5.1 Introduction to Step 2
Step 2 is one of the most critical steps in the standard’s revenue framework
since it establishes the unit of account for revenue recognition. A material
miscalculation in this step will often lead to an error in the recognition of
revenue. This step requires an entity to identify what it has promised to the
customer. In many arrangements, this will be obvious and therefore simple; in other
arrangements, however, there are critical judgments that an entity must make in
determining the correct unit of account (i.e., performance obligation).
The decision tree below illustrates the revenue standard’s process for
identifying performance obligations in a contract.
This chapter also addresses topics such as stand-ready obligations, options for
additional goods and services, warranties, and nonrefundable up-front fees because
these topics are integral to the proper identification of performance
obligations.
When identifying a performance obligation, an entity should determine whether it is a principal or an
agent in the transaction because that determination will affect how (and sometimes when) the entity
reports the revenue earned. While step 2 is probably the best stage of the revenue recognition process
for determining whether an entity is a principal or an agent, there are many considerations that go
into that determination. Accordingly, principal-versus-agent considerations are discussed separately in
Chapter 10.
In addition, an entity’s contract with a customer may give the customer a choice of
whether to purchase additional goods or services. In some cases, options for
additional goods or services are marketing or promotional efforts to gain future
contracts with customers. However, in other cases, such options may be considered
performance obligations, which are referred to as material rights. While the
determination of whether a customer option for additional goods or services gives
rise to a material right should be performed as part of step 2, there are many
considerations related to material rights that affect the other steps of the revenue
recognition model. Accordingly, material right considerations are discussed
separately in Chapter 11.