the amount of data needed to train and maintain a foundation

model, entities may incur significant storage costs. An entity could choose to purchase or lease

hardware for storage or to purchase cloud storage services from third parties.

Generative AI applications interact with and rely on a foundation model to generate outputs on the basis

of user prompts. The dependency of AI applications on foundation models can be thought of as similar

to the reliance of traditional software applications on operating systems. As a large-scale, pretrained

language model, a foundation model serves as an engine that software developers train and calibrate

for specific scenarios when creating their own generative AI applications. Currently, a limited number of

companies have developed foundation models and some have provided access to this technology as

open-source software or software sold as part of a hosting arrangement.

Because of the complexity of foundation models, the development of this technology is expected

to be labor- and resource-intensive. We therefore expect most generative AI application developers

to leverage existing foundation models in their applications rather than create their own. However,

foundation models can vary in size and some entities might develop a private foundation model or LLM

that is trained only on entity-specific data.

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4.3.2.2 Generative AI Applications

Generative AI application developers are likely to incur additional training costs in refining foundation

models to generate outputs tailored to their applications. Foundation models might be further trained

through a combination of the following methods:

•

Fine-tuning

— Using specific data to train the foundation model to create outputs for a subset

of prompts beyond the existing scenarios for which the model was trained. For example, a

company that is creating a generative AI application to produce medical diagnoses for a user’s

symptoms may need to fine-tune the foundation model by acquiring information from medical

encyclopedias, patient data, online databases of research articles, and scientific publications. An

entity would expect to incur data acquisition and labor costs related to fine-tuning.

•

Prompt engineering

— Creating or adjusting the prompt to communicate with the foundation

model to output an optimal answer. A company could incur specific internal or external software

development costs in creating the prompt.

•

Adversarial training

— Two different deep-learning models can be pitted against each other to

train both models. In this approach, one model, the generator, creates synthetic data samples

while the other model, the discriminator, receives synthetic data samples and real data samples.

The generator’s objective is to produce samples that are indistinguishable from real data, while

the discriminator’s goal is to become better at distinguishing between real and generated data.

An entity would expect to incur data acquisition, software development, and other labor costs

related to adversarial training.

In addition to the data and training costs, an entity may also incur traditional software development

costs (e.g., costs related to developing the software application user interface, infrastructure, graphics,

and content) when creating a generative AI application. These costs may also be subject to capitalization

or expense under ASC 985-20, ASC 350-40, or other U.S. GAAP.

4.3.3 Accounting Considerations Related to Generative AI Development Costs

Because generative AI is a form of software, general software development accounting considerations

apply to generative AI costs, including whether the related project will be used for internal purposes

(including being sold as a service) or sold or marketed externally. Similar costs may be incurred, and

similar considerations will be relevant, regardless of whether an entity is developing a foundation model

(or LLM) or an application that leverages an existing model.

4.3.3.1 Generative AI Software Used as Internal-Use Software or Software

Marketed or Sold Only as a Hosting Arrangement

Although the development of foundation models marked a crucial milestone in NLP and AI research,

there was initially significant uncertainty about whether this technology would meet its specified

performance requirements. Development risks affect whether costs incurred to develop software can

be capitalized. Different guidance applies depending on whether the software (e.g., a foundation model

or application) is being developed for internal use or for external sale or marketing. Entities developing

AI software for internal use or to be sold or marketed as a hosting arrangement would consider

applying the capitalization guidance in ASC 350-40 on internal-use software. Alternatively, ASC 985-20

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would apply if an entity intends to sell or market its AI software as software licenses. With respect to

internal-use software, ASC 350-40-15-2A states the following:

ASC 350-40

15-2A

Internal-use software has both of the following characteristics:

a.

The software is acquired, internally developed, or modified solely to meet the entity’s internal needs.

b.

During the software’s development or modification, no substantive plan exists or is being developed to

market the software externally.

When AI software is developed for internal use, a significant portion of the software development costs

may be incurred during the preliminary project stage. Unlike ASC 985-20 (discussed further below), ASC

350-40 does not require the establishment of technological feasibility

13

for capitalization but does have

other requirements for capitalization depending on the stage of development. Generally, development

costs incurred during the application development stage are capitalized, while costs incurred during the

preliminary project stage and postimplementation-operation stage are expensed as incurred.

The following are some indicators of when an entity is in the preliminary project stage and when costs

should therefore be expensed as incurred in accordance with ASC 350-40:

•

The entity is considering allocating resources (i.e., developers, financial budget) between

different projects (e.g., different AI applications or other software projects).

•

The entity is still determining the performance requirements for the AI application or the

infrastructure requirements necessary for the application to operate.

•

The entity is holding ongoing conversations with vendors (e.g., foundation model vendors,

hardware vendors, cloud computing vendors) to determine which products are best aligned with

the entity’s software performance requirements.

•

The entity is still exploring alternatives related to achieving the performance requirements

identified (i.e., using internal software developers to train foundation models versus hiring third-

party consultants).

•

The entity is determining whether there is an existing technology for developing a specific

generative AI application to meet the identified performance requirements.

The preliminary project phases for many AI applications and software projects may be longer than those

for other software development projects given the use of new and advanced technologies as well as the

emergence of high-risk development issues that could affect the successful completion of the project.

Once the preliminary project stage is complete and the application development phase commences,

entities developing AI applications will need to identify and capitalize the direct internal and external

costs incurred to develop the AI application. When both foundation models and AI applications are being

developed or implemented at the same time, entities will need to carefully track internal and external

costs to ensure they are appropriately deferred or capitalized in accordance with the guidance in ASC

350-40. In addition, the development and implementation of foundation models and AI applications

may involve new activities (e.g., training) performed by employees who have not historically tracked time

spent on developing software. In these circumstances, entities may need to create new processes and

controls to track these costs accurately.

13

Current guidance in ASC 350-40 stipulates that to proceed from the preliminary project stage to the application development stage, a company

would have to determine that the technology it needs to meet the performance requirements exists. However, as previously noted, ASU 2025-06

removes from ASC 350-40 all references to development stages. See

Section 4.4

for further discussion of the ASU.

