C.4 Step 2 — Identify Performance Obligations (Chapter 5 of the Roadmap)
C.4.1 Immaterial Goods or Services — TRG Agenda Papers 12 and 25
Paragraph BC87 of ASU 2014-09 indicates that before an entity
can identify performance obligations in a contract with its customers, it must
first identify all promised goods or services in the contract. Paragraph BC89
notes that the FASB and IASB “decided that all goods or services promised to a
customer as a result of a contract give rise to performance obligations.”
Further, paragraph BC90 states that the boards “decided not to exempt an entity
from accounting for performance obligations that the entity might regard as
being perfunctory or inconsequential.”
TRG members discussed various options, including whether to (1)
specifically address “perfunctory or inconsequential” items in the text of the
revenue standard, (2) delete the wording from paragraph BC90 (as quoted above),
and (3) add other implementation guidance.
While some TRG members discussed the potential need to add the
concept of “inconsequential or perfunctory” to the revenue standard, there
appeared to be general agreement that such an addition would not be necessary.
Further, most TRG members believed that the evaluation of promised goods or
services in a contract would lead to about the same number of deliverables as
under legacy U.S. GAAP.
In April 2016, the FASB issued ASU 2016-10, which amends certain
aspects of the revenue standard, including the guidance on identifying
performance obligations. ASU 2016-10 states that an entity “is 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.” In addition,
the ASU indicates that an entity should consider materiality of items or
activities only at the contract level (as opposed to aggregating such items and
performing an assessment at the financial statement level). For additional
information, see Chapter
5.
C.4.2 Stand-Ready Obligations — Implementation Q&A 22 (Compiled From TRG Agenda Papers 16 and 25)
The revenue standard notes that promises in a contract with a
customer may be explicit or implicit and lists examples of promised goods or
services. One such example is “[p]roviding a service of standing ready to
provide goods or services . . . or of making goods or services available for a
customer to use as and when the customer decides,”11 referred to as stand-ready obligations.
The following broad types of promises or arrangements may
constitute stand-ready obligations:
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Type A — The obligation to deliver goods or services is within the entity’s control, but additional development of the goods, services, or intellectual property (IP) is required.
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Type B — The obligation to deliver goods or services is outside both the entity’s and the customer’s control.
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Type C — The obligation to deliver goods or services is solely within the customer’s control.
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Type D — The obligation is a promise to make goods or services available to the customer continuously over the contractual period.
The principle in the revenue standard requires an entity to
understand the nature of the promise. For example, in a contract to provide a
specified number of goods or services, the nature of the promise to the customer
is to provide those specified goods or services regardless of whether the
customer was able to specify the timing of transfer.
Further, Type A promises (e.g., a promise in a software or
biotechnology licensing arrangement to provide updates or upgrades when and if
available) should be closely evaluated to determine whether, in addition to a
stand-ready obligation, there are implicit promises to provide specified goods
or services. An implicit promise to provide a specified good or service may
result from the entity’s customary business practices, specific statements, or
other communications. All facts and circumstances should be evaluated to
determine the nature of the promise in the contract.
C.4.3 Distinct in the Context of the Contract — TRG Agenda Papers 9 and 11
ASC 606-10-25-21 lists three factors (not all-inclusive) to help
entities assess whether goods or services are distinct in the context of the
contract.
Stakeholder views differ on whether (and, if so, to what extent)
the existence of factors such as a customized or complex design, an entity’s
learning curve to produce the contractual goods or services, or the customer’s
motivation for purchasing the goods or services affects whether goods or
services are distinct in the context of the contract.
While TRG members generally agreed that such factors are not
individually determinative of whether goods or services are distinct in the
context of the contract, there were inconsistent views on whether the evaluation
should be performed (1) from the customer’s perspective, (2) from the entity’s
perspective, or (3) only on the basis of the contract. Some TRG members believed
that the entity should consider what items the customer has been promised and
whether the promised items will be integrated in some way. For example, many TRG
members agreed that an entity would need to evaluate the impact of design
services it performs in determining the performance obligations under a contract
(e.g., if the customer obtains control of the rights to the manufacturing
process developed by the entity).
