SEC Comment Letters on ASC 606

One example of the SEC seeking additional information about distinct goods or services can be seen in a May 2019 thread with Adobe Inc. The SEC asked how Adobe determined that its services should be considered one performance obligation:

Please provide us with a comprehensive analysis of how you determined that the Creative Cloud and Document Cloud on-premise software and the related cloud functionality are highly integrated and interrelated and are therefore accounted for as a single performance obligation. Refer to 606-10-25-21.

In its response, Adobe explained how the software and cloud service constituted a single performance obligation:

The nature of our promise to our Creative Cloud customers includes not only what design tasks can be completed, but also how those design tasks can be completed. Being able to work seamlessly across these assets is a core expectation of the solution, not simply a “bonus feature” or a “nice-to-have,” and this promise is only fulfilled by the combination of on-premise, on-device, and cloud functionality.

In an April 2019 thread, the SEC asked Toll Brothers, Inc. how it accounted for outdoor services, such as landscaping and completion of driveways, as distinct from the completion of the home. Toll Brothers supported its decision with the following explanation:

In certain locations, these [outdoor] features cannot be completed prior to closing of the home sale due to unfavorable weather conditions. The Company’s sales agreements generally provide for this contingency and state that the home buyer is obligated to close on the home sale despite these features being incomplete, with the Company promising to fulfill its obligations when weather permits. … We do not provide a significant service in integrating the outdoor features and the delivered home. … The outdoor features and the home do not modify or customize each other. … The outside features are not highly interdependent or highly interrelated with the home because the home buyer could buy the home and use it for its intended purposes without such outside features. … As a result, upon closing of a home, if these outdoor features are incomplete, we defer a portion of the home sales revenue and costs related to these obligations until such time as the obligations are completed.

In May 2019, the SEC asked KB Home about how customer acceptance provisions impacted its revenue recognition policy:

Explain the nature of the acceptance provisions of the land development work by land buyers and describe your analysis under ASC 606-10-25-30 and ASC 606-10-55-85 through ASC 606-10-55-88 in determining that recognizing revenue for the land sale prior to buyer acceptance is appropriate.

KB Home’s response is a good example of the thought process behind when to recognize revenue. KB Home’s contracts typically have two performance obligations: “[1] delivery of the applicable land parcel(s) at the close of escrow and [2] post-closing land development work.”

For the delivery of the land parcels, KB Home explained:

The determination of when a land buyer accepts delivery of and takes control of the applicable land parcel(s) is objectively determinable at a point in time. … At this time, the land buyer can independently benefit from owning and controlling the land irrespective of whether any post-closing land development work is performed. As a result, we recognize revenue for the delivery of the land parcel(s) at a point in time, the close of escrow.

For the post-closing land development work, KB Home explained:

We enhance the property a land buyer owns and controls through the course of our performance of the work, the land buyer receives those benefits and we simultaneously establish an enforceable right to payment for such performance as it is completed. … The land buyer obtains control over the post-closing land development work incrementally as it is performed and, accordingly, we recognize revenue for such work over time in accordance with ASC 606-10-25-27 through ASC-10-25-29, which is generally prior to formal acceptance of all land development work by the land buyer.

Because the two different services transfer to the customer in very different patterns, KB Home decided it was appropriate to account for one over time and the other at a point in time.

In a January 2019 thread, the SEC questioned P.A.M. Transportation’s decision regarding when to recognize revenue:

We note revenue is generated and your customer receives benefit as the freight progresses toward delivery locations. In this regard, please explain why recognition of revenue at a point in time (i.e. upon completion of delivery to the receiver’s location) rather than over time is appropriate. As part of your response, please tell us your consideration of the guidance outlined in ASC 606-10-25-27 and ASC 606-10-55-5 and 6 in determining your accounting treatment.

