Chapter 5 — Step 2: Identify the Performance Obligations
Chapter 5 — Step 2: Identify the Performance Obligations
5.1 Introduction to Step 2
Step 2 is one of the most critical steps in the standard’s revenue framework
since it establishes the unit of account for revenue recognition. A material
miscalculation in this step will often lead to an error in the recognition of
revenue. This step requires an entity to identify what it has promised to the
customer. In many arrangements, this will be obvious and therefore simple; in other
arrangements, however, there are critical judgments that an entity must make in
determining the correct unit of account (i.e., performance obligation).
The decision tree below illustrates the revenue standard’s process for
identifying performance obligations in a contract.
This chapter also addresses topics such as stand-ready obligations, options for
additional goods and services, warranties, and nonrefundable up-front fees because
these topics are integral to the proper identification of performance
obligations.
When identifying a performance obligation, an entity should determine whether it is a principal or an
agent in the transaction because that determination will affect how (and sometimes when) the entity
reports the revenue earned. While step 2 is probably the best stage of the revenue recognition process
for determining whether an entity is a principal or an agent, there are many considerations that go
into that determination. Accordingly, principal-versus-agent considerations are discussed separately in
Chapter 10.
In addition, an entity’s contract with a customer may give the customer a choice of
whether to purchase additional goods or services. In some cases, options for
additional goods or services are marketing or promotional efforts to gain future
contracts with customers. However, in other cases, such options may be considered
performance obligations, which are referred to as material rights. While the
determination of whether a customer option for additional goods or services gives
rise to a material right should be performed as part of step 2, there are many
considerations related to material rights that affect the other steps of the revenue
recognition model. Accordingly, material right considerations are discussed
separately in Chapter 11.
5.2 Promises in Contracts With Customers
5.2.1 In General
Identification of all promises in a contract is important because promises are what comprise
performance obligations and entities recognize revenue on the basis of the satisfaction of performance
obligations. ASC 606-10-25-18 lists examples of what could constitute a promise in a contract:
ASC 606-10
25-18 Depending on the
contract, promised goods or services may include, but
are not limited to, the following:
-
Sale of goods produced by an entity (for example, inventory of a manufacturer)
-
Resale of goods purchased by an entity (for example, merchandise of a retailer)
-
Resale of rights to goods or services purchased by an entity (for example, a ticket resold by an entity acting as a principal, as described in paragraphs 606-10-55-36 through 55-40)
-
Performing a contractually agreed-upon task (or tasks) for a customer
-
Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use as and when the customer decides
-
Providing a service of arranging for another party to transfer goods or services to a customer (for example, acting as an agent of another party, as described in paragraphs 606-10-55-36 through 55-40)
-
Granting rights to goods or services to be provided in the future that a customer can resell or provide to its customer (for example, an entity selling a product to a retailer promises to transfer an additional good or service to an individual who purchases the product from the retailer)
-
Constructing, manufacturing, or developing an asset on behalf of a customer
-
Granting licenses (see paragraphs 606-10-55-54 through 55-60 and paragraphs 606-10-55-62 through 55-65B)
-
Granting options to purchase additional goods or services (when those options provide a customer with a material right, as described in paragraphs 606-10-55-41 through 55-45).
5.2.2 Implied Promises
ASC 606-10
25-16 A contract with a customer generally explicitly states the goods or services that an entity promises to
transfer to a customer. However, the promised goods and services identified in a contract with a customer may
not be limited to the goods or services that are explicitly stated in that contract. This is because a contract with
a customer also may include promises that are implied by an entity’s customary business practices, published
policies, or specific statements if, at the time of entering into the contract, those promises create a reasonable
expectation of the customer that the entity will transfer a good or service to the customer.
For some contracts, it will be easy to identify all promises because they are
all specifically stated. However, the FASB and IASB decided to require entities
to identify the implied promises as well. The reason for the boards’ decision,
as discussed in paragraph BC87 of ASU 2014-09, was to ensure that all
of the promises in a contract are appropriately identified so that when an
entity allocates consideration to the performance obligations identified, it
will recognize revenue when control of all of the promised goods and services in
the contract is transferred to the customer. Paragraph BC87 goes on to state,
“The Boards also noted that the implied promises in the contract do not need to
be enforceable by law. If the customer has a valid[1] expectation, then the customer would view those promises as part of the
negotiated exchange (that is, goods or services that the customer expects to
receive and for which it has paid).” Therefore, promises that an entity’s
customer reasonably expects the entity to fulfill even though they are not
explicitly stated in the contract are implied promises that should be accounted
for.
Connecting the Dots
Software companies may be familiar with identifying implied promises through
software upgrades and updates that are not explicitly identified in the
arrangement. In addition, a manufacturer of furniture may provide a
written warranty to its customers to repair the products in the first
year after purchase. However, if the manufacturer also has historically
provided repairs free of charge beyond the first year in accordance with
the manufacturer’s customary business practice, an implied promise may
exist.
The concept of implied promises is important because if an entity does not identify an implied promise in a contract,
it could recognize revenue at the wrong time. For example, the entity could recognize all
revenue from the contract because it has satisfied all explicitly stated promises in the contract.
However, because the entity still has an unidentified implied promise to satisfy for the customer,
no consideration was allocated to that promise. As a result, the entity recognized more revenue
from the contract than it should have at that point.
The guidance on implied promises will require an entity to use judgment to
determine whether a customer has a reasonable expectation based on
customary business practices or the entity’s previous transactions with
the customer that the entity will provide a good or service not
specifically stated in the contract.
5.2.2.1 Illustrative Examples in ASC 606 of Explicit and Implicit Promises (ASC 606-10-55-151 Through 55-157A)
Cases A, B, and C of Example 12 in ASC 606, which are reproduced below, further discuss explicit and
implicit promises.
ASC 606-10
Example 12 — Explicit and Implicit Promises in a Contract
55-151 An entity, a manufacturer, sells a product to a distributor (that is, its customer), who will then resell it to
an end customer.
Case A — Explicit Promise of Service
55-152 In the contract with the distributor, the entity promises to provide maintenance services for no
additional consideration (that is, “free”) to any party (that is, the end customer) that purchases the product from
the distributor. The entity outsources the performance of the maintenance services to the distributor and pays
the distributor an agreed-upon amount for providing those services on the entity’s behalf. If the end customer
does not use the maintenance services, the entity is not obliged to pay the distributor.
55-153 The contract with the customer includes two promised goods or services — (a) the product and (b) the
maintenance services (because the promise of maintenance services is a promise to transfer goods or services
in the future and is part of the negotiated exchange between the entity and the distributor). The entity assesses
whether each good or service is distinct in accordance with paragraph 606-10-25-19. The entity determines
that both the product and the maintenance services meet the criterion in paragraph 606-10-25-19(a). The
entity regularly sells the product on a standalone basis, which indicates that the customer can benefit from
the product on its own. The customer can benefit from the maintenance services together with a resource the
customer already has obtained from the entity (that is, the product).
55-153A The entity further
determines that its promises to transfer the product
and to provide the maintenance services are
separately identifiable (in accordance with
paragraph 606-10-25-19(b)) on the basis of the
principle and the factors in paragraph 606-10-25-21.