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4.3.3.1.1 Illustrative Examples of Accounting for the Costs of Developing Software

Involving Generative AI After the Adoption of ASU 2025-06

The examples below illustrate the application of ASC 350-40 to the accounting for the costs of

developing software involving generative AI after the adoption of ASU 2025-06.

14

Example 4-9

Entity Y offers hosted ERP solutions to its customers as SaaS. On January 15, 20X0, Y’s CEO approved and

committed to funding a project to evaluate how Y can incorporate AI into its SaaS offerings to provide a

technical accounting support module. The module would be able to read customer contracts and extract key

terms from the documents (the “extract functionality”) and, using generative AI technology trained on publicly

available guidance, disclosures, and examples, create an output of revenue recognition considerations in the

customer contract (the “write functionality”).

On January 15, 20X0, the technology necessary for providing the write functionality does not exist, and Y would

need to use a combination of third-party tools and an in-house model to develop it. Entity Y has not selected

the third-party tools and does not currently have the appropriate talent resources to perform the necessary

in-house activities to develop the intended functionality. In addition, not all the significant performance

requirements have been identified.

By contrast, the extract functionality is based on existing concepts and technology. Entity Y determines that

it has decided what the software needs to do, and its in-house development personnel have the resources

and capabilities to replicate the existing tool in the market. Accordingly, Y begins developing the extract

functionality.

On February 28, 20X0, Y hired generative AI specialists to work on the write functionality and entered into a

service contract to access an LLM from a reputable third party. Through June 30, 20X0, Y evaluates how the AI

specialists it hired can leverage and build on its existing LLM. As of June 30, 20X0, Y determined that the tool

will be limited to identifying the distinct performance obligations in the contract; however, certain novel or

unproven functions still need to be developed for the software to perform this task.

As of September 30, 20X0, the AI specialists have made significant progress toward developing the model

and completed the coding and testing necessary to demonstrate that the write functionality can perform

the intended task in accordance with the design specifications selected by Y. Although Y has resolved the

development uncertainty, the model will still need to be trained on sufficient data to achieve the desired

functionality.

On December 15, 20X0, Y completes the model training necessary to demonstrate that the write functionality

can perform the performance obligation assessment in accordance with the design specifications.

14

See

Section 4.4

for further discussion of ASU 2025-06.

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Chapter 4 — Software and Software-Related Costs

Example 4-9 (continued)

The appropriate accounting for the costs incurred to develop the functionality depends on Y’s evaluation of the

unit of account (i.e., what constitutes the “software project”). There are two acceptable views:

•

View A

— The extract and write functionality were funded as a single software project and therefore

represent a single unit of account.

For each of the key dates above, Y assesses whether the internal and external costs incurred to develop

the application meet the capitalization requirements in ASC 350-40-25-12 as follows:

o

On January 15, 20X0, although the CEO approved the funding for the project, the capitalization

criteria in ASC 350-40-25-12 are not met because of significant development uncertainties.

o

As of February 28, 20X0, although Y has hired the AI specialists and entered into a service contract

to access a third-party LLM in developing its tool, significant development uncertainties remain.

Accordingly, as of February 28, 20X0, Y has determined that the software still does not meet the

requirement in ASC 350-40-25-12(c).

o

As of June 30, 20X0, Y has identified a specific accounting output that the software must be able to

write, and as a result, it has identified the significant performance requirements that are known and

not expected to change. However, the ultimate technology that Y intends to develop remains novel,

unique, and unproven. Accordingly, as of June 30, 20X0, Y has determined that the software still does

not meet the requirement in ASC 350-40-25-12(c).

o

As of September 30, 20X0, the AI specialists have resolved the software development risk related

to the novel portions of the project through coding and testing. On the basis of such progress, the

development uncertainty associated with the novel, unique, and unproven aspects of the software

development described in ASC 350-40-25-12A has been resolved through coding and testing, and Y

therefore concludes that the software meets the requirements in ASC 350-40-25-12(c).

Eligible software development costs incurred after September 30, 20X0, would be capitalized, including

those related to the model developed in-house and implementing the LLM model. Entity Y would

capitalize the costs incurred for training the model that were necessary to establish that the write

functionality can perform the performance obligation assessment in accordance with the design

specifications through December 15, 20X0.

•

View B

— Because Y can provide the extract functionality even if the write functionality is not developed,

each functionality represents a separate software project.

On January 15, 20X0, the CEO approved both projects. Because it is probable that the extract

functionality will be completed (i.e., there is no significant development uncertainty associated with the

software project), Y begins capitalizing eligible development costs allocable to such software project.

The milestones in View B for the write functionality are the same as those in View A, and costs related to

the write project incurred after September 30, 20X0, are capitalized.

Example 4-10

Assume the same facts as in

Example 4-9

, except that after Entity Y’s technical accounting module is ready for

its intended use, Y determines that there is a demand for an enhancement to its software that would provide

principal-versus-agent analyses for revenue contracts.

On the basis of what it learned from its original technical accounting module project, Y believes that it can

develop the new functionality with internal expertise and that although the functionality does not yet exist,

the only development risk is related to systematizing the logic inherent in the accounting rules related to the

guidance on principal versus agent. On January 31, 20X1, the CEO approves the software enhancement.

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Example 4-10 (continued)

Entity Y determines that the desired functionality represents an upgrade to its current software; therefore, it

considers the guidance in ASC 350-40-25-17A through 25-17E and concludes that (1) it is probable that the

upgrade will result in additional functionality and (2) it should evaluate the upgrade as a new software project.

Entity Y once again considers the guidance in ASC 350-40-25-12 and 25-12A and determines that as of January

31, 20X1, management has committed to funding the project and that the probable-to-complete recognition

threshold is met. In making this determination, Y considers the factors in ASC 350-40-25-12A and notes that

the performance requirements are defined for principal-versus-agent analyses and that although the upgrade

will result in additional functionality, there are no significant development uncertainties associated with such

functionality. Management reaches this decision on the basis of the successful release of Y’s previous technical

accounting module and concludes that no new technological innovations or novel, unique, unproven functions

and features need to be developed for the new functionality to be created. Rather, the same logic and coding

will be used to create the new module, and only routine coding, testing, and model training will be needed to

create the new functionality.