The TRG also discussed how the entity’s knowledge of its
customer’s intended use of the goods or services would affect the determination
of whether the goods or services were highly interrelated. Many TRG members
expressed the view that an entity should consider whether the goods or services
could fulfill their intended purpose on a stand-alone basis or whether they are
inseparable because they affect the ability of the customer to use the combined
output for which it has contracted.
ASU 2016-10 refines the criteria for assessing whether promised
goods and services are distinct, specifically the “separately identifiable”
principle (the “distinct within the context of the contract” criterion) and
supporting factors. To further clarify this principle and the supporting
factors, the ASU adds six new examples and amends other examples to demonstrate
the application of the guidance to several different industries and fact
patterns. For further information, see Chapter 5.
C.4.4 Series of Distinct Goods or Services — Implementation Q&As 19 and 20 (Compiled From TRG Agenda Papers 27 and 34)
To promote simplicity and consistency in application,12 the revenue standard includes the concept of a series of distinct goods or
services that are substantially the same and have the same pattern of transfer
(the “series provision”).13 Accordingly, goods and services constitute a single performance obligation
if (1) they are “bundled” together because they are not distinct or (2) they are
distinct but meet the criteria that require the entity to account for them as a
series (and thus as a single performance obligation).
The FASB staff noted that:
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Goods or services do not need to be transferred consecutively (i.e., an entity should look to the series provision criteria in ASC 606-10-25-15 to determine whether the goods or services are a series of distinct goods or services for which the entity is not explicitly required to identify a consecutive pattern of performance). Further, while the term “consecutively” is used in the Background Information and Basis for Conclusions of ASU 2014-09, the FASB staff noted that whether the pattern of performance is consecutive is not determinative of whether the series provision applies.
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The accounting result for the series of distinct goods or services as a single performance obligation does not need to be the same as if each underlying good or service were accounted for as a separate performance obligation. Implementation Q&A 20 states that “[s]uch a requirement would almost certainly make it more difficult for entities to meet the requirement, and because the series provision is not optional, it likely would require entities to undertake a ‘with and without’ type analysis in a large number of circumstances to prove whether the series provision applies or not.”
C.4.5 Application of the Series Provision — Implementation Q&A 18 (Compiled From TRG Agenda Papers 39 and 44)
Stakeholders raised questions related to whether performance
obligations in long-term contracts meet the criteria to be accounted for under
the series guidance. Implementation Q&A 18 addresses how entities should
determine whether distinct goods or services are substantially the same. An
entity’s first step is to determine the nature of its promise of providing
services to its customer. For example, an entity will need to determine whether
the nature of the promise is to stand ready to perform or to provide a specified
quantity of a service. If the nature of the promise is to provide a single
service over a specified period or to stand ready, the evaluation would then
focus on whether each time increment is distinct and substantially the same.
Implementation Q&A 18 provides four examples that illustrate
the application of the framework for determining whether an entity is required
to apply the series guidance. The FASB staff’s analysis of one of those examples
in relation to step 2 of the revenue standard is summarized below.
Example and Analysis
A
provider of hotel management services enters into a
20-year contract to manage a customer’s properties. The
service provider receives consideration based on 1
percent of monthly rental revenue, reimbursement of
labor costs incurred, and an annual incentive fee of 8
percent of gross operating profit.
Step 2 —
Identifying a Performance Obligation
An entity would need to determine (1)
the nature of the services promised to the customer and
(2) whether the promised services are distinct and
substantially the same. The nature of the promised
service in the example was believed to be a single
integrated management service comprising distinct
activities (e.g., management of hotel employees,
accounting services, training, and procurement).
Day-to-day activities do not need to be identical to be
substantially the same. Therefore, while these
activities could vary from day to day, the nature of the
service is one that provides an integrated management
service and represents a single performance obligation
instead of multiple performance obligations (for each
underlying activity or different combinations of
activities).
C.4.6 Determining the Period Over Which an Entity Should Recognize a Nonrefundable Up-Front Fee — Implementation Q&A 52 (Compiled From TRG Agenda Papers 18, 25, 32, and 34)
A nonrefundable up-front fee (e.g., a one-time activation fee in
a month-to-month service contract) should be recognized over the contract period
if the entity concludes that the fee does not provide a material right.