The product and the maintenance services are not
inputs to a combined item in this contract. The
entity is not providing a significant integration
service because the presence of the product and the
services together in this contract do not result in
any additional or combined functionality. In
addition, neither the product nor the services
modify or customize the other. Lastly, the product
and the maintenance services are not highly
interdependent or highly interrelated because the
entity would be able to satisfy each of the promises
in the contract independent of its efforts to
satisfy the other (that is, the entity would be able
to transfer the product even if the customer
declined maintenance services and would be able to
provide maintenance services in relation to products
sold previously through other distributors). The
entity also observes, in applying the principle in
paragraph 606-10-25-21, that the entity’s promise to
provide maintenance is not necessary for the product
to continue to provide significant benefit to the
customer. Consequently, the entity allocates a
portion of the transaction price to each of the two
performance obligations (that is, the product and
the maintenance services) in the contract.
Case B — Implicit Promise of Service
55-154 The entity has historically provided maintenance services for no additional consideration (that is, “free”)
to end customers that purchase the entity’s product from the distributor. The entity does not explicitly promise
maintenance services during negotiations with the distributor, and the final contract between the entity and the
distributor does not specify terms or conditions for those services.
55-155 However, on the basis of its customary business practice, the entity determines at contract inception
that it has made an implicit promise to provide maintenance services as part of the negotiated exchange with
the distributor. That is, the entity’s past practices of providing these services create reasonable expectations of
the entity’s customers (that is, the distributor and end customers) in accordance with paragraph 606-10-25-16.
Consequently, the entity assesses whether the promise of maintenance services is a performance obligation.
For the same reasons as in Case A, the entity determines that the product and maintenance services are
separate performance obligations.
Case C — Services Are Not a Promised Service
55-156 In the contract with the distributor, the entity does not promise to provide any maintenance services.
In addition, the entity typically does not provide maintenance services, and, therefore, the entity’s customary
business practices, published policies, and specific statements at the time of entering into the contract have
not created an implicit promise to provide goods or services to its customers. The entity transfers control of
the product to the distributor and, therefore, the contract is completed. However, before the sale to the end
customer, the entity makes an offer to provide maintenance services to any party that purchases the product
from the distributor for no additional promised consideration.
55-157 The promise of maintenance is not included in the contract between the entity and the distributor
at contract inception. That is, in accordance with paragraph 606-10-25-16, the entity does not explicitly or
implicitly promise to provide maintenance services to the distributor or the end customers. Consequently, the
entity does not identify the promise to provide maintenance services as a performance obligation. Instead, the
obligation to provide maintenance services is accounted for in accordance with Topic 450 on contingencies.
55-157A Although the maintenance services are not a promised service in the current contract, in future
contracts with customers the entity would assess whether it has created a business practice resulting in an
implied promise to provide maintenance services.
5.2.2.2 Accounting for Virtual Goods
Many developers of online games allow customers to access
and play the games for no charge. Rather than licensing the software to
their customers, the developers generally host the software for their
customers to access. Arrangements that allow customers of online game
developers to access and play online games are accounted for as a service
(hosted software as a service [SaaS]) rather than as the transfer of a
software license because the customers typically cannot take possession of
the software associated with the online games.
To enhance the gaming experience of customers who can access and play online
games for no charge, online game developers may give them the option to
purchase virtual goods or services (i.e., virtual items). These virtual
items are generally classified as either (1) consumables (i.e., items that
are consumed by a specific action and are no longer available to a customer
once consumed, such as virtual groceries) or (2) durables (i.e., items that
are accessible to a customer for use throughout the entire game, such as a
virtual house). In addition, customers may have the ability to purchase
virtual currency, which enables them to purchase other virtual items.
In effect, customers are enhancing their gaming experience
through optional purchases. Some of these purchases are “consumed” by a
player immediately or shortly after he or she gains access to them, and
others are consumed by the player over time. Nevertheless, even when an item
is consumed immediately, it may still have an ongoing effect on the player’s
gaming experience (e.g., if consumption of the item enables the player to
reach another level that would otherwise have been inaccessible).
Generally, a developer is not contractually obligated to continue making an
online game available to a customer. Further, a developer can terminate a
customer’s account at any time for no cause, regardless of whether the
customer has purchased virtual items. Nevertheless, many developers have a
customary business practice of notifying customers when they are planning to
shut down an online game, although such notification is not contractually
required.
Generally, an implied promise would exist since the developer has implicitly
promised to provide hosting services after the customer purchases a virtual
item. Without the hosting services, the customer would not be able to use
and benefit from the enhanced gaming experience that it receives through the
game as a result of purchasing the virtual item. Although the developer is
not contractually obligated (i.e., it has not explicitly promised) to
continue hosting the online game for the customer, it has established a
customary business practice of (1) continuing to host the online game and
(2) notifying customers when it is planning to shut down the game. The
developer’s customary business practice creates a reasonable expectation
that the developer will continue to host the software so that the virtual
item (or the enhanced gaming experience derived from the virtual item) will
remain available to the customer.
A developer should carefully consider the nature of the
implied promise to its customer in determining the appropriate recognition
model. Customers often simultaneously receive and consume the benefits of
the developer’s performance of making the hosted software available to the
customer. Consequently, the developer may determine that it should recognize
revenue for its implied promise either at a point in time (e.g., upon
consumption) or over time by using a method that faithfully depicts its
performance in transferring control of the promised services (i.e., the
benefits of the enhanced gaming experience related to the purchase of
virtual items promised to the customer). Immediate recognition of revenue at
the point in time when a customer purchases a virtual item may not be
appropriate if the benefits of the enhanced gaming experience are provided
over time. Rather, the entity may need to consider the period over which the
customer benefits from the enhanced gaming experience that it receives by
purchasing the virtual item when determining the appropriate period and
pattern of revenue recognition.
We believe that the following may be relevant factors for an entity to
consider in making this assessment:
- Whether the nature of the implied promise is to provide an enhanced gaming experience through the hosted service over time or to enable the player to consume virtual items.
- The period over which the enhanced gaming experience is provided if the benefits are consumed throughout the hosting period (e.g., user life, gaming life).
- The life span over which, or number of times, the virtual item may be accessed or used.
- Whether the virtual item must be used immediately or may be stored for later use.
- How and over what period the virtual item benefits the customer’s gaming experience (e.g., a consumable such as a virtual meal that is used immediately vs. a durable that allows a player to “level up” within the game in such a way that the increased performance continues to enhance the gaming experience).
- Whether the benefit of purchasing the virtual item on the customer’s gaming experience is temporary or permanent.
For additional information about the timing of revenue recognition, see
Chapter 8.
5.2.3 Immaterial Promises
ASC 606-10
25-16A An entity is not
required to assess whether promised goods or services
are performance obligations if they are immaterial in
the context of the contract with the customer. If the
revenue related to a performance obligation that
includes goods or services that are immaterial in the
context of the contract is recognized before those
immaterial goods or services are transferred to the
customer, then the related costs to transfer those goods
or services shall be accrued.
25-16B An entity shall not apply the guidance in paragraph 606-10-25-16A to a customer option to acquire
additional goods or services that provides the customer with a material right, in accordance with paragraphs
606-10-55-41 through 55-45.
When the FASB and IASB were developing the revenue standard, they received
feedback, as noted in paragraph BC88 of ASU 2014-09, that there can be
situations in which promises in contracts could be considered “marketing
expenses or incidental obligations.” The boards considered the feedback but
decided that allowing management to determine whether promises are a marketing
expense would result in too much subjectivity on the part of management and
therefore could lead to inconsistent application of the concept. As a result,
the boards determined that every promise, either on its own or jointly with
other promises, should give rise to a performance obligation.