Entity Y therefore begins capitalizing development costs of the new module after January 31, 20X1.

4.3.3.2 Generative AI Software That Will Be Sold or Marketed Externally

If an entity plans to license its generative AI software externally, the software would be within the scope

of ASC 985-20. The costs of developing software within the scope of ASC 985-20 cannot be capitalized

until technological feasibility is established, which typically occurs toward the end of the development

period when all high-risk development issues have been resolved through coding or testing. ASC 985-20-

25-1 states the following:

ASC 985-20

25-1

All costs incurred to establish the technological feasibility of a computer software product to be sold,

leased, or otherwise marketed are research and development costs. Those costs shall be charged to expense

when incurred as required by Subtopic 730-10.

As a result, minimal costs tend to be capitalized when software is developed to be marketed or sold

externally unless the costs incurred are subject to other GAAP.

4.3.3.3 Generative AI Software Acquired as a Cloud Computing Arrangement

Rather than develop AI software for internal use, an entity may engage with a third party to develop an

AI solution that will be accessed as part of a cloud computing arrangement. In such circumstances, the

AI software will only be accessed as part of a hosting arrangement. The ASC master glossary defines a

hosting arrangement as follows:

In connection with accessing and using software products, an arrangement in which the customer of the

software does not currently have possession of the software; rather, the customer accesses and uses the

software on an as-needed basis.

Under ASC 350-40, costs incurred to implement a hosting arrangement that is a service contract

would be subject to the same recognition and measurement guidance as costs incurred to develop or

acquire internal-use software. However, any costs deferred in accordance with this guidance would be

presented in the same manner as any prepayments made for the underlying service.

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4.3.3.4 Data Acquisition Costs

As noted above, entities developing foundation models and AI applications may need significant

amounts of data to train the models. Entities will need to consider whether the costs of acquiring the

data should be (1) expensed as incurred, (2) recognized as a separate intangible asset, or (3) considered

for capitalization as part of the AI application or foundation model.

Costs incurred to acquire data from a third party should be evaluated to determine whether it is

appropriate to capitalize the costs as a separate intangible asset. The guidance in ASC 350-30 would

apply to data that are acquired individually or as a group of other assets (that do not constitute a

business) and that have an alternative use (i.e., in more than one software project). ASC 350-30-25-1

states that “[a]n intangible asset that is acquired either individually or with a group of other assets shall

be recognized.” Further, ASC 350-30-25-4

15

states the following regarding the acquisition of intangible

assets:

ASC 350-30

25-4

Intangible assets that are acquired individually or with a group of assets in a transaction other than a

business combination or an acquisition by a not-for-profit entity may meet asset recognition criteria in FASB

Concepts Statement No. 5,

Recognition and Measurement in Financial Statements of Business Enterprises

, even

though they do not meet either the contractual-legal criterion or the separability criterion (for example,

specially-trained employees or a unique manufacturing process related to an acquired manufacturing plant).

Such transactions commonly are bargained exchange transactions that are conducted at arm’s length, which

provides reliable evidence about the existence and fair value of those assets. Thus, those assets shall be

recognized as intangible assets.

Pending Content (Transition Guidance: ASC 805-60-65-1)

25-4

Intangible assets that are acquired individually or with a group of assets in a transaction other than a

business combination, an acquisition by a not-for-profit entity, or a joint venture upon formation may meet

asset recognition criteria in FASB Concepts Statement No. 5,

Recognition and Measurement in Financial

Statements of Business Enterprises

, even though they do not meet either the contractual-legal criterion or

the separability criterion (for example, specially-trained employees or a unique manufacturing process

related to an acquired manufacturing plant). Such transactions commonly are bargained exchange

transactions that are conducted at arm’s length, which provides reliable evidence about the existence and

fair value of those assets. Thus, those assets shall be recognized as intangible assets.

Pending Content (Transition Guidance: ASC 105-10-65-9)

25-4

Intangible assets that are acquired individually or with a group of assets in a transaction other

than a business combination, an acquisition by a not-for-profit entity, or a joint venture upon formation

may qualify for recognition even though they do not meet either the contractual-legal criterion or the

separability criterion for being an identifiable asset (for example, specially-trained employees or a unique

manufacturing process related to an acquired manufacturing plant). Such transactions commonly are

bargained exchange transactions that are conducted at arm’s length, which provides reliable evidence

about the existence and fair value of those assets. Thus, those assets shall be recognized as intangible

assets.

15

The amendments in

ASU 2023-05

— which are effective prospectively for all joint venture formations with a formation date on or after January

1, 2025 — add to the exclusions in ASC 350-35-25-4 intangible assets acquired individually or with a group of assets in a joint venture upon

formation. In addition, the amendments in

ASU 2024-02

— which are effective for fiscal years beginning after December 15, 2024, for public

business entities and fiscal years beginning after December 15, 2025, for all other entities — remove all concepts statement references from

the Codification. However, we do not believe that the removal of the reference to Concepts Statement 5 from ASC 350-30-25-4 will affect the

application of the guidance in this paragraph to data acquisition costs.

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Acquired data will lack physical substance and will most likely be acquired as part of a contract that

defines the rights controlled by the entity. In these cases, the acquired data are likely to meet the

definition of an asset (because the data are separately identifiable and provide an entity with a present

right to future economic benefits) and could be recognized separately as an intangible asset. Entities

would need to determine the useful life of the acquired data and perform an impairment assessment in

accordance with ASC 350.

Connecting the Dots

The existing guidance in ASC 350-30-25-4 refers to the asset recognition criteria in

FASB

Concepts Statement 5

. However, as noted in footnote 15, ASU 2024-02 removed the references

to the concepts statements throughout the Codification. Further, the definition of an asset in

FASB Concepts Statement 5 was amended by FASB Concepts Statement 8. The definition of an

asset in paragraph E17 of

FASB Concepts Statement 8, Chapter 4

, is as follows:

An asset has the following two essential characteristics:

a.

