In our previous issue of this serial we discussed how to identify a contract with a customer. Once it has been determined that a contract with a customer is within the scope of Topic 606, the next step is to identify the performance obligations in the contract.
In Step 2, the goods or services that a customer expects to receive are evaluated at the inception of the contract to determine if they individually or collectively meet the definition of performance obligations. While conceptually this evaluation appears straight forward, there are some considerations which can complicate this analysis, including principal vs. agent determination and implied performance obligations. As we further discuss performance obligations, keep in mind that a performance obligation is simply a promise to transfer to the customer a good or service (or a bundle of goods or services) that is distinct. As with Step 1, a systematic approach to evaluating the conditions of Step 2 will likely be the best practice.
Principal vs. Agent
Whether or not an entity is operating as a principal or an agent within a transaction is critical in determining what the obligations of the entity selling a good or service are, and in subsequent steps within the revenue recognition guidance, the pattern of revenue recognition.
An entity sells advertising space on billboards. The determination of whether or not the entity is acting as principal or an agent will determine what the performance obligations of the entity are. If the entity is the principal, for instance the owner of the billboard, and sells the use of the billboard to a customer, its performance obligation could be the placement of the advertising on the billboard for a period of time.
Alternatively, assume the entity did not own the billboard, but was instead acting as an agent for the owner of the billboard. In that scenario, the billboard owner would be the customer of the entity and the performance obligation provided could be the contracting with a third party to place an advertisement on the billboard.
Distinguishing Principal and Agent
Under existing U.S. GAAP, Topic 605, when distinguishing whether an entity is the principal or agent in a transaction there are various indicators which are considered. The indicators have weighting that establishes their order of importance. Under Topic 606, the evaluation will not change significantly as it still utilizes indicators; however the weighting of indicators is removed in favor of evaluating an arrangement based on its facts and circumstances. The indictors that an entity may be acting as an agent include:
- Another party is primarily responsible for fulfilling the contract.
- The entity does not have inventory risk before or after the goods have been ordered by a customer, during shipping or upon return.
- The entity does not have discretion in establishing prices for the other party's goods or services and therefore, the benefit that the entity can receive from those goods or services is limited.
- The entity's consideration is in the form of a commission.
- The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the other party's goods or services.
Things to Consider
- Performance obligations are the goods and services that are provided to a customer in a revenue contract. In some cases, multiple goods and services are bundled to create a distinct bundle of goods or services which represent a performance obligation.
- A performance obligation within a contract is one that is with a customer. In some instances, an entity is an agent and this may significantly change the evaluation of performance obligations within the contract.
- Performance obligations can be explicitly stated in a contract or implied in a contract, such as a discounted renewal option. The performance obligation may even be a component of an existing good or service. For example, the sale of post-contract support, which includes a maintenance plan and telephone support, would likely include two distinct performance obligations.
- The bundling of goods and services into performance obligations for accounting purposes may result in different groupings of goods and services being tracked for revenue recognition purposes than have historically been used. This may result in the need to change systems and processes to accommodate the units of account.
- A right of return would not be a performance obligation; rather it is a form of variable consideration, which will be addressed in Step 3. Warranties, loyalty programs and discounts on additional goods or services could be a performance obligation.
While these indicators will be familiar to those entities that have evaluated whether they are a principal or agent within a transaction prior to Topic 606, it is important to perform a new evaluation and to perform the evaluation in the context of the new guidance. Under Topic 606, these indicators are related to the performance of an obligation and the transfer of goods or services to a customer. Therefore, these indicators are used to assist in determining the goods or services an entity controls prior to the transfer of the goods or services occurring.
The examples excerpted from the accounting standard update in the Appendix are helpful in understanding the difference between acting as a principal and an agent.