Paragraph BC90 of ASU 2014-09 notes that the boards “decided not to exempt an
entity from accounting for performance obligations that the entity might regard
as being perfunctory or inconsequential. Instead, an entity should assess
whether those performance obligations are immaterial to its financial
statements.”
However, questions arose about whether it was necessary for an entity to
identify immaterial goods or services when identifying performance
obligations.
In April 2016, the FASB issued ASU 2016-10,2 which states that an entity “is not required to assess whether promised
goods or services are performance obligations if they are immaterial in the
context of the contract with the customer.” In addition, the ASU indicates that
an entity should consider materiality of items or activities only at the
contract level (as opposed to aggregating such items and performing an
assessment at the financial statement level). This change should not apply to an
entity’s assessment of optional goods and services offered to a customer, which
the entity must evaluate under ASC 606-10-55-42 and 55-43 to determine whether
they give the customer a material right (i.e., an optional good offered for free
or at a discount, such as that provided through loyalty point programs, may not
be material for an individual contract but could be material in the aggregate
and accounted for as a material right). Material rights are further discussed in
Chapter 11.
ASU 2016-10 permits entities to choose not to evaluate whether immaterial items
or activities represent performance obligations. Thus, the exclusion of such
immaterial items or activities under the revenue standard would not be
considered a departure from GAAP and need not be aggregated as a
misstatement.
5.2.3.1 Accounting for Perfunctory or Inconsequential Performance Obligations
Under ASC 606, perfunctory or inconsequential promises in a
contract may be, but are not presumed to be, immaterial in the context of
the contract.
Example 5-1
Entity X enters into a contract to
transfer Product A and Item B to a customer. Product
A and Item B meet the criteria in ASC 606-10-25-19
to be considered distinct and do not meet the
criteria in ASC 606-10-25-14(b) (i.e., they do not
constitute a series of distinct goods or services
that are substantially the same and have the same
pattern of transfer to the customer). Item B may be
either a substantive promise in the arrangement
(e.g., free maintenance on Product A for two years)
or inconsequential (e.g., certain promises to
participate in a joint committee, delivery of an
installation or training manual, a simple
installation process that only requires unpacking
and plugging in, a simple inspection service).
Even if Item B is considered
perfunctory or inconsequential, X cannot ignore the
guidance in ASC 606 when determining whether and, if
so, how to account for it. Perfunctory or
inconsequential promises in a contract may be, but
are not presumed to be, immaterial in the context of
the contract. As a result, X may need to reevaluate
historical conclusions by using the framework
outlined in ASC 606-10-25-16A and 25-16B.
5.2.3.2 Framework for Identifying Immaterial Promised Goods or Services
ASC 606-10-25-16A and 25-16B (reproduced in Section 5.2.3) provide guidance on
immaterial goods and services. Stakeholders have asked about the framework
an entity should use to identify a potential good or service that is
immaterial in the context of the contract. We believe that the following
considerations are relevant to the assessment of whether a good or service
is immaterial in the context of the contract:
-
An entity may conclude that a potential good or service is immaterial in the context of the contract if the estimated stand-alone selling price of the potential good or service is immaterial (quantitatively) compared with the total consideration in the contract (i.e., the amount that would be allocated to such good or service is immaterial in the context of the contract).
-
An entity may conclude that a potential good or service is immaterial in the context of the contract if it determines that the customer does not consider the potential good or service material to the contract (i.e., the entity would evaluate qualitative factors, including the customer’s perspective, in determining whether a potential good or service is immaterial in the context of the contract).
-
An entity may conclude that a potential good or service is immaterial in the context of the contract if it determines that the customer would have entered into the contract and paid the same (or similar) consideration if the potential good or service was excluded from the contract.
In addition, we think that when an entity performs an
assessment to identify immaterial promised goods or services, it should also
consider the guidance in ASC 606-10-25-16B on customer options (i.e.,
potential material rights) as well as the SEC staff’s view of “material” as
discussed in SAB
Topic 1.M. For additional information about the
accounting for material rights, see Chapter
11.
5.2.4 Consideration of Activities
ASC 606-10
25-17 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.
There is a difference between promises and activities in contracts. The FASB and
IASB wanted this to be clear because the revenue standard is based on
recognizing revenue as an entity transfers control of goods or services to
customers. When an entity promises goods and services to customers, it is going
to transfer those goods or services to the customers. In contrast, activities
that an entity is required to undertake to fulfill promises in a contract do not
necessarily transfer goods or services to the customer. Therefore, since the
completion of an activity does not represent transfer of control, an entity
would not recognize revenue on the basis of the completion of an activity.
5.2.4.1 Assessing Whether a Preproduction Activity Forms Part of the Delivery of a Promised Good or Service
In some long-term supply arrangements, before goods can be
delivered to a customer, an entity may be required to undertake
preproduction activities such as “up-front” engineering and design (e.g., to
create new technology or adapt existing technology to the needs of the
customer). Because of the nature of the underlying tasks, preproduction
activities are often carried out over time.
If a preproduction activity transfers a good or service to a
customer as the preproduction activity is carried out, it will be
appropriate, subject to the other requirements of ASC 606, to recognize
revenue as the preproduction activity is carried out.3
If a preproduction activity does not transfer a good or
service to a customer as the preproduction activity is carried out, no
revenue should be recognized as the preproduction activity is carried out.
Instead, the associated costs should either be capitalized (e.g., if they
meet the criteria in ASC 340-40-25-5) or expensed as incurred.
When performing an assessment of whether preproduction
activities transfer a good or service to a customer, an entity should
identify the nature of its promise(s) to the customer to determine whether
the preproduction activity represents either of the following:
-
A promised good or service (or part of a promised good or service) that is transferred to the customer.
-
A fulfillment activity that does not transfer a good or service to the customer.
In making this determination, an entity will need to use
judgment. In addition to the guidance in ASC 606-10-25-14 through 25-22 on
identifying performance obligations, an entity might look to the guidance in
ASC 606-10-25-27 through 25-29 on satisfying a performance obligation over
time.
One scenario in which a performance obligation is satisfied
over time is when the “customer simultaneously receives and consumes the
benefits provided by the entity’s performance as the entity performs” (see
ASC 606-10-25-27(a)). A determination that the customer simultaneously
receives and consumes benefits as the entity carries out the preproduction
activity would indicate that the preproduction activity is, or forms part
of, a performance obligation. In the entity’s assessment of whether the
customer simultaneously receives and consumes benefits, it may be helpful to
consider, in accordance with ASC 606-10-55-6, whether another entity would
need to substantially reperform the preproduction activities if that other
entity were to fulfill the remaining performance obligation to the customer.
When making this assessment, the reporting entity should assume that the
other entity would not have the benefit of any asset that the reporting
entity would continue to control if the contract were terminated.
Another scenario in which a performance obligation is
satisfied over time is when the entity’s performance creates or enhances an
asset that the customer controls as the asset is created or enhanced. A
determination that the preproduction activity creates or enhances an asset
that the customer controls as the asset is created or enhanced would
indicate that the preproduction activity is, or forms part of, a performance
obligation.
