EP6 Transaction Price

Join us for a conversation about transaction price where we discuss the impact of termination for convenience clauses, multi-year contracts, significant financing, non-cash consideration, and principle vs agent.

Transcript

EP06 Transaction Price

Published: May 11, 2023 

Welcome to the RevRec Gals Podcast, where two consultants with over 30 years combined experience share stories about the implementation and challenges of revenue recognition accounting.

I'm Susan. And I'm Natasha. And we are the RevRec Gals.

<Natasha> Hello, and welcome back to another episode of the RevRecGals. Today, we'll be talking about the transaction price. So, what does it mean to define our transaction price within ASC606 so we know what to recognize as revenue? Susan, I know this is a big topic and there's so much to cover. Why don't we just go ahead and jump in to, I'll call it the softball. What do we do with taxes and shipping that often show up on our invoices as part of our transactions?

<Susan> Taxes are a world in and of themselves, as we know. There's always a tax department that's working on making sure we're taxing properly. So that really becomes its own line to be recognized. Freight, though, there are different options. Typically, it is recognized as revenue, but it's not added together as part of the total transaction price that you're going to then later allocate based on your performance obligations. What have you seen different companies opt for when it comes to recognizing freight?

<Natasha> What I've seen is that typically companies will make a choice to exclude freight from its transaction price. I think it's simpler. The guidance is pretty clear that there is an assessment that has to happen of if you're collecting a fee on behalf of another entity, in which case you're acting as an agent versus the principal, you would exclude that from the transaction price. And in most cases, I think that most of my customers really are acting as an agent when it comes to freight. And so, what I have seen is that typically it is excluded. Usually it's immaterial, and so people just don't spend too much time on it. But I think in most cases, they feel they're really acting as an agent when it comes to those shipping fees, and it's best to just exclude the fee from the overall transaction price.

<Susan> The difference here, what I sometimes hear, is if you're doing more than passing through just that cost, and you're adding a shipping and handling fee on top of it, then it becomes a revenue item. But even then, it's not typically allocated as part of the revenue contract, so they may have a separate revenue line for freight itself.

<Natasha> That makes sense. I would imagine, in those instances, they have a pretty standard fee that they add. That's probably also immaterial to the overall contract, some sort of standard shipping and handling that gets tacked onto every transaction, in which case, why would you allocate anything to or from it? It's pretty clear what the price is. And as far as the taxes go, in theory, you could do some sort of evaluation each and every time, but there is a policy election that you can make to exclude taxes in general, and that way it sort of eases the operational burden if every transaction excludes taxes from a revenue accounting perspective, rather than trying to assess each and every transaction individually to determine if you are actually acting as the agent in that particular transaction.

<Susan> I've never heard of a company that hasn't just excluded taxes and dealt with it separately.

<Natasha> Exactly. For most of my clients, I think it's pretty clear there wouldn't be a transaction that it wouldn't be acting as an agent, but I would imagine there's a reason they came up with that. And so, I'm sure there are companies out there where maybe it stops being so clear, there's a little bit of gray, taxes are different state by state. And so, it just gets so complicated that I think that practical expedient is just, everyone says, I don't want to mess with it. We're not going to do this evaluation. We're just going to recognize net and end of story.

<Susan> Yeah, makes sense.

<Natasha> So then once we figured out what our transaction price is, we decided to exclude taxes, and freight is its own separate line, potentially.  I think the other thing, sort of before we dive further into what is the transaction price is, let's reflect back on what we figured out our contract is. Is it a single contract? Are there linkage contracts? What's the full picture as far as our transaction price goes?

<Susan> Yeah, this goes back to our prior episodes where we talked about linked contracts. Like maybe you got the order for the software or the hardware on the last day of the month, but you know that there's a support contract coming. So, these two combined become your total contract value.

<Natasha> The other one that I sometimes see is when you have a parent company or a parent entity negotiating a combined contract on behalf of multiple children or, you know.

<Susan> Subsidiaries.

