Authored by: Phil Santarelli
Once an entity has determined that it has a contract with a customer as defined in Accounting Standards Codification (ASC) 606, the entity must determine what the performance obligations are. A performance obligation is defined in the ASC Master Glossary as:
A promise in a contract with a customer to transfer to the customer either:
a) A good or service (or a bundle of goods or services) that is distinct
b) A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
With the reminder that a contract with a customer can be written or oral as long as it has commercial substance, let’s explore some of the key concepts in identifying performance obligations.
In many revenue transactions, the promise is explicitly stated as either a good or a service. For example, retailer A agrees to sell customer Jones a new television. The performance obligation, embodied in the customer invoice, is delivering the television into the hands of Jones in exchange for the stated consideration. In another scenario, garage B agrees to change the oil in Smith’s vehicle in exchange for the stated consideration. Here again the customer invoice is the contract. There are countless numbers of such transactions happening daily. They are straightforward and ASC 606 is generally easily applied. However, there are many more contracts which contain multiple performance obligations. For these, careful analysis and judgment are required.
Generally, performance obligations are clearly stated in the contract. However, performance obligations can also be implicit in the contract if (based on the entity’s stated policies, business practices, or specific statements), when entering into the contract, the promises create a valid expectation on the part of the customer.
For instance, in the above examples, if the retailer agrees at the time of the sale to deliver the television to the customer, this may create a separate performance obligation. If the garage always washes the customer’s car after changing the oil, this may be a separate performance obligation. Although these are inherently simple, other performance obligations require more judgment to identify. Especially when applying the guidance to complex contracts.
Note that performance obligations do not include administrative tasks that an entity may need to undertake to fulfill the contract, as these do not transfer a good or service to a customer.
Recently the FASB issued an Accounting Standards Update (ASU) 2016-10, Identifying Performance Obligations and Licensing, to provide some clarification as to how an entity evaluates performance obligations. The entity does not need to consider promises that are immaterial in the context of the contract. Additionally, if elected as an accounting policy, shipping and handling activities after the customer has obtained control of the good may be considered to be an activity to fulfill the promise of the good rather than a separate performance obligation. Therefore, in the examples above, we believe both the retailer and the garage could make an accounting election to treat the additional services as part of the fulfillment of the promised good (television) and service (oil change).
Distinct goods or services
Examples (not intended to be limiting) of promised goods or services are provided in ASC 606 as follows:
- Sale of goods produced by an entity (for example, inventory of a manufacturer)
- Resale of goods purchased by an entity (for example, merchandise of a retailer)
- Resale of rights to goods or services purchased by an entity (for example, a ticket resold by an entity acting as a principal, as described in paragraphs 606-10-55-36 through 55-40)
- Performing a contractually agreed-upon task (or tasks) for a customer
- Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use as and when the customer decides
- Providing a service of arranging for another party to transfer goods or services to a customer (for example, acting as an agent of another party, as described in paragraphs 606-10-55-36 through 55-40)
- Granting rights to goods or services to be provided in the future that a customer can resell or provide to its customer (for example, an entity selling a product to a retailer promises to transfer an additional good or service to an individual who purchases the product from the retailer)
- Constructing, manufacturing, or developing an asset on behalf of a customer
- Granting licenses (see paragraphs 606-10-55-54 through 55-65)
- Granting options to purchase additional goods or services (when those options provide a customer with a material right, as described in paragraphs 606-10-55-41 through 55-45).1
The key factor in assessing the promises is whether they are distinct. A promise is distinct if both of these conditions are met:
(a) The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).
(b) The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the good or service is distinct within the context of the contract).2
The customer must obtain an economic benefit from the use of the good or service. This can be through use, consumption, resale, or through other indicators that economic value was obtained. In some cases, the customer may have to add other resources in order to obtain the economic value. This is acceptable as long as such resources are readily available. This is demonstrated by the customer already having obtained such a resource from the entity or through other available sources; or if the resource is separately sold by the entity or others. Indicators that an entity can benefit from a good or service include the fact that an entity regularly sells such a good or service.
Factors that indicate a promise is separately identifiable, as noted in (b), are:
- The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract into a bundle of goods or services that represent the combined output for which the customer has contracted. In other words, the entity is not using the good or service as an input to produce or deliver the combined output specified by the customer.
- The good or service does not significantly modify or customize another good or service promised in the contract.
- The good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract. For example, the fact that a customer could decide to not purchase the good or service without significantly affecting the other promised goods or services in the contract might indicate that the good or service is not highly dependent on, or highly interrelated with, those other promised goods or services.3
If the promises do not meet the requirements for separating, the performance obligations shall be combined into one performance obligation. A contract could have several performance obligations which in themselves include sets of promises that are not distinct and cannot be separated.
In practice, we believe that making the determination as to whether the promise is separately identifiable may present some challenges. Some examples of applying the guidance, derived from the ASC 606 examples, follow:
Goods and services are not distinct
A contractor enters into an agreement with a hospital to build a new wing. The contract states that the contractor is responsible for overall project management, and states various goods and services to be provided, including engineering, site work, construction of the building, all HVAC and finishing services.