Example 5-2
An entity enters into a contract
with a customer to develop and produce a new
product. As part of its development of that new
product for the customer, the entity performs
engineering and development activities. The entity
determines that (1) the customer will own the
intellectual property (patents) that results from
those activities and (2) those activities are
creating an asset that the customer controls as the
asset is created.
Accordingly, the entity concludes
that (1) the engineering and development activities
are transferring a good or service to the customer
over time and (2) those activities are, or form part
of, the performance obligation(s) in the contract
with the customer.
The above issue is addressed in Q&A 16 (compiled from
previously issued TRG Agenda Papers 46 and 49) of the FASB staff’s Revenue Recognition Implementation Q&As
(the “Implementation Q&As”). For additional information and Deloitte’s
summary of issues discussed in the Implementation Q&As, see Appendix C.
5.2.4.2 Promise to Stand Ready to Accept a Returned Product
Entities often offer customers the right to return a product
within a certain period after its initial sale, provided that the product
has not been used or damaged. ASC 606-10-55-24 states that an “entity’s
promise to stand ready to accept a returned product during the return period
should not be accounted for as a performance
obligation in addition to the obligation to provide a refund”
(emphasis added). Therefore, a right of return is not a separate performance
obligation. However, a customer’s right to return a product may affect the
amount of revenue recognized (the transaction price) because revenue may
only be recognized for goods that are not expected to be returned.
For further discussion of sales with a right of return, see Section
6.3.5.3. For stand-ready obligations to provide goods or
services, see Section
5.4.3.
5.2.4.3 Shipping and Handling Activities
ASC 606-10
25-18A An entity that promises a good to a customer also might perform shipping and handling activities
related to that good. If the shipping and handling activities are performed before the customer obtains control
of the good (see paragraphs 606-10-25-23 through 25-30 for guidance on satisfying performance obligations),
then the shipping and handling activities are not a promised service to the customer. Rather, shipping and
handling are activities to fulfill the entity’s promise to transfer the good.
25-18B If shipping and handling activities are performed after a customer obtains control of the good, then
the entity may elect to account for shipping and handling as activities to fulfill the promise to transfer the good.
The entity shall apply this accounting policy election consistently to similar types of transactions. An entity that
makes this election would not evaluate whether shipping and handling activities are promised services to its
customers. If revenue is recognized for the related good before the shipping and handling activities occur, the
related costs of those shipping and handling activities shall be accrued. An entity that applies this accounting
policy election shall comply with the accounting policy disclosure requirements in paragraphs 235-10-50-1
through 50-6.
Stakeholders asked the FASB to clarify whether shipping and handling services
that do not represent the predominant activity in the contract should be
accounted for as a promised service (i.e., potentially a separate
performance obligation to which a portion of the transaction price must be
allocated) or as a fulfillment cost that should be accounted for under the
new fulfillment cost guidance in ASC 340-40.
In April 2016, the FASB issued ASU 2016-10,4 which provides a practical expedient that permits an entity to account
for shipping and handling activities that occur after the customer has
obtained control of a good as fulfillment activities (i.e., an expense)
rather than as a promised service (i.e., a revenue element). An entity may
also elect to account for shipping and handling activities that occur after
control of the good is transferred to the customer as a promised service.
When the practical expedient is elected and revenue for the related good is
recognized before the shipping and handling activities occur, the entity
should accrue the costs of the shipping and handling activities at the time
control of the related good is transferred to the customer (i.e., at the
time of sale).
ASU 2016-10 also explains that shipping and handling activities performed before control of a product
is transferred do not constitute a promised service to the customer in the contract (i.e., they represent
fulfillment costs).
Connecting the Dots
The election to account for shipping and handling services as a promised service (a revenue
element) or a fulfillment activity (a cost element) typically should not apply to entities whose
principal service offering is shipping or transportation. Further, we believe that such election
(1) should be applied consistently and (2) is available to entities that recognize revenue for the
sale of goods either at a point in time or over time.
In a speech at the 2017 AICPA Conference on Current SEC and PCAOB Developments, Barry Kanczuker, associate chief accountant in the SEC’s Office of the Chief Accountant (OCA), provided the following guidance on the classification of shipping and handling expenses:
The staff has received questions under Topic 606 regarding the classification of shipping and handling expenses. Under Topic 606, if the shipping and handling activities are performed before the customer obtains control of the good, a registrant would account for the shipping and handling as activities to fulfill the promise to transfer the good. If shipping and handling is performed after a customer obtains control of the good, an entity may either account for shipping and handling as a promised service to the customer or elect to account for shipping and handling as activities to fulfill the promise to transfer the good. The questions we received related specifically to those shipping and handling expenses that were accounted for as activities to fulfill the promise to transfer the good, and these questions arose because the prior guidance on classification of shipping and handling expenses, and the explicit policy election regarding classification of such costs, was superseded by the new revenue standard, which now does not include any guidance that addresses the classification of shipping and handling expenses.
Given the noted absence of any guidance, I believe an entity will need to apply reasonable judgment in determining the appropriate classification of shipping and handling expenses for those shipping and handling activities that are accounted for as activities to fulfill the promise to transfer the good. Hence, the staff noted it would not object to the following approaches. First, the staff noted that it would not object to classification of these expenses within cost of sales. Second, given that there is no explicit guidance within Topic 606 related to the classification of shipping and handling expenses, the staff noted that it also would not object to an entity continuing to apply its previous policy regarding classification of these expenses, which could potentially be outside of cost of sales. I believe that a registrant that classifies significant shipping and handling costs outside of cost of sales should consider whether it should disclose the amount of such costs and the line item or items on the income statement that include them, similar to the disclosures required under the previous guidance. [Footnotes omitted]
5.2.4.4 Mobilization Activities
In some industries, entities may perform “mobilization” activities at or near
contract inception to fulfill their performance obligations under contracts
within the scope of ASC 606 (e.g., transportation of equipment to the
construction site). Questions have arisen about how an entity should account
for such mobilization activities. Frequently, these activities do not result
in the transfer of a good or service to the customer; rather, they represent
set-up activities and are therefore not accounted for as part of the
performance obligation(s) in the contract with the customer. Refer to
Section
13.3.5 for a discussion about the accounting for incurred
costs related to set-up activities and mobilization.
Footnotes
[1]
In April 2016, the FASB issued ASU 2016-10.
As a result of ASU 2016-10, the customer’s “valid” expectation, as
discussed in paragraph BC87 of ASU 2014-09, was changed to the
customer’s “reasonable” expectation under ASC 606-10-25-16.
2
The IASB did not amend IFRS 15 to expressly address
immaterial promises. Accordingly, IFRS 15 does not include similar
guidance on determining the materiality of promised goods or services.
Rather, an entity’s overall materiality considerations should be used in
the evaluation of promised goods or services under IFRS 15. The boards
do not expect a significant difference in application. For a summary of
differences between U.S. GAAP and IFRS Accounting Standards on
revenue-related topics, see Appendix A.
3
Such a preproduction activity could be a performance
obligation in its own right or could form part of a larger
performance obligation.
4
The IASB did not amend IFRS 15 to expressly address
shipping and handling activities. Accordingly, IFRS 15 does not
include similar elections. See Appendix A for a summary of
differences between U.S. GAAP and IFRS Accounting Standards on
revenue-related topics.
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.
-
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.
-
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 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. 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.
-
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.8
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
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).
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.”9
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.”10 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.