<Natasha> Subsidiaries, thank you. Yes, so they might be negotiating a deal with multiple subsidiaries, and ultimately maybe they want the paperwork or the individual order forms to be for those individual subsidiaries, but it's still one negotiated combined contract. And you might think, oh, that doesn't matter, but the reality is those contracts if looked at separately could end up in different stratifications for SSP. And so, all of a sudden, if you have one large subsidiary, and then a small subsidiary, well, that small subsidiary is getting pricing that reflects the larger subsidiary. And so, it's really important to combine them so that you look at it as a whole. This isn't a $150,000 deal and a $10,000 deal. This is actually a $160,000 deal, and it needs to be looked at that way.

<Susan> Well, also another example you gave in a previous episode was for SaaS and professional services. Where any software and professional services, are they really negotiated together? And should they be combined?

<Natasha> Currently, what's popular in the SaaS and software space is to maximize your ARR.

<Susan> ARR being annual recurring revenue?

<Natasha> Annual recurring revenue, yes. And so, the organizations don't really want to put much in the way of services on the contract. If you think you can extract $50,000 from a customer, you want that to be considered ARR and recurring revenue rather than one-time implementation services or consulting services up front that may not be appropriately classified as ARR. And so, it's really important to link those because what you might see is huge discount on the service side, maybe even given away for free, and maybe an inflated price on the software or the SaaS side. And so, it's important to look at those together so you can combine that transaction price and allocate it across all of the performance obligations. 

So, let's also talk about future purchases.

<Susan> There are times where somebody will buy a three-year contract, and they have the right to pay annually. So, one of the things to think about is, is there a three-year commitment or is there a one-year commitment with the option to renew? Another one being, one thing we talked about before, cancellation rights. Do they have cancellation rights unilateral that they can cancel after the first year? And so, Natasha, what have you seen? Have you seen people deal with that question of what are these future commitments and which ones are part of the contract value?

<Natasha> This is such a fun one. So, and this is a great demonstration of, again, how you think of ASC606 as a five-step model, and I think people think it goes one, two, three, four, five. And in reality, here we are talking about the transaction price, which is step three, but really this idea of what's committed refers back to step one. What is the contract? You brought up this great point of cancellation rights or termination rights. So often, these can be worded very differently, and subtle changes in the wording change the way you would treat it. And so, I actually just did a full review of a customer where we went through all the termination clauses to figure out what's really going on here, what's really a committed contract. Because those contracts had three-year terms, they had a right to cancel for breach. That's just a standard business practice, but you don't expect to breach the contract. The contracts were refundable when they were breached, but then they also had a termination for convenience. That termination for convenience did not have any sort of penalty. So, in your example of a three-year contract, they could cancel after the first year and not have to pay the second or third year invoice. And in that case, really, it's just that first year that's actually considered a committed contract. So, you have a one-year contract term, and the transaction price really should only include that first year amount. And this is particularly interesting if you have transaction price that increases over time, where the first year might be 100, second year might be 200, the third year might be 300, because now your committed transaction price is really only that 100 in the first year, and you have to wait for that second and third year to really be considered committed as part of a contract. In my mind, this three-year contract with annual opt-out, it can be phrased in different ways. You could have a three-year contract, and you can terminate at the end of each one year, or you could have a one-year contract with these auto-renewals for second and third year. In substance, they're the same thing, but they're articulated differently in the contract. Another variation that I've seen is a termination for convenience, where it could be throughout the contract term, or at a specific time period. So maybe it's quarterly, quarterly opt-out, where you actually invoice up front for the whole year, but in theory, you could cancel upon a certain number of days' notice or at certain intervals throughout the contract. If you have a refund clause associated with that, that means that's a termination clause for convenience with no penalty, and your contract really is just the committed portion, net, of that clause.

<Susan> So in your example, it would just be a quarterly contract?

<Natasha> Yes, I have seen the dreaded rolling termination clause where a customer can cancel upon 30 days' written notice at any time in the contract for a refund, in which case you only have 30 days committed at a time.

<Susan> Yeah, I've seen that before too.

<Natasha> Yeah, no one likes this.

<Susan> No, they don't.