It is a present right.

b.

The right is to an economic benefit.

A present right of an entity to an economic benefit entitles the entity to obtain this benefit from

the right and to restrict others’ access to it. We believe that rights to data acquired from a third

party would generally meet the definition of an asset. Further, while there are differences in the

definition of an asset under the two concepts statements, the differences are not expected to

significantly change what does and what does not represent an asset. Accordingly, we believe

that rights to data acquired from a third party would generally meet either definition of an asset.

Although costs incurred to acquire data from a third party would generally be capitalizable as an

intangible asset, data acquisition costs would be expensed as incurred under ASC 730-10 if the data

will be used in R&D activities

and

do not have alternative future uses.

16

Such data costs would include

those incurred for a specific software development project that is within the scope of ASC 985-20 for

which technological feasibility has not been established. This is because, as noted above, costs incurred

to develop technological feasibility are considered R&D activities within the scope of ASC 730-10. ASC

730-10-25-2 states, in part:

Elements of costs shall be identified with research and development activities as follows (see Subtopic 350-50

for guidance related to website development):

[17]

. . .

c.

Intangible assets purchased from others. The costs of intangible assets that are purchased from

others for use in research and development activities and that have alternative future uses (in research

and development projects or otherwise) shall be accounted for in accordance with Topic 350. The

amortization of those intangible assets used in research and development activities is a research and

development cost.

However, the costs of intangibles that are purchased from others for a

particular research and development project and that have no alternative future uses (in

other research and development projects or otherwise) and therefore no separate economic

values are research and development costs at the time the costs are incurred

. [Emphasis

added]

16

The term “alternative future use” is not defined in U.S. GAAP. However, Section 3.14 of the AICPA Accounting and Valuation Guide

Assets Acquired

to Be Used in Research and Development Activities

states, “For an asset acquired in an asset acquisition for use in R&D activities to have an

alternative future use, the task force believes that

(a)

it is reasonably expected that the reporting entity will use the asset acquired in the alternative

manner and anticipates economic benefit from that alternative use, and

(b)

the reporting entity’s use of the asset acquired is not contingent on

further development of the asset subsequent to the acquisition date (that is, the asset can be used in the alternative manner in the condition in

which it existed at the acquisition date)” (footnote omitted).

17

The amendments in ASU 2025-06 supersede the current guidance on Web site development costs and move the current requirements for

recognizing Web site–specific development costs, as amended, from ASC 350-50 to ASC 350-40. In addition, the ASU removes the parenthetical

reference to ASC 350-50 in ASC 730-10-25-2. See paragraphs BC105 and BC106 of the ASU.

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Chapter 4 — Software and Software-Related Costs

Changing Lanes

While ASU 2025-06 still requires the criteria in existing ASC 350-40-12(b) to be met for entities

to begin capitalizing software costs (see ASC 350-40-25-12(b), as amended by the ASU, and

ASC 350-40-25-12(c), as added by the ASU), the ASU removes all references to development

stages and includes new guidance to clarify that entities should not capitalize costs if there is

“significant uncertainty associated with the development activities of the software.”

Data may also be acquired for a specific software project that is being developed for internal use and

does not have an alternative future use (e.g., other software projects). In this case, rather than being a

separate intangible asset, the data costs may be direct external costs incurred to develop internal-use

software within the scope of ASC 350-40. Specifically, an entity could purchase data to train generative AI

applications, resulting in the creation of new functionalities. If the AI software project is in the application

development stage, it may be appropriate to capitalize the data acquisition costs as direct costs incurred

during that phase. Alternatively, as discussed further below, if the data and resulting training were only

necessary to maintain the existing features or functionality of the generative AI application, capitalization

would not be appropriate because the costs would be akin to maintenance costs. Further, any costs

incurred in the preliminary project phase of development should be expensed as incurred.

If acquired data have an alternative future use (as discussed above) and are separately recorded as an

intangible asset in accordance with ASC 350-30, we do not believe that the subsequent amortization

of the intangible asset would be included as a cost eligible for capitalization under the internal-use

software guidance. In such circumstances, the subsequent amortization would not be considered a

direct cost incurred during the application development stage and would therefore not be within the

scope of ASC 350-40.

18

4.3.3.5 Upgrades and Enhancements

After the initial release of their generative AI software, entities will most likely improve the functionality

of their application through additional software development and fine-tuning. An entity that develops AI

software for internal use should consider whether incurring these costs is associated with an upgrade or

enhancement to internal-use software as described in ASC 350-40-25-7 through 25-9:

19

ASC 350-40

25-7

Upgrades and enhancements are defined as modifications to existing internal-use software that result in

additional functionality — that is, modifications to enable the software to perform tasks that it was previously

incapable of performing. Upgrades and enhancements normally require new software specifications and

may also require a change to all or part of the existing software specifications. In order for costs of specified

upgrades and enhancements to internal-use computer software to be capitalized in accordance with

paragraphs 350-40-25-8 through 25-10, it must be probable that those expenditures will result in additional

functionality.

25-8

Internal costs incurred for upgrades and enhancements shall be expensed or capitalized in accordance

with paragraphs 350-40-25-1 through 25-6.

25-9

Internal costs incurred for maintenance shall be expensed as incurred.

18

The current guidance in ASC 350-40-30-1 states that the only internal-use software costs that would be capitalized are the following:

•

“External direct costs of materials and services consumed in developing or obtaining internal-use computer software” (ASC 350-40-30-1(a)).

•

“Payroll and payroll-related costs . . . for employees who are directly associated with and who devote time to the internal-use computer

software project, to the extent of the time spent directly on the project” (ASC 350-40-30-1(b)).

•

“Interest costs incurred while developing internal-use computer software” (ASC 350-40-30-1(c)).

ASU 2025-06 amends this guidance to include a fourth category: “Costs to develop or obtain software that allows for access to or conversion of old

data by new systems” (ASC 350-40-30-1(d), an added subparagraph consisting of content moved from existing ASC 350-40-25-3).

19

ASU 2025-06 amends the content currently in ASC 350-40-25-7 through 25-9 and moves it to added ASC 350-40-25-17A through 25-17C.