In this instance, it appears that the SEC had actually misinterpreted P.A.M.’s original disclosure. P.A.M. does recognize revenue over time as the SEC suspected it should. However, P.A.M.’s response still provides a good explanation for its decision:

Since the benefit from the freight transportation service performed by the Company on behalf of its customers is simultaneously received and consumed by customers as the service is performed, the Company determined that the conditions described in ASC 606-10-25-27(a) and 606-10-55-5 are true. In addition, the Company considered that another entity would not need to substantially re-perform the work that the Company has completed to date if the other entity were to fulfill the remaining performance obligation to our customer, as described in ASC 606-10-55-6.

In July 2019, NextGen Healthcare, Inc. responded to the SEC’s comment:

You disclose that if you are unable to estimate sales returns, revenue recognition may be delayed until the right of return period lapses. Please tell us how this policy complies with ASC 606-10-32-5 through 606-10- 32-7.

NextGen Healthcare realized that the disclosure made it sound like the company occasionally failed to estimate sales returns, which would be in violation of the standard. It reassured the SEC that it does estimate sales returns and clarified the wording of its disclosure:

We estimate expected sales returns and other forms of variable consideration considering our customary business practice and contract-specific facts and circumstances, and we consider such estimated potential returns as variable consideration when allocating the transaction price to the extent it is probable that there will not be a significant reversal of cumulative revenue recognized.

In a June 2019 thread with Trip.com Group Ltd., the SEC suggested that commission revenue should really be accounted for as variable consideration and questioned why Trip.com is not accounting for it that way:

We note that you recognize commission revenue from hotel reservations when the reservation becomes non-cancellable. Please describe your cancellation provisions and explain why they impact the timing of revenue recognition. Refer to ASC 606-10-32-5.

Instead of arguing that the cancellation provisions were not variable, Trip.com argued that cancellation provisions did not impact the timing of revenue recognition because the amount was not variable at the time the performance obligation was completed.

[The] performance obligation for hotel reservation services is completed when a reservation becomes non-cancellable. In this regard, the consideration stipulated in the service contract with a hotel customer does not include a variable amount when it completes the performance obligation.

Misonix, Inc. had a license agreement with Hunan that included guaranteed minimum royalty payments of $6 million ($2 million for three years). However, Misonix only recorded $960,000 of these payments up front. The SEC asked them to explain this apparent discrepancy in a June 2019 thread.

Misonix explained that it was accounting for the minimum royalty payments as variable consideration because of “uncertainties associated with the Company’s collection of the guaranteed minimal royalty payments.” The response further explained that Misonix was uncertain whether Hunan would have a viable revenue stream to make the payments. In order to start earning a revenue stream, Hunan must first build a production factory and obtain Chinese regulatory approval. In addition, this product is “the first manufacturing venture by Hunan,” which adds additional risk.

Minimum guaranteed royalties are unlikely to be paid if Hunan is unable to obtain approval to sell products in China. The value of the license and the technology transferred will inherently be more to Misonix if and when Hunan receives approval and has completed the build-out of its manufacturing facility, and therefore the value of the technology and license as it was transferred creates an implicit price concession with upward price mobility in the event that these elements, which are out of the control of Misonix, are achieved.

Interestingly, an additional factor cited by Misonix is that during negotiations with Hunan, Misonix’s R&D team made progress on new technology that might decrease the value of the license sold to Hunan:

While this new technology is not included in the license and distribution arrangement, Misonix believes that the ultimate value that we have placed on the sale of the IP and license agreement decreased due to the new technology and that management is willing to accept the $5,000,000 upfront payment [separate from the minimum royalty payments] as payment for the older technology which has been sold to Hunan.

Based on these factors, Misonix determined that the guaranteed minimum royalty payments were in fact variable consideration and used the most likely method to determine the amount of revenue to recognize ($960,000). To determine this amount, it considered its three-year agreement to sell the product to Hunan until Hunan can build its own factory and get approval:

Misonix will recognize gross profit on the anticipated needs for generators and disposables as the sole source of product for Hunan and acknowledges this as an implicit price concession (in accordance with ASC 606-10-55-99 to 101) during the duration of the time period until Hunan is able to manufacture and sell its products in the territory.

The gross profit from these sales is the only consideration that Misonix considered to be probable.