<Natasha> And often sales won't even like those because usually, or a well-crafted commission plan anyway, will only commission on that committed portion, because that's really all that the customer has committed to.

<Susan> Well, that's where you also have to look at the operational side of things, because if you have like a PO that covers your product and one year of services, but they're really committed to a three-year contract, then when you're doing the revenue recognition side, you have to incorporate that backlog of annual support if that is actually part of the contract. So, what helps differentiate a true commitment versus an option?

<Natasha> I think that's where the devil's in the details of the wording and the contract. And so, when I think of, sometimes it will actually say termination for convenience, termination for cause, cancellation. Sometimes those words are actually used. I actually think the cancellation one is the most confusing because at what point is it a termination versus a return right that can get kind of fuzzy in certain circumstances. So, I really think you have to look at what are the refund rights? What are the termination clauses? What's written in the contract? What's written on the order form? What's really truly committed at the end of the day? And what are the expectations? You might have to consult with legal. I find these clauses, if read carefully, are usually pretty understandable. I would say, do not rely on sales or a deal desk to get this right, because it is nuanced, and it is confusing. And I think if read too quickly or missing a couple words can make a big difference. So, I do think getting into the contract and reading, what does it say? And as needed, you can consult with the legal team.

<Susan> One thing you did mention was that right of return. So, if you do have this termination clause, one thing you want to make sure is that any refunds are for the unrealized portion. So, the perspective portion and not refunding revenue that you've already recognized.

<Natasha> Exactly. And that's sometimes tricky because I've seen clauses that say, within the first 30 days, you can cancel at any time, which to me reads more like a return clause. So, the first 30 days, you can cancel at any time, and you don't owe anything, almost like a money back guarantee or a free trial, something like that.

<Susan> That could also be a warranty. There’s a whole assessment that has to happen around that 30 days to see what's the essence of it.

<Natasha> Yes, that's a great point. And then using very similar language, it could potentially represent a warranty, but it could also represent termination right. I saw one the other day that said, you can cancel this contract at any time with a pro rata refund of the remaining contract term, which is really more of a termination right than a return right. But it used extremely similar language, and that's why I think actually getting into the contract and reading it is so important, because if you're in conversation with someone on the business side, they say, oh, there's a cancellation right. Okay, but what kind of cancellation right?

<Susan> Yeah.

<Natasha> Can we be more specific? Is there a refund? Oh, I think there's a refund, or oh, no, there's definitely no refund. But when they say there's definitely no refund, they mean there's a pro rata refund, or there's no refund, but it's quarterly or annual billing. And so, you really have to get into the contract, look at it with a sort of discerning eye to figure out what is the net commitment here? What can they not get out of when this contract is signed?

<Susan> Yeah, that's the same with future purchases. Have they truly committed, they're going to pay second year, they're going to pay third year? Or have you just said, if you decide to renew, here will be the price? And even if you have that, then you start talking about, is there the potential for a material right?

<Natasha> Yep, being able to distinguish and identify if this is an optional purchase, does this represent a material right, which they're, in effect, saying, we're going to pay more upfront for this right to purchase something at a discount later on, that otherwise they wouldn't be able to obtain that sort of pricing.

<Susan> Then you're looking at what is the likelihood that they are going to renew. That goes into a question of what is your typical customer like? Does your typical customer have three years? If you do have these extremely discounted future options, perhaps you do have a material right because the likelihood they're going to renew is very high. And so, then you have to start considering that as part of your total contract value.

<Natasha> Yeah, and I think that's another great example of where we are talking about transaction price in step three, but we're also referring to the idea of is there a material right, which would represent a separate performance obligation, which brings us back to step two. And it, sort of, forecasts what are we going to be doing in step four when we allocate all this. So, it's such a great example of how this guidance isn’t a straight line. It's a zigzag of how you conclude on one topic can impact how you conclude in other areas. Doing that evaluation is so important because if you don't get it right, it messes up your allocation and ultimately messes up your revenue amount and timing.

<Susan> So let's move on and talk about other things that impact total contract value, such as significant financing.