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Upgrades and enhancements to generative AI applications that are sold or marketed externally, and that

are within the scope of ASC 985-20, would be subject to the same capitalization threshold as the initial

product development (i.e., an entity is required to establish technological feasibility of the upgrade or

enhancement to capitalize associated costs).

Maintenance activities would be expensed as incurred for all software. ASC 350-40 does not define the

term “maintenance,” but ASC 985-20-20 defines it as follows:

Activities undertaken after the product is available for general release to customers to correct errors or keep

the product updated with current information. Those activities include routine changes and additions.

A key consideration related to incurring data costs to train the AI software after initial deployment is

whether additional training results in the creation of new functionality (e.g., whether the AI application

can perform a different task) or whether ongoing training is necessary to retain the relevance of the AI

application (e.g., maintain its intended functionality). Data and associated training that are intended to

keep an AI application current or relevant would most likely be considered maintenance. Unless the

costs are separately capitalizable as an intangible asset, such costs would be expensed as incurred.

In contrast, training that creates new functionality might be considered an upgrade or enhancement.

Therefore, entities will need to determine whether the additional fine-tuning they are performing

maintains the current software features of their generative AI application or whether the fine-tuning

introduces additional software features that did not previously exist. This would dictate whether the data

costs incurred to perform the fine-tuning should be capitalized

20

as costs incurred to develop a software

upgrade, expensed as software maintenance, or evaluated for capitalization separately as an intangible

asset.

4.3.3.6 Computation Resources and Storage Costs

In supporting generative AI applications and the underlying foundation or LLM model, an entity

may incur significant costs related to (1) hardware for computation resources and (2) storage costs.

Generally, such costs will be accounted for under U.S. GAAP other than ASC 985-20 and ASC 350-40.

Servers, computers, GPUs, and CPUs purchased to increase an entity’s computational power and build

out its storage infrastructure would be accounted for as long-lived assets under ASC 360.

If an entity enters into a hosting arrangement with a vendor to leverage the vendor’s computation or

storage capabilities, it is likely that the arrangement will be accounted for as a service arrangement.

Typically, in such circumstances, (1) the entity does not have “the contractual right to take possession

of the software at any time during the hosting period without significant penalty”

21

or (2) it is not

“feasible for the [entity] to either run the software on its own hardware or contract with another party

unrelated to the vendor to host the software.”

22

Accordingly, the costs incurred to implement third-party

infrastructure or storage services would be evaluated for capitalization in accordance with ASC 350-40

and, if capitalized, would be deferred as a prepaid asset and recognized over the contract period (as

well as over periods for which contractual renewals are reasonably certain to be exercised). Note that

ongoing costs to use or maintain the third-party infrastructure or storage services would not meet the

deferral criteria.

20

ASU 2025-06 amends the guidance currently in ASC 350-40-25-7 (and moves it to added ASC 350-40-25-17A) to clarify that costs of specified

upgrades and enhancements to internal-use computer software are to be “evaluated for capitalization” in accordance with added ASC 350-40-25-

17B through 25-17E (which consist of content moved from ASC 350-40-25-8 through 25-11, as amended).

21

ASC 985-20-15-5(a).

22

ASC 985-20-15-5(b).

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Chapter 4 — Software and Software-Related Costs

In addition, as noted above, AI applications typically need to be developed to work with one or more AI

foundation or LLM models. An entity that enters into a hosting arrangement with a vendor to purchase

a foundation model will need to determine whether it has (1) purchased or licensed software or

(2) purchased a service arrangement. The entity must perform this assessment regardless of whether

the foundation model will be used to create a generative AI application for internal use or whether it will

be sold as a hosting arrangement or an on-premise license. We expect that most entities will determine

that the foundation models or LLMs they acquire will be through a service contract, which could be

accounted for as a prepaid asset if an up-front payment is made for the future use of the functionality.

4.4 New Accounting Standard — ASU 2025-06 on the Accounting for and

Disclosure of Software Costs

In September 2025, the FASB issued

ASU 2025-06

, which amends certain aspects of the accounting for

and disclosure of software costs under ASC 350-40. Rather than revising the guidance on this topic in its

entirety, the Board made targeted improvements to address specific issues raised by stakeholders. The

ASU does not amend the cost guidance for software licenses that are within the scope of ASC 985-20.

To improve the operability of the guidance for entities regardless of whether they use linear or nonlinear

software development methods, ASU 2025-06 removes all references to development stages from ASC

350-40. Under current GAAP, capitalization of software development costs for internal-use software is

required once the preliminary project stage is complete. Under the ASU, however, only the following

criteria in amended ASC 350-40-25-12(b) and added ASC 350-40-25-12(c) must be met for entities to

begin capitalizing software costs:

•

“Management, with the relevant authority, implicitly or explicitly authorizes and commits to

funding a computer software project.”

•

“It is probable that the project will be completed and the software will be used to perform the

function intended (referred to as the probable-to-complete recognition threshold).”

While an entity is already required under existing ASC 350-40-25-12(b) to meet the above criteria

before it can begin to capitalize software costs, ASU 2025-06 provides new guidance on how to evaluate

whether the probable-to-complete recognition threshold has been met. Specifically, that threshold

would not be met when there is “significant uncertainty associated with the development activities of the

software (referred to as ‘significant development uncertainty’).” ASC 350-40-25-12A (added by the ASU)

specifies that there is significant development uncertainty if either of the following factors exists:

•

“The software being developed has technological innovations or novel, unique, or unproven

functions or features, and the uncertainty related to those technological innovations, functions,

or features, if identified, has not been resolved through coding and testing.”

•

“The significant performance requirements of the software have not been identified, or the

identified significant performance requirements continue to be substantially revised.”

In addition, ASU 2025-06 clarifies that entities must apply the disclosure requirements in ASC 360-10 on

property, plant, and equipment to capitalized costs accounted for under ASC 350-40 regardless of how

they present those costs in the financial statements.

ASU 2025-06 is effective for all entities for fiscal years beginning after December 15, 2027, including

interim reporting periods within those fiscal years, with early adoption permitted.