A performance obligation is defined as a promise in a contract with a customer to transfer to the customer either:
- A good or service (or a bundle of goods or services) that is distinct
- A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
While a performance obligation is often explicit in a contract, for instance the transfer of a specifically identified product, it need not be explicitly stated in a contract to meet the definition. These implied performance obligations can become one of the most difficult components of a contract to evaluate. The FASB has provided numerous examples of what can qualify as a performance obligation including:
- 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
- Providing a service of standing ready to provide goods or services (e.g., 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 (e.g., acting as an agent of another party)
- Granting rights to goods or services to be provided in the future that a customer can resell or provide to its customer (e.g., 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
- Granting options to purchase additional goods or services (when those options provide a customer with a material right)
While not a comprehensive list of everything that can be a performance obligation, it illustrates the many different types of obligations that can arise in a contract. It is important to note that the evaluation of a contract for performance obligations such as these is done at the inception of the contract with the customer. Also noteworthy is that if an entity is an agent in a contract, the contract may explicitly call for the transfer of a product or service from the principal to the customer, but such a transfer would not be a performance obligation from the perspective of the agent in the transaction.
Let us provide a final word of caution with respect to identifying performance obligations. A performance obligation exists whenever the customer would view the promise made as part of the exchange, even if such a view is driven by customary business practices or industry behavior as opposed to the explicit terms of the contract. Further, the fact that something is given for free within a contract does not exclude it from being a performance obligation. Examples of free items that may be given away but would constitute performance obligations include free handsets given away with telephone service and free oil changes given with the purchase of a new car.
Separate Performance Obligations
The next evaluation required is to determine if the performance obligations are separate. A separate performance obligation is one that will be a unit of account in future steps and will thus have its own pattern of revenue recognition separate from the other performance obligations. A performance obligation is separate when it is either a distinct good or service, or a series of goods or services that are substantially the same and that have the same pattern of transfer to the customer. If a good or service does not meet one of these criteria it is bundled with other appropriate goods or services within the revenue contract until a bundle of goods or services is arrived at that is distinct.
Distinct Performance Obligations
In order for a performance obligation to be distinct it must meet two criteria.
- 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, and
- The entity's promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.
Put another way, the good or service must be capable of being distinct and distinct within the context of the contract.
Generally, a good or service can be thought of as being distinct if it is regularly sold on its own by the entity, however, this is not a definitive test of whether it is distinct. Rather, consideration should be given whether the customer can benefit on their own from the good or service by using it, holding it to generate economic benefits or selling the good or service for an amount greater than scrap value. The evaluation of the benefit from the good or service includes subjective judgment. The evaluation does not need to be standalone in the context of the specific good or service; rather an entity should evaluate the benefit that can be received in the context of other goods or services that an entity has already transferred to the customer. The evaluation should also be based on the nature of the good or service itself and not the contractual limitations of the customer. It is possible that a good or service has a benefit to the customer in conjunction with other goods or services that are readily available from another party.
In some situations, the evaluation of whether a good or service is distinct will hinge on how the good or service is used in the context of the contract. A good or service is not distinct in the context of a contract when the good or service is an input in the creation of a single output of the contract. If a good or service is not distinct in the context of a contract then it is bundled with other promised goods or services until a distinct bundle is identified. The bundling of individually but not contractually distinct goods or services is most commonly seen in the construction industry but may apply to any industry.
An entity that builds custom homes enters into a contract to build a house for a customer. The construction of the house includes the digging out and pouring of a foundation, the construction of the exterior, installing electrical systems, HVAC and plumbing, and applying the finishing to the house. Many different goods and services are promised within the contract and could on their own provide benefits to the customer. However, because the final output of the contract is a completed house, the various promised goods and services (i.e., inputs to the creation of a single output) would be bundled into a single performance obligation.
The ability of a customer to purchase additional goods or services at a discount as a result of a revenue contract will be a performance obligation when the right to purchase at a discount is material to the customer. Evaluating the existence of a material right will require significant judgment and careful consideration will need to be given to whether the right is representative of a standalone selling price for the additional good or service.
