Question

Case 17-7 Mesmerizing Marketers
Mesmerizing Marketers (MM) is a marketing company that offers a variety of marketing offerings to its customers. Specifically:
• MM will create a TV commercial for $1M, build an app for $500K, and build a Facebook page for $250K. These amounts represent MM’s charges for these items when MM sells them separately to customers. The TV commercial, the app, and the Facebook page are not interrelated; that is, each functions independently of the other offerings.
• If a customer purchases all aforementioned items together, the total cost is $1.5M. Payment terms are 50 percent consideration due at contract signing, with the remaining 50 percent due over the rest of the development period (25 percent at mid-point, 25 percent at completion).
• If the app is downloaded 500K times or more in the first month, there is a one-time bonus of $250K payable to MM.
Stone, a customer, approaches MM with the hopes of reinventing its image to a younger customer base. Stone has a verbal agreement with MM that is based on MM’s unsigned quote to Stone on November 30, 20X5, for one TV commercial, one app, and a Facebook page. The agreement creates enforceable rights and obligations pursuant to MM’s customary business practices. None of these items can be redirected by MM to another customer. MM performed a credit check on Stone and has determined that Stone has the intention and ability to pay MM for fulfilling its portion of the contract. Stone is required to pay MM for performance completed to date if Stone cancels the contract with MM for reasons other than MM’s failure to perform under the contract as promised.
Stone makes a payment on November 30, 20X5, in the amount of $750K pursuant to the agreement. From the date of the quote, it takes MM six months to develop and produce the TV commercial, two weeks to complete the Facebook page, and three months to complete a fully functioning app. MM does not think that the app will be downloaded 500K times in the first month because Stone’s customer base does not quickly accept newly developed technology. On the basis of its experience with similar technology, MM has determined that it takes over three months for Stone’s users to begin to download its apps.
Required
MM’s CFO is trying to understand the new revenue recognition model and has asked you to explain how MM would account for the above scenario under the new standard.
1. How should MM account for the above offering with Stone under the new revenue recognition model?
2. How would your conclusions change if:
a. The app sold to Stone is actually downloaded more than 500K times in the first month?
b. MM believed at the outset that there is about a 75 percent chance that the app will
be downloaded more than 500K times and it is probable that there will not be a
significant reversal of revenue?

Answer 1

Answer to question 1

The new revenue recognition model prescribes a five step approach, which is applied to the facts of the case as follows:

Step 1: Identify the contract

Key conditions outlined in the standard

• Contract should be enforceable
• It may be in writing or oral, whatever legal form is acceptable in the geography
• It should have commercial substance
• Rights and obligations of both parties should be clearly identifiable
• Payment terms should be clear
• Transfer of consideration must be probable

All above conditions are satisfied by the arrangement between these 2 parties, i.e. they have a verbal agreement which is enforceable as per customary business practices, rights and obligations are clear, i.e. development of webpage, application, etc. Consideration is clear, and credit check by the entity states that the customer has ability and willingness to pay.

Therefore, the requirements of Step 1 are principally complied with.

Step 2: Identify the performance obligations

Step 2 requires the entity to identify separable performance obligations. In this case, there are 23 separable performance obligations:

• TV Commercial
• Application
• Facebook page

In commercial parlance, all three obligations are distinct, more so, because all three are also separately sold by the company

Step 3: Determine transaction price

Transaction value is determined in Step 3. The transaction value, i.e. USD 1.5 mn forms the starting point for determining the transaction price. Other items that need consideration are:

1. Variable consideration: This transaction has a variable consideration element, i.e. success fee if application is downloaded for more than a particular number of time, the entity will be paid an extra sum. Variable consideration is recognised as revenue only if it is certain that the entity will realise the consideration and there will be no significant reversal of the revenue recognised. As mentioned in the facts of the case, the entity does not think the performance target will be met due to slow offtake by customers, therefore, the additional USD 250k will not be recognised as revenue
2. Financing element: not applicable as the contract is getting executed and paid for within a span of 1 year
3. Non cash consideration payable: Not applicable in this case
4. Consideration payable to customer: not applicable in this case

Therefore, the final transaction value will be USD 1.5 mn

Step 4: Allocate transaction value

Step 4 involves allocation of transaction value to different performance obligations. This allocation is required to be performed on the basis of standalone selling price. As the standalone price for all obligations is available, the allocation can be easily made as follows:

Performance obligation	Standalone selling price	%age of total price	Allocation of transaction price*
TV commercial	1,000,000	57.14%	857,143
Application	500,000	28.57%	428,571
Facebook page	250,000	14.29%	214,286
Total	1,750,000

Allocation is transaction value (1,500,000* %age)

Step 5: Recognise revenue as and when performance obligations are complete

In this case, the performance obligation is fulfilled over a period of time because the entity is construction an asset with no alternative use and is also entitled to payment for work done till date in case the contract is cancelled. Therefore, as and when the work related to all the above obligations is complete, the entity can recognise revenue using the percentage completion method for the respective performance obligations.

Therefore, for the facebook page, MM will recognise the revenue within 2 weeks, if the work is completed. Likewise for theapplication, entire revenue of USD 428k will be recognised over a period of 3 months and revenue related to TV commercial (USD 857k) will be recognised over a period of 6 months. The entity may choose to use the input or output method for determining the stage of completion for revenue recognition.

Answer to Question 2.a

In case the application is actually downloaded more then 500k times, MM becomes entitled to additional revenue of 250k. This will be accounted for as a change in accounting estimate (as MM earlier did not anticipate this revenue, and hence did not account for it, but downloads took place). As and when the information on downloads is available to MM, it will recognise an additional revenue of 250k.

Answer to Question 2.b

In case at the outset, MM actually believes that the app will be downloaded more than 500k times and there will be no significant reversal of revenue, the total transaction price will be 1,750,000. The allocation of revenue will change as follows:

Amount for application includes the variable consideration fo 250,000 over and above the amount mentioned in the first table