<Natasha> I think actually we worked on a client together at the very beginning of 606 being adopted, where this was something we had to evaluate because I think at that particular client, they had discounted pricing if a customer paid for three years in advance, as opposed to an annual fee each year. And so that was the first client where I had to actually think about this. Do you remember that, Susan?

<Susan> Yeah, I do remember thinking about that. Like, are we really providing discounting or is this a business decision?

<Natasha> Right.

<Susan> And does this benefit both parties because there's less administration that has to happen? So, is it really a financing option?

<Natasha> Yes. And I think this was sort of early on, and so there had been less of a precedent set around, okay, what are people really doing out in the world? This is an example that if you look at the guidance at face value, literally, I think the guidance says something about if there's different pricing based on the timing of when you pay upfront versus, I think they use fancier words than I just used, but conceptually. So, this looks like a perfect example, like, oh, this is what they're talking about. But to your point, what we found over time and what people are generally doing is saying, hey, this discount isn't for the purposes of financing, that's not what's really going on. We're not saying, hey, we need you to finance our operation, so we want you to pay up front. We're saying, we want to get this customer on the hook. We want, you know, they want to buy now, and we want to incentivize them to commit for three years versus one. And this is a standard practice in the industry to get people to commit to those longer-term contracts by offering a smaller price upfront. And so, exactly like you said, this was a business strategy decision and really had nothing to do with financing.

<Susan> Yeah, the one time I have seen a financing component was a customer that had hardware, and they would allow the customer to pay a certain amount every month or every quarter for that hardware. They even had the right to have it fixed and maintained. But at the end, they had the right to own that product. And the product had a significant value at the end of the period. It wasn't like it was just a scrap value. It actually had a value. So, it was considered to have a financing component to it because of that ownership right and the value at the end of the contract.

<Natasha> Right. I've seen that too with hardware. I saw it for a biotech client where, and I think this is often the case where there might even be a third party involved, in which case it makes it very clear. You know, a third party is coming in and providing financing, and then it becomes a question of what's your role and all of that.

<Susan> That reminds me, I have seen a company where they had a third party do the financing, and they therefore got out of the financing.

<Natasha> Yes, but you do have to be careful about what is your transaction price. What is it really? I've also seen it on the procurement side of what is the interest rate? What is the principal? What are we actually paying for this piece of equipment? Which was surprisingly not clear, and I think again is why this guidance comes into play, because it might not be super explicit on the paperwork. And sometimes you really have to dig to figure out what's really going on here. What are these monthly payments? There's a third party involved. What role are we playing here? Are we facilitating financing with a third party, or is this financing party working with us? Are we the principal versus the agent? So, it can be tricky, but I think the long and short of it is the transaction price has to reflect the price after considering any potential interest payments associated with financing.

<Susan> How about non-cash considerations? I have seen non-cash considerations where the vendor was giving something to the customer. So, there was an exchange of rights. In this case, the customer was getting some warrants, which potentially gave them some ownership rights in the company. So, in that case, we had to value what we were giving to the customer and deduct it out of the total contract value. So, we've been talking about adding, and this is one where there's a potential that the contract value is actually less.

<Natasha> So if I was selling you something, and then you're also providing me with a warrant?

<Susan> It's consideration payable to the customer. So, I have some consideration I'm giving back to the customer as a part of that transaction. It's not a separate transaction, it's negotiated together, and so therefore, I have to deduct that. Also, I've seen smaller companies, companies would do an exchange of software, and maybe one company may or may not give a little bit of monetary consideration. So, then you're talking about, well, you can't just say, oh, nothing happened here. You are getting something in return for your software, so you have to value that.

