Chapter 5 — Step 2: Identify the Performance Obligations

5.3 Identifying Performance Obligations in a Contract

5.3.1 In General

After identifying the promises in a contract with a customer, an entity must determine whether a promise or multiple promises represent performance obligations to the customer. To accomplish this, the entity should determine whether the promises in the contract are distinct in accordance with ASC 606-10-25-14.

ASC 606-10

25-14 At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise 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 (see paragraph 606-10-25-15).

The identification of performance obligations is critical to the recognition of revenue because entities will use performance obligations as a means to measure the progress of satisfying the transfer of control of the goods or services. However, such identification will require judgment and will sometimes be time-consuming and complex.

Connecting the Dots

The process of identifying performance obligations is sometimes referred to as “unbundling,” which is not optional. Proper identification of the performance obligations in a contract is a critical aspect of the core principle of ASC 606, which is to “recognize revenue to depict the transfer of promised 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.” Failure to identify and account for the separate performance obligations in a contract could result in the incorrect timing of revenue recognition.

As a practical matter, however, it may not be necessary to apply the detailed guidance in ASC 606 on unbundling if the amounts recognized and disclosed in the financial statements will be the same irrespective of whether unbundling is performed. For example, when control of two or more goods or two or more services is transferred at exactly the same time, or on the same basis over the same period, and if those items do not need to be segregated for disclosure purposes, it will not be necessary to unbundle each of those concurrently delivered items because the amount and timing of revenue recognized and disclosed under the model would not differ if the items were unbundled. The boards acknowledged this in paragraph BC116 of ASU 2014-09 as follows:

In their redeliberations, the Boards observed that paragraph 606-10-25-14(b) applies to goods or services that are delivered consecutively, rather than concurrently. The Boards noted that Topic 606 would not need to specify the accounting for concurrently delivered distinct goods or services that have the same pattern of transfer. This is because, in those cases, an entity is not precluded from accounting for the goods or services as if they were a single performance obligation, if the outcome is the same as accounting for the goods and services as individual performance obligations.

In addition, paragraph BC47 of ASU 2016-10 states:

In many contracts, distinct sets of rights are coterminous. That is, the rights are transferred to the customer at the same point in time (in the case of licenses that provide a right to use intellectual property) or over the same period of time (in the case of licenses that provide a right to access intellectual property). Consistent with the discussion in paragraph BC116 of Update 2014-09, an entity would not be required to separately identify each set of distinct rights if those rights are transferred concurrently. For example, a licensor would not be precluded from accounting for the two sets of distinct rights in Example 61B as a single performance obligation if the facts of that example were modified such that the customer was able to begin to use and benefit from both sets of rights on January 1, 20X1 (rather than Class 1 on January 1, 20X1, and Class 2 on January 1, 20X2).

The next sections discuss various types of performance obligations. However, for a discussion of material rights, see Chapter 11.

5.3.2 Criteria to Be Distinct

ASC 606-10

25-19 A good or service that is promised to a customer is distinct if both of the following criteria are met:

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 (that is, the good or service is capable of being distinct).
The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

25-22 If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation.

To be a performance obligation, a promised good or service must be both (1) capable of being distinct and (2) distinct within the context of the contract. Early in the development of the revenue standard, the FASB and IASB thought that goods and services should have a distinct function.5 Entities asked for further explanation of what that meant. Accordingly, the boards provided the guidance in ASC 606-10- 25-19(a) and (b) (paragraph 27(a) and (b) of IFRS 15).

Not all promises individually will meet both of these criteria. Under ASC 606-10-25-22, if an entity assesses a promise and determines that the promise does not meet the criteria, the entity is required to combine the promise with other promised goods or services in the contract until the criteria are met. For illustrations of how an entity should combine the promises in a contract until those promises meet the criteria to be a performance obligation, see Cases A, B, and C of Example 10 in ASC 606, which are reproduced in Section 5.3.2.3.

5.3.2.1 Capable of Being Distinct

The first criterion in ASC 606-10-25-19 that must be met for a promised good or service to be distinct (i.e., the good or service is capable of being distinct) is expanded in ASC 606-10-25-20.

ASC 606-10

25-20 A customer can benefit from a good or service in accordance with paragraph 606-10-25-19(a) if the good or service could be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits. For some goods or services, a customer may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. 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 (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.

As noted in paragraph BC99 of ASU 2014-09, the FASB and IASB determined that the first criterion for assessing whether goods or services in a contract are distinct would require an entity to assess whether a customer could economically benefit from the goods or services on their own or together with other readily available resources. “Readily available resources” could be those that have already been transferred to the customer as part of the current contract or prior contracts. The fact that a good or service is typically sold on its own is an indicator that the good or service meets the first criterion.

In paragraph BC97 of ASU 2014-09, the FASB and IASB describe an arrangement that fails the “capable of being distinct” criterion. Specifically, the boards state that if an entity transfers control of a machine to a customer, but the machine will not provide an economic benefit to the customer without installation that only the entity can perform, the machine is not distinct.

Application of the “capable of being distinct” criterion is further illustrated in Example 56, Case A, of the revenue standard. In that example, which is reproduced in Section 12.3, an entity determines that a pharmaceutical patent license is not distinct from the entity’s promise to manufacture the drug for the customer because the customer cannot benefit from the license without the corresponding manufacturing service.

The assessment of whether the customer can economically benefit from the goods or services on its own should not be based on the customer’s intended use of the goods or services. As stated in paragraph BC101 of ASU 2014-09, the FASB and IASB “observed that it would be difficult, if not impossible, for an entity to know the customer’s intentions in a given contract.” Accordingly, paragraph BC100 of ASU 2014-09 notes that the assessment of whether the customer can benefit from the goods or services on its own “should be based on the characteristics of the promised goods or services themselves” and should exclude “contractual limitations that might preclude the customer from obtaining readily available resources from a source other than the entity.”

However, paragraph BC102 of ASU 2014-09 indicates that in developing the revenue standard, the FASB and IASB determined that it may be impractical to separate every promised good or service that is capable of being distinct. More importantly, the boards noted that doing so could produce outcomes that (1) are not decision-useful and (2) do not faithfully represent an entity’s performance related to delivering on its promises in a contract. A simple example to illustrate this notion is a construction-type contract in which an entity transfers to a customer multiple goods or services — such as raw materials and construction labor services — that are capable of being distinct. Separating, measuring, and recognizing revenue for each of these goods or services would result in the recognition of revenue when the materials and other services are provided instead of as the entity performs by using the materials to construct an item promised to the customer and for which the customer ultimately contracted.

Accordingly, the FASB and IASB developed a second criterion that must also be met for a promised good or service to be distinct. Specifically, under ASC 606-10-25-19(b) (paragraph 27(b) of IFRS 15), the promised good or service must be distinct within the context of the contract.

5.3.2.2 Distinct Within the Context of the Contract

ASC 606-10

25-21 In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable in accordance with paragraph 606-10-25-19(b), the objective is to determine whether the nature of the promise, within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs. Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following:

The entity provides a significant service of integrating goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. In other words, the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer. A combined output or outputs might include more than one phase, element, or unit.
One or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract.
The goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfill its promise by transferring each of the goods or services independently.

As indicated in ASC 606-10-25-19(b), the second criterion that must be met for a promise to be a performance obligation is that the promised good or service is distinct within the context of the contract. The FASB and IASB decided to include this criterion because there could be situations in which a good or service is typically sold on its own and therefore is capable of being distinct, but the entity’s contract with the customer requires the entity to provide additional goods and services and what the customer is actually acquiring is the combined goods and services (e.g., as in the construction-type contract noted in Section 5.3.2.1). Accordingly, the entity should combine the goods and services so that it can recognize revenue associated with the performance obligation in a way that truly depicts the transfer of control of the promised goods and services.

As discussed in paragraph BC103 of ASU 2014-09, the second separation criterion was developed to help stakeholders identify “separable risks.” That is, “the individual goods or services in a bundle would not be distinct if the risk that an entity assumes to fulfill its obligation to transfer one of those promised goods or services to the customer is a risk that is inseparable from the risk relating to the transfer of the other promised goods or services in that bundle.” Observing that the concept of separable risks was not well understood by stakeholders, the boards indicated that the objective of the second criterion is to evaluate whether an entity’s promise to transfer a good or service is “separately identifiable” from other promises in the contract. However, this framework was also not well understood, and stakeholders requested that the FASB provide additional guidance on the second criterion to clarify when a promise is separately identifiable. As a result, the FASB issued ASU 2016-10, which clarifies the intent of the “separately identifiable” principle in ASC 606-10-25-21 by providing, in a manner consistent with the notion of separable risks, what paragraph BC31 of ASU 2016-10 describes as “three factors that indicate that an entity’s promises to transfer goods or services to a customer are not separately identifiable.” Accordingly, the focus is now on the bundle of goods or services instead of individual goods or services.

5.3.2.2.1 Providing a Service to Integrate a Good or Service With Other Goods or Services

As discussed in paragraph BC107 of ASU 2014-09, when an entity evaluates whether a contract with a customer provides for a significant service of integrating a good or service with other goods or services, the entity should consider whether the risk of transferring that good or service is inseparable from the risk of transferring the other goods or services because the promise in the contract is to ensure that the individual goods or services are incorporated into the combined output for which the customer has contracted. An example of the factor in ASC 606-10-25-21(a) is a construction contract to build a house (as noted in Section 5.3.2.1). The contract will require the entity to provide the materials and labor needed to build the house. However, identifying all items that are capable of being distinct, such as wood or cement, would not represent the entity’s true obligation because the customer is not purchasing those items individually. Rather, the customer contracted with the entity to purchase a house. Therefore, it would make more sense to identify the performance obligation as the entity’s overall promise to build a house.

This concept is further discussed in paragraph BC29 of ASU 2016-10, which states that the entity should consider “whether the multiple promised goods or services in the contract are outputs or, instead, are inputs to a combined item (or items).” The paragraph goes on to explain that the combined item “is greater than (or substantively different from) the sum of those promised (component) goods and services.” If multiple promised goods or services represent inputs rather than individual outputs, such goods or services would not be separately identifiable.

In a speech at the 2018 AICPA Conference on Current SEC and PCAOB Developments, OCA Professional Accounting Fellow Sheri York discussed her views on determining whether an entity provides a significant integration service that results in a combined performance obligation of equipment and services:

In a recent consultation with OCA, a registrant provided its customer with a commercial security monitoring service by integrating a variety of cameras and sensors . . . with the registrant’s technology platform. . . . The registrant believed it was providing a significant service of integrating the goods and services in the contract into a bundle that represented the combined output for which the customer had contracted. More specifically, the delivery of a “smart” security monitoring service would not be possible if the equipment were not integrated with the technology platform. . . . In this fact pattern, the entity demonstrated reasonable judgment that they were providing a significant integration service that transformed the equipment and services into a combined output that provided the customer with an overall service offering that was greater than the customer could receive from each individual part. [Footnotes omitted]

5.3.2.2.2 Significant Modification or Customization

In certain circumstances, an entity’s contract with a customer may contain a promise to modify or customize another promised good or service in the contract such that the customer’s expectation is the delivery of the modified or customized good or service. An example of the factor in ASC 606-10-25-21(b) is a software contract in which the entity promises to customize software for the customer (see paragraphs BC109 and BC110 of ASU 2014-09). In determining how many performance obligations exist, the entity would have to consider whether the customer could really benefit from the software without the customization.

5.3.2.2.3 Goods or Services Are Highly Interdependent or Interrelated

In certain cases, goods or services are so highly interdependent or interrelated that the utility of each individual good or service is significantly affected by other goods or services in the contract. The factor in ASC 606-10-25-21(c) is illustrated by a third scenario described in ASU 2014-09, in which an entity designs and manufactures a new experimental product for a customer (see paragraphs BC111 and BC112 of ASU 2014-09). The entity expects that as it develops the product, it will have to make many revisions to the product to meet the customer’s needs. The entity also expects the manufacturing process to affect the product’s design because the entity will need to determine how to manufacture the product for the customer. Since both the design and the manufacturing of the product are necessary to satisfy the contract with the customer and neither process alone will provide the customer with a product that it can use, both processes would be combined and treated as one performance obligation.

Paragraphs BC32 and BC33 of ASU 2016-10 further expand on the concept of whether goods or services are highly interdependent of interrelated. Paragraph BC32 of ASU 2016-10 states, in part:

The separately identifiable principle is intended to consider the level of integration, interrelation, or interdependence among promises to transfer goods or services. That is, the separately identifiable principle is intended to evaluate when an entity’s performance in transferring a bundle of goods or services in a contract is, in substance, fulfilling a single promise to a customer. Therefore, the entity should evaluate whether two or more promised goods or services (for example, a delivered item and an undelivered item) each significantly affect the other (and, therefore, are highly interdependent or highly interrelated) in the contract. The entity should not merely evaluate whether one item, by its nature, depends on the other (for example, an undelivered item that would never be obtained by a customer absent the presence of the delivered item in the contract or the customer having obtained that item in a different contract).