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.
5.3.3.4 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
5
See paragraph BC98 of ASU 2014-09.
6
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.
7
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.
8
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.
10
Quoted from Implementation Q&A 19
(compiled from previously issued TRG Agenda Papers 27 and
34).
5.4 Defining the Nature of the Promise
5.4.1 In General
As previously discussed, performance obligations can vary greatly across industries, within industries,
and even within a company. An entity must assess its contracts with customers to determine what
performance obligations it needs to satisfy. Once it completes this task, the entity will have to determine
the appropriate pattern of satisfaction of the performance obligations (see Chapter 8 for discussion
of step 5). As noted in paragraph BC159 of ASU 2014-09, an entity does not have a “free choice” in
determining the appropriate method for measuring progress toward satisfaction of the performance
obligations; rather, the entity should use judgment to choose a measurement method that faithfully represents
the pattern of satisfaction of the performance obligation. To accomplish this, the entity should assess
the nature of the promises in its performance obligations (i.e., consider how and when it will satisfy its
performance obligations).
5.4.2 Impact of Exclusivity on the Identification of Performance Obligations
Certain contracts with customers may include conditions related
to exclusivity that restrict the entity’s ability to sell goods or services to
other customers or in certain geographies. The exclusivity may be limited in
time or may be indefinite.
For example, an entity may provide a customer with an exclusive
license of IP, thus preventing the entity from issuing licenses of that IP to
other customers. Alternatively, an entity may enter into an exclusive
distribution arrangement to provide goods or services to a customer in a
specific geographic area, thereby limiting the entity’s ability to sell goods or
services to other customers in that geographic area.
Generally, it is not appropriate to identify exclusivity as a
performance obligation in a contract with a customer.
In paragraph BC412(b) of ASU 2014-09, the FASB and IASB
discussed the effect of exclusivity clauses in the context of licenses of IP.
They acknowledged that many respondents to the boards’ 2010 exposure draft on
revenue “explained that a distinction based on exclusivity was inconsistent with
the control principle because exclusivity does not affect the determination of
the entity’s performance.” In addition, the boards noted that “exclusivity is
another restriction that represents an attribute . . . rather than the nature of
the underlying intellectual property or the entity’s promise in granting a
license.” As a result, exclusivity is not accounted for separately in a license
arrangement.
Although the discussion above was in the context of licenses of
IP, the comments made are equally valid in the context of other goods and
services. Accordingly, exclusivity would generally be seen as an attribute of
the goods or services supplied, as opposed to a separate promise in itself,
because exclusivity does not affect the nature of the entity’s performance to
provide the underlying goods or services.
5.4.3 Stand-Ready Obligations
Contracts promise specific goods and services, but sometimes they also promise
to deliver those goods and services over a specified period. ASC 606-10-25-18(e)
describes a service of “standing ready” to provide goods or services
(“stand-ready obligation”). The customer receives and consumes a benefit from a
stand-ready obligation — namely, the assurance that a service (e.g., snow
removal during the winter) is available to the customer when and if needed or
called upon. When an entity enters into a contract with a customer and agrees to
make itself available to provide goods and services to the customer over a
specified period, such a promise is generally viewed as a stand-ready
obligation. In this type of arrangement, (1) a customer may make requests of the
entity to deliver some or all of the goods and services at some point during the
period defined in the contract, or (2) the delivery of some or all of the goods
and services on a when-and-if-available basis may be in the control of the
entity.
The TRG discussed stand-ready obligations because of the
concerns and questions that stakeholders have raised. Stakeholders have
identified four broad types of promises or arrangements that may constitute
stand-ready obligations, including those for which the obligation to deliver
goods or services is:
-
Within the entity’s control, but for which additional development of the goods, services, or IP is required (“Type A”).
-
Outside both the entity’s and the customer’s control (“Type B”).
-
Solely within the customer’s control (“Type C”).
The fourth category identified is promises to make an entity’s
goods or services available to the customer continuously over the contractual
period — such as a health club membership, which is the only example of
measuring progress toward completion of a stand-ready obligation in the revenue
standard11 (“Type D”). A potential way to account for a Type D arrangement is for the
entity to record revenue ratably over the performance period on a straight-line
basis. Straight-line revenue recognition results because (1) the customer is
required to pay regardless of how frequently he or she uses the health club and
(2) the entity stands ready to make its goods or services available to the
customer on a constant basis over the contract period.
Because the revenue standard provides an example of Type D
arrangements but not others, questions have arisen regarding the identification
of other stand-ready obligations (i.e., Types A through C) and how to
appropriately measure progress toward completion of delivering the promised
goods or services. Specifically, views differ on (1) what constitutes the nature
of the promise in the aforementioned arrangements (e.g., whether it is the act
of standing ready or the actual delivery of the goods or services to the
customer) and (2) the methods used to measure progress toward the complete
satisfaction of a stand-ready obligation (e.g., a time-based, input, or output
method).
Entities will need to use judgment when evaluating arrangements
that have characteristics of Types A through C as described above. Sections 5.4.3.1 and 5.4.3.2 provide additional guidance to help
entities make the necessary judgments.
5.4.3.1 Assessing Whether a Promise Is a Stand-Ready Performance Obligation
Distinguishing a performance obligation to deliver goods or
services from a stand-ready obligation to deliver goods or services may be
complex and will require an entity to consider the arrangement’s relevant
facts and circumstances. However, an entity should begin by identifying the
nature of the promise in the contract. For example, the determination of
whether the promise is an obligation to provide one or more defined goods or
services or is instead an obligation to provide an unknown type or quantity
of goods or services might be a strong indicator of the nature of the
entity’s promise in the contract. While in either case the entity
might be required to “stand ready” to deliver the good(s) or service(s)
whenever called for by the customer or upon the occurrence of a contingent
event (e.g., snowfall), the fact that the entity will not know when or how
extensively the customer will receive the entity’s good(s) or service(s)
during the contract term may be a strong indicator that the entity is
standing ready to perform.
Example 18 in ASC 606-10-55-184 through 55-186 discusses
stand-ready obligations in health club memberships. The example notes that
the entity’s promise is to provide a service of making the health clubs
available because the extent to which a customer uses the health clubs does
not affect the amount of the remaining goods and services to which the
customer is entitled. This is consistent with the discussion in paragraph
BC160 of ASU 2014-09.
Other examples of stand-ready performance obligations may
include the following:
-
Snow removal services — An entity promises to remove snow on an “as needed” basis. In this type of arrangement, the entity does not know and most likely cannot reasonably estimate whether, how often, and how much it will snow. This suggests that the entity’s promise is to stand ready to provide these services on a when-and-if-needed basis.
-
Software updates and upgrades — An entity promises to make unspecified (i.e., when-and-if-available) software updates and upgrades available to a customer, and the entity has no discernible pattern of providing updates and upgrades. The nature of the entity’s promise is fundamentally one of providing the customer with assurance that any updates or upgrades developed by the entity during the period will be made available because the entity stands ready to transfer updates or upgrades when and if they become available.
-
SaaS — An entity promises to make its SaaS available to the customer, and the customer has unlimited usage of the SaaS over the contract term.
-
Extended warranty — A customer purchases an extended product warranty for a good (e.g., equipment), and the entity promises to remediate any issues with the product when and if problems arise. That is, the entity is standing ready to make repairs when and if needed. For further discussion, see Connecting the Dots below.