<Natasha> I've seen the exchange of software too, and it was funny because for a client, somewhat recently we were going through their standard transaction agreement and hidden in there I saw something about a marketplace situation where they have a marketplace that resells third-party add-ons to their product. So, the customer goes to this marketplace, they've already purchased from the main company, but they might want to add on features. And as part of those transactions, the main company has these partnership agreements with the people that are going to list on their marketplace. And as part of that, they negotiated that they get to use whatever those add-ons are. So, they're actually receiving for free these non-cash considerations. And so, in most cases, we were able to conclude that it was immaterial, but it was hiding in there. I had the question, has anyone thought about this? Have you guys talked about this? Does anyone know what's here? You know, it was something their legal team and the marketplace team and the product team had put together, and maybe the accounting team just wasn't aware of it, and no one thought to bring the accounting team in on that conversation because it's non-monetary. But just because there's no dollar of value assigned to it doesn't mean we're not interested, or it doesn't impact revenue.

<Susan> One other topic, you briefly touched upon it. It's the whole concept of principal versus agent. Tell us a little more about the principal versus agent assessment.

<Natasha> I'm so glad you asked that because I keep alluding to it and we haven't actually talked about it. Within the guidance, there's this idea of principal versus agent, and so, when we use the term agent or principal, they mean very specific things. The idea here at a thousand foot view is, what is your relationship with the customer? Are they purchasing from you, or are you facilitating a purchase between the customer and some third party? You could do this in a few different ways. So, I just gave an example of you are interacting with the customer. Maybe you're even signing a contract with a customer, but you may or may not be the principal. You could be the agent on behalf of a third party. Alternatively, maybe you are that third party, and you're doing business with a customer through some sort of reseller or distributor of your product, in which case you have to do an assessment of is your customer, the reseller or distributor, or is your customer the end user of the product? Both assessments are the same concept. Who's the principal? Who's the agent? And likewise, who's your customer? Who are you the principal to? And that assessment can be super tricky and highly judgmental. Sometimes it's very, very clear, but I have come across many instances where it's not clear. The whole concept is based on this idea of control. A principal controls the products before they're being delivered to the customer. In a tangible product world, sometimes it's simpler, but sometimes it's not. And then with software instances, it can be really tricky because there's not physical control. So, it has to be sort of this legal or conceptual control. And one of the terms that the guidance uses is something directs the use of, or can preclude others from directing the use of. That's the idea there.

<Susan> To delve in a little more when you talk about the control is, especially with hardware, who physically is holding that hardware? Who now has title to it before it goes to the end customer? But that's not always the case, because sometimes they'll allow for drop shipments. So, the vendor is the one shipping it out, but essentially the reseller is controlling where it goes. And I think even more telling than that is who is defining the price to the end user. If you have situations where the vendor is saying, well, you can only sell it in this small range of pricing, then you have a little bit trickier determination of, are they really just an agent for you because you defined the pricing? I did have a company once, they were selling through a reseller. I was asked, can we recognize the value that the reseller is selling it for? And the reality was, we don't get a PO for the value the reseller is selling it for. We don't even know what that value is. So how could you possibly take revenue on something you haven't even been a part of the negotiation for?

<Natasha> What you touched on is one of the criteria or indicators in the guidance, which is this idea of who's controlling the pricing. To your point, sometimes you don't even have visibility. So, maybe you even go through a full assessment and decide you’re principal. But if you don't have the visibility to what they're actually charging, then you can't recognize revenue based on gross anyway. And so there could be a practical component of, we don't have that visibility. So regardless of how we conclude, we have to recognize net, because we don't know for sure what that end transaction price is.

<Susan> Well, and also the reseller is taking the credit risk with the end user. So, that's another area where it's kind of gray, because sometimes the reseller will say, I won't pay you vendor until I get paid. So then is the reseller really taking the credit risk? But then it goes back to your point is, do you even know how much they're selling it for?

<Natasha> Like what happens if they have a return or a money back guarantee or any sort of termination right? What happens? Does the reseller take the hit there? Or does it get passed through to the vendor? So that's actually another one of the criteria or indicators to evaluate. There is also the idea of who's on the hook for actually providing the service. And so, sometimes what you look at is, who's actually providing the support? Does the customer see the reseller as the person that they're engaging with? Or do they see the vendor as the person they're engaging with? So, who would they go to if there's a problem? Who are they going to call and say, hey, I can't log in, can you help me? And so, sometimes you look at who's on the hook or who's required to provide that service.

