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Beware of the never-ending contract

A number of complicating factors can come into play when automatically combining contracts and performing associated reallocations, resulting in the never-ending contract.

August 2, 2017

A blog post by Bryan Anderson, partner, Deloitte & Touche LLP*

A disturbing accounting concept, which I hope becomes fake news, is percolating through certain types of industries and arrangements. It’s the view that, if you price an arrangement below its stand-alone selling price (SSP), and if there are other outstanding arrangements with the same customer, then you should combine all arrangements as one contract.


Consider this: Company A enters into a 12-month arrangement with a customer to provide a performance obligation that’s recognized ratably (contract #1) for $120. The SSP is $120. So no funny business going on there. Seven months later, Company A enters into another arrangement with the same customer to provide another performance obligation that’s recognized ratably over 12 months (contract #2). But this time the transaction price is $90 and the SSP is $120.

Hmm! Company A has given the customer a discount. But why?

  1. Was there a complaint about Company A’s performance on contract #1, leading Company A to cave on price in contract #2?
  2. Was Company A below its targets, so it decided to provide the service to everyone at lower prices to generate more business for a brief period of time?
  3. Did the market shift such that $90 is the new value for the service? Note that Company A’s policy is to update SSP every six months. So it will take some time for the SSP to catch up with market changes.
  4. Is the price of the performance obligation so volatile that pricing is all over the place and just isn’t possible?
  5. Was the salesperson highly motivated to get the deal done because it was year-end and the $90 was needed to hit a bonus target?

I’m sure there are other reasons for companies to give discounts on contracts. And many of them have zero relation to other existing contracts. That being said, I think everyone would agree that if the first point (a complaint about Company A’s performance) was the reason for the discount, then the contracts should absolutely be combined and the modification guidance followed. But what’s the right process for conducting this analysis?

  • Option 1: Manually review every contract that has a transaction price lower than the SSP. If this situation doesn’t happen very often, you can probably develop a process to analyze and document whether the discount in the contract is related to other arrangements or contracts. Yes, that would be painful, but it’s possible. If this happens across thousands of transactions and customers, then analyzing each one probably isn’t feasible.
  • Option 2: Automatically combine contracts and perform associated reallocations (the never-ending contract). Most revenue engines can handle allocations and contract combinations, so this may not be a huge system issue. (Provided that you have a revenue allocation system that doesn’t rely on spreadsheets). But this option results in the never-ending contract.
  • Option 3: Institute a business policy that discounts cannot be granted for other contracts. Sounds like a great, simple way to eliminate this issue, but likely require upfront business processes and documentation that may or may not be things operations/sales people would be excited to take on.

If you concluded that the contracts in the example above were economically linked, you would combine the contracts, perform reallocation between the two performance obligations, and go on your merry way. This may not seem like a big deal. But most companies won’t have a fact pattern that’s as simple as this one. Some complicating factors could include:

  • If there are many contracts with a customer and a discount issue comes up, which contracts do you combine? (Brace yourself, it’s likely to be all of them.)
  • Once you get on the combination merry-go-round, when do you get off? Only when the remaining performance obligations have been satisfied and all other new contracts with the customer are at SSP.
  • If you combine contracts and there are various satisfied performance obligations, should some of the discount be allocated to the completed performance obligations (i.e., apply cumulative catch-up accounting)? If yes, it’s also likely that the catch-up is an out-of-period adjustment that would need to be disclosed. (Is there an emoji for kicking someone when they’re down?)
  • Pretty much every performance obligation in the massive contract combination will have some adjustment to it. And that will make internal and external financial statement analysis even more challenging.

I could go on, but I think you get the picture.

I’m not suggesting that anyone can—or should—ignore the potential for economically linked transactions. But if your company has significant pricing variations for similar performance obligations and long-term arrangements, then don’t be surprised if this issue lands on your desk.

*Note: The views expressed in this blog are those of the blogger and not official statements by Deloitte Touche Tohmatsu Limited or any of its member firms, including Deloitte & Touche LLP.

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

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