Paragraph BC33(b) of ASU 2016-10 discusses how the utility of a promised good or service may depend on the other promised goods or services in a contract and therefore each good or service may significantly affect the other. Paragraph BC33(b) of ASU 2016-10 states, in part:

[T]he evaluation of whether two or more promises in a contract are separately identifiable also considers the utility of the promised goods or services (that is, the ability of each good or service to provide benefit or value). This is because an entity may be able to fulfill its promise to transfer each good or service in a contract independently of the other, but each good or service may significantly affect the other’s utility to the customer. For example, in Example 10, Case C, or in Example 55, the entity’s ability to transfer the initial license is not affected by its promise to transfer the updates or vice versa, but the provision (or not) of the updates will significantly affect the utility of the licensed intellectual property to the customer such that the license and the updates are not separately identifiable. They are, in effect, inputs to the combined solution for which the customer contracted. The “capable of being distinct” criterion also considers the utility of the promised good or service, but merely establishes the baseline level of economic substance a good or service must have to be “capable of being distinct.” Therefore, utility also is relevant in evaluating whether two or more promises in a contract are separately identifiable because even if two or more goods or services are capable of being distinct because the customer can derive some economic benefit from each one, the customer’s ability to derive its intended benefit from the contract may depend on the entity transferring each of those goods or services.

If the functionality of a promised good or service is significantly limited or diminished without the use of another promised good or service, and vice versa, that significantly limited or diminished functionality may indicate that the goods or services (1) are highly interdependent or highly interrelated (i.e., they significantly affect each other) and (2) function together as inputs to a combined output. This, in turn, may indicate that the promises are not distinct within the context of the contract since the customer cannot obtain the intended benefit of one good or service without the other. That is, while the customer may be able to obtain some functionality from a good or service on a stand-alone basis, it would not obtain the intended outputs from each good or service individually because each good or service is critical to the customer’s intended use of the combined output. In this situation, the entity cannot fulfill its promise to the customer by transferring each good or service independently (i.e., the customer could not choose to purchase one good or service without significantly affecting the other good or service in the contract).

In addition, transformative functionality should be assessed separately from additive functionality. Transformative functionality comprises features that significantly affect the overall operation and interaction of the combined output. To be transformative, the inputs must significantly affect each other. That is, the promised goods or services are inputs to a combined output such that the combined output has greater value than, or is substantively different from, the sum of the inputs. By contrast, additive functionality comprises features that provide an added benefit to the customer without substantively altering (1) the manner in which the functionality is used and (2) the benefits derived from the functionality of a good or service on a stand-alone basis. Even if added functionality is significant, it may not be transformative. It is more likely that goods or services are highly interdependent or highly interrelated when the functionality of the combined output is transformative rather than additive.

In a speech at the 2017 AICPA Conference on Current SEC and PCAOB Developments, Joseph Epstein, professional accounting fellow in the OCA, provided the following guidance on the identification of performance obligations — specifically, whether an entity’s promise to transfer a good or service to a customer is separately identifiable from other promises in the contract:

I’d also like to take this opportunity to remind registrants that in evaluating whether two or more promised goods or services each significantly affect the other (and, therefore, are highly interdependent or highly interrelated), registrants should not merely evaluate whether one item, by its nature, depends on the other. Rather, those goods or services should significantly affect each other. [Emphasis added, footnote omitted]

Sarah Esquivel, associate chief accountant in the OCA, elaborated on this topic in a speech at the 2018 AICPA Conference on Current SEC and PCAOB Developments. In her speech, Ms. Esquivel described a fact pattern related to the identification of performance obligations in a contract for the sale of off-the-shelf patent application software. The software enabled the customer to prepare patent applications and also allowed the customer to print out the applications so that they could be submitted by mail. In addition, the contract included a free, one-time service of electronically submitting a patent application to the appropriate government agency. Ms. Esquivel made the following comments on whether the electronic submission service and the software were sufficiently interdependent or interrelated to constitute a single performance obligation:

In this fact pattern, the service was a convenience to the customer, but it was not required . . . . In addition, the choice of whether or not to use the service did not significantly impact the utility of the software, and thus the identified promises did not significantly affect each other, and therefore were not highly interdependent or highly interrelated. As a result, OCA objected to the registrant’s conclusion that the promises in the contract comprised a single performance obligation. [Footnote omitted]

This example emphasizes the view that entities should not merely evaluate whether one item depends on the other (one-way dependency); rather, they should evaluate whether the goods or services significantly affect each other (interdependency, or two-way dependency).

In a speech at the 2019 AICPA Conference on Current SEC and PCAOB Developments, OCA Professional Accounting Fellow Susan Mercier expanded on those views presented at the previous AICPA Conferences on determining whether an entity provides a combined performance obligation of software and updates. In addition, Ms. Mercier provided commentary of the use of the term “solution”:

While I understand that the term “solution” is commonly used nomenclature, I would observe that the staff is not persuaded that promises should be combined into a single performance obligation simply because a registrant labels those promises as a “solution” that the “customer wants.” . . . I think that the notion of considering if the registrant’s combined output is greater than or substantively different from the sum of the parts is helpful in many cases. . . .

In [a recent] consultation, the registrant licenses software that allows its customers, application (“app”) developers, to build and deploy, and therefore monetize, their own apps on various third-party platforms. The third-party platforms include phones as well as home entertainment systems, which, as you can imagine, are frequently undergoing their own updates. The registrant’s software and updates ensure that the app built using the software is compatible with all platforms that it supports, both when the app is initially deployed on a platform and over time as that platform is updated. Therefore, the registrant partners with the third-party platforms to understand their timelines for internal updates so that the registrant can ensure compatibility by initiating corresponding updates to its software. Without these updates, the customer’s ability to benefit from the software would be significantly limited over the contract term.

Ultimately, the staff did not object to the registrant’s conclusion that the software and updates represent a single performance obligation. In the staff’s view, the registrant’s promises to provide the software and the updates are, in effect, inputs that together fulfill a single promise to the customer — that is, to continually be able to deploy and monetize content using third-party platforms of the customer’s choice in a rapidly changing environment — and that the updates are integral to maintaining the utility of the software. In other words, in this fact pattern, the staff thinks that the combined output (whether or not you label it a “solution”) is greater than, or substantively different than, the individual promises (that is, the software and the updates). [Footnotes omitted]

Further, in a speech at the 2020 AICPA Conference on Current SEC and PCAOB Developments, OCA Professional Accounting Fellow Kevin Cherrstrom provided insights (similar to those provided by Ms. Mercier above) into an arrangement in which a software license and updates are highly interdependent or interrelated and there is significant two-way dependency between the software and the updates:

First, I would like to discuss a fact pattern whereby a registrant concluded that its software license, along with updates to the software license, represent a single performance obligation. The assessment of whether a software license is distinct from related services can have a significant effect on the financial statements. Revenue from software and services that are one combined performance obligation would be recognized over time, while revenue from a software license that is distinct would be recognized when control of the software license transfers to the customer.

The registrant developed a new data analytics software platform that it provides to its customers under a one-year license. The software’s core functionality allows its customers to aggregate data from multiple sources and analyze that data on a real-time basis. To achieve that result, the software must be updated periodically in response to both a customer’s internal changes, such as new data sources or hardware added to the customer’s IT environment, and to external changes, such as updates to third-party software that impact the ability of the registrant’s software to obtain real-time data from those third-party systems. As part of the registrant’s promises to its customer, it monitors the software for required updates and provides updates to the licensed software as needed, on an on-going basis, throughout the contract term.

The registrant performed a detailed assessment to determine the nature of each of its updates in order to identify those specific updates that are critical to maintaining the utility of the software. The frequency of the critical software updates varies depending on each customer’s unique IT environment, ranging from critical updates provided on a daily basis for customers with more dynamic IT systems, to critical updates every few months for customers with static IT environments. Regardless of the frequency of each customer’s critical updates, if they were not provided to the customer, the software would not be able to access and analyze the customer’s data. The registrant concluded that the software license and updates are highly interdependent or interrelated, such that they significantly affect one another, and there is a significant two-way dependency between the software and the related updates.

In this fact pattern, the staff did not object to the registrant’s conclusion that the software license and related updates should be combined into a single performance obligation.

5.3.2.3 Applying the “Distinct” Criteria

Now that the concepts have been established, the examples below will help illustrate how to apply them in different situations.

ASC 606-10

Example 10 — Goods and Services Are Not Distinct

Case A — Significant Integration Service

55-137 An entity, a contractor, enters into a contract to build a hospital for a customer. The entity is responsible for the overall management of the project and identifies various promised goods and services, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing.

55-138 The promised goods and services are capable of being distinct in accordance with paragraph 606-10- 25-19(a). That is, the customer can benefit from the goods and services either on their own or together with other readily available resources. This is evidenced by the fact that the entity, or competitors of the entity, regularly sells many of these goods and services separately to other customers. In addition, the customer could generate economic benefit from the individual goods and services by using, consuming, selling, or holding those goods or services.

55-139 However, the promises to transfer the goods and services are not separately identifiable in accordance with paragraph 606-10-25-19(b) (on the basis of the factors in paragraph 606-10-25-21). This is evidenced by the fact that the entity provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.

55-140 Because both criteria in paragraph 606-10-25-19 are not met, the goods and services are not distinct. The entity accounts for all of the goods and services in the contract as a single performance obligation.

Case B — Significant Integration Service

55-140A An entity enters into a contract with a customer that will result in the delivery of multiple units of a highly complex, specialized device. The terms of the contract require the entity to establish a manufacturing process in order to produce the contracted units. The specifications are unique to the customer based on a custom design that is owned by the customer and that were developed under the terms of a separate contract that is not part of the current negotiated exchange. The entity is responsible for the overall management of the contract, which requires the performance and integration of various activities including procurement of materials; identifying and managing subcontractors; and performing manufacturing, assembly, and testing.

55-140B The entity assesses the promises in the contract and determines that each of the promised devices is capable of being distinct in accordance with paragraph 606-10-25-19(a) because the customer can benefit from each device on its own. This is because each unit can function independently of the other units.

55-140C The entity observes that the nature of its promise is to establish and provide a service of producing the full complement of devices for which the customer has contracted in accordance with the customer’s specifications. The entity considers that it is responsible for overall management of the contract and for providing a significant service of integrating various goods and services (the inputs) into its overall service and the resulting devices (the combined output) and, therefore, the devices and the various promised goods and services inherent in producing those devices are not separately identifiable in accordance with paragraphs 606-10-25-19(b) and 606-10-25-21. In this Case, the manufacturing process provided by the entity is specific to its contract with the customer. In addition, the nature of the entity’s performance and, in particular, the significant integration service of the various activities mean that a change in one of the entity’s activities to produce the devices has a significant effect on the other activities required to produce the highly complex specialized devices such that the entity’s activities are highly interdependent and highly interrelated. Because the criterion in paragraph 606-10-25-19(b) is not met, the goods and services that will be provided by the entity are not separately identifiable, and, therefore, are not distinct. The entity accounts for all of the goods and services promised in the contract as a single performance obligation.

Case C — Combined Item

55-140D An entity grants a customer a three-year term license to anti-virus software and promises to provide the customer with when-and-if available updates to that software during the license period. The entity frequently provides updates that are critical to the continued utility of the software. Without the updates, the customer’s ability to benefit from the software would decline significantly during the three-year arrangement.

55-140E The entity concludes that the software and the updates are each promised goods or services in the contract and are each capable of being distinct in accordance with paragraph 606-10-25-19(a). The software and the updates are capable of being distinct because the customer can derive economic benefit from the software on its own throughout the license period (that is, without the updates the software would still provide its original functionality to the customer), while the customer can benefit from the updates together with the software license transferred at the outset of the contract.

55-140F The entity concludes that its promises to transfer the software license and to provide the updates, when-and-if available, are not separately identifiable (in accordance with paragraph 606-10-25-19(b)) because the license and the updates are, in effect, inputs to a combined item (anti-virus protection) in the contract. The updates significantly modify the functionality of the software (that is, they permit the software to protect the customer from a significant number of additional viruses that the software did not protect against previously) and are integral to maintaining the utility of the software license to the customer. Consequently, the license and updates fulfill a single promise to the customer in the contract (a promise to provide protection from computer viruses for three years). Therefore, in this Example, the entity accounts for the software license and the when- and-if available updates as a single performance obligation. In accordance with paragraph 606-10-25-33, the entity concludes that the nature of the combined good or service it promised to transfer to the customer in this Example is computer virus protection for three years. The entity considers the nature of the combined good or service (that is, to provide anti-virus protection for three years) in determining whether the performance obligation is satisfied over time or at a point in time in accordance with paragraphs 606-10-25-23 through 25-30 and in determining the appropriate method for measuring progress toward complete satisfaction of the performance obligation in accordance with paragraphs 606-10-25-31 through 25-37.