See Section 8.5.10 for
additional considerations on measuring progress toward the complete
satisfaction of a stand-ready obligation that is satisfied over time.
The above issue is addressed in Implementation Q&A 22 (compiled from previously
issued TRG Agenda Papers 16 and 25). For additional information and Deloitte’s summary
of issues discussed in the Implementation Q&As, see Appendix C.
Connecting the Dots
In Implementation Q&A 22, the FASB staff discusses
maintenance contracts under which a customer would receive repair or
maintenance services as needed over a prescribed period. The Q&A
states the following:
The staff thinks that whether the obligation is
to provide a defined good or service (or goods or services), or
instead, to provide an unknown type or quantity of goods or
services might be a strong indicator as to the nature of the
entity’s promise in the contract. The staff notes, however, that
in either case the entity might be required to “stand ready” to
deliver the good(s) or service(s) whenever the customer calls
for them or upon the occurrence of a contingent event (for
example, snowfall).
If an entity has entered into maintenance contracts to
provide maintenance services on equipment only on an as-needed basis, it
may be appropriate for the entity to account for its performance
obligations under those contracts as stand-ready obligations by
recording revenue as the stand-ready services are provided. However, the
entity must evaluate its contracts that include maintenance goods or
services to determine the nature of its promises on the basis of the
specific facts and circumstances of each contract.
Assessing whether the promise in a maintenance contract
is a stand-ready obligation will require judgment. However, an entity
may consider indicators supporting a conclusion that a stand-ready
obligation does not exist. Such indicators include, but are not limited
to, the following:
-
The contract contains a promise to provide services that is specific about amounts and timing, as opposed to a promise to provide services as needed.
-
The services vary in nature, frequency, or complexity each time they are performed.
-
The goods or services are highly integrated or interrelated as a result of the complexity involved in providing them, making it difficult for another entity to take over the maintenance services.
-
Modifications to the contract often include promises for specific additional goods or services.
If an entity concludes that it does not have a
stand-ready obligation, it would account for the goods or services on
the basis of the specific promises in the contract.
5.4.3.2 Determining Whether a Contract Includes a Stand-Ready Obligation or an Obligation to Provide a Defined Amount of Goods or Services
It will sometimes be necessary to determine whether the
nature of an entity’s promise under a contract is (1) to stand ready to
provide goods or services or (2) to provide a defined amount of discrete
goods or services. A promise to stand ready to provide goods or services is
often satisfied over time as the customer benefits from being able to call
upon a resource if and when needed throughout the stand-ready obligation
period. However, an obligation to provide a defined amount of discrete goods
or services is satisfied when or as those discrete goods or services are
transferred to the customer.
An entity may be required to use judgment to distinguish
between a stand-ready obligation and an obligation to provide a defined
amount of goods or services. It will often be helpful for an entity to focus
on the extent to which a customer’s use of a resource affects the remaining
resources to which the customer is entitled. A determination that the nature
of the entity’s obligation to the customer is to provide resources as and
when required by the customer and that the customer’s future entitlement is
unaffected by the extent to which resources have already been provided is
indicative of a stand-ready obligation. In contrast, a determination that
the contract is to supply a specified number of units of the resource and
that the remaining entitlement diminishes as each unit is consumed is
indicative of an obligation to provide a defined amount of goods or
services.
Paragraph BC160 of ASU 2014-09 discusses the concept of a
stand-ready obligation as follows:
To meet [the]
objective of depicting the entity’s performance, an entity would need to
consider the nature of the promised goods or services and the nature of
the entity’s performance. For example, in a typical health club
contract, the entity’s promise is to stand ready for a period of time
(that is, by making the health club available), rather than providing a
service only when the customer requires it. In this case, the customer
benefits from the entity’s service of making the health club available.
This is evidenced by the fact that the extent to
which the customer uses the health club does not, in itself, affect
the amount of the remaining goods or services to which the customer
is entitled. In addition, the customer is obliged to pay the
consideration regardless of whether it uses the health club.
Consequently, in those cases, the entity would need to select a measure
of progress based on its service of making goods or services available
instead of when the customer uses the goods or services made available
to them. [Emphasis added]
Example 5-11
Company X enters into a software
arrangement with Customer Y, who pays up-front
nonrefundable consideration in exchange for a
software license and a specified quantity of service
credits. The credits can be redeemed for consulting
services as and when needed by the customer over a
three-year term.
Each credit is equivalent to a
predetermined number of consulting hours. The
agreement requires X to be available to provide
consulting services in exchange for credits when
requested by Y. The credits expire after the
three-year term; however, customers generally use
all of their credits.
As discussed above, for an entity to
distinguish between a stand-ready obligation and an
obligation to provide a defined amount of goods or
services, it will often be helpful to focus on the
extent to which the customer’s use of a resource
affects the remaining resources to which the
customer is entitled.
In the circumstances described, Y
pays in advance for a defined amount of consulting
services to be provided by X when and if needed by
Y. In contrast to the example in paragraph BC160 of
ASU 2014-09, when Y redeems credits for consulting
services, this does affect the amount of the
remaining services to which it is entitled,
indicating that X’s promise is to deliver specified
services rather than to stand ready.
In this example, assuming that X
does not expect to be entitled to breakage, X should
recognize revenue as the consulting services are
provided to Y for redeemed credits or when the
credits expire at the end of the three-year
arrangement.
However, if X’s obligation was to
provide an unspecified amount of consulting services
over time (e.g., an obligation to provide whatever
level of consulting services was needed by Y), a
different revenue recognition pattern would most
likely result because X’s promise would be to stand
ready. In this scenario, Y’s entitlement to future
consulting services would not be affected by the
extent to which Y had already received consulting
services.
See Section 8.5.10 for
an additional illustration of this distinction.
5.4.3.2.1 Determining Whether a SaaS Arrangement Represents a Stand-Ready Obligation or an Obligation to Provide a Specified Amount of Services
To determine the appropriate revenue recognition model to apply to its
SaaS arrangements, an entity must first determine the nature of its
promise to provide services. In some arrangements, the entity may price
a SaaS arrangement on the basis of the expected volume of usage, but it
may not always be clear whether the nature of the promise is (1) an
obligation to provide a specified amount of services (e.g., a promise to
process 5,000 transactions) or (2) a stand-ready obligation to provide
services if and when the customer needs them (e.g., a promise to make
the SaaS available throughout a specified term to process all
transactions submitted during the period).
An entity will need to carefully consider the rights and obligations in
the contract to identify the nature of the promise and to determine an
appropriate measure of the progress toward complete satisfaction of the
performance obligation.
The following factors may indicate that the nature of the entity’s
promise is an obligation to provide a specified amount of services:
-
The customer has the right to “roll over” unused volume into a future period.
-
The customer’s right to use the SaaS terminates upon reaching the specified volume.
-
Upon reaching the specified volume, the customer must make a separate purchasing decision with respect to additional services and the entity is not obligated to provide those services before the customer exercises its rights (e.g., the customer and entity need to enter into a contract modification to continue service).
The following factors may indicate that the nature of the entity’s
promise is to stand ready to provide the service:
-
The contract does not include any specified volumes of usage (i.e., the customer has “unlimited access” to the SaaS).
-
The specified volume is set as the maximum amount the customer can use, but it is not substantive (e.g., the limit is set as a protective measure and, in reality, is substantially higher than is actually expected to be used by the customer).