For more information about ASU 2025-06, see Deloitte’s September 18, 2025,

Heads Up

.

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4.5 SEC Comment Letter Trends

The SEC staff will occasionally issue comments related to software development costs to registrants in

the technology industry. For example, if a registrant only sells software as SaaS but has not capitalized

any software costs, the SEC staff may ask the registrant to explain why no development costs were

capitalized. The staff may also ask for more details about the development process for internal-use

software, recently developed offerings, added functionality, and what consideration was given to

disclosing policies related to such software. In addition, the staff may ask questions regarding the

income statement classification and the description of any expenses related to software development

(e.g., amortization expense or expensed development costs).

For more information, see

Section 6.5.1.1

of Deloitte’s Roadmap

SEC Comment Letter Considerations,

Including Industry Insights

.

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Chapter 5 — Other Accounting and

Financial Reporting Topics

5.1 Acquisitions and Divestitures

The technology industry has undergone significant changes throughout the years, and technology

entities must continually innovate to stay competitive. Specifically, technology entities must find new

ways to improve the effectiveness and efficiency of their operations, increase their R&D capabilities,

access new markets and data, expand their pipeline of products in development, increase their talent

pool, and tap into alternative sources of innovation. As a result of these challenges and opportunities,

technology entities frequently engage in merger and acquisition (M&A) activity. In addition, technology

entities may divest some of their noncore assets to focus on their main business lines and access the

capital they need to remain competitive.

It is important for entities to correctly apply the guidance on accounting for M&A transactions because

of the significantly different accounting outcomes that exist in this area of financial reporting. For

example, the application of the guidance in ASC 805 on accounting for business combinations can differ

significantly depending on whether the acquired entity is considered a “business” or an “asset.” Similarly,

application of the guidance in ASC 205 on the presentation and disclosure of discontinued operations

related to divestiture transactions fundamentally affects financial statement presentation.

5.1.1 Definition of a Business

An entity must use significant judgment in (1) evaluating whether a transaction represents the

acquisition of a “business” as defined in ASC 805-10 and (2) accounting for transactions after that

determination has been made. Entities apply the definition of a business in ASC 805 in many areas of

accounting, including acquisitions, disposals, reporting-unit determinations, and consolidation.

The distinction between businesses and assets is important because the accounting for a business

combination significantly differs from the accounting for an asset acquisition. For example, an entity

may acquire a mature technology entity that has substantive processes, employees, and revenue-

generating products. If the acquiree meets the definition of a business, the acquirer may end up

recognizing substantial goodwill. On the other hand, an entity may acquire IP that represents the sole

asset purchased and does not meet the definition of a business. In that circumstance, the acquirer

would not recognize any goodwill. For more information, see

Section 2.4

of Deloitte’s Roadmap

Business

Combinations

.

5.1.2 Asset Acquisitions

In applying the framework in ASC 805, entities must account for transactions that do not meet the

definition of a business as asset acquisitions. For such transactions, the accounting requirements

related to transaction costs, measurement of assets acquired and liabilities assumed, and recognition of

intangible assets may differ from those for business combinations.

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The table below summarizes some of the key differences between the accounting for a business

combination and the accounting for an acquisition of an asset group determined not to be a business.

Issue

Accounting in a Business

Combination

Accounting in an Asset Acquisition

General principle

Fair value model: assets and liabilities

are recognized at fair value, with certain

exceptions.

Cost accumulation model: the cost of the

acquisition, including certain transaction

costs, is allocated to the assets acquired

on the basis of relative fair values, with

some exceptions. This allocation results

in the recognition of those assets at other

than their fair values.

Scope

Acquisition of a business as defined in

ASC 805-10.

Acquisition of an asset or a group of

assets (and liabilities) that does not meet

the definition of a business in ASC 805-10

or qualify as a VIE under ASC 810-10.

Acquisition-related

costs or transaction

costs

Acquisition-related costs are expensed

as incurred, except for costs of issuing

debt and equity securities, which are

accounted for under other GAAP.

Direct and incremental costs are included

in the cost of the acquisition, except for

costs of issuing debt and equity securities,

which are accounted for under other

GAAP. Indirect costs are expensed as

incurred.

Contingent

consideration

Recognized at fair value and classified

as a liability, equity, or an asset on the

acquisition date on the basis of the terms

of the arrangement. Subsequently, any

changes in the fair value of contingent

consideration classified as a liability or as

an asset are recognized in earnings until

settled.

Contingent consideration that is

accounted for as a derivative is recognized

at fair value under ASC 815. Otherwise,

such consideration generally is recognized

under ASC 450 when it becomes probable

and reasonably estimable or when the

contingency is resolved by analogy to

FASB Statement 141.

Goodwill

If the sum of the consideration

transferred, the fair value of any

noncontrolling interests, and the fair

value of any previously held interests

exceeds the sum of the identifiable

assets acquired and liabilities assumed,

goodwill is recognized as the amount of

the excess.

Goodwill is not recognized. Instead, any

excess of the cost of the acquisition over

the fair value of the net assets acquired is

allocated to certain assets on the basis of

relative fair values.

Gain from bargain

purchase

Recognized in earnings on the acquisition

date.

Generally not recognized in earnings.

Instead, any excess of the fair value of the

net assets acquired over the cost of the

acquisition is typically allocated to certain

assets on the basis of relative fair values.

Contingencies

Measured at fair value, if determinable;

otherwise, measured at their estimated

amounts if probable and reasonably

estimable. If such assets or liabilities

cannot be measured during the

measurement period, they are accounted

for separately from the business

combination in accordance with ASC 450.

Accounted for in accordance with

ASC 450 on the acquisition date and

subsequently. Loss contingencies are

recognized when they are probable and

reasonably estimable. Gain contingencies

are recognized on the earlier of when

they are realized or are realizable and

are thus not recognizable in an asset

acquisition.

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Chapter 5 — Other Accounting and Financial Reporting Topics

(Table continued)

Issue

Accounting in a Business

Combination

Accounting in an Asset Acquisition

Form of consideration

given — acquiring

entity’s equity

instruments

(measurement date)

The acquiring entity’s equity instruments

are required to be measured at fair value

as of the acquisition date.