Example 11 — Determining Whether Goods or Services Are Distinct

Case A — Distinct Goods or Services

55-141 An entity, a software developer, enters into a contract with a customer to transfer a software license, perform an installation service, and provide unspecified software updates and technical support (online and telephone) for a two-year period. The entity sells the license, installation service, and technical support separately. The installation service includes changing the web screen for each type of user (for example, marketing, inventory management, and information technology). The installation service is routinely performed by other entities and does not significantly modify the software. The software remains functional without the updates and the technical support.

55-142 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity observes that the software is delivered before the other goods and services and remains functional without the updates and the technical support. The customer can benefit from the updates together with the software license transferred at the outset of the contract. Thus, the entity concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available and the criterion in paragraph 606-10-25-19(a) is met.

55-143 The entity also considers the principle and the factors in paragraph 606-10-25-21 and determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises (thus, the criterion in paragraph 606-10-25-19(b) is met). In reaching this determination the entity considers that although it integrates the software into the customer’s system, the installation services do not significantly affect the customer’s ability to use and benefit from the software license because the installation services are routine and can be obtained from alternate providers. The software updates do not significantly affect the customer’s ability to use and benefit from the software license because, in contrast with Example 10 (Case C), the software updates in this contract are not necessary to ensure that the software maintains a high level of utility to the customer during the license period. The entity further observes that none of the promised goods or services significantly modify or customize one another and the entity is not providing a significant service of integrating the software and the services into a combined output. Lastly, the entity concludes that the software and the services do not significantly affect each other and, therefore, are not highly interdependent or highly interrelated because the entity would be able to fulfill its promise to transfer the initial software license independent from its promise to subsequently provide the installation service, software updates, or technical support.

55-144 On the basis of this assessment, the entity identifies four performance obligations in the contract for the following goods or services:

The software license
An installation service
Software updates
Technical support.

55-145 The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each of the performance obligations for the installation service, software updates, and technical support are satisfied at a point in time or over time. The entity also assesses the nature of the entity’s promise to transfer the software license in accordance with paragraphs 606-10-55-59 through 55-60 and 606-10-55-62 through 55-64A (see Example 54 in paragraphs 606-10-55-362 through 55-363B).

Case B — Significant Customization

55-146 The promised goods and services are the same as in Case A, except that the contract specifies that, as part of the installation service, the software is to be substantially customized to add significant new functionality to enable the software to interface with other customized software applications used by the customer. The customized installation service can be provided by other entities.

55-147 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity first assesses whether the criterion in paragraph 606-10-25-19(a) has been met. For the same reasons as in Case A, the entity determines that the software license, installation, software updates, and technical support each meet that criterion. The entity next assesses whether the criterion in paragraph 606-10-25-19(b) has been met by evaluating the principle and the factors in paragraph 606-10-25-21. The entity observes that the terms of the contract result in a promise to provide a significant service of integrating the licensed software into the existing software system by performing a customized installation service as specified in the contract. In other words, the entity is using the license and the customized installation service as inputs to produce the combined output (that is, a functional and integrated software system) specified in the contract (see paragraph 606-10-25-21(a)). The software is significantly modified and customized by the service (see paragraph 606-10-25-21(b)). Consequently, the entity determines that the promise to transfer the license is not separately identifiable from the customized installation service and, therefore, the criterion in paragraph 606-10-25-19(b) is not met. Thus, the software license and the customized installation service are not distinct.

55-148 On the basis of the same analysis as in Case A, the entity concludes that the software updates and technical support are distinct from the other promises in the contract.

55-149 On the basis of this assessment, the entity identifies three performance obligations in the contract for the following goods or services:

Software customization which is comprised of the license to the software and the customized installation service
Software updates
Technical support.

55-150 The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each performance obligation is satisfied at a point in time or over time and paragraphs 606-10-25-31 through 25-37 to measure progress toward complete satisfaction of those performance obligations determined to be satisfied over time. In applying those paragraphs to the software customization, the entity considers that the customized software to which the customer will have rights is functional intellectual property and that the functionality of that software will not change during the license period as a result of activities that do not transfer a good or service to the customer. Therefore, the entity is providing a right to use the customized software. Consequently, the software customization performance obligation is completely satisfied upon completion of the customized installation service. The entity considers the other specific facts and circumstances of the contract in the context of the guidance in paragraphs 606-10-25-23 through 25-30 in determining whether it should recognize revenue related to the single software customization performance obligation as it performs the customized installation service or at the point in time the customized software is transferred to the customer.

Case C — Promises Are Separately Identifiable (Installation)

55-150A An entity contracts with a customer to sell a piece of equipment and installation services. The equipment is operational without any customization or modification. The installation required is not complex and is capable of being performed by several alternative service providers.

55-150B The entity identifies two promised goods and services in the contract: (a) equipment and (b) installation. The entity assesses the criteria in paragraph 606-10-25-19 to determine whether each promised good or service is distinct. The entity determines that the equipment and the installation each meet the criterion in paragraph 606-10-25-19(a). The customer can benefit from the equipment on its own, by using it or reselling it for an amount greater than scrap value, or together with other readily available resources (for example, installation services available from alternative providers). The customer also can benefit from the installation services together with other resources that the customer will already have obtained from the entity (that is, the equipment).

55-150C The entity further determines that its promises to transfer the equipment and to provide the installation services are each separately identifiable (in accordance with paragraph 606-10-25-19(b)). The entity considers the principle and the factors in paragraph 606-10-25-21 in determining that the equipment and the installation services are not inputs to a combined item in this contract. In this Case, each of the factors in paragraph 606-10-25-21 contributes to, but is not individually determinative of, the conclusion that the equipment and the installation services are separately identifiable as follows:

The entity is not providing a significant integration service. That is, the entity has promised to deliver the equipment and then install it; the entity would be able to fulfill its promise to transfer the equipment separately from its promise to subsequently install it. The entity has not promised to combine the equipment and the installation services in a way that would transform them into a combined output.
The entity’s installation services will not significantly customize or significantly modify the equipment.
Although the customer can benefit from the installation services only after it has obtained control of the equipment, the installation services do not significantly affect the equipment because the entity would be able to fulfill its promise to transfer the equipment independently of its promise to provide the installation services. Because the equipment and the installation services do not each significantly affect the other, they are not highly interdependent or highly interrelated.

On the basis of this assessment, the entity identifies two performance obligations (the equipment and installation services) in the contract.

55-150D The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each performance obligation is satisfied at a point in time or over time.

Case D — Promises Are Separately Identifiable (Contractual Restrictions)

55-150E Assume the same facts as in Case C, except that the customer is contractually required to use the entity’s installation services.

55-150F The contractual requirement to use the entity’s installation services does not change the evaluation of whether the promised goods and services are distinct in this Case. This is because the contractual requirement to use the entity’s installation services does not change the characteristics of the goods or services themselves, nor does it change the entity’s promises to the customer. Although the customer is required to use the entity’s installation services, the equipment and the installation services are capable of being distinct (that is, they each meet the criterion in paragraph 606-10-25-19(a)), and the entity’s promises to provide the equipment and to provide the installation services are each separately identifiable (that is, they each meet the criterion in paragraph 606-10-25-19(b)). The entity’s analysis in this regard is consistent with Case C.

Case E — Promises Are Separately Identifiable (Consumables)

55-150G An entity enters into a contract with a customer to provide a piece of off-the-shelf equipment (that is, it is operational without any significant customization or modification) and to provide specialized consumables for use in the equipment at predetermined intervals over the next three years. The consumables are produced only by the entity, but are sold separately by the entity.

55-150H The entity determines that the customer can benefit from the equipment together with the readily available consumables. The consumables are readily available in accordance with paragraph 606-10-25-20 because they are regularly sold separately by the entity (that is, through refill orders to customers that previously purchased the equipment). The customer can benefit from the consumables that will be delivered under the contract together with the delivered equipment that is transferred to the customer initially under the contract. Therefore, the equipment and the consumables are each capable of being distinct in accordance with paragraph 606-10-25-19(a).

55-150I The entity determines that its promises to transfer the equipment and to provide consumables over a three-year period are each separately identifiable in accordance with paragraph 606-10-25-19(b). In determining that the equipment and the consumables are not inputs to a combined item in this contract, the entity considers that it is not providing a significant integration service that transforms the equipment and consumables into a combined output. Additionally, neither the equipment nor the consumables are significantly customized or modified by the other. Lastly, the entity concludes that the equipment and the consumables are not highly interdependent or highly interrelated because they do not significantly affect each other. Although the customer can benefit from the consumables in this contract only after it has obtained control of the equipment (that is, the consumables would have no use without the equipment) and the consumables are required for the equipment to function, the equipment and the consumables do not each significantly affect the other. This is because the entity would be able to fulfill each of its promises in the contract independently of the other. That is, the entity would be able to fulfill its promise to transfer the equipment even if the customer did not purchase any consumables and would be able to fulfill its promise to provide the consumables even if the customer acquired the equipment separately.

55-150J On the basis of this assessment, the entity identifies two performance obligations in the contract for the following goods or services:

The equipment
The consumables.

55-150K The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each performance obligation is satisfied at a point in time or over time.

5.3.2.3.1 Assessing the Availability of Alternative Service Providers and Its Impact on the Identification of Performance Obligations

The illustrative examples in ASC 606 provide certain facts used to support a determination of whether a promised good or service is distinct and therefore a separate performance obligation. However, some facts may vary between examples while the conclusions are consistent. For instance, in Example 11, Case C (ASC 606-10-55-150A through 55-150D), one of the facts provided to support the conclusion that the equipment and installation services represent two performance obligations is that others can provide the installation services. However, in Example 11, Case E (ASC 606-10-55-150G through 55-150K), the conclusion that the equipment and specialized consumables are two performance obligations is reached even though the specialized consumables are not available from other entities. This is because the entity in the example would be able to fulfill each of its promises in the contract (i.e., each promise to provide an item of equipment and consumables) independently of the other promises.

If a good or service (e.g., installation service) is unavailable from alternative providers, or available from only a limited number of alternative providers, an entity is not precluded from considering the good or service a separate performance obligation. The unavailability of a good or service from alternative providers is a factor for an entity to consider in evaluating whether the good or service is distinct (and therefore a separate performance obligation), but that factor is not individually determinative (as noted in the examples cited above). Entities need to use judgment in evaluating whether a promise to provide a good or service, in addition to other goods or services, is capable of being distinct and is distinct within the context of the contract (i.e., separately identifiable) in accordance with ASC 606-10-25-19. In making that determination, an entity may focus on why a good or service is or is not available from other providers, especially when evaluating the following factors in ASC 606-10-25-21 to conclude on whether the good or service is separately identifiable:

Whether there is a significant service of integrating goods or services.
Whether the good or service significantly modifies or customizes another good or service.
Whether the good or service and one or more other goods or services are highly interdependent or highly interrelated.

For example, if an entity sells equipment and provides installation of that equipment, the determination of whether the installation services are available from another entity would be a factor to be considered in the evaluation of whether the installation is distinct within the context of the contract, but that factor alone would not be determinative. It is important for the reporting entity to consider why the installation is unavailable from (or available from only a limited number of) alternative providers to determine whether the installation is separately identifiable in accordance with ASC 606-10-25-21. For example, if the entity has a standard installation process that does not significantly customize or modify the equipment for the entity’s customer, the entity may conclude that the installation is separately identifiable regardless of whether there are no other installation providers or only a limited number of such providers. However, installation services that are unique and significantly modify or customize the equipment for the customer may suggest that the services are not separately identifiable and therefore are not distinct within the context of the contract.

5.3.2.3.2 Identifying Performance Obligations in Co-Branded Credit Card Arrangements

An entity (e.g., a retailer or an airline) may enter into a co-branded or private-label credit card arrangement with a financial institution under which the financial institution issues credit cards that bear the entity’s brand name or logo to individual consumers. In both co-branded and private-label credit card arrangements, the financial institution is issuing credit and operating the card on its own behalf. Under a private-label credit card arrangement, the credit card can be used to purchase goods or services from only the entity (the “sponsoring entity”). However, under a co-branded credit card arrangement, the credit card can be used to purchase goods or services from any merchant that accepts that type of credit card (e.g., MasterCard or Visa). When a cardholder uses a private-label or co-branded credit card to make purchases, he or she generally earns loyalty or rewards points that can be redeemed for free or discounted products or services from the sponsoring entity.

Under co-branded credit card arrangements, the sponsoring entity usually has various obligations to the financial institution, including:

Licensing its brand name (for use on the credit card and marketing materials).
Providing access to its customer list (for marketing purposes).
Marketing the credit card program.
Providing products or services (or discounts on products or services) as part of a loyalty or rewards program.
Maintaining the loyalty or rewards program.