Groupon, Inc. has two types of revenue streams. Product revenue is reported gross and service revenue is reported net. The SEC asked for more details about this decision in an August 2018 thread:

Please provide us with a comprehensive discussion regarding your involvement in direct sales of merchandise inventory through your Goods category and how you considered the involvement of third parties in determining that product revenue should be reported on a gross basis. Reference 606-10-55-36 through 40.

Groupon explained that its product revenue transactions are distinctly separate from its service revenue transactions where third-party sellers use its site to sell products. With product revenue transactions, Groupon “sells merchandise inventory directly to customers.” It has four different methods of obtaining merchandise inventory and delivering the products to its customers: drop-ship, pre-purchased inventory, post-purchased inventory, and consignment. Despite the different methods, the inventory risk and customer perception are fairly similar in all cases. Groupon stated that “products are shipped in Groupon-branded packaging, the customer has no knowledge of the vendor from which the Company acquired the merchandise inventory, and the Company has back-end inventory risk for any product returns.” For pre-purchased inventory, the company has front-end inventory risk as well. With this background, Groupon explains how it considered the three criteria in ASC 606-10-55-39 to determine it should account for these transactions on a gross basis.

Criterion A: “The entity is primarily responsible for fulfilling the promise to provide the specified good or service.”

Groupon explained:

From the customer’s perspective, the Company is the party that is responsible for fulfilling the promise to deliver the related merchandise inventory. The Company does not identify the vendor from which it obtained the merchandise inventory in product revenue transactions. Additionally, Groupon-branded packaging is used to ship the merchandise. A customer also would contact Groupon’s customer service department to the extent that there are issues with the merchandise or if the customer wants to initiate a return.

Criterion 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.”

Groupon explained:

The Company does not have inventory risk prior to a customer order, as it takes title only for a short period before title passes to the customer upon delivery. However, it has “back-end” inventory risk upon product returns and the Company’s customer service policies and practices offer a general right of return. … The Company has no contractual or implicit right to return merchandise to the original vendor following customer returns of that merchandise. … The Company has a low overall recovery rate on returned merchandise, which demonstrates that it has substantive economic risk of loss upon product returns.

Criterion C: “The entity has discretion in establishing the price for the specified goods or services.”

Groupon explained:

The Company establishes the selling price of merchandise inventory in product revenue transactions.

Groupon concluded:

The Company determined that it is the principal because it is primarily responsible for satisfying the performance obligation, it has general inventory risk upon product returns, it has physical loss inventory risk while inventory is in-transit, and it establishes pricing. Therefore, the Company concluded that it controls the merchandise inventory before it is transferred to the customer and should record revenue from those transactions on a gross basis in its consolidated statements of operations.

In an April 2019 thread, the SEC questioned JetBlue Airways Corporation about its principal vs. agent decision concerning interline and code-sharing agreements. In this case, JetBlue determined it was an agent with respect to these services when it sold tickets for other airlines and the principal when other airlines sold tickets for JetBlue. JetBlue first explained that the revenue from these arrangements was not material but proceeded to explain its thought process anyway:

The operating carrier for each flight segment is the principal as the operating carrier controls the services before being transferred to the customer. Tickets sold by other airlines where JetBlue operates a segment of the ticket are recognized as passenger revenue at the estimated value to be billed to the other airline when travel is provided. For segments operated by other airline partners on tickets sold by JetBlue, the Company has determined that it is acting as an agent on behalf of the other airlines as they are responsible for their portion of the contract. JetBlue, as the agent, recognizes revenue after the travel has occurred for the net amount, which represents the commission to be retained by JetBlue for any segments flown by other airlines.

In a June 2019 thread, the SEC asked Misonix Inc. to justify exempting a guaranteed minimum royalty payment from the sales-based and usage-based royalty exception. The issue was complicated because the guaranteed minimum royalty payment wasn’t actually guaranteed—Misonix was treating it as variable consideration and only recorded a portion of the payment as revenue at the time of license transfer (additional information about this issue is under “Variable Consideration at Misonix Inc.” in number four above).