ASC 805-50 does not provide guidance on

the measurement date for the acquiring

entity’s equity securities issued as

consideration in an asset acquisition.

Intangible assets

Recognized at fair value if they are

identifiable (i.e., if they are separable or

arise from contractual rights).

Finite-lived intangible assets recognized

on the basis of relative fair value under

ASC 350-10 if they meet the asset

recognition criteria in

FASB Concepts

Statement 5

. Indefinite-lived intangible

assets are recognized at amounts that do

not exceed fair value.

Assembled workforce

Not recognized because it is presumed

not to be identifiable.

Recognized because it is presumed to

meet the asset recognition criteria in

FASB Concepts Statement 5.

In-process research

and development

(IPR&D)

Measured at fair value and recognized

as an indefinite-lived intangible asset

until completion or abandonment of the

related project, then reclassified as a

finite-lived intangible asset and amortized.

Expensed under ASC 730 unless the

IPR&D has an alternative future use.

Deferred taxes

Generally recognized for most temporary

book/tax differences related to assets

acquired and liabilities assumed under

ASC 740.

Generally recognized for temporary book/

tax differences in an asset acquisition

by using the simultaneous equations

method in accordance with ASC 740.

Lease classification

Under ASC 842-10-55-11, the acquirer

retains the acquiree’s previous lease

classification “unless there is a lease

modification and that modification is not

accounted for as a separate contract in

accordance with paragraph 842-10-25-8.”

ASC 805-50 does not provide guidance

on an entity’s classification of a lease

acquired in an asset acquisition.

Measurement period

In accordance with ASC 805-10-25-13,

the acquirer reports provisional amounts

for the items for which the accounting “is

incomplete by the end of the reporting

period in which the combination occurs”

and is allowed up to one year to adjust

those provisional amounts. This time

frame is referred to as the measurement

period.

ASC 805-50 does not address a

measurement period in the context of an

asset acquisition.

For more information, see

Appendix C

of Deloitte’s Roadmap

Business Combinations

.

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5.1.3 Business Combinations

5.1.3.1 Acquired Revenue Contracts

In October 2021, the FASB issued

ASU 2021-08

, which requires entities to recognize and measure

contract assets and contract liabilities from contracts acquired in a business combination that are

within the scope of ASC 606 or ASC 610-20 by applying the guidance in ASC 606. The ASU also provides

for practical expedients that allow entities to account for the aggregate effect of all modifications, and

determine stand-alone selling prices, as of the acquisition date. However, the ASU does not change

the accounting for customer-related intangibles, such as customer relationships, which entities are

required to measure at fair value. The ASU’s stated purpose is “to improve the accounting for acquired

revenue contracts with customers in a business combination by addressing diversity in practice and

inconsistency related to the following:

1.

Recognition of an acquired contract liability

2.

Payment terms and their effect on subsequent revenue recognized by the acquirer.”

5.1.3.2 Acquired Technology and IPR&D

Technology entities often contemplate opportunities for expanding their current portfolio of products

by making strategic acquisitions. As a result, an entity may acquire substantively complete technology-

based IP in a business combination (i.e., technology-based intangible assets that are not IPR&D). If those

assets represent identifiable intangible assets (i.e., they arise from contractual or other legal rights or are

separable), they would generally be recognized at their fair value.

Entities may also acquire technology-based IP that is still being developed. The accounting for costs

associated with the purchase of such IP currently in development as part of a business combination may

vary significantly from the typical accounting treatment of R&D costs incurred by technology entities as

part of their normal operations.

For example, before being acquired in a business combination, an entity may incur R&D expenditures

related to the entity’s continued development of software to be sold on an on-premise basis that would

be expensed as incurred in accordance with ASC 985-20 and ASC 730-10. That is, before consummation

of the business combination, the acquiree would not have recorded any asset related to R&D costs

incurred before technological feasibility was established. To the extent that the acquiree was using or

planning to use the unrecognized asset for R&D activities to further the development of the software,

the asset would represent acquired IPR&D to the acquirer.

If, instead, the acquiree incurred development costs for software that will solely be sold on a cloud

basis, such development costs would be subject to the requirements of ASC 350-40, and some of those

costs may have been capitalized before the business combination. In that circumstance, the capitalized

development costs would not be R&D expenses and would not represent IPR&D acquired in a business

combination. Rather, the acquirer would generally recognize the internal-use software, as acquired

during the business combination, at its fair value if it represents an identifiable intangible asset. For

more information, see

Section 4.10

of Deloitte’s Roadmap

Business Combinations

.

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Chapter 5 — Other Accounting and Financial Reporting Topics

5.1.3.3 Reacquired Rights

Technology entities frequently acquire businesses in a vertical merger. As part of a business

combination, an acquirer may reacquire a right that it had previously granted to the acquiree under a

contractual arrangement. For example, the acquiree may have been granted a right to use the acquirer’s

technology under an exclusive IP licensing arrangement before the business combination. That

reacquired right would be considered an identifiable intangible asset but would be measured on the

basis of the related contract’s remaining term regardless of whether a fair value measurement would

reflect potential contract renewals. In addition, if the terms of the preexisting contractual relationship

giving rise to a reacquired right are favorable or unfavorable relative to the terms of current market

transactions for the same or similar items, the acquirer must recognize a settlement gain or loss

separately from the accounting for the business combination. For more information, see

Section 4.3.7

and

Section 6.2.2.6

of Deloitte’s Roadmap

Business Combinations

.

5.1.3.4 Compensation Arrangements

Technology entities frequently acquire businesses in which significant value is attributed to the

workforce. Therefore, it is important for an acquirer to evaluate the acquiree’s preexisting compensation

arrangements and any new or modified compensation arrangements to determine the appropriate

accounting. For example, the acquiree may have arrangements in place to provide specified employees

with additional compensation (e.g., stock-based compensation) or accelerated compensation (i.e.,

acceleration of vesting) that is predicated on a change in control. The ultimate accounting conclusion

could vary depending on whether such arrangements were established before or after the negotiations

for the business combination began. In addition, the acquirer may agree to provide contingent

payments to selling shareholders who are also employees. Further, selling shareholders may decide to

share some of the proceeds that they are entitled to receive with nonshareholder employees. When

determining whether the acquirer should account for these arrangements as part of the business

combination or separately as compensation, entities must frequently use judgment and consider the

specific facts and circumstances. For more information, see

Section 6.2.3

and

Section 6.2.5

of Deloitte’s

Roadmap

Business Combinations

.