The sponsoring entity in a co-branded credit card arrangement generally receives some combination of (1) an up-front or incentive fee upon executing the credit card arrangement (such as a signing bonus), (2) a fee for each new cardholder who signs up for a credit card (sometimes referred to as a “bounty fee”), (3) a specified percentage of the cardholders’ annual purchases or program profits, and (4) reimbursements from the financial institution for certain costs, such as products or services provided under the rewards program, marketing expenses, or other related expenses (such as credit card processing fees).

A sponsoring entity should carefully evaluate its contractual arrangement with a financial institution when identifying its performance obligations, as described more fully in the next sections.

5.3.2.3.2.1 Identifying the Promised Goods or Services in Co-Branded Credit Card Arrangements

The first step in the evaluation is to identify all of the promised goods or services in the contract. A typical co-branded credit card arrangement consists of the following promised goods or services:

License of brand name.
Access to customer list.
Marketing activities.
Maintaining the loyalty or rewards program.

Although the sponsoring entity has an obligation to maintain the loyalty or rewards program, maintenance activities related to the loyalty or rewards program generally do not constitute a promised good or service in the arrangement. Rather, the maintenance and administration of the loyalty or rewards program are typically activities that a sponsoring entity undertakes to fulfill its contract with the financial institution (specifically, its obligation to license its brand name and provide access to its customer list). That is, having a loyalty or rewards program makes the sponsoring entity’s brand name more valuable to the financial institution because individuals are more likely to sign up for the credit card when they know that they can earn loyalty or rewards points and redeem them with the sponsoring entity. In addition, sponsoring entities generally maintain a loyalty or rewards program for purposes other than the fulfillment of their credit card arrangements and therefore would undertake these activities even without entering into a contract with a financial institution. Therefore, we generally do not believe that these activities transfer a separate good or service to the financial institution.

5.3.2.3.2.2 Identifying the Performance Obligations in Co-Branded Credit Card Arrangements

The next step in the evaluation is to identify which of the promised goods or services in the contract represent distinct performance obligations. In general, we believe that a co-branded credit card arrangement such as the one described above contains at least two performance obligations: (1) a license bundled with access to the sponsoring entity’s customer list (the “brand performance obligation”) and (2) an obligation to provide products or services in the future for free or at a discount (the “rewards performance obligation”). On the basis of the entity’s assessment, marketing the credit card program may constitute a performance obligation of its own or may be combined with the brand performance obligation.

Considerations relevant to the determination of which promised goods or services in a co-branded credit card arrangement are distinct (i.e., capable of being distinct and separately identifiable) are as follows:

Brand performance obligation — Generally, the right to use an entity’s brand name is not sold separately from access to the entity’s customer list. Nevertheless, we believe that both the license of the sponsoring entity’s brand name and access to the sponsoring entity’s customer list are capable of being distinct because the financial institution could benefit from each one in conjunction with other readily available resources. That is, the sponsoring entity could sell each item separately, and the financial institution could separately perform the other activities (marketing and supply of products or services) on its own to derive economic benefits from the arrangement. However, we do not believe that the license to the brand name and the customer list are separately identifiable because the license and access to the customer list are highly interdependent.

Generally, a significant portion of the value to the financial institution in this type of arrangement comes from the financial institution’s right to market to the sponsoring entity’s loyalty or rewards members, which is provided through access to the sponsoring entity’s customer list. In addition, strong brand recognition is intended to entice potential customers to enter into an arrangement with the financial institution for the co-branded credit card. Therefore, the value of the two items combined significantly exceeds the sum of the values that could be ascribed to the two individually. That is, the brand and access to the sponsoring entity’s customer list are highly interdependent.

In addition, the AICPA Audit and Accounting Guide Revenue Recognition (the “AICPA Guide”) provides interpretive guidance on co-branded credit card arrangements in the airline industry. Although this guidance focuses on airlines, it is also applicable to other types of companies that participate in co-branded credit card arrangements. Specifically, paragraphs 10.6.54 through 10.6.56 of the AICPA Guide state the following:

10.6.54 Generally, a significant portion of the value to the financial institution in these arrangements comes from its right to market to the airline loyalty members, which is provided through access to the airline’s customer list. Frequently, the majority of the airline’s most profitable customers are also members of the airline loyalty program. These members include many high-wealth individuals who have a better credit history and have higher levels of spending compared to the general population of credit card holders. As a result, a portfolio of credit cards with a shared demographic of airline loyalty memberships tends to be more profitable to the financial institution than a portfolio that is made up of individuals that are not part of an airline frequent flyer program. This is often one of the most important factors that leads to significant value being ascribed to these co-branded agreements. Additionally, strong brand recognition helps drive both new and repeat customer traffic to the airline, resulting in significant value associated with access to the airline’s customer list.

10.6.55 Historically, airlines have not separately sold the right to use their brand and access their customer list outside of these types of arrangements. Although it is possible that these items could be sold separately, FinREC [the AICPA’s Financial Reporting Executive Committee] believes their integration into the co-branded credit card agreement generally meets the “highly interdependent or highly interrelated” criteria in FASB ASC 606-10-25-21c. This is because the utility of the access to the customer list and use of the brand (and, therefore, the ability for each to provide value) are dependent upon each other. That is, the value of the two combined together significantly exceeds the sum of the value that could be ascribed to each individually.

10.6.56 Therefore, FinREC believes that the use of the airline brand and access to its customer list are not distinct and, as such, should be combined into a single performance obligation, subsequently referred to in this section as the brand performance obligation. Access to the customer list and use of the brand are referred to as the brand elements.
Rewards performance obligation — The rewards performance obligation represents the sponsoring entity’s obligation to honor a cardholder’s redemption of loyalty or rewards points for free or discounted products or services in the future that are provided to the cardholder in connection with entering into a credit card agreement with the financial institution or through the use of the co-branded credit card. We believe that in this context, the rewards performance obligation could be accounted for in the same manner as a material right, which an entity is required to treat as a separate performance obligation under ASC 606-10-55-41 through 55-45. While we recognize that this obligation is technically to the customer’s customer (i.e., the cardholder) rather than the customer itself (i.e., the financial institution), we believe that the same principle applies since the sponsoring entity is promising the financial institution that it will provide and redeem the loyalty points. That is, the sponsoring entity is committed to providing goods or services in the future for free or at a discount, and accounting recognition should be given to this obligation. In some cases, the sponsoring entity may be separately selling loyalty points to the financial institution, whereas in other cases, the sponsoring entity grants the financial institution the right to issue loyalty points on its behalf. In both types of situations, the sponsoring entity has essentially granted the financial institution the right to provide loyalty or rewards points to cardholders on the basis of their spending level, and we believe that this right is appropriately accounted for as a separate performance obligation.

Similarly, paragraph 10.4.06 of the AICPA Guide states, in part, that “because mileage credits can be accumulated and redeemed for free or discounted goods and services (such as free travel, upgrades, and other awards), the mileage credits that have been accumulated represent a material right to a customer. As such, they should be accounted for separately as a performance obligation.”
Marketing activities — Many co-branded credit card arrangements include some element of marketing activities. We believe that the marketing activities performed by the sponsoring entity typically are capable of being distinct because other entities (e.g., marketing agencies) regularly sell similar services on a stand-alone basis. In addition, the financial institution is able to benefit from these services along with other resources that have already been obtained from the sponsoring entity (i.e., the brand performance obligation). However, careful evaluation of the nature of marketing activities is required to determine whether they represent a separate performance obligation. For example, there may be certain marketing activities that only the entity is capable of providing (e.g., promotion of the card by sales personnel at the time of checkout) and that are not sold on a stand-alone basis. In addition, the marketing activities may not be separately identifiable in the contract because those activities and one or more other elements in the arrangement (e.g., the brand performance obligation) may be highly interdependent or highly interrelated. This is because the marketing activities may be specific to the co-branded credit card program, thereby enhancing the value of the brand used by the financial institution. That is, the marketing activities may be part of the sponsoring entity’s obligation to maintain and support the value of the sponsoring entity’s brand as the brand is used by the financial institution. Even if an entity concludes that the marketing activities are distinct within the context of the contract and therefore compose a separate performance obligation, that performance obligation would often be satisfied over the same period as the brand performance obligation. Therefore, the timing of revenue recognition may not differ between the alternative views.

5.3.2.3.3 Identifying Performance Obligations in a Cloud Computing Arrangement That Includes Implementation Services

Entities that sell a cloud-based or hosted software solution (e.g., in a SaaS arrangement)6 often include implementation services. These services are performed either (1) at the outset of the customer arrangement or (2) during the SaaS term (in many cases because of added modules or features of the SaaS solution7). Depending on the facts and circumstances of the arrangement, an entity may need to use judgment to determine whether the implementation services represent (1) activities that do not transfer a good or service to the customer, (2) a promise that is not distinct from the SaaS, or (3) a distinct performance obligation.

5.3.2.3.3.1 Identifying Whether Implementation Services Are a Promised Good or Service

ASC 606-10-25-17 states the following regarding the identification of promised goods or services in an arrangement:

Promised goods or services do not include activities that an entity must undertake to fulfill a contract unless those activities transfer a good or service to a customer. For example, a services provider may need to perform various administrative tasks to set up a contract. The performance of those tasks does not transfer a service to the customer as the tasks are performed. Therefore, those setup activities are not promised goods or services in the contract with the customer.

In addition, ASC 606-10-55-53 states:

An entity may charge a nonrefundable fee in part as compensation for costs incurred in setting up a contract (or other administrative tasks as described in paragraph 606-10-25-17). If those setup activities do not satisfy a performance obligation, the entity should disregard those activities (and related costs) when measuring progress in accordance with paragraph 606-10-55-21. That is because the costs of setup activities do not depict the transfer of services to the customer. The entity should assess whether costs incurred in setting up a contract have resulted in an asset that should be recognized in accordance with paragraph 340-40-25-5.

Further, paragraph BC93 of ASU 2014-09 indicates that even if an activity is “required to successfully transfer the goods or services for which the customer has contracted,” that activity may not “directly transfer goods or services to the customer.”

Implementation Q&A 48 (compiled from previously issued TRG Agenda Papers 41 and 44) contains an example in which the FASB staff discusses up-front implementation services that are provided with a SaaS solution. In the example, (1) the hosting period begins when the implementation services are complete and the customer cannot access or use the service until that time, (2) the vendor’s solution is proprietary and no other vendors can provide the implementation services, (3) the customer cannot derive any benefit from the implementation services or the SaaS until implementation is complete, and (4) the implementation services are not capable of being distinct from the hosting services. While the example is intended to illustrate considerations related to whether the implementation services were relevant to an entity’s measurement of progress toward completion of a performance obligation, it also addresses whether such implementation services would represent a performance obligation at all. According to the FASB staff, “the nature of the entity’s overall promise is the hosting service and the implementation service does not transfer a service to a customer”; thus, the services would be disregarded in a manner similar to the treatment of the set-up activities described in ASC 606-10-25-17. This view is analogous to that discussed in Example 53 in ASC 606-10-55-358 through 55-360, in which set-up activities related to transaction processing services “do not transfer a good or service to the customer and, therefore, do not give rise to a performance obligation.”

Since the nature and composition of implementation services can vary in practice, we do not believe that the example in Implementation Q&A 48 was intended to address all types of implementation services. Accordingly, an entity would have to carefully analyze the facts and circumstances of its SaaS arrangements and related implementation services to determine whether the activities a vendor performs for implementation services (1) transfer a good or service to the customer or (2) are akin to set-up activities. The entity’s analysis would be based on whether the customer obtains control of the implementation services as they are performed. In the determination of whether the customer obtains such control, we believe that it may be helpful for the entity to consider the following:

Whose assets are being enhanced, improved, or customized by those activities. If the implementation activities are performed on the entity’s internal infrastructure and applications (i.e., “behind the firewall”), the activities most likely do not transfer a good or service to the customer and the entity therefore would not consider the services in identifying performance obligations. This would be the case even if the customer benefits from the implementation activities. Because the activities are performed on the entity’s assets, the entity retains control of any benefits those activities confer. By contrast, if the implementation activities are performed on the customer’s infrastructure and applications, the activities may represent the transfer of a promised good or service to the customer. Paragraph BC129 of ASU 2014-09 discusses “situations in which an entity’s performance creates or enhances an asset that a customer clearly controls as the asset is created or enhanced.” It states, in part:
In those cases, because the customer controls any work in process, the customer is obtaining the benefits of the goods or services that the entity is providing . . . . For example, in the case of a construction contract in which the entity is building on the customer’s land, the customer generally controls any work in process arising from the entity’s performance.
Whether the services are provided directly to the customer (i.e., the services are simultaneously received and consumed by the customer; another entity would not need to substantially reperform the entity’s performance to date). Paragraph BC125 of ASU 2014-09 states, in part:
In many typical “service” contracts, the entity’s performance creates an asset only momentarily because that asset is simultaneously received and consumed by the customer. In those cases, the simultaneous receipt and consumption of the asset that has been created means that the customer obtains control of the entity’s output as the entity performs . . . . For example, consider an entity that promises to process transactions on behalf of a customer. The customer simultaneously receives and consumes a benefit as each transaction is processed.

