ASC 606 Revenue Recognition Series: Identifying Performance Obligations in the Contract (Part III)

In our last article on revenue recognition, we discussed step one under ASC 606: Revenue from Contracts with Customers (“ASC 606”), how to determine whether an arrangement is a contract. The Financial Accounting Standards Board’s (“FASB”) second step shows how to determine when the contracted promises qualify as a performance obligation, the unit of measurement that accounts for revenue. This step will likely be seen by many as the most difficult in the new framework and will inherently introduce a lot of judgement from management. In order to ease the implementation of this new standard, FASB has provided strong guidelines and examples to demonstrate how one should navigate the decision of whether a promise in a contract is a performance obligation. Below we discuss this guidance and the potential problems that could arise when attempting to apply it.

Performance Obligations

What are performance obligations? FASB defines a performance obligation as a promise within the contract that is both distinct on its own and distinct within the nature of the contract.

To be distinct on its own, the customer must be able to benefit from the good or service on its own without the other promised goods or services or with resources readily available to them. This is a similar concept to a ‘unit of accounting’ under the current GAAP language on multiple element arrangements. However, the new guidance has its own specific parameters to judge deliverables by.

This standard focuses in on the nature of the promise and whether the customer is able to benefit from that promise by itself. Consideration must be given to how and when a customer can benefit from the promised good or service. For example, similar to multiple element arrangement guidelines in legacy GAAP, if the entity has a history of selling that item by itself then that would provide evidence that a customer can benefit from it alone and thus it is distinct.

A good or service would also be considered distinct if the customer can benefit from it in conjunction with readily available resources. These resources may be sold separately by any entity or may already be owned by the customer.

Determining whether a promised good or service is distinct within the context of the contract could be challenging. To do this, the entity should consider the promised goods or services from the customer’s perspective – what is the customer’s expectation? For example, if a contract promises to customize an off-the-shelf software system to meet a customer’s needs, then the promises to provide software and to customize it cannot reasonably be seen as two performance obligations. The customer’s expects to receive one customized product. In situations like this, management would likely identify only one performance obligation. Even if there are multiple goods or services promised in a contract that are capable of being distinct, it may not be appropriate to treat them as separate performance obligations. A separate approach would lead to an accounting treatment that is not consistent with the nature of the entity’s promise in the contract. Therefore, a contract will likely have fewer performance obligations than listed deliverables.

This step determines what the nature of all the promises within the contract are. Management should ask themselves a series of questions when making this determination. Can the customer benefit from each individual promise separately? Are all or some of these promises inputs to an overall promise where the customer couldn’t benefit from it unless it’s combined?

The guidance does provide some factors that suggest that two or more promises to transfer goods or services to a customer are not separately identifiable in the context of the contract. This means they should be combined until they form a distinct deliverable to the customer. These considerations include:

• Significant service of integrating goods or services.
• Goods and services that significantly modify each other.
• Highly interdependent or interrelated goods or services.

Significant Service of Integrating Goods or Services

This provision is based on the concept that if promised goods or services are ultimately inputs to a larger, combined good or service, then under the contract they are not separate performance obligations. FASB determined that if an entity has to perform significant integration services in order to provide the ultimate promised good or service, then all goods and services related to providing that final product should be combined into one performance obligation.

For example, let’s say an engineering firm is hired to create a robotic valve that will be used by doctors to help treat a heart condition. The contract indicates that the engineering firm will design the prototype, develop the beta version of the valve, test the beta version of the valve, and create the final version of the valve. In evaluating whether these deliverables are distinct by themselves, most would conclude that they are because the customer can take the design to a different firm to be created. The beta version has value and can be used on its own. However, in the context of this contract, the customer is not contracting to receive these individual deliverables. The customer has contracted the engineering firm to obtain the final product, the complete valve. In this particular situation, the engineering firm could conclude that the contract only has one performance obligation that they should account for – delivery of the final valve.

Goods and Services that Significantly Modify Each Other

This provision is based on the concept that if any promised goods or services significantly modify or customize another promised good or service, they are most likely inputs to a larger output, a single performance obligation. The customized valve example above is a great demonstration of this fact pattern. The customer views the customized valve as one ultimate deliverable, not as two separate deliverables of the valve and the customization services. In this case, the two deliverables are combined into one performance obligation.

Highly Interdependent or Interrelated

This final provision describes goods and services that are so interrelated that a customer could not benefit from one being delivered without the other at the same time. This is best understood through the reasoning, “I cannot do X without Y, and I cannot do Y without X.” If this statement is true concerning two or more promises in the contract, it is likely a single performance obligation.

For example, a customer contracts a medical technology company for a specialized machine including the installation of the machine. The machine is not sold elsewhere and requires a very specialized installation process that can only be done by the company providing the machine. In this instance, the customer cannot use the machine without the installation, and it cannot utilize the installations without the machine. Both promises are inputs to a combined single performance obligation.

Series of Goods or Services

We’ve already discussed how an entity would identify performance obligations for a single or bundle of goods or services. FASB also provides guidance on how to recognize revenue in contracts for a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. In order to qualify as a series of distinct goods or services, the promised goods or services must:

• Be distinct goods or services that meet the criteria to be recognized over a period of time.
• The measure of progress as each distinct good or service is transferred to the customer is the same for all those promised in the series.

If both of these criteria are met, then the promised goods or services should be accounted for as a single performance obligation.

What does all of this mean in practice? Management must determine if the ultimate promise to the customer is the same distinct thing over and over, or the same thing over and over that eventually make up a distinct good or service. If it’s the former, then revenue should be recognized as the distinct goods or services are delivered to the customer in a way that represents the progress of the transfer of control.

Let’s consider a contract with a customer for nightly office cleaning services for a 12-month period. While the actual services performed each night may vary from vacuuming to window cleaning, the nature of the promise to the customer is the same each night – the office will be cleaned. The customer benefits from the service each night independent of the cleaning services on other nights, so the cleaning service each night represents a distinct good. Additionally, the services meet the criteria in ASC 606-10-25-27(a) for being recognized over time and the services are delivered in a nightly pattern. As such, the services are considered one performance obligation and are recognized ratably over the 12-month service period.

Material Right

ASC 606 introduces the new concept of a material right, which requires significant judgement on the part of management. A material right is an option to purchase additional goods or services at a price that is less than what the customer would have paid if they had not entered into the contract. If this right exists in the contract, then it should be accounted for as a separate performance obligation.

The key here is that the option is only a material right if the discount provided is significantly more than what the customer would typically pay on a standalone basis. If a contract provides an option to purchase additional goods or services at a discount that is often offered to customers when it’s purchased on a standalone basis, then there is no material right and the option is not considered a performance obligation.

Consider a gym entering into a contract with a customer who pays a $100 membership fee and commits to a 12-month term at $50 per month. At the end of the year, if the customer chooses to renew the contract the monthly fee will remain at $50 per month. Since the renewal doesn’t require an additional membership fee, the customer has the material right to continue their membership at the discounted rate because they paid the initial fee. The gym would have to defer revenue allocated to the material right to renew in year one. If the customer does not opt to renew, then the amount deferred would then be recognized in full at the end of the 12-month term. If the customer does renew at the end of the initial term, then the gym must estimate how many years it believes the customer will continue to renew. If management estimates that the customer will renew two times, for a total of three years, then the portion of the contract consideration allocated to the material right to renew would be recognized ratably over the two renewal terms.

The determination of a material right is inherently going to introduce management judgement. Management should focus on whether the discount is greater than the discount that would be offered if the item were sold on a standalone basis.

Missed Part I and Part II of the series? Read it now.

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