We are nearing the effective dates of the highly anticipated revenue recognition standard, ASC 606. For public entities, the effective date of fiscal years beginning after December 15, 2017 is quickly approaching. For everyone else, there is an additional year to get ready, with an effective date of fiscal years beginning after December 15, 2018. Of course, early adoption is permitted for those who can’t wait to get started.
The core principle of the standard is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Sounds simple, right? Well, as they say, the devil is often in the details. To help you understand these details, we are issuing a series of articles, each one taking a closer look at one of the five steps in the revenue recognition model. In our first article, we focused on identifying the contract. In this article, we will be focusing on step 2 – identifying performance obligations in the contract.
So what exactly is a performance obligation? At its simplest form it can be described as what it is that 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 goods or services) to a customer that are either:
- Distinct, or
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. The same pattern of transfer occurs if:
- Each distinct good or service in the series would meet the criteria to be a performance obligation over time;
- The same method would be used to measure the entity’s progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer;
- This “series guidance” was introduced to address practicality concerns around certain repetitive transactions for which each individual act would otherwise represent a distinct performance obligation. A common example would be a cleaning contract for monthly cleaning services.
A good or service that is not distinct should be combined with other goods or services until the entity identifies a bundle of goods or services that are distinct.
Is it a Distinct Good or Service?
A good or service is distinct if both of the following criteria are met:
- The good or service is capable of being distinct.
- The good or service is distinct within the context of the contract.
To be capable of being distinct, the customer must be able to benefit from the good or service either on its own or together with other resources that are readily available to the customer. Basically, can the good or service be used, consumed, sold (other than for scrap value) or otherwise held in a way that generates economic benefits. At times this may be in conjunction with other resources readily available to the customer. A readily available resource is a good or service that is sold separately (by the entity or another entity), or a resource that the customer has already obtained from the entity or from other transactions or events. If an entity regularly sells an element separately, this indicates that a customer can benefit from it and therefore the element is likely distinct.
ASC 606 requires judgment in determining whether a good or service is distinct within the context of the contract. Factors that indicate that two or more promised goods or services may not be distinct include:
- The entity provides a significant service of integrating the goods or services with other goods or services promised in the contract (i.e. the entity is using the goods or services as an input to produce the combined output specified by the customer).
- The goods or services significantly modify or customize another good or service promised in the contract.
- The goods or services are highly interdependent or highly interrelated with other promised goods or services (e.g. each of the goods or services is significantly affected by one or more of the other goods or services in the contract).
An example of goods not being distinct within the context of a contract would be certain construction contracts. In many construction contracts, bricks are sold separately, so they are capable of being distinct. However, in a contracts to construct buildings, it does not make sense to treat each brick as a separate performance obligation.
It is important to recognize that the concept of being distinct is from the customer’s perspective.
What Does a Performance Obligation Look Like?
Contracts with customers generally state explicitly the goods or services that an entity promises to transfer to a customer. However, promised goods or services in a contract may also be implied by an entity’s customary business practices, published policies, or specific statements if those promises create a reasonable expectation of the customer that the entity will transfer a good or service to the customer. It should be noted that entities are not required to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer.
Below are examples of promises that, depending on the contract, could be considered performance obligations under the new standard.
- Sale of goods produced by an entity (e.g. inventory of a manufacturer)
- Resale of goods purchased by an entity (e.g. merchandise of a retailer)
- Resale of rights to goods or services purchased by an entity (e.g. a ticket resold by an entity acting as a principal)
- Performing a contractually agreed-upon task (or tasks) for a customer
- Standing ready to provide goods or services (e.g. unspecified updates to software that are provided on a when and if available basis)
- 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)
- Constructing, manufacturing, or developing an asset on behalf of a customer (e.g. building an asset for the specifications of a customer)
- Granting licenses or rights to use intangible assets
- Granting options to purchase additional goods or services (when those options provide the customer with a material right)
- Granting rights to goods or services to be provided in the future that the customer can resell or provide to its customer
An option to purchase additional goods or services to a customer is a separate performance obligation if it constitutes a material right beyond a marketing offer. ASC 606 contains specific guidance on how to make this determination which is based on assessing whether that customer has acquired a right to purchase a good or service at price that it otherwise wouldn’t have been entitled to absent entering into the contract. This is performed by comparing the option price to the standalone selling price of the good or service.
Whether or not shipping and handling activities are considered promised services to a customer depend on the terms. If the shipping and handling activities are performed before the customer obtains control of the good, then the shipping activities are not a promised service to the customer. Rather, they are considered fulfillment activities. If the shipping and handling activities are performed after a customer obtains control of the good, then the entity may elect to account for the activities as fulfillment costs vs as a separate performance obligation. The policy election should also be disclosed in the financial statement footnotes.
Finally, ASC 606 specifically states that activities that an entity must undertake to fulfill a contract, but do not transfer a good or service to a customer, do not represent performance obligations. Examples include the various administrative tasks that are needed to set up a contract. This is similar to the existing guidance on set-up fees in SAB 104.
What about Warranties?
ASC 606 provides guidance on identifying whether a warranty represents a contractual obligation accounted for under other GAAP as a liability (ASC 460) or a separate performance obligation under the new standard. ASC 606 contemplates two different kinds of warranties:
- Assurance warranties – these are not considered to be separate performance obligations and consist of assurances that the product will function as specified. As such, these would continue to be accounted for in accordance with existing GAAP for standard warranties. That is, at the time of the sale, an entity would estimate the costs to be incurred under the warranty and accrue for them with the corresponding debt recorded as an expense.
- Service warranties – are viewed to be a separate performance obligation that provides the customer with an additional service and do represent separate performance obligations. This differs from the accounting for certain separately priced extended warranty arrangements under US GAAP for which the allocation is based on the separately stated price for the extended warranty agreement.
To make the distinction, one evaluates if 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. If the warranty cannot be purchased separately, the entity further evaluates the warranty based on three indicators:
- Whether the warranty is required by law (if so, then it is not a performance obligation, and therefore not a service warranty);
- The length of the coverage period (the longer the period the more likely it is a service warranty)
- The nature of the tasks to be performed.
Identifying performance obligations within contracts is a crucial step of the five step model. This identification helps to shape when and how much of the revenue will be recognized for each performance obligation in the contract. Entities should be reviewing their contracts to determine and document performance obligations. Once you have done that, you will be ready for Step Three of the revenue recognition model – determining the transaction price.
Please contact your local Warren Averett advisor with any questions regarding revenue recognition under ASC 606.