To the extent that the activities do not transfer a good or service to the customer, they should not be considered in the identification of performance obligations. See Section 8.9.4 for considerations related to the recognition of fees that may have been contractually assigned to activities that do not result in the transfer of a promised good or service to the customer.

Example 5-3

Company S enters into a noncancelable SaaS arrangement with Customer T for a three-year term. As part of the arrangement, S has agreed to perform certain activities to add functionality to the SaaS before the commencement of the contract term (i.e., customization services) for an incremental fee. The added functionality is needed for the SaaS to work as intended by T. To perform the customization services, S must make modifications to its software applications that will be used to provide the SaaS. Customer T can only access the added functionality through the SaaS and has no other rights to the enhancements. That is, S continues to retain ownership of the improvements.

The customization services are not promised goods or services to the customer. Since the customization services will take place behind the firewall, the functionality is added only to S’s assets, which S controls. The services will not enhance, improve, or customize a customer-controlled asset. Therefore, the arrangement does not result in a promise to transfer (i.e., does not transfer control of) services to the customer and would not be assessed as a promise under the contract. Rather, the customization services would be akin to set-up activities as described in ASC 606-10-25-17.

Example 5-4

Assume the same facts as in the example above except that Company S has also agreed to perform other implementation activities before the commencement of the contract term (i.e., implementation services) for an incremental fee. These activities, which are performed on Customer T’s assets, include adapting and configuring T’s infrastructure and T’s in-place systems for communication with S’s infrastructure. In addition, S will convert and migrate T’s data in a format that is compatible with the SaaS platform and train T’s employees in the SaaS’s optimal use.

In this scenario, the additional implementation services are promised goods or services to the customer. Most of the activities enhance, improve, or customize T-controlled assets (i.e., T’s infrastructure, in-place systems, and data). In addition, the training is provided directly to T’s employees (as opposed to S’s employees), which permits T to simultaneously receive and consume the benefit conferred by the training. Therefore, the implementation services represent promises to transfer services to the customer and should be assessed as such under the contract.

5.3.2.3.3.2 Identifying Whether Implementation Services Are a Distinct Performance Obligation

If an entity has determined that implementation services represent promised goods or services to the customer, it would next assess whether such services and the SaaS are (1) each a distinct performance obligation or (2) a combined performance obligation. Under ASC 606-10-25-19, for a promised good or service to be a separate performance obligation, the promise must be both (1) capable of being distinct (i.e., 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 (2) distinct within the context of the contract (i.e., the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract).

We believe that the following factors (not all-inclusive) may be helpful in an entity’s determination of whether implementation services are a distinct performance obligation (the analysis may in some circumstances need to be performed separately for each promise because implementation services often consist of multiple activities that represent separate promises):

Whether the entity or other entities (e.g., consulting firms, SaaS competitors) provide the implementation services on a stand-alone basis — We believe that this is a key consideration in the entity’s assessment of whether the implementation services are distinct. For example, if the entity has a number of partnerships or alliances with other organizations that enable those other businesses to provide the implementation services to the entity’s customers, the implementation services are likely to be distinct.
Whether the implementation services will provide an asset or incremental benefit to the customer without the SaaS arrangement (i.e., alternative use) — An entity would evaluate whether the implementation services (1) are specific to the SaaS arrangement or (2) can be leveraged by the customer for use in other SaaS arrangements or circumstances. For example, an entity may provide professional services that enable the customer to use the SaaS to more efficiently analyze data. If those same professional services can be applied to other competitors’ SaaS solutions, the services may be distinct.
Whether the customer must obtain the implementation services to use and benefit from the SaaS arrangement (i.e., whether the SaaS is functional without the implementation services) — An entity would evaluate whether the customer can maintain a reasonable degree of utility of the SaaS without the implementation services. For example, a SaaS that has no utility or value without the entity’s implementation services may be an indicator that the implementation services are not distinct.
Whether there are instances in which the SaaS was provided to customers without implementation services — Customers’ frequent purchasing of the entity’s SaaS without purchasing its implementation service may be an indicator that the implementation services are distinct.
Whether the implementation services significantly alter any features or functionality of the SaaS — For example, the implementation services may include significant customization of the customer’s infrastructure and applications to enable the SaaS to process transactions it could not process otherwise. Such customization may be an indicator that the implementation services are not distinct; however, if the customization’s benefits could be applied to another SaaS platform (i.e., another readily available resource), the implementation services may be distinct.
Whether the implementation services and the SaaS are so significantly integrated, interrelated, or interdependent that the entity could not fulfill its promises to transfer the implementation services and the SaaS independently — For example, to enable the SaaS to perform unique functions that are critical to the customer’s intended use of the SaaS, the implementation services may require significant customization of both the entity’s and the customer’s systems. In such cases, the implementation services may not be distinct because there is likely to be an interdependency between the implementation services and the SaaS (i.e., as a result of the services, there is an enhancement to the combined functionality of the SaaS and the customer’s systems). In addition, as discussed in Section 5.3.2.3.3.1, the customization of the entity’s systems is not likely to be a promised good or service in the arrangement.
Whether using the SaaS or providing implementation services requires a highly specialized or complex skill set that neither the customer nor third parties possess — For example, an entity may provide to a governmental agency a highly customized and complex SaaS solution that requires the entity to employ scientists. If there is significant risk associated with the entity’s ability to provide the implementation services and the level of effort and time needed to complete them is extensive, the implementation services may not be distinct. By contrast, if it is not difficult to configure or set up the customer’s systems and interfaces, the implementation services may be distinct.
Whether the entity markets the implementation services and the SaaS as a combined solution — While marketing the services and SaaS in such a manner is not a determinative factor, it may support a conclusion that the implementation services are not distinct.

5.3.2.3.4 Identifying Performance Obligations in Arrangements That Include Smart Devices, Updates, and Cloud-Based Services

Many technology entities offer solutions in which a customer purchases (1) a smart device with an embedded software component (e.g., firmware), (2) maintenance and support (i.e., postcontract customer support [PCS]), and (3) a cloud-based service. In these offerings, the firmware allows the smart device to connect to the cloud-based application, which is physically hosted on the technology entity’s systems (or hosted by the entity’s cloud-computing vendor) and accessed by the customer over the Internet. For arrangements in which the software is always embedded in the smart device and the software is essential to the device’s core functionality, an entity will typically conclude that the embedded software (e.g., firmware) is not distinct from the smart device. This is because the software is a component of the tangible device and integral to the functionality of that device in accordance with ASC 606-10-55-56(a).

Because PCS and a cloud-based service typically are sold together, are coterminous, and have the same pattern of transfer (i.e., ratably over time as stand-ready obligations), they will be referred to collectively as “subscription services.” In some cases, the smart device and both the PCS and the cloud-based service may constitute a combined performance obligation. However, there may be instances in which the smart device and either the PCS (without the cloud-based service) or the cloud-based service (without the PCS) constitute a combined performance obligation.

Connecting the Dots

At the 2021 AICPA & CIMA Conference on Current SEC and PCAOB Developments, OCA Senior Associate Chief Accountant Jonathan Wiggins noted that complex consultations on the identification of performance obligations have included fact patterns in which an entity promises to provide (1) a good or service up front, such as a software license or a “smart” device, and (2) a related service over time, such as PCS for the software license or a cloud-based service for the smart device. This topic was also addressed by Ms. York in her speech at the 2018 AICPA Conference on Current SEC and PCAOB Developments. In that speech, Ms. York discussed a consultation with an SEC registrant regarding the identification of performance obligations with respect to a commercial security monitoring service. The registrant’s technology platform incorporated an element of artificial intelligence (AI) to create a “smart” security monitoring service. As Ms. York observed, the registrant concluded that the promises in the contract were not distinct within the context of the contract because it “believed it was providing a significant service of integrating the goods and services in the contract into a bundle that represented the combined output for which the customer had contracted.” Ms. York noted that the SEC staff did not object to the registrant’s conclusion.

The functionality of smart devices and subscription services can vary between offerings to customers and between entities. When identifying performance obligations in these arrangements, an entity should consider the guidance in ASC 606-10-25-19 to determine whether the smart device and the subscription services are distinct (i.e., whether each promise is capable of being distinct and distinct within the context of the contract). While a smart device and related subscription services are each often capable of being distinct, determining whether they are distinct within the context of the contract is much more challenging. An entity should consider the guidance in ASC 606-10-25-21 in making such a determination.

We believe that an entity may consider the following indicators, which are not individually determinative or all-inclusive, in determining whether its smart device is distinct from its subscription services:

Whether the entity’s smart device and subscription services are ever sold separately — The entity’s practice of selling the smart device and the subscription services separately typically indicates that there are two separate performance obligations (i.e., the promises should not be combined) since the customer may benefit from the smart device or the subscription services offering on its own.8 In addition, separate sales also suggest that the smart device and the subscription services each have significant stand-alone functionality, which indicates that those items are distinct within the context of the contract.
Whether the customer can benefit from each product or service (i.e., the smart device or the subscription services) either on its own or together with other resources that are readily available to the customer — For example, suppose that the customer has the ability to (1) obtain from a different vendor a smart device or subscription services offering that is the same as or similar to that sold by the entity, (2) use the alternative vendor’s smart device with the entity’s subscription services (or use the alternative vendor’s subscription services with the entity’s smart device), and (3) receive substantially the same functionality as that of the entity’s combined offering. That ability may indicate that the entity’s smart device and subscription services are each capable of being distinct and are distinct within the context of the contract since (1) the entity is not providing a significant integration service for the device and the subscription services and (2) it is less likely that the smart device and the subscription services are highly interdependent or highly interrelated.

Alternatively, suppose that the functionality of the smart device is significantly integrated with (rather than just improved by) the subscription services in such a way that the entity’s combined offering provides significant additional capabilities that cannot be obtained from an alternative vendor providing the subscription services. In that case, the presence of an alternative vendor providing a portion of the same utility with its subscription services would indicate that the promises are capable of being distinct, but the integrated nature of the promises would indicate that the promises are not distinct within the context of the contract.
Whether the subscription services significantly modify the smart device — The subscription services and the smart device may not be distinct within the context of the contract if rather than just enhancing the capabilities of the smart device, the subscription services modify and significantly affect the functionality of the smart device. For example, suppose that the subscription services (1) employ AI or machine learning that teaches and significantly affects the functionality of the smart device and (2) cannot employ the AI or machine learning without using the functionality of the smart device. This situation would indicate that the subscription services and the smart device are not distinct within the context of the contract because rather than just enhancing the capabilities of the smart device, the subscription services modify and significantly affect the functionality of the smart device.
Whether the absence of either the smart device or the subscription services significantly limits or diminishes the utility (i.e., the ability to provide benefit or value) of the other — If the smart device’s functionality is significantly limited or diminished without the use of the subscription services, and vice versa, that significantly limited or diminished functionality may indicate that the smart device and the subscription services (1) are highly interdependent or highly interrelated (i.e., they significantly affect each other) and (2) function together as inputs to a combined output. This, in turn, may indicate that the promises are not distinct within the context of the contract since the customer cannot obtain the intended benefit of the smart device or the subscription services without the other. That is, while the customer may be able to obtain some functionality from the smart device on a stand-alone basis, it would not obtain the intended outputs from the smart device if the smart device is not updated by or connected to the subscription services because the subscription services are critical to the customer’s intended use of the combined solution. In this situation, the entity cannot fulfill its promise to the customer by transferring the smart device or the subscription services independently (i.e., the customer could not choose to purchase one good or service without significantly affecting the other good or service in the contract).
Whether the functionality of the combined smart device and subscription services is transformative rather than additive — Transformative functionality should be assessed separately from added functionality. Transformative functionality comprises features that significantly affect the overall operation and interaction of the smart device and the subscription services (e.g., integrated data analytics, pushdown learning, customization). To be transformative, the smart device and the subscription services must significantly affect each other. That is, the smart device and the subscription services are inputs to a combined output such that the combined output has greater value than, or is substantively different from, the sum of the inputs. By contrast, added functionality comprises features that provide an added benefit to the customer without substantively altering (1) the manner in which the functionality is used and (2) the benefits derived from that functionality of the smart device or the subscription services on a stand-alone basis. Even if the added functionality is significant, it may not be transformative. It is more likely that the smart device and the subscription services are highly interdependent or highly interrelated when the functionality of the combined offering is transformative rather than additive.