Misonix first summarized guidance from Financial Accounting Standards Board (FASB) Transition Resource Group (TRG) Memo 58 to justify not using the sales-based and usage-based royalty exception:

FASB TRG members generally agreed that a minimum guaranteed amount of sales- or usage-based royalties in a license of functional IP should be recognized as revenue at the point in time that the entity transfers control of the license to the customer, like other revenue for this type of IP license.

Based on that guidance, Misonix then explained that:

Management determined that these guaranteed minimum royalties were in fact variable consideration in the contract through an implicit price concession, but that they did not qualify as sales- and usage-based royalties for which the exception in ASC 606-10-55-65 would apply as to the recognition of revenue.

One significant judgment in royalty contracts is whether the license in question is the predominant item to which the royalty relates. In a September 2018 thread, the SEC asked Revance Therapeutics, Inc. to explain how it determined that the license granted was the predominant item in the collaboration.

Revance explained:

The license granted to Mylan drives the economic value in the arrangement. The sales-based royalties and contingent sales-based milestones relate to the license and can only begin to be earned once the development efforts have been successfully completed and the only remaining performance obligation is a license to the underlying IP. Without the license, Mylan cannot sell the product post FDA approval, and therefore would not be able to derive economic value in the future.

Corbus Pharmaceutical Holdings, Inc. had a licensing contract with Kaken. Among other things, this contract included a responsibility to conduct initial development studies and transfer all data to Kaken “for the purposes of obtaining regulatory approval.” In a June 2019 thread, the SEC asked about the material promises in this agreement:

Your disclosure on page 19 indicates that under the agreement with Kaken you will be responsible for conducting clinical studies and other development activities for the initial indications of the licensed products. It is unclear how you considered these development obligations when assessing the material promises under the agreement. Please tell us how you determined whether your development obligations represent a material promise under the agreement.

Concerning the ongoing initial development studies for the drug, Corbus explained:

The Company is conducting such Phase 3 study … for its own purposes as part of its overall development strategy for [the drug]. … Therefore, the conduct of the [testing] is not solely a promise made to transfer a good or service to Kaken and the performance of the development itself is not a promise to a customer in the scope of ASC 606.

On the other hand, the promise to transfer the clinical data to Kaken is a material promise because “it was a bargained for element of the arrangement that is an obligation for the Company and transfers a ‘good’ in the form of clinical data for the benefit of the customer.”

In an August 2018 thread with Delta Air Lines, Inc., the SEC questioned whether the benefits associated with its loyalty program were a material right:

The description of your Medallion loyalty program on your website indicates it includes various benefits such as move to the front of the line, waived fees, and other elite benefits. Please tell us if you consider loyalty status to be a material right that must be accounted for as a separate performance obligation or a marketing program.

Delta explained that it used indicators from an airline industry position paper from the AICPA Airlines Revenue Recognition task force to help with this determination:

One of the indicators relevant to making this determination was whether “the entity has a business practice of providing tier status (or similar status benefits) to customers who have not entered into the appropriate level of past qualifying revenue transactions with the entity.” As common in the airline industry, we offer status to attract new high-value customers in anticipation that the customer will enter into future revenue transactions with Delta. … Although status is also achieved by travel with us, the business practices and uses of the program are evidence that we provide status as a marketing incentive to attract customers and incent future travel.

In an October 2019 response to the SEC’s request, Axon Enterprise, Inc. explained the methods it used to determine standalone selling prices:

On at least an annual basis, we analyze standalone sales of our products and services by reviewing the sales activity of those products and services during the year that has just been completed. For example, in establishing standalone selling prices for 2019, we analyzed standalone transactions that occurred during 2018. After excluding sales transactions that consist of multiple performance obligations, we analyze the distribution of these standalone transactions. In our most recent analysis of standalone transactions, greater than 90% occurred at list price. The outcome of our analysis determines the standalone selling prices we establish for the subsequent calendar year, which generally equates to the list prices of our goods and services from the calendar year that has just been completed.

For goods or services where the standalone selling price is not directly observable through analysis of standalone sales, we determine the standalone selling price using information that may include market conditions, time value of money and other observable inputs. For example, if we have similar commercial offerings with multiple performance obligations and the only difference between two commercial offerings is that one includes a particular performance obligation while the other does not, we will look at the difference in the selling prices of the two offerings as indicative of the standalone selling price of that particular performance obligation.

