Accounting: The Language of Business - Vol. 2 (Intermediate: Part 117)

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 Revenue Recognition (Part D)

by

Charles Lamson

Step 2: Identify the Performance Obligations in the Contract

Recall from Exhibit 8.1 in Part 114 and reintroduced below that in order to accomplish the objectives of revenue recognition, companies must follow five steps. This post discusses Step 2.

A seller needs to identify the various performance obligations in a contract to allocate the transaction price to these different performance obligations and to recognize revenue when or as it satisfies each individual one. Conceptually, a performance obligation is a promise to transfer a good or service that is distinct. As shown in Exhibit 8.3, a performance obligation is either:

• A promise to transfer a good or service, or bundle of goods or services, that is distinct, or

• A promise to transfer a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer (A series of goods or services that have the same pattern of transfer if the performance obligation is satisfied over time per FASB ASC 606-10-25-27 and the same method would be used to measure the entity's progress toward satisfaction of the performance obligation according to paragraphs 31 and 32 of FASB ASC 606-10-25. See paragraphs 14 and 15 of FASB ASC 606-10-25 for a discussion of the identification of performance obligations.)

The determination of performance obligations starts with identifying the promised goods and services. After identifying the goods or services in the contract, the seller must determine which goods and services are distinct. The notion of distinct goods and services is critical to determining separate performance obligations. To be distinct, a good or service must meet two conditions:

1. The customer can benefit from the good or service on its own or in conjunction with other readily available resources to the customer, and

2. The promise of the seller to deliver that good or service is separately identifiable from other promises in the contract.

It is often clear that a customer can benefit from the product or service on its own (or in conjunction with other assets). At other times, this determination requires more judgment. If the good or service can be used, consumed, or sold for a nontrivial amount, then it passes the test of being distinct. A good or service is also distinct if the customer can benefit from it in conjunction with other readily available resources. Another resource is considered to be a readily available resource if it is sold separately by the seller or another entity, or if the customer already has obtained it from the seller or in some other transaction. For example, consider a set of earbuds packaged with a mobile phone. Because the earbuds can be sold separately and can be used with other electronic devices, the earbuds are a readily available resource.

A promise to deliver a good or service is separately identifiable if it is not highly dependent or interrelated to another promise in the contract to deliver another good or service. Judgment may be involved in the determination of whether the promise to deliver the good or service is separate from other promises. For example, consider a lawn care company that mows the lawn and then blows clippings off the sidewalk and driveway. Blowing the clipping is highly dependent on having the lawn mowed. Without mowing the lawn, there would be no clippings to blow away. So, blowing the clippings is not separately identifiable from the promise to mow the lawn.

At times a seller may provide a “ free” good or service with the contract, such as in the telecommunications industry where entities offer free mobile phones with a service agreement. These goods and services should be considered as possible performance obligations even though they are identified in the contract as being free of charge.

Also, the promised good or service does not have to be explicitly identified in the contract. If the customer has a valid expectation that the seller will provide the good or service, then this item should also be assessed as a possible performance obligation.

An entity should aggregate the goods or services promised in a contract until it identifies a bundle of goods or services that is distinct and thus defined as a separate performance obligation. There may be only one performance obligation identifiable in a contract. Example 8.4 illustrates how to identify separate performance obligations.

 Modification of this contract will result in a different outcome as seen an example 8.5.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 379-381*

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