Conversely, if the nonrefundable up-front fee provides the customer with a
material right, the fee should be recognized over the expected service period to
which the material right is related. An entity should consider both qualitative
and quantitative factors to determine whether a nonrefundable up-front fee
provides the customer with a material right. Factors to consider include the
price a new customer would pay for the same service, availability and pricing of
service alternatives, and the entity’s average customer life.
C.4.7 Assessing Whether Preproduction Activities Are a Promised Good or Service — Implementation Q&A 16 (Compiled From TRG Agenda Papers 46 and 49)
An entity should first evaluate the nature of its promise to the
customer and, in doing so, consider whether a preproduction activity is a
promised good or service (i.e., the preproduction activity transfers control of
a good or service to the customer) or a fulfillment activity. Further, the
criteria for determining whether an entity transfers control of a good or
service over time14 may be helpful in this assessment. If an entity determines that a
preproduction activity transfers control of a good or service to a customer over
time, it should include the preproduction activity in its measure of progress
toward complete satisfaction of its performance obligation(s).
C.4.8 Warranties — Implementation Q&A 17 (Compiled From TRG Agenda Papers 29 and 34)
The revenue standard provides guidance on when an entity should
account for a warranty as a performance obligation (e.g., if a customer has a
choice to purchase a warranty or the warranty provides a service in addition to
the assurance that the product complies with agreed-upon specifications). If the
warranty is a performance obligation, the entity would account for the warranty
by allocating a portion of the transaction price to that performance
obligation.15 The guidance includes three factors that the entity would consider in
making such a determination: (1) whether the warranty is required by law, (2)
the length of the coverage period, and (3) the nature of the tasks that are
promised.16
Questions continually arise about how an entity would determine
whether a product warranty that is not separately priced is a performance
obligation (i.e., whether the warranty represents a service rather than a
guarantee of the product’s intended functionality). For illustrative purposes,
the FASB staff offered an example in which a luggage company provides a lifetime
warranty to repair any damage to the luggage free of charge and noted that such
a warranty would be a separate performance obligation because the company agreed
to fix repairs for any damage (i.e., repairs extend beyond those that fix
defects preventing the luggage from functioning as intended).
The luggage example illustrates a relatively straightforward set of facts and
circumstances. However, the conclusion for other warranty arrangements may be
less clear. Accordingly, an entity will need to assess the substance of the
promises in a warranty arrangement and exercise judgment on the basis of the
entity’s specific facts and circumstances.
In addition, while the duration of the warranty (e.g., the lifetime warranty in
the luggage company example discussed) may be an indicator of whether a warranty
is a separate performance obligation, it is not determinative.
C.4.9 Identifying Performance Obligations in the Franchisor Industry — Implementation Q&A 24
Before the adoption of the revenue standard, franchisors would
generally recognize initial franchise fees when the franchisee location opened
in accordance with industry-specific GAAP. Under ASC 606, franchisors will need
to determine whether any preopening activities represent distinct goods or
services in addition to the right to use the franchisor’s IP. The transaction
price is allocated to distinct goods or services on the basis of their relative
stand-alone selling prices, and revenue is recognized when or as control of
those distinct goods or services is transferred. There is no presumption about
the number of performance obligations in a franchisor arrangement, and entities
should apply judgment to individual franchisor arrangements to determine the
number of performance obligations.
In January 2021, the FASB issued ASU 2021-02, which allows a
franchisor that is not a PBE (a “private-company franchisor”) to use a practical
expedient when identifying performance obligations in its contracts with
customers (i.e., franchisees) under ASC 606. When using the practical expedient,
a private-company franchisor that has entered into a franchise agreement would
treat certain preopening services provided to its franchisee as distinct from
the franchise license. In addition, a private-company franchisor that applies
the practical expedient must make a policy election to either (1) apply the
guidance in ASC 606 to determine whether the preopening services that are
subject to the practical expedient are distinct from one another or (2) account
for those preopening services as a single performance obligation. The practical
expedient and policy election are intended to reduce the cost and complexity of
applying ASC 606 to preopening services associated with initial franchise fees.
For additional information, see Section 5.3.5.