<Susan> I do see a lot where resellers provide first line support. But it may be very high level of, oh, checking that the computer is plugged in and that it's working properly and things like that before they pass it on to the vendor.

<Natasha> The three indicators, as far as what you assessed in the principal verse agent, who has the primary responsibility to provide the specified goods or services, who has discretion to establish the prices, and then who has inventory risk. And that inventory risk is tricky I think, so the idea of credit risk sort of goes away with 606 as opposed to 605, but inventory risk in some ways can also provide the same concept in that who is on the hook if they decide to cancel, who is on the hook if they decide to return, that is an indicator of who's actually providing the service. Does it get passed through to the vendor or does it stop with the reseller? And they are the ones that are taking that risk. It's a little bit tricky because with software and SaaS, resellers don't typically purchase 100 widgets and then resell them. Typically, they purchase sort of live and new instance as they're selling it. 

Susan, you alluded to something there that was super interesting, the idea of consideration payable to a customer, which is another way that the transaction price can be impacted. And this can take different forms. You just mentioned one. Is there any other area that you've seen that?

<Susan> I have seen similar kind of assessments when you're working with another company to develop a product. So maybe you have a joint development project, and as part of that, you're going to provide your partner with a number of products or some of the software that comes out of it. So that's where you have to look at, is there a component? Like, they're giving you money to help with the development, but at the end, are you giving them back something? And what's the potential value of those products that you're giving back to them?

<Natasha> I'm so excited that that's the example you came back with, because I've seen something very similar, and I actually think this is where it gets really gray. I think there are some cleaner versions of consideration payable to a customer, but this idea of joint development or collaboration, there is a collaboration agreement guidance specifically, and if you fall under that guidance, you get scoped out of 606 completely. And so, coming up with that scoping question is a big one. Interestingly, if you get scoped into that collaboration guidance, there is not really clear guidance on what to do, so you use other guidance by analogy, which might bring you back to 606 anyway. I think this is why it can be so tricky, because you almost have to do this scoping out of 606 exercise first of what guidance are we under, and then there's this idea of some performance obligations can be under one guidance, and the other performance obligations can be under different guidance, because even the principal or agent assessment is done on a performance obligation level. So maybe part of it is a collaboration, and then part of it is just normal business operations. And then once you've figured out your scoping, then there's this idea of are we paying consideration to a customer, and does that impact our transaction price? I've seen it like you in sort of a collaborative instance. And what was interesting about this example is there was an existing relationship, a partnership reseller relationship, that had been going on for many, many years. That existing relationship was negotiated just like all of their other reseller agreements. There was a pretty standard pricing practice in place. There was nothing unusual about it. Then one of their resellers came back, and now they were doing a big, huge, I guess you would call it a professional services agreement. And there was a question of, is this a collaboration agreement? Is this a revenue-generating agreement? It was not clear. We hadn't really thought about this until the auditors came back and said, well, is this consideration payable to a customer? Because they're your customer when they're selling your product, but now you're paying them for services. And we all scratched our head and go, do we have to ask that question? Are you sure? But it became a big, hairy exercise of, are we paying consideration to our customer? And as part of that, you have to do a fair value assessment to say, are you paying market rates? That can be super easy when you're buying laptops from Apple for use in your business, because tons of people buy laptops from Apple. The price is pretty clear, you go to the website, maybe they have a business portal, and they have business pricing, and that's pretty obvious.

<Susan> Well, and it's also not negotiated as part of the contract, so it's a very separate purchasing decision.

<Natasha> Yes, very black and white, very clear. But in these other ones where it's highly negotiated, it's a big deal, it's services, it's not easy to get fair value on services. People don't generally post their service hourly rates on their websites. So, I think it's a super interesting topic.

<Susan> This concludes our discussion on transaction price. If there are areas where you would like us to dive in deeper or new topics to discuss, drop us an email at RevRecGals at gmail.com. Thanks for listening.

The examples discussed are based on specific company dynamics. Check in with your auditors before making changes to your current processes.

Specializing in revenue recognition may result in employment for life. Please consult your friends and family before pursuing this career.