All of the promised goods and services are capable of being distinct as they could be provided by other entities so the customer could benefit from them by adding resources. However, the goods and services are not distinct in the context of the contract as the entity provides significant services in integrating all of the promises to deliver a finished building, for which the hospital has contracted. Because both of the above criteria were not met, the contract contains one performance obligation.4
Distinct goods and services
A software company enters into a contract to deliver the following to a customer: a software license, installation services, software updates, and online technical support for a period of two years. Analyzing the promises besides the software license:
The installation services are routinely provided by other entities and do not significantly modify the software. Therefore, the customer can benefit from the service on its own by adding other readily obtained resources, i.e. the software license.
The software license is delivered separately and can function without the updates or the technical support. Therefore, the customer can benefit from the license on its own.
The updates and technical support are also separately available as the entity sells the products separately.
The entity thus determines that the contract has four performance obligations:
- Software license
- Installation services
- Software updates
- Technical support
Revenue will be recognized as each obligation is fulfilled by the entity.5
Assume the same facts in the software example, except that as part of the installation services, the software is to be significantly customized to meet the customer’s special needs. In this situation, since the customer could not obtain the special custom installation services from another vendor and therefore could not obtain the benefit of the software license from readily obtained resources, the software license and custom installation are combined into one performance obligation. Thus, the contract has three performance obligations:
- Software license and custom installation
- Software updates
- Technical support
Revenue will be recognized as each is fulfilled by then entity. Specifically, in this example the consideration related to the software license itself could not be recognized until the customization services were completed.6
Assessing explicit and implicit promises in a contract
As noted above, the contract can contain additional performance obligations that are implied by the entity’s business practices. The following examples provide guidance on how to analyze such situations. The basic facts relate to a manufacturer that sells a product to a distributor who in turn sells the products to an end user.
Explicit promise of service
The contract states the manufacturer will provide free maintenance service without additional consideration (free). (This is similar to many new cars now sold with free periodic maintenance for a period of years.) The maintenance services will be outsourced to the distributor. The entity determines that this arrangement constitutes a separate promise, as the maintenance could be provided by the distributor or a third party, and therefore is distinct. As such, the consideration for the product is allocated to two performance obligations.7
Implicit promise of service
The entity has historically provided free maintenance for its products. There is nothing specific in the contract (either with the distributor or the end user), but the entity determines that the end user has a valid expectation of free maintenance based on the entity’s customary business practice. In this case, once again, the entity determines there are two performance obligations.8
Services that are not a performance obligation
In this situation, the contract with the distributor does not contain an explicit promise of free maintenance, nor does the entity’s customary business practices indicate that free maintenance would be expected by the end user. However, after the products have been delivered to the distributor and before the sale to the end user, the manufacturer unilaterally decides to provide free maintenance and notifies the distributor of its intent. In this situation, since the free maintenance was not part of the contract or negotiated for by any parties, it is not considered a separate performance obligation. In this situation, the manufacturer would apply the guidance in ASC 450 with respect to contingencies.9
ASC 606 provides specific guidance with respect to warranties. Many products are sold with an explicit or implied warranty that the product or service will function as intended. This can be driven by standard business practices or sometimes specific laws. In other cases, customers can also purchase an additional warranty for separate consideration, which extends the normal warranty service period or perhaps provides additional services.
If the customer has an option to purchase a warranty separately, then this is a distinct performance obligation and should be accounted for in accordance with the relevant guidance. That is, the total consideration associated with the product and warranty should be allocated based on relative sales value and the revenue allocated to the warranty obligation should be recognized over the warranty period, generally using the straight line method.
If the customer does not have the option to purchase a warranty separately, then this is not a separate performance obligation. The entity should account for these warranties in accordance with current product warranty guidance provided in ASC 460-10.
The guidance in ASC 606 provides several indicators as to whether or not the warranty should be considered a separate performance obligation as follows:
a. Whether the warranty is required by law: If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.
b. The length of the warranty coverage period: The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.
c. The nature of the tasks that the entity promises to perform: If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.10
Entities that currently provide such warranties will likely experience a change in how these are being accounted for under current GAAP. The amount and timing of revenue may differ.
In conclusion, for many entities, analyzing contracts for separate performance obligations may be relatively straightforward and not involve additional judgments, but for other entities with implied or explicit multiple promises in contracts, the process may be more difficult. The identification of separate performance obligations is critical, as ultimately it will determine the timing of when revenue may be recognized and how much. It is reasonably possible that the need to identify these separate performance obligations will change the historical patterns of revenue recognition. Entities should begin to analyze standard business practices and assess the impacts this requirement may have. Complying with the requirements for identifying separate performance obligations is likely to require changes in business process and internal control over financial reporting.
For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, contact our team.
1 ASC 606-10-25-18
2 ASC 606-10-25-19
3 ASC 606-10-25-21
4 Derived from ASC 606-10-55-(137-140)
5 Derived from ASC 606-10-55-(141-145)
6 Derived from ASC 606-10-55-(146-150)
7 Derived from ASC 606-10-55-(152-153)
8 Derived from ASC 606-10-55-(154-155)
9 Derived from ASC 606-10-55-(156-157)
10 ASC 606-10-55-33