When performing this assessment, the entity may need to consider proprietary software embedded in the smart device. For example, the entity may design customized embedded software that enhances the smart device’s functionality when combined with the entity’s subscription services. However, embedded software that limits the smart device’s functionality to working only with the entity’s subscription services would not represent a transformative relationship. This is because it would only establish a functional dependency.
Whether the entity’s smart devices and subscription services are always sold on a one-to-one basis — If the entity has a practice of selling smart devices without the subscription services, this may indicate that the customer can obtain its intended benefit from the smart devices separately. For example, if a customer purchases the entity’s subscription services and 10 devices and has an option to subsequently purchase additional devices without additional subscription services, the entity is able to fulfill any promise to provide additional devices without any related subscription services. If the entity is able to fulfill its promise to provide a smart device independently from its promise to provide subscription services, the smart device and the subscription services may not be highly interdependent or highly interrelated. By contrast, if a customer is always required to purchase additional subscription services for each smart device purchased, this may indicate that the smart device and the subscription services are not distinct.
Whether the smart devices are sold on a stand-alone basis through a distribution channel or in an aftermarket — If the entity’s smart devices are sold on a stand-alone basis by other third parties and the entity will sell its subscription services separately to any customer that has purchased or obtained a smart device from a third party, the entity is able to fulfill its promise to provide subscription services independently from any promise to provide smart devices. This indicates that the smart device and the subscription services are not highly interdependent or highly interrelated. By contrast, if the entity will not sell its subscription services to a customer unless the customer has purchased a smart device directly from the entity, this may indicate that the smart device and the subscription services are not distinct.
Whether the entity’s marketing materials support a conclusion that the arrangement is for a combined solution rather than separate products or service offerings — The entity’s marketing materials may help clarify what the entity has promised to deliver to its customer and may provide evidence of the customer’s intended use of the smart device and the subscription services. Circumstances in which an entity markets its product as a “solution” (i.e., the materials discuss the functions, features, and benefits of the combined offering with little or no discussion of the smart device and the subscription services separately) may help support a conclusion that the entity’s promise is a combined performance obligation. However, the entity should exercise caution when relying on its marketing materials since the manner in which the entity markets its combined offering would not, by itself, be sufficient to support a conclusion that the smart device and the subscription services represent a combined performance obligation.

Example 5-5

Entity X sells a bundled cybersecurity solution to protect against advanced cybersecurity threats to enterprise customers. In its standard revenue contracts, X promises to provide customers with a smart device (i.e., hardware with embedded software) and annual subscription services. The smart device has behavior and security analytics engines that use machine learning and AI to monitor and protect a customer’s IT infrastructure (including e-mails, Internet applications, endpoints, and networks) on a real-time basis against cyberattacks. The subscription services include (1) a cloud-based service that pulls data on cyberattacks and other intelligence updates from various sources and (2) PCS that consists of support and critical software updates that enable the cloud-based service to stay compatible with the smart device. The cloud-based service is provided hourly in response to evolving cybersecurity threats, and software updates are provided on a daily or weekly basis. Entity X never sells the smart device without subscription services, but subscription services are sold separately on a renewal basis (approximately 95 percent of X’s customers renew each year). Customers are required to purchase subscription services with each smart device purchased, and the smart device must be purchased from X directly (i.e., there are no distributors or resellers). Customers are also prohibited from reselling the smart device, and X will not sell subscription services to a customer that has not purchased the smart device directly from X (i.e., there is no aftermarket for the smart device).

The smart device on a stand-alone basis is functional and will monitor and prevent some level of cyberattacks. However, given the nature of the security updates and the cybersecurity environment for enterprise customers, the utility of the smart device diminishes significantly and quickly without the subscription services since the smart device would not be able to respond to evolving cybersecurity threats. The subscription services have no utility without the smart device, and there is significant integration of, and interaction between, the smart device and the subscription services such that together, they provide the functionality required by the customer. The smart device and the subscription services are proprietary and can only be used with each other; no similar third-party subscription services are compatible with X’s smart device, and no similar third-party smart devices are compatible with X’s subscription services. Entity X markets its smart device and subscription services as a single integrated offering; X does not describe the smart device or subscription services separately, and it refers only to the features, functionality, and benefits of the combined offering.

Entity X determines that there is a transformative relationship between the smart device and the subscription services such that they are inputs to a combined output. Further, because the smart device and the subscription services each have little or no utility without the other, they are highly interrelated and highly interdependent. Entity X therefore concludes that there is a single performance obligation in its contracts.9

We believe that it is reasonable to conclude that there is one performance obligation for the following reasons:

Entity X’s smart device is never sold separately.
The customer cannot obtain the intended benefit from the smart device or the subscription services offering on its own. There are no smart devices or subscription services available from other vendors that can function with X’s offering.
The functionality of the smart device is significantly integrated with the subscription services in such a way that only together can they provide the functionality (i.e., the intended benefit) required by the customer.
The absence of either the smart device or the subscription services significantly limits or diminishes the utility (i.e., the ability to provide benefit or value) of the other. The smart device’s functionality is significantly limited or diminished without the use of the subscription services, and vice versa. Therefore, the smart device and the subscription services (1) are highly interdependent and interrelated (i.e., they significantly affect each other) and (2) function together as inputs to a combined output. The customer cannot obtain the full intended benefit of the smart device or the subscription services on a stand-alone basis because the smart device and the subscription services are each critical to the customer’s intended use of the security solution.
The functionality of the combined smart device and subscription services is transformative rather than additive. That transformative functionality comprises features that significantly affect the overall operation and interaction of the smart device and the subscription services in such a way that the smart device and the subscription services significantly affect each other.
Entity X always sells the smart device and the subscription services on a one-to-one basis. In addition, the smart device must be purchased from X directly (i.e., there are no distributors or resellers). Customers are also prohibited from reselling the smart device, and X will not sell subscription services to a customer that has not purchased the smart device directly from X (i.e., there is no aftermarket for the smart device). Therefore, X cannot fulfill its promise to the customer by transferring the smart device or the subscription services independently (i.e., the customer could not choose to purchase one good or service without significantly affecting the other good or service in the contract).
Entity X’s marketing materials support a conclusion that the arrangement is for a combined solution rather than separate product or service offerings.

Example 5-6

Entity Y sells GPS tracking devices (with embedded software) that enable its customers to monitor the location of its various products. In its standard revenue contracts, Y also sells a one-year cloud-based subscription service so that customers can monitor the devices online and perform data analytics. The devices have minimal functionality unless a customer has an active subscription service (i.e., the subscription service is required to enable a customer to monitor the devices). Likewise, if a customer has an active subscription service without an associated device, the subscription service will not monitor anything. The subscription service does not alter or modify the existing firmware on the device. In addition, Y is not providing a significant integration service that transforms the device and subscription service into a combined output.

Entity Y markets and sells the device and the subscription service as one bundled offering but does have stand-alone sales of the device and the subscription service. In addition to selling the device directly, Y sells the device to independent distributors. The device can also be resold in an aftermarket. If a customer purchases a device from a reseller or in an aftermarket, the customer will purchase the subscription service separately from Y. In addition, Y sells the subscription service separately on a renewal basis (approximately 95 percent of Y’s customers renew each year).

Entity Y concludes that it has multiple performance obligations in its contracts with direct customers: (1) each device and (2) the subscription service.

We believe that it is reasonable to conclude that there are multiple performance obligations for the following reasons:

While Y markets and sells the device and the subscription service as one bundled offering, it has stand-alone sales of the device and the subscription service. Entity Y sells the device separately to distributors and sells the subscription service separately to direct customers.
Entity Y is not providing a significant integration service that transforms the device and the subscription service into a combined item.
The device is not modified by the subscription service.
The device and the subscription service are not highly interdependent or highly interrelated. Although the customer can only benefit from the functionality of the device with the subscription service (i.e., the device would have minimal functionality without the subscription service) and the device is required for the subscription service to function, the device and the subscription service do not significantly affect each other. This is because Y would be able to fulfill each of its promises in its contracts independently of the other, since (1) the device is sold separately through independent distributors and an aftermarket, and (2) Y will sell its subscription service separately to any customer that has purchased the device from a distributor or in the aftermarket. In addition, independent distributors and customers can obtain the benefits from the device separately by reselling it, and the buyer of the device can benefit from it by separately purchasing subscription services from Y.

5.3.3 Series Guidance

As previously noted, ASC 606-10-25-14 provides the following guidance on what constitutes a performance obligation:

ASC 606-10

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 (see paragraph 606-10-25-15).

ASC 606-10-25-14(b) explains that a performance obligation can be a series of goods or services; however, the performance obligation must meet certain requirements to qualify as a series. Specifically, the goods or services must have substantially the same pattern of transfer to the customer as though they were a single performance obligation. As explained in paragraph BC113 of ASU 2014-09, the FASB and IASB came to this conclusion to provide the series guidance because it would promote consistent application of the revenue standard across similar goods and services. Further, the ASU’s Background Information and Basis for Conclusions indicates that without the series provision, an entity could encounter operational challenges in managing numerous performance obligations and allocating the transaction price to those performance obligations on a stand-alone selling price basis.

The following guidance in ASC 606-10-25-15 clarifies the meaning of “the same pattern of transfer”:

ASC 606-10

25-15 A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met:

Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in paragraph 606-10-25-27 to be a performance obligation satisfied over time [see Section 8.4].
In accordance with paragraphs 606-10-25-31 through 25-32 [see Section 8.5], 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.

5.3.3.1 Determining Whether Distinct Goods or Services Are Substantially the Same

For distinct goods or services to be considered substantially the same to be accounted for as a series under ASC 606-10-25-14(b), it is not necessary for each increment of distinct goods or services to be identical. Instead, it is necessary to evaluate whether there is a series of distinct goods or services that are substantially the same.

The evaluation of whether distinct goods or services are substantially the same requires significant judgment based on the relevant facts and circumstances of the contract.

An entity should first determine the nature of the promised goods or services to be provided under the contract by evaluating whether the nature of the arrangement is to provide the customer with a specified quantity of distinct goods or services or to stand ready to provide an undefined quantity of goods or services over the duration of the contract period.

This issue is addressed in Implementation Q&A 18 (compiled from previously issued TRG Agenda Papers 39 and 44). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

5.3.3.1.1 Specified Quantity of Distinct Goods or Services

Generally, arrangements to deliver a specified quantity of similar goods or services result in repetitive delivery of the goods or services. An entity should evaluate whether each repetitive good or service is substantially the same as the others, as illustrated in the example below.

Example 5-7

Monthly Cleaning Services

Company A provides Customer Z monthly cleaning services for one year. Company A has been contracted to clean Z’s offices once a month, for a total of 12 cleaning services in a year. Company A concludes that each monthly service (1) is distinct, (2) meets the criteria for recognizing revenue over time, and (3) uses the same method for measuring progress. In addition, A concludes that the cleaning services each month are substantially the same and result in the transfer of substantially the same service (office cleaning) to the customer each month. Therefore, A concludes that the monthly cleaning services satisfy the requirements of ASC 606-10-25-14(b) to be accounted for as a single performance obligation.

5.3.3.1.2 Undefined Services Over a Contract Period

A contract may require an entity to perform various activities as part of transferring services over the contract period. In these circumstances, an entity would need to determine whether the nature of the promise is to provide the customer with (1) multiple different services or (2) one integrated service (with different activities). In making this determination, an entity might first determine the nature of the services by evaluating the benefit provided to the customer. If the entity determines that the customer benefits from the integrated service over the contract term, it should then evaluate whether each time increment (e.g., hour, day, or week) is substantially the same. In these situations, each time increment of service may be substantially the same even if the underlying activities differ. Consider the examples below.

Example 5-8

Hotel Management Services

Company B provides hotel management services to Customer Y that include hiring and managing employees, procuring goods and services, and advertising and marketing the hotel. In a given day, B could clean guest rooms, perform marketing efforts to increase occupancy, and operate the concierge desk.

Company B concludes that the nature of the contract is to provide integrated hotel management services over the term of the contract and not a specific quantity of specified services (e.g., cleaning 100 guest rooms per day). The underlying activities in providing the hotel management services can vary significantly from day to day; however, the daily services are activities that are required to satisfy B’s obligation to provide an integrated hotel management service. Therefore, the integrated service of hotel management transferred to the customer is substantially the same during each period. That is, Y receives substantially the same benefit each period.

Company B concludes that each increment of service (i.e., day or week) is distinct, meets the criteria for recognizing revenue over time, and uses the same method for measuring progress. Therefore, B would conclude that the hotel management services satisfy the requirements of ASC 606-10-25-14(b) to be accounted for as a single performance obligation.

Example 5-9

IT Outsourcing Services

Company C provides IT outsourcing services to Customer X for a five-year period. The IT outsourcing services include providing X with server capacity, maintenance of the customer’s software portfolio, and access to an IT help desk.

