The New Revenue Recognition Model – Step 2: Identifying Performance Obligations
What Is a Performance Obligation?
In its purest form, a performance obligation can be described as what you are required to do for your customer. ASC 606 defines a performance obligation as a promise to transfer goods or services (or a bundle of products or services) to a customer that are either:
- Distinct in featuring unique requirements for the provider of goods and services to customers; or
- A collection of distinct goods or services with the same pattern of transfer to the customer. The same pattern of transfer occurs if:
- Each distinct product or service would constitute a performance obligation over time;
- Progress towards complete satisfaction of the performance obligation to transfer each distinct product or service would be evaluated using the same method
If a promised good or service is not distinct, it should be considered with other products or services to make it distinct.
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What Is a Distinct Good or Service?
To be considered distinct, the customer must benefit from the good or service either on its own or together with other resources readily available to the customer.
A readily available resource is a good or service that the customer has already obtained from the supplier or other provider. If a good or service is typically sold separately, this indicates that a customer can benefit from the use of that item. As a result, it is likely distinct.
ASC 606 requires judgment in determining whether a good or service is distinct within the context of the contract. It is important to recognize that the concept of being distinct is from the customer’s perspective.
What Are Typical Performance Obligations?
Contracts generally explicitly state the goods or services that an entity promises to transfer to a customer. However, promised goods or services might imply terms that include an entity’s customary business practices, published policies or specific statements.
Depending on the contract, performance obligations under ASC 606 may include:
- Sale of manufactured goods
- Resale of goods (e.g., merchandise of a retailer)
- Resale of rights to goods or services (e.g., a ticketing agent selling tickets)
- Performing a contractually agreed-upon task(s)
- Standing ready to provide goods or services (e.g., unspecified updates to software supplied on a when-available and if-available basis)
- Arranging for another party to transfer goods or services to a customer (e.g., acting as an agent of another party)
- Constructing, manufacturing or developing an asset (e.g., building an asset for the specifications of a customer)
- Granting licenses or rights to use intangible assets
- Granting rights to goods or services to be provided in the future that the customer can resell or provide to customers
Whether or not shipping and handling activities are considered promised services to a customer depend on the terms. Shipping and handling activities are not a promised service if they occur before customers obtain the goods. But shipping and handling activities can either be considered a fulfillment cost or a separate performance obligation if they take place after a customer receives the goods.
Finally, ASC 606 states that performance obligations do not include any activities that do not transfer goods or services to customers but must be performed in order to fulfill a contract.
What about Warranties?
ASC 606 provides guidance on identifying whether a warranty represents a contractual obligation accounted for as a liability (ASC 460) or a separate performance obligation under the new standard. ASC 606 specifies two different kinds of warranties:
- Assurance warranties – These are not separate performance obligations and consist of assurances that the product will function as specified.
- Service warranties – These are separate performance obligations that provide customers with an additional service and do represent separate performance obligations.
To make the distinction, one evaluates whether the customer can purchase the warranty separately. If so, this indicates that the warranty is a separate service and, as such, is a service warranty.
Now what?
Identifying performance obligations within contracts is a crucial step in the five-step model. This identification helps to shape when and how much revenue will be recognized for each performance obligation in the contract. Entities should review their contracts to determine and document performance obligations.
Subsequently, you will be ready to tackle step three of the revenue recognition model – determining the transaction price.
Read more about revenue recognition Step 1, Step 3, Step 4 and Step 5.
This article was originally written and published on October 16, 2017, and was most recently updated and revised on December 31, 2019.