Varonis Systems Inc. used the residual approach for software licenses in its analysis, and the SEC asked the company for further information in a July 2019 thread:

You disclose that you use the residual approach to determine the software licenses’ standalone selling prices due to the lack of history of selling software license on a standalone basis when software licenses, maintenance, and professional services were sold in bundled packages. Please tell us how you evaluated other methods to estimate standalone selling price of your software licenses. Also, please tell us if and how you considered whether the selling price of the software is highly variable. Refer to ASC 606-10-32-34.

Varonis’ response shows the detailed analysis that companies must go through to justify using the residual method. First, Varonis determined that it could not use the adjusted market assessment approach because its software licenses are “highly differentiated” from and do not have direct correlations with competitors’ products. In addition, it could find list prices for competitors’ products but not actual selling prices. Second, Varonis could not use the cost-plus-margin approach because the “software licenses do not have clear identifiable fulfillment costs.” The cost-plus-margin approach would also not be appropriate because it does not match Varonis’ pricing and selling strategies which are based much more on customer classification and volume of users than a markup on cost. Third, Varonis determined that the residual approach could be used because the other two performance obligations in the contract are sold on a standalone basis.

Varonis also performed an analysis of licensing prices to prove that they were highly variable. The company requested confidential treatment of the specifics of this analysis, so the numbers are redacted. However, the information provided does show that Varonis looked at minimum, maximum, and median discount percentage and states that the variation was significant.

In a June 2019 thread, the SEC asked for more details on National Instruments Corp’s pricing policies surrounding its software licenses:

Please tell us how you determine standalone selling price for your software licenses. In this regard, you disclose here that you have established pricing practices for software licenses bundled with maintenance, which are separately observable in renewal transactions. Please tell us what observable renewal transactions are available as it relates to the perpetual licenses or explain further what other methodologies are used to determine the standalone selling price for such licenses.

First, National Instruments explained what information it does have about standalone selling prices:

Our perpetual and term license products are typically bundled with one year of software maintenance services (“license bundles”). Consequently, we do not have directly observable standalone selling prices for the vast majority of our software license offerings. However, software maintenance renewals are sold on a standalone basis to perpetual license customers. The maintenance renewal pricing is based on a consistent percentage of the current list price for the license bundle.

Unlike Varonis, Inc. (the previous example), National Instruments does not use the residual method, likely because its sales are not characterized by the same volatility that Varonis described. National Instruments has determined that “there is a consistent value relationship between our software licenses and software maintenance” based on internal price lists:

The value relationship is supported by the directly observable selling prices of i) software license bundles and ii) software maintenance renewals. We apply the value relationship, expressed as a percentage, to the observable selling price of the license bundle to determine the SSP [standalone selling price] for the underlying software license and software maintenance. We generally use the applicable list price as a starting point when determining our observable selling price for the license bundle, adjusting as needed based on directly observable sales data. In accordance with ASC 606-10-32-33 we maximize the use of observable inputs and apply estimation methods consistently in similar circumstances. Said differently, we typically determine the SSP of a software license by multiplying the observable selling price (generally, the list price) of the license bundle by the following percentage:

SSP of license (as % of license bundle price) = 100% – (Maintenance renewal SSP as % of license bundle price)

The transaction price is then allocated to all separate performance obligations on a relative standalone selling price basis.

One interesting thread between the SEC and Boeing Co. showed the significance of the contract determination:

We note from news media reports on June 8, 2019 that Flyadeal, Saudi Arabian Airlines Corp.’s budget airline, has cancelled their full order of $5.9 billion dollars of 30 737 MAX’s with an option for 20 more in favor of Airbus. We did not note a press release furnished on Form 8-K related to this significant order cancellation related specifically to the issues with the 737 MAX. Please tell us how you determined that a current report on Form 8-K is not considered necessary in this situation.