Company C considers the nature of the promise to X. Company C concludes that its promise to X is to provide continuous access to an integrated outsourced IT solution and not to provide a specified quantity of services (e.g., processing 100 transactions per day). The underlying activities in providing IT outsourcing services can vary significantly from day to day; however, the daily services are activities performed to fulfill C’s integrated IT outsourcing service and are substantially the same. Company C concludes that for each period, (1) C is providing an integrated IT outsourcing service; (2) the customer is continuously receiving substantially the same benefit, which is distinct; and (3) each increment of time is substantially the same (i.e., each increment provides the same integrated IT outsourcing solution).

Company C concludes that each distinct increment of time meets the criteria for recognizing revenue over time and uses the same method for measuring progress. Therefore, C concludes that the IT outsourcing services satisfy the requirements of ASC 606-10-25-14(b) to be accounted for as a single performance obligation.

5.3.3.2 Mandatory Treatment of a Series of Distinct Goods or Services as a Single Performance Obligation

Some entities may find it preferable to account for goods and services individually instead of as a series even though the goods and services meet the requirements of the series guidance. If an entity concludes that a series of distinct goods or services meets the requirements of ASC 606-10-25-14(b), it is required to treat that series as a single performance obligation (i.e., it cannot choose to regard the distinct goods or services in the series as individual performance obligations). Paragraph BC113 of ASU 2014-09 clarifies the boards’ intent to mandate the use of this simplification, stating that they “decided to specify that a promise to transfer a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer would be a single performance obligation if two criteria are met” (emphasis added).

5.3.3.3 Other Issues Related to the Determination of Whether the Series Guidance Applies

In discussion with the TRG, the FASB staff noted that an entity may determine that 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 staff further noted that a single performance obligation that comprises a series of distinct goods or services rather than a bundle of goods or services that are not distinct affects (1) how variable consideration is allocated, (2) whether contract modifications are accounted for on a cumulative catch-up or prospective basis, and (3) how changes in the transaction price are treated. Because of the potential implications associated with whether goods or services are determined to be a series, stakeholders have raised questions about:

Whether goods must be delivered (or services must be performed) consecutively for an entity to apply the series provision.
Whether the accounting result for the series of distinct goods or services as a single performance obligation needs to be the same as if each underlying good or service were accounted for as a separate performance obligation. The staff noted that it does not believe that the accounting result needs to be “substantially the same.” Further, the staff stated 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.”10

5.3.3.3.1 Applying the Series Provision When the Pattern of Transfer Is Not Consecutive

A series of goods or services will often be transferred consecutively (e.g., under a contract to provide the same package of cleaning services each consecutive week for 52 weeks). However, sometimes the series of goods or services will not be delivered each week on a consecutive basis (e.g., under a cleaning contract in which services are not provided in certain weeks but are provided in other weeks on an overlapping basis whereby cleaning begins before the previous week’s work has been completed).

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 it “does not think whether the pattern of performance is consecutive is determinative to whether the series provision applies.”11 That is, goods or services do not need to be transferred consecutively to qualify as a series of distinct goods or services under ASC 606-10-25-14(b) and, specifically, to have the “same pattern of transfer to the customer.”

As noted in Section 5.3.3, the series requirement is intended to simplify the application of the revenue model in ASC 606 and to promote consistency in the identification of performance obligations. In certain instances, it requires identification of a single performance obligation even though the underlying goods and services are distinct (i.e., when distinct goods or services are provided in a series). ASC 606-10-25-15 lists the two criteria that must be met for an entity to conclude that a series of two or more goods or services is a single performance obligation:

“Each distinct good or service . . . would meet the criteria . . . to be a performance obligation satisfied over time,” in accordance with ASC 606-10-25-27.
The “same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation,” in accordance with ASC 606-10-25-31 and 25-32.

Neither of these criteria refers to the consecutive transfer of goods or services to the customer, and both criteria could be met in each of the cleaning contract examples described above. Therefore, the applicability of ASC 606-10-25-14(b) does not depend on whether the goods (services) will be consecutively delivered (performed).

The above issue is addressed in Implementation Q&A 19 (compiled from previously issued TRG Agenda Papers 27 and 34). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

5.3.3.3.2 Whether Treating Distinct Goods or Services as a Series Under ASC 606-10-25-14(b) Must Produce the Same Accounting Result as Treating Each Distinct Good or Service as a Separate Performance Obligation

The application of ASC 606-10-25-14(b) does not have to produce the same accounting result as treating each distinct good or service as a separate performance obligation.

5.3.3.4 Illustrative Example of a Series of Distinct Goods or Services (ASC 606-10-55-157B Through 55-157E)

Example 12A in ASC 606, which is reproduced below, further discusses the accounting for a series of distinct goods or services.

ASC 606-10

Example 12A — Series of Distinct Goods or Services

55-157B An entity, a hotel manager, enters into a contract with a customer to manage a customer-owned property for 20 years. The entity receives consideration monthly that is equal to 1 percent of the revenue from the customer-owned property.

55-157C The entity evaluates the nature of its promise to the customer in this contract and determines that its promise is to provide a hotel management service. The service comprises various activities that may vary each day (for example, cleaning services, reservation services, and property maintenance). However, those tasks are activities to fulfill the hotel management service and are not separate promises in the contract. The entity determines that each increment of the promised service (for example, each day of the management service) is distinct in accordance with paragraph 606-10-25-19. This is because the customer can benefit from each increment of service on its own (that is, it is capable of being distinct) and each increment of service is separately identifiable because no day of service significantly modifies or customizes another and no day of service significantly affects either the entity’s ability to fulfill another day of service or the benefit to the customer of another day of service.

55-157D The entity also evaluates whether it is providing a series of distinct goods or services in accordance with paragraphs 606-10-25-14 through 25-15. First, the entity determines that the services provided each day are substantially the same. This is because the nature of the entity’s promise is the same each day and the entity is providing the same overall management service each day (although the underlying tasks or activities the entity performs to provide that service may vary from day to day). The entity then determines that the services have the same pattern of transfer to the customer because both criteria in paragraph 606-10-25-15 are met. The entity determines that the criterion in paragraph 606-10-25-15(a) is met because each distinct service meets the criteria in paragraph 606-10-25-27 to be a performance obligation satisfied over time. The customer simultaneously receives and consumes the benefits provided by the entity as it performs. The entity determines that the criterion in paragraph 606-10-25-15(b) also is met because the same measure of progress (in this case, a time-based output method) would be used to measure the entity’s progress toward satisfying its promise to provide the hotel management service each day.

55-157E After determining that the entity is providing a series of distinct daily hotel management services over the 20-year management period, the entity next determines the transaction price. The entity determines that the entire amount of the consideration is variable consideration. The entity considers whether the variable consideration may be allocated to one or more, but not all, of the distinct days of service in the series in accordance with paragraph 606-10-32-39(b). The entity evaluates the criteria in paragraph 606-10-32-40 and determines that the terms of the variable consideration relate specifically to the entity’s efforts to transfer each distinct daily service and that allocation of the variable consideration earned based on the activities performed by the entity each day to the distinct day in which those activities are performed is consistent with the overall allocation objective. Therefore, as each distinct daily service is completed, the variable consideration allocated to that period may be recognized, subject to the constraint on variable consideration.

5.3.3.5 Application of the Series Provision in Life Sciences Arrangements

Entities in the life sciences industry may enter into service arrangements with other entities in the industry as part of their product development process. For example, the developer of a drug compound or other IP may enter into an arrangement with an entity that agrees to provide it with clinical outsourcing support services (“R&D services”). These R&D services may involve various tasks such as patient enrollment, clinical trial site management, and activities related to regulatory filings. While the two entities agree to a set of objectives, the entity providing the R&D services may not promise or guarantee an end result. Instead, the entity providing the R&D services satisfies its performance obligation by making available access to clinical professionals to advance the R&D efforts toward agreed-upon objectives. Given the nature of such R&D services, the services may not be performed consistently or consecutively over the service period, and their nature and scope may change as the work progresses.

An entity’s application of ASC 606 to a contract with a customer may be affected by whether the entity determines that its promises to the customer represent (1) a single combined performance obligation comprising multiple activities that are not distinct or (2) a single performance obligation consisting of a series of distinct increments. Specifically, the application of the guidance on allocating variable consideration, accounting for contract modifications, and providing disclosures related to remaining performance obligations differs for a series of distinct increments of goods or services. We believe that the determination of whether R&D services provided by entities in the life sciences industry represent a series may require significant judgment.

The first step in the evaluation of whether an entity’s promise to provide R&D services to a customer represents a series is to assess whether the nature of the promise is one of the following:

The delivery of a specified quantity of goods or services.
A stand-ready obligation to provide an indefinite amount of goods or services during a specified period.

If the nature of the promise is to deliver a specified quantity of goods or services, the entity must determine whether each good or service is distinct, is substantially the same as the other goods or services, and has the same pattern of transfer to the customer as that of the other goods or services. If, on the other hand, the nature of the promise is to stand ready for a specified period, the entity must determine whether, for each increment of time, its promise of standing ready to provide the R&D services is distinct, is substantially the same as its promise for each of the other increments of time, and has the same pattern of transfer to the customer as its promise for each of the other increments of time.

Contracts in the life sciences industry to perform R&D services appear in various forms. For example, some contracts may include a license to IP in addition to the R&D services. If it is determined that the license and the R&D services are both within the scope of ASC 606 but are not distinct promises (or if the customer already has control of a license and the entity’s only promise in the contract is to provide R&D services), the series guidance may not apply to the combined performance obligation if the R&D services provided throughout the development period are cumulative in that each increment of service builds on and is dependent on the increments that precede it (i.e., such services would not be considered distinct within the context of the contract). In such a case, the R&D services would generally be accounted for as a single combined performance obligation consisting of multiple activities that are not distinct, as opposed to a series of distinct increments of time or service. In certain other cases, R&D services may meet the criteria to be accounted for as a series, as illustrated in the example below.

Example 5-10

CRO, a contract research organization, enters into an arrangement with Pharma, the developer of a new drug compound, to perform daily R&D services for Pharma as needed during phase 3 clinical trials by giving Pharma access to clinical professionals. In exchange for the R&D services provided to Pharma, CRO will receive a daily fee per person and success-based milestone payments.

The activities to be performed may vary each day as CRO and Pharma work toward agreed-upon objectives in connection with the phase 3 clinical trials. While the activities may vary by day, they represent fulfillment activities associated with providing the daily R&D services and do not represent separate promises in the arrangement. Further, CRO has determined that such services are readily available in the marketplace and are not cumulative because each day’s research and corresponding results are not dependent on the prior day’s research; thus, each day of services does not build on activities that precede it, and each day of services and the activities that precede it are not integrated, interdependent, or interrelated. That is, no day of services significantly affects either CRO’s ability to fulfill another day of services or the benefit to Pharma of another day of services.

CRO determines that Pharma is a customer within the context of providing the services and therefore likewise concludes that the services are within the scope of ASC 606. In addition, CRO determines that the services to be provided to Pharma meet the criteria in ASC 606-10-25-27(a) for recognition of revenue over time since the services performed during each increment of time contribute to Pharma’s development of the drug compound and thereby allow Pharma to simultaneously receive and consume the benefits provided by CRO’s performance as each task is performed.

Nature of the Promise

CRO determines that the nature of its promise is to stand ready to provide daily R&D services as needed during phase 3 clinical trials. Accordingly, CRO must assess whether, for each increment of time, its promise of standing ready to provide the R&D services (1) is distinct, (2) is substantially the same as its promise for each of the other increments of time, and (3) has the same pattern of transfer to the customer as its promise for each of the other increments of time.

Distinct

Pharma benefits from each day of services on its own since the services contribute to Pharma’s development of the drug compound and are readily available in the marketplace. Consequently, CRO concludes that each increment of services is capable of being distinct.

In addition, CRO determines that each increment of services is distinct within the context of the contract. This is because each day of services (1) does not significantly modify or customize another day of services and (2) does not significantly affect CRO’s ability to fulfill another day of services or the benefit to Pharma of another day of services since the R&D services are not cumulative, as noted above.

Substantially the Same

CRO determines that for all of the increments of time during which R&D services are performed, its promise of standing ready to perform those services is substantially the same. While the specific tasks or services performed during each increment of time will vary, the nature of the overall promise to provide Pharma with daily R&D services remains the same throughout the contract term.

Same Pattern of Transfer

CRO determines that the services have the same pattern of transfer to Pharma because both criteria in ASC 606-10-25-15 are met. The criterion in ASC 606-10-25-15(a) is met because each distinct service meets the criteria in ASC 606-10-25-27 to be a performance obligation satisfied over time since Pharma simultaneously receives and consumes the benefits provided by CRO as CRO performs. The criterion in ASC 606-10-25-15(b) is met because the same measure of progress (in this case, a time-based output method) would most likely be used to measure the progress of CRO toward satisfying its promise to provide the daily R&D services.