-
The entity is required to stand ready to provide the service over the entire contractual period regardless of whether the customer exceeds the specified volume (i.e., the customer can continue use of the SaaS without requesting such ability from the entity, even if it has to pay an incremental fee for the excess).
If the nature of the entity’s promise is to provide a specific amount of
services, revenue is typically recognized when (or as) those services
are provided. Breakage may be considered if a customer is not expected
to use all the specified volume (see Section
8.8).
If the nature of the entity’s promise is to stand ready to provide the
SaaS, there are additional considerations related to applying the series
guidance, determining an appropriate measure of progress, and
determining how variable consideration (if present) is recognized.
5.4.3.3 Unspecified Future Goods or Services in a Software Arrangement — Timing of Revenue Recognition
There can be situations in which the contract with a customer is not specific
about what is promised to a customer. This type of contract could appear to
be a stand-ready obligation. A common example of this situation arises in
software contracts.
An entity may enter into a contract with a customer that
includes two performance obligations: (1) a license of software and (2) a
promise to provide unspecified updates and upgrades12 to the software on a “when and if available” basis. The unspecified
updates and upgrades are different from, and extend beyond, an
assurance-type warranty.
When a contract with a customer transfers the rights to unspecified future
updates, upgrades, or products, an entity is required to use judgment to
determine whether the nature of the promise (performance obligation) is
either of the following:
- To stand ready to maintain or enhance the software as needed.
- To develop and provide a new or significantly enhanced version of the software.
If the nature of the promise represents an obligation by the entity to stand
ready to maintain or enhance the software as needed to ensure that the
customer can continue to receive and consume the benefit of the software
throughout the contract term, the value to the customer is transferred over
time as the entity stands ready to perform. That is, the entity would (1)
satisfy the performance obligation over time and (2) determine the
appropriate measure of progress to recognize revenue over time.
If the nature of the promise represents an implied obligation to develop and
provide new or significantly enhanced versions of the software through
specified upgrades, the benefits of those upgrades are received and consumed
when and if they are made available to the customer. That is, the
performance obligation is only satisfied at the individual points in time
when those upgrades are delivered to the customer.
Footnotes
11
ASC 606-10-55-184 through 55-186.
12
The nature of the entity’s promise when it commits
to provide unspecified updates and upgrades to a customer differs
from the entity’s obligation when it commits to deliver specified
upgrades. This discussion addresses only unspecified updates and
upgrades. For specified upgrades, the analysis will most likely be
different since specified upgrades will often be a separate
performance obligation.
5.5 Warranties
5.5.1 In General
Early in the drafting of the revenue standard, the FASB and IASB thought to
treat all warranties similarly because generally, all warranties represent an
entity’s promise to stand ready to repair or replace the good or service that
the entity has provided to a customer in accordance with the terms of the
parties’ contract. However, stakeholders informed the boards that some
warranties are different from others and that entities should account for such
warranties differently. The boards agreed with the stakeholders’ feedback.
5.5.2 Types of Warranties
ASC 606-10
55-30 It is common for an entity to provide (in accordance with the contract, the law, or the entity’s customary
business practices) a warranty in connection with the sale of a product (whether a good or service). The nature
of a warranty can vary significantly across industries and contracts. Some warranties provide a customer with
assurance that the related product will function as the parties intended because it complies with agreed-upon
specifications. Other warranties provide the customer with a service in addition to the assurance that the
product complies with agreed-upon specifications.
It is important to determine what type of warranty an entity offers to a customer because the way in
which revenue is recognized will vary depending on that determination. An entity should determine
whether it offers the customer an assurance-type warranty or a service-type warranty. An assurance-type
warranty provides the customer with the peace of mind that the entity will fix or possibly replace
a good or service if the original good or service was faulty. It is the type of warranty with which most
customers are familiar. In contrast, a service-type warranty provides the customer with a service that is
incremental to the assurance that the good or service will meet the expectations agreed to in the contract.
5.5.3 Determining Whether a Warranty Is a Performance Obligation (Service-Type Warranties)
ASC 606-10
55-31 If a customer has the option to purchase a warranty separately (for example, because the warranty
is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide
the service to the customer in addition to the product that has the functionality described in the contract.
In those circumstances, an entity should account for the promised warranty as a performance obligation in
accordance with paragraphs 606-10-25-14 through 25-22 and allocate a portion of the transaction price to that
performance obligation in accordance with paragraphs 606-10-32-28 through 32-41.
55-34 If a warranty, or a part
of a warranty, provides a customer with a service in
addition to the assurance that the product complies with
agreed-upon specifications, the promised service is a
performance obligation. Therefore, an entity should
allocate the transaction price to the product and the
service. If an entity promises both an assurance-type
warranty and a service-type warranty but cannot
reasonably account for them separately, the entity
should account for both of the warranties together as a
single performance obligation.
55-35 A law that requires an
entity to pay compensation if its products cause harm or
damage does not give rise to a performance obligation.
For example, a manufacturer might sell products in a
jurisdiction in which the law holds the manufacturer
liable for any damages (for example, to personal
property) that might be caused by a consumer using a
product for its intended purpose. Similarly, an entity’s
promise to indemnify the customer for liabilities and
damages arising from claims of patent, copyright,
trademark, or other infringement by the entity’s
products does not give rise to a performance obligation.
The entity should account for such obligations in
accordance with the guidance on loss contingencies in
Subtopic 450-20 on contingencies.
The decision tree below illustrates the revenue standard’s process for
determining whether a warranty represents a separate performance obligation.
An entity may need to use judgment to determine whether a warranty is a
service-type warranty (i.e., performance obligation). This is important because,
depending on the outcome of the entity’s assessment, consideration could be
allocated to the performance obligation and consequently change the pattern of
revenue recognition.
To assess the nature of a warranty, an entity should consider whether the
warranty provides an additional service. An easy way to determine this is if a
warranty is sold separately. A contract is considered separately priced if the
customer has the option of purchasing the contract for an expressly stated
amount separate from the price of the product. As discussed in paragraph BC371
of ASU 2014-09, an entity could also separately negotiate a warranty with a
customer and determine that a performance obligation exists.
However, a warranty does not necessarily have to be separately sold or separately negotiated to be
considered a performance obligation. To determine whether a warranty is a performance obligation, an
entity should consider various indicators in accordance with ASC 606-10-55-33.
ASC 606-10
55-33 In assessing whether a warranty provides a customer with a service in addition to the assurance that the
product complies with agreed-upon specifications, an entity should consider factors such as:
- Whether the warranty is required by law — If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.
- The length of the warranty coverage period — The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.
- The nature of the tasks that the entity promises to perform — If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.
A warranty that provides a service in
addition to the entity’s assurance that the goods or services
transferred to a customer will function as intended or meet agreed-upon
specifications would represent a separate performance obligation. Accordingly,
the entity would need to allocate a portion of the transaction price to the
separate service and recognize the related revenue when (or as) performance is
completed even when this warranty is neither separately priced nor separately
negotiated.
If the warranty merely provides what ASC 606-10-55-30 describes
as “assurance that the related product will function as the parties intended
because it complies with agreed-upon specifications,” the assurance is not a
service and therefore not a separate performance obligation. For an
assurance-type warranty obligation incurred in connection with the sale of a
product (i.e., an obligation that is not separately priced or sold or otherwise
a separate performance obligation), the costs associated with providing the
warranty would be accrued in accordance with ASC 460-10 (see ASC
606-10-55-32).