Boeing’s response hinged on the definition of a contract:

The order described in the Staff’s comment was a non-binding arrangement and never the subject of a binding agreement. As a result, the arrangement did not satisfy the criteria of a contract with a customer as defined in ASC 606-10-25-1.

Because the order was not a contract, the revenue was not recorded in any prior financial statements, so the cancellation of the order did not trigger a current report on Form 8-K.

The SEC’s thread with Nuvasive, Inc. in June 2018 is an interesting example:

We note your disclosure that under ASC 606, your charge sheet orders are considered to be a contract with a customer when the company agrees to attend a scheduled surgery with its products as requested by the hospital or surgeon. You also disclose that the scheduling of the surgery and the usage of your products is determined to be a contract. Please clarify for us the point in time at which a contract is established.

Nuvasive explained that it relies on ASC 606’s provision that contracts may be “implied by an entity’s customary business practices”:

Consistent with industry practice, the Company’s sales process begins when the Company receives a request from the hospital or surgeon to attend a specific surgical procedure with the Company’s products at a specified time and place. The Company then agrees to attend a scheduled surgery (via a sales representative) with its products as requested by the hospital or surgeon.

In some cases, Nuvasive will have written contracts with pricing and terms prior to the surgery, but other times it will not:

In cases where a written agreement has not been previously executed between the Company and the hospital, the scheduling of the surgery coupled with the actual consumption of the Company’s products in a surgery is determined to be an implied contract based on customary business practices. Additionally, the consumption of Company products in a surgery that was previously requested by a hospital creates enforceable rights and obligations between the Company and the hospital. … The business practice of attending a scheduled surgery, in which a hospital uses the Company’s products and confirms their use with a charge sheet, creates a contract even when there is no written agreement between the parties prior to surgery.

ACI Worldwide has some contracts with termination provisions, and the SEC asked for an analysis of the impact of those provisions on the duration of the contract. In an October 2018 response, ACI explained that it does not have a lot of contracts with termination provisions, but when it does, it considers “the period over which the Company and/or the customer have enforceable rights” based on the guidance in ASC 606-10-25-3:

An analysis is performed when a contract does include penalty language to determine if the penalty is substantive. If the contract allows the customer to exercise its termination right without penalty or required payments, the contract term is limited to the committed period as that is the period which has enforceable rights.

If the customer is required to pay penalties or pay the remainder of the contract value, an assessment is made to determine if the termination option is substantive (i.e. the customer would not be compelled to exercise the termination option because the penalties and/or required payments are significant in the context of the contract). This is a matter of significant judgment and is evaluated both quantitatively and qualitatively.

If the termination penalty is substantive, the contract term is the shorter of the stated term or the period up to the point at which the customer can terminate without paying the penalty or required payments. If the termination penalty is not substantive, the contract term is the period of enforceable rights and obligations (i.e. the committed period).

In a December 2018 thread, the SEC asked Assertio Therapeutics, Inc. if it “concluded the license was a right to use license or a right to access license and why.” Assertio explained the evolution in its thought process regarding this matter:

The Company’s initial view was that the regulatory restrictions made the License similar to a symbolic license because Collegium [the licensee] cannot manufacture the product without the Company’s continued support of the intellectual property. … This ongoing support significantly affected the utility of the intellectual property licensed by Collegium because, without this support, Collegium would not be able to obtain value from the License. Further, the License is predominantly for the commercialization of an FDA-approved product and, therefore, similar to the license of a brand.

However, after further consideration following a change in the Company’s management in 2018, amendments to the Collegium Agreement and the Company’s continued experience executing this transaction, the Company now believes that the License is a functional license. This revised conclusion is based upon the Company’s recognition that symbolic licenses of intellectual property are uncommon in similar arrangements within the industry. Furthermore, despite the nuances of the Collegium Agreement, the Company does not believe that the criteria in paragraph 606-10-55-60 are met as the activities necessary to maintain the Collegium Agreement do not impact the intellectual property or change the functionality of the intellectual property. Moreover, the functionality of the intellectual property is not expected to change over time.

In this arrangement, the license was bundled with another performance obligation, so the symbolic vs. functional distinction did not affect the revenue recognition timing, as it would have otherwise.