Conclusion

On the basis of the above, CRO concludes that the R&D services are a series and accounts for them accordingly.

Connecting the Dots

It is common in the life sciences industry for an entity to transfer a license of IP along with R&D services to the customer as a single performance obligation. The license may not be capable of being distinct without the R&D services. That is, the R&D services performed by the entity may be novel and associated with proprietary IP, requiring the entity to provide the R&D services for the customer to benefit from the license. In determining when revenue should be recognized for the single performance obligation with two promised goods (the delivery of the license and R&D services), the entity must determine whether the single performance obligation is satisfied over time or at a point in time. In this type of transaction, the criteria in ASC 606-10-25-27(a) and (b) for recognizing revenue over time may be met. The entity may conclude that the criterion in ASC 606-10-25-27(a) is met if it determines that the work that it has completed to date (related to the R&D services) would not need to be substantially reperformed by another entity if the other entity were to step in to fulfill the remaining performance obligation to the customer (since this would mean that the customer simultaneously receives and consumes the benefits provided by the entity’s performance of the R&D services as the entity performs those services). In addition, the entity may conclude that the criterion in ASC 606-10-25-27(b) is met if it determines that (1) the customer obtains control of the license (i.e., the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the license) and (2) the R&D services provided will enhance the license.

Alternatively, life sciences entities may enter into a contract with a customer to perform R&D services and provide the customer with an option to exclusively license the IP resulting from the R&D services at a stated price during the period in which the R&D services are performed or for a certain specified period after performance of the R&D services is completed. The option is priced at its stand-alone selling price and therefore does not represent a material right. The promise to provide R&D services may represent a single performance obligation; if so, the entity must determine whether the performance obligation is satisfied over time or at a point in time. In this type of transaction, the criterion in ASC 606-10-25-27(a) for recognizing revenue over time may be met. The entity may conclude that the criterion in ASC 606-10-25-27(a) is met if it determines that the work that it has completed to date (related to the R&D services) and is controlled by the customer would not need to be substantially reperformed by another entity if the other entity were to step in to fulfill the remaining performance obligation to the customer (since this would mean that the customer simultaneously receives and consumes the benefits provided by the entity’s performance of the R&D services as the entity performs those services).

For additional information specific to the life sciences industry, see Deloitte’s Life Sciences Industry Accounting Guide.

5.3.4 Identifying Performance Obligations in Real Estate Sales

Sometimes, a seller remains involved with property that has been sold. Under the revenue standard, if the arrangement includes ongoing involvement with the property, the seller must evaluate each promised good or service under the contract to determine whether it represents a separate performance obligation, constitutes a guarantee, or prevents the transfer of control. If a promised good or service is considered a separate performance obligation, an allocated portion of the transaction price should be recognized when (or as) the entity transfers control of the related good or service to the customer.

For example, assume that as part of a sale of land, the seller agrees to erect a building on the land in accordance with agreed-upon specifications. If the sale of land and the construction of the building are considered separate performance obligations, the seller would be required to recognize an allocated portion of the total transaction price as control of each good or service is transferred to the customer. However, if the sale of land and the construction of the building are not considered separate performance obligations, the consideration received in connection with the sale of the land would be included in the transaction price attributed to the performance obligation (i.e., the combined obligation to transfer the land and construct the building). The transaction price would be recognized when (or as) the combined performance obligation is satisfied.

Connecting the Dots

Common Areas and Other Amenities in a Community Development

Implementation concerns have been raised by various stakeholders in the real estate industry, including real estate developers and construction and engineering entities.

Real estate developers have questioned the accounting for contracts for which it is expected that certain amenities or common areas will be provided in a community development (to be owned by either a homeowners association or the local municipality). Specifically, they have asked whether these common areas and other amenities should be accounted for as separate performance obligations. We believe that a developer that intends to provide common areas (e.g., a community center, parks, tennis courts) to a homeowners association as part of a development would generally not consider such an arrangement to represent a promise to deliver goods or services in the separate contracts to sell real estate (e.g., a single-family home) to its other customers. That is, the agreement with the homeowners association would not be combined with an agreement to sell real estate to a separate customer. Further, we believe that control of the common areas will not be transferred to the community homeowners but will be transferred to the homeowners association instead. Consequently, the expected construction of the common areas would not represent a performance obligation of the developer. Note that the guidance in ASC 970 requires a developer to use a cost accrual approach upon sale of the real estate to account for costs of the common areas.

Phases of Engineering, Design, Procurement, and Construction

Construction and engineering entities often enter into contracts that include promises that are completed over a number of phases. Such phases often include engineering, design, procurement, and construction of a facility or project. Stakeholders have raised questions and have had differing views about whether phases of a project (e.g., in typical design-and-build contracts) are distinct performance obligations or part of one combined performance obligation because they may not be distinct in the context of the contract. Under the revenue standard, it may be difficult to assess whether phases of engineering, design, procurement, and construction are part of one combined performance obligation (e.g., because the phases are highly interdependent and highly interrelated or part of a significant service of integration) or are distinct performance obligations.

Such difficulty may affect the way revenue (or other gains or losses, if the transaction is with a noncustomer) is recognized (e.g., (1) at a point in time or over time and (2) the measure of progress if revenue is recognized over time). Accordingly, entities will need to exercise significant judgment and consider the specific facts and circumstances of each contract.

Given that the accounting could vary significantly depending on whether an arrangement involves multiple distinct performance obligations, entities should carefully analyze their sales contracts to determine whether any promises of goods or services represent distinct performance obligations.

5.3.5 Private-Company Franchisor Practical Expedient for Identifying Performance Obligations

In January 2021, the FASB issued ASU 2021-02, which allows a franchisor that is not a public business entity (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. The practical expedient is intended to reduce the cost and complexity of applying ASC 606 to preopening services associated with initial franchise fees.

As used in ASU 2021-02, the terms “franchise agreement,” “franchisor,” and “public business entity” are defined as follows:

ASC Master Glossary

Franchise Agreement

A written business agreement that meets the following principal criteria:

The relation between the franchisor and franchisee is contractual, and an agreement, confirming the rights and responsibilities of each party, is in force for a specified period.
The continuing relation has as its purpose the distribution of a product or service, or an entire business concept, within a particular market area.
Both the franchisor and the franchisee contribute resources for establishing and maintaining the franchise. The franchisor’s contribution may be a trademark, a company reputation, products, procedures, manpower, equipment, or a process. The franchisee usually contributes operating capital as well as the managerial and operational resources required for opening and continuing the franchised outlet.
The franchise agreement outlines and describes the specific marketing practices to be followed, specifies the contribution of each party to the operation of the business, and sets forth certain operating procedures that both parties agree to comply with.
The establishment of the franchised outlet creates a business entity that will, in most cases, require and support the full-time business activity of the franchisee. (There are numerous other contractual distribution arrangements in which a local businessperson becomes the authorized distributor or representative for the sale of a particular good or service, along with many others, but such a sale usually represents only a portion of the person’s total business.)
Both the franchisee and the franchisor have a common public identity. This identity is achieved most often through the use of common trade names or trademarks and is frequently reinforced through advertising programs designed to promote the recognition and acceptance of the common identity within the franchisee’s market area

The payment of an initial franchise fee or a continuing royalty fee is not a necessary criterion for an agreement to be considered a franchise agreement.

Franchisor

The party who grants business rights (the franchise) to the party (the franchisee) who will operate the franchised business.

Public Business Entity

A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.

It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.

An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.

Franchisors applying the revenue guidance in ASC 606 may need to exercise significant judgment to determine whether preopening services provided to franchisees (e.g., site selection assistance, training, and other services) are distinct from one another, the franchise license, and any other goods or services promised in the contract. This determination will affect the timing of revenue recognition related to the franchisee’s payment of initial franchise fees to the franchisor.

Private-company franchisors expressed concerns about the cost and complexity of applying ASC 606, particularly with respect to the accounting for initial franchise fees. Many franchise agreements include an up-front payment (i.e., the initial franchise fee) plus a royalty paid to a franchisor throughout the term of the arrangement. Under ASC 606, some franchisors may be required to defer revenue recognition related to some or all of the initial franchise fee over the term of the franchise license.

ASU 2021-02 added ASC 952-606 to provide a practical expedient that allows a private-company franchisor that has entered into a franchise agreement to treat certain preopening services provided to a franchisee as distinct from the franchise license. Those preopening services consist of the following activities:

“Assistance in the selection of a site.”
“Assistance in obtaining facilities and preparing the facilities for their intended use, including related financing, architectural, and engineering services, and lease negotiation.”
“Training of the franchisee’s personnel or the franchisee.”
“Preparation and distribution of manuals and similar material concerning operations, administration, and record keeping.”
“Bookkeeping, information technology, and advisory services, including setting up the franchisee’s records and advising the franchisee about income, real estate, and other taxes or about regulations affecting the franchisee’s business.”
“Inspection, testing, and other quality control programs.”

If a private-company franchisor applies the practical expedient, it must disclose that fact.

If a private-company franchisor does not elect to use the practical expedient, or if its contracts with customers include other promised goods or services that are not consistent with the activities in the above list, the entity must apply the guidance in ASC 606 on identifying performance obligations. 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. A private-company franchisor that elects to account for those preopening services as a single performance obligation is required to disclose this accounting policy. Further, an entity that applies the guidance in ASU 2021-02 should apply it consistently to contracts with similar characteristics and in similar circumstances.

Although the practical expedient simplifies step 2 of ASC 606 (i.e., identifying the performance obligations), entities are still required to apply the rest of the guidance in ASC 606, including the guidance on (1) identifying other performance obligations (e.g., equipment sales), (2) determining the stand-alone selling prices of the performance obligations, (3) allocating the transaction price to the performance obligations, and (4) determining the timing of revenue recognition. Further, ASU 2021-02 applies only to certain preopening services provided by private-company franchisors, and entities not within the scope of the ASU’s guidance are precluded from applying the ASU directly or by analogy.

ASU 2021-02 provides an illustrative example that is codified in ASC 952-606-55-1 through 55-5 as follows:

ASC 952-606

Example 1 — Identifying Performance Obligations

55-1 An entity enters into a contract with a customer and promises to grant a franchise license to open a restaurant location. The franchise license term is 10 years. In addition to the license, the entity also promises to provide two services related to the opening of the franchise location — site selection and training. The entity receives a fixed fee of $25,000, as well as a sales-based royalty of 5 percent of the customer’s sales for the term of the license. The fixed consideration of $25,000 is payable on or before the opening of the restaurant location.

55-2 The entity first assesses whether it is eligible for the practical expedient for identifying performance obligations in paragraph 952-606-25-2. The entity determines that it is eligible because it is not a public business entity, it is a franchisor that is within the scope of Topic 952, and it has entered into a franchise agreement with a customer.

55-3 In applying the practical expedient, the entity compares its pre-opening services (training and site selection) to the list of services in paragraph 952-606-25-2 instead of applying the guidance in paragraph 606-10-25-19. The entity determines that those services may be accounted for as distinct from the franchise license because they are consistent with the list of services in paragraph 952-606-25-2. The entity makes an accounting policy election to account for all pre-opening services that are consistent with the list in paragraph 952-606-25-2 as a single performance obligation. Therefore, the entity determines that it has two performance obligations — a franchise license and pre-opening services.

55-4 The entity then applies the guidance in paragraphs 606-10-32-28 through 32-45 to allocate the transaction price to the performance obligations and the guidance in paragraphs 606-10-25-23 through 25-37 and 606-10-55-65 through 55-65B to determine when and how to recognize revenue for satisfaction of the performance obligations.

55-5 The entity discloses its use of the practical expedient and its accounting policy election to treat the pre-opening services as a single performance obligation in accordance with the disclosure requirements in paragraphs 952-606-50-1 through 50-2.

Footnotes

See paragraph BC98 of ASU 2014-09.

In this publication, it is assumed that a SaaS arrangement is accounted for as a service contract because the customer does not have the ability to take possession of the underlying software license on an on-premise basis.

If a customer purchases additional implementation services after the SaaS term has commenced, the entity would generally apply the modification guidance in ASC 606 and perform the same analysis as if it were analyzing implementation services purchased up front. For additional information about the accounting for contract modifications, see Chapter 9.

If an entity sells subscription services separately as renewals and does not sell subscription services to a party that did not acquire the smart device from the entity, the separate sales of the subscription services would not, in and of themselves, suggest that the smart device and the subscription services are distinct within the context of the contract.

Often in these arrangements, a customer is required to pay an up-front fee for the smart device but is not required to pay that fee again upon renewal of the subscription services. In those circumstances, if the smart device is not distinct from the subscription services, an entity should consider whether a material right has been provided.

Quoted from Implementation Q&A 20 (compiled from previously issued TRG Agenda Papers 27 and 34).

Quoted from Implementation Q&A 19 (compiled from previously issued TRG Agenda Papers 27 and 34).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.