Stock-based compensation awards held by grantees of the acquiree are often exchanged for stock-

based compensation awards of the acquirer. In this circumstance, the acquirer must analyze the terms

of both the preexisting and the replacement awards to determine what portion of the replacement

awards is related to precombination vesting (i.e., past goods or services) and therefore part of the

consideration transferred in the business combination. The portion of replacement awards that is

related to postcombination vesting (i.e., future goods or services) should be recognized as compensation

cost in the postcombination period. For more information on this topic and other stock-based

compensation arrangements associated with business combinations, see

Section 6.2.3

of Deloitte’s

Roadmap

Business Combinations

.

5.1.3.5 SEC Reporting Requirements

A technology entity that is an SEC registrant must also consider certain SEC reporting requirements

when it acquires a business, an asset, or a group of assets. For instance, the registrant must

separately evaluate whether the acquired business or assets meet the definition of a business for

SEC reporting purposes under SEC Regulation S-X, Rule 11-01(d), since this definition differs from the

U.S. GAAP definition of a business under ASC 805-10. For more information about the SEC’s reporting

requirements, see

Section C.5

of Deloitte’s Roadmap

Business Combinations

and Deloitte’s Roadmap

SEC Reporting Considerations for Business Acquisitions

.

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Deloitte |

Technology Industry Accounting Guide (2026)

5.1.4 Divestitures

Technology entities frequently divest businesses and product lines to focus on their core or more

profitable businesses. The determination of whether a group of assets represents a business

is important not only in acquisitions but also in divestitures. Generally, ASC 810 addresses the

deconsolidation and derecognition of divestitures of subsidiaries or groups of assets that meet the

definition of a business. ASC 810 also applies to divestitures of subsidiaries that do not meet the

definition of a business unless such divestitures are specifically addressed by other U.S. GAAP, such as

ASC 606 (revenue transactions) and ASC 610-20 (derecognition of nonfinancial assets and in-substance

nonfinancial assets). For more information, including SEC reporting requirements, see

Appendix F

of Deloitte’s Roadmap

Consolidation — Identifying a Controlling Financial Interest

. For considerations

related to revenue transactions and the derecognition of nonfinancial assets, see Deloitte’s Roadmap

Revenue Recognition

.

5.1.4.1 Disposals of Long-Lived Assets and Discontinued Operations

Additional considerations are required when long-lived assets (e.g., IP) are classified as held for sale or

may be disposed of in ways other than by sale (e.g., abandonment). In addition, discontinued operations

are reported separately from continuing operations. To be reported as a discontinued operation, the

disposal must be “a strategic shift that has (or will have) a major effect on an entity’s operations and

financial results”

1

(e.g., major geographic area, major line of business). Therefore, the determination of

whether a disposal qualifies for discontinued-operations reporting requires (1) an assessment of both

qualitative and quantitative factors and (2) the use of judgment. For more information, including SEC

reporting requirements, see Deloitte’s Roadmap

Impairments and Disposals of Long-Lived Assets and

Discontinued Operations

.

5.1.4.2 Carve-Out Financial Statements

Carve-out financial statements are commonly prepared for divestitures of businesses and product lines.

A carve-out occurs when a parent entity segregates a portion of its operations and prepares a distinct

set of financial information in anticipation of a sale, spin-off, or divestiture of the “carve-out entity.” The

carve-out entity may consist of all or part of an individual subsidiary, multiple subsidiaries (or portions of

such subsidiaries), an individual segment, multiple segments, or a specific group of products.

The form and content of carve-out financial statements may vary depending on the situation. For

example, if the acquisition is small, a strategic buyer of a carve-out entity may be satisfied with an

unaudited balance sheet and income statement for the most recent fiscal year. Another public buyer,

however, may require a full set of SEC-compliant audited financial statements, including footnotes.

Further, another buyer may require that the periods be audited but may not be concerned with SEC

reporting considerations. The existence of a foreign buyer could present different requirements and

challenges in addition to those noted above, such as working closely with the foreign buyer on IFRS

conversion of certain financial statement line items.

For more information, see Deloitte’s Roadmap

Carve-Out Financial Statements

.

1

Quoted from ASC 205-20-45-1B.

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Chapter 5 — Other Accounting and Financial Reporting Topics

5.1.5 Common-Control Transactions

As technology entities seek to rebalance their portfolios and potentially prepare for public offerings, they

may engage in common-control transactions. A common-control transaction is typically a transfer of net

assets or an exchange of equity interests between entities under the control of the same parent. While

a common-control transaction is similar to a business combination for the entity that receives the net

assets or equity interests, such a transaction does not meet the definition of a business combination

because there is no change in control over the net assets. Therefore, the accounting and reporting for a

transaction between entities under common control is outside the scope of the business combinations

guidance in ASC 805-10, ASC 805-20, ASC 805-30, and ASC 805-40 and is instead addressed in ASC

805-50. Since there is no change in control over the net assets from the parent’s perspective, there is no

change in basis in the net assets. ASC 805-50 requires the receiving entity to recognize the net assets

received at their historical carrying amounts, as reflected in the ultimate parent’s financial statements.

For more information, see

Appendix B

of Deloitte’s Roadmap

Business Combinations

.

5.1.6 Equity Method Investments and Joint Ventures

5.1.6.1 Equity Method Investments

Technology entities frequently enter into strategic partner or alliance arrangements with other entities.

In many of those circumstances, the technology entity becomes an investor by purchasing an interest in

the other entity. That interest should be carefully evaluated to determine whether the investor should

apply ASC 810, ASC 323, or other U.S. GAAP (e.g., ASC 321). The flowchart below illustrates the