Loyalty programs may be performance obligations in the same manner as the offering of a discount. A loyalty program, if it is determined to offer a material right, would be a separate performance obligation and would have consideration in the contract allocated to it in later steps of the revenue recognition model.
Warranties, explicit in the contract or implied by practice, must be evaluated to determine if they are a performance obligation or not. Considerations when evaluating warranties include whether they are required by law, the length of time they cover and the nature of tasks performed. The standard addresses two types of warranties:
- An assurance-type warranty would not be a separate performance obligation. These warranties are promises that the good or service is as specified in the contract.
- A service-type warranty is one that provides a service to the customer in addition to the assurance of the good or service is as specified in the contract. Warranties which are purchased at the option of the customer or that provide services beyond fixing defects that exist when the sale occurs, are examples of service-type warranties.
In order to assist in determining whether a performance obligation is distinct in the context of a contract the FASB provided three indicators that a performance obligation is separately identifiable:
- 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.
It is important to note that these indicators are not all inclusive and they must be evaluated in the context of the contract. For instance, if an agreement is for computer equipment and the installation of the equipment into a server farm, the performance obligations could be the equipment and the installation service. Even if the entity provides these services separately in some instances, careful evaluation would be required because it may be that the two performance obligations are so highly interrelated that they are not distinct, thus they could be evaluated for revenue recognition as a combined unit.
Series of Distinct Goods or Services
When the performance obligations of an entity under a revenue contract consist of a series of goods or services that are substantially the same and have the same pattern of recognition, questions arise as to whether the series should be treated as one performance obligation or whether each individual good or service is separate.
An entity enters into a three-year agreement to maintain and service copiers. The service is performed on a reoccurring monthly basis.
Should the performance obligation of the contract be a single performance obligation, three to align with the three-year contract, or 36 individual performance obligations to align with the months of service?
In order to evaluate the questions raised by the example, the FASB provided two criteria that if met would result in the contracted services being a single performance obligation. These criteria are:
- Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria to be a performance obligation satisfied over time.
- The same method would be used to measure the entity's progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.
The first of these criteria will be more fully discussed in our Revenue Recognition Serial on Step 5 Recognize revenue when (or as) the entity satisfies a performance obligation, however, in general, a good or service is satisfied over time when:
- the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs
- the entity's performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced, and
- the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
The measurement of progress, which is also a topic that will be more fully discussed in Step 5, involves determining the appropriate input or output method that would appropriately measure the progress toward completing the satisfaction of a performance obligation.
In some instances such as our illustrative example, the outcome of determining whether there is one performance obligation or multiple performance obligations may not have an impact on the measurement of revenue because the pattern of recognition would ultimately be the monthly performance. However, if this example were changed such that there was a financing component - such as a large upfront payment - or there were other performance obligations that related to the maintenance, the impact of whether the contract is a single, three annual or 36 monthly performance obligations could be significant.
Non-distinct Goods and Services
When it is determined that a good or service is not distinct it is combined with other goods and services within a revenue contract until a distinct bundle of goods and services is represented. In some cases, the bundling process may result in all the goods and services within a contract being one unit of account.
In order to successfully complete the remaining steps in the revenue recognition model it will be important that management arrive at an appropriate conclusion for what are the performance obligations of the revenue contract and whether any of the goods or services should be bundled. The evaluation may require new or enhanced procedures and systems to be able to track bundles of goods or services that were not previously bundled for accounting purposes, to separate previously bundled goods or services or to track new implicit performance obligations, such as options to renew at significant discounts.
Identifying the performance obligations will often require a team approach with input from those selling the good or service; those who manufacture, install the good or perform the service; in addition to accounting personnel. Since the assessment of contracts will be ongoing as new contracts are executed, items to support the assessment of contracts such as controls, procedures and information systems will be necessary.
For More Information
If you have any specific questions, comments or concerns, please share them with James Comito of MHM's Professional Standards Group or your MHM service professional. You can reach James at firstname.lastname@example.org or 858.795.2029.
MHM's Revenue Recognition Serial
Published on October 28, 2014