Assessing the substance of the promise in a warranty arrangement
that is neither separately priced nor separately negotiated often will require
judgment. To aid in such an assessment, ASC 606-10-55-33 lists three factors
that an entity should consider in determining whether a warranty provides the
customer with a service in addition to the entity’s assurance that the good or
service complies with agreed-upon specifications: (1) whether the warranty is
required by law, (2) the length of the coverage period, and (3) the nature of
the tasks that are promised.
Questions continually arise about how an entity would determine
whether a product warranty that is not separately priced is a performance
obligation (i.e., whether the warranty represents a service rather than a
guarantee of the product’s intended functionality). For illustrative purposes,
TRG members in March 2015 discussed an example in which a luggage company
provides a lifetime warranty to repair any damage to the luggage free of charge
and noted that such a warranty would be a separate performance obligation
because the company agreed to repair any damage (i.e., repairs that
extend beyond those that fix defects preventing the luggage from functioning as
intended).
TRG members generally agreed with the conclusion that the
warranty in the luggage example would represent a separate performance
obligation but that it “illustrates a relatively [straightforward] set of facts
and circumstances that demonstrate an instance of when a warranty provides a
service.”13 However, the conclusion for other warranty arrangements may be less clear.
Accordingly, an entity will need to assess the substance of the promises in a
warranty arrangement and exercise judgment on the basis of the entity’s specific
facts and circumstances.
In addition, while the duration of the warranty (e.g., the
lifetime warranty in the luggage company example discussed) may be an indicator
of whether a warranty is a separate performance obligation, it is not
determinative.
Example 5-12
In accordance with customary business
practices, a luggage manufacturer provides all customers
with a one-year warranty that covers only manufacturing
defects.
This warranty does not represent a
separate performance obligation because it only provides
assurance that the luggage will function as intended
over a short (and customary) period. This is an
“assurance-type” warranty, which should be accounted for
under ASC 460. As a result, there is no revenue deferral
for the warranty.
Example 5-13
A luggage manufacturer provides all
customers with a lifetime warranty that covers all
defects and damages, including those arising from normal
wear and tear.
This warranty represents a separate
performance obligation because the manufacturer has
agreed to provide repairs for all damage (i.e., it has
agreed to provide a service of repairing the luggage for
all damage, which extends beyond rectifying
manufacturing defects) and over a longer period than is
customary (i.e., the life of the luggage). The luggage
manufacturer should (1) determine the stand-alone
selling price of the repair service and allocate an
appropriate portion of the transaction price to it and
(2) recognize that portion as revenue over the period in
which the service is delivered.
The above issue is addressed in Implementation Q&A 17 (compiled from previously issued
TRG Agenda Papers 29 and 34). For additional information and Deloitte’s summary of
issues discussed in the Implementation Q&As, see Appendix C.
5.5.4 Warranties Within the Scope of Other Guidance (Assurance-Type Warranties)
Warranties could be within the scope of guidance outside the revenue standard
under certain circumstances. For example, warranties that are determined to be
separate performance obligations in accordance with the guidance in ASC
606-10-55-30 through 55-35 might appear to be insurance contracts. However, such
warranties would only be considered insurance contracts within the scope of
applicable guidance in ASC 944 if they are directly issued by a third-party
insurance entity. Further, a warranty could be within the scope of the guidance
on product warranties in ASC 460-10 if it only provides assurance that a product
complies with agreed-upon specifications, as explained in ASC 606-10-55-32.
ASC 606-10
55-32 If a customer does not have the option to purchase a warranty separately, an entity should account for
the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless
the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to
the assurance that the product complies with agreed-upon specifications.
Example 44 in ASC 606 illustrates how to account for an
assurance-type warranty.
ASC 606-10
Example 44 — Warranties
55-309 An entity, a
manufacturer, provides its customer with a warranty with
the purchase of a product. The warranty provides
assurance that the product complies with agreed-upon
specifications and will operate as promised for one year
from the date of purchase. The contract also provides
the customer with the right to receive up to 20 hours of
training services on how to operate the product at no
additional cost. The training services will help the
customer optimize its use of the product in a short time
frame. Therefore, although the training services are
only for 20 hours and are not essential to the
customer’s ability to use the product, the entity
determines that the training services are material in
the context of the contract on the basis of the facts
and circumstances of the arrangement.
55-310 The entity assesses
the goods and services in the contract to determine
whether they are distinct and therefore give rise to
separate performance obligations.
55-311 The product and
training services are each capable of being distinct in
accordance with paragraphs 606-10-25-19(a) and
606-10-25-20 because the customer can benefit from the
product on its own without the training services and can
benefit from the training services together with the
product that already has been transferred by the entity.
The entity regularly sells the product separately
without the training services.
55-312 The entity next
assesses whether its promises to transfer the product
and to provide the training services are separately
identifiable in accordance with paragraphs
606-10-25-19(b) and 606-10-25-21. The entity does not
provide a significant service of integrating the
training services with the product (see paragraph
606-10-25-21(a)). The training services and product do
not significantly modify or customize each other (see
paragraph 606-10-25-21(b)). The product and the training
services are not highly interdependent or highly
interrelated as described in paragraph 606-10-25-21(c).
The entity would be able to fulfill its promise to
transfer the product independent of its efforts to
subsequently provide the training services and would be
able to provide training services to any customer that
previously acquired its product. Consequently, the
entity concludes that its promise to transfer the
product and its promise to provide training services are
not inputs to a combined item and, therefore, are each
separately identifiable.
55-313 The product and
training services are each distinct in accordance with
paragraph 606-10-25-19 and therefore give rise to two
separate performance obligations.
55-314 Finally, the entity
assesses the promise to provide a warranty and observes
that the warranty provides the customer with the
assurance that the product will function as intended for
one year. The entity concludes, in accordance with
paragraphs 606-10-55-30 through 55-35, that the warranty
does not provide the customer with a good or service in
addition to that assurance and, therefore, the entity
does not account for it as a performance obligation. The
entity accounts for the assurance-type warranty in
accordance with the requirements on product warranties
in Subtopic 460-10.
55-315 As a result, the
entity allocates the transaction price to the two
performance obligations (the product and the training
services) and recognizes revenue when (or as) those
performance obligations are satisfied.
5.5.5 Implicit Warranty Beyond the Contractual Period
In addition to providing a warranty that guarantees that an
entity’s product or service complies with agreed-upon specifications for a
specified period, entities in many industries may continue to provide
warranty-type services (e.g., repairs) beyond the original specified period as
part of their customary business practices. In accordance with ASC 606-10-55-34,
if an entity’s warranty, or part of its warranty, provides a customer with a
service in addition to the assurance that the product complies with agreed-upon
specifications, the promised service represents a performance obligation.
Regardless of whether the warranty services are explicitly
promised in the contract for a specified period or are implied by customary
business practices, the entity must assess whether the services to be provided
represent an assurance-type warranty (which should be accounted for in
accordance with ASC 460-10) or a promised service (in addition to the assurance
that the product complies with agreed-upon specifications) in the contract. This
assessment requires an analysis of the nature of (1) the products or services
that are subject to the specific warranty and (2) any other products or services
that are provided as part of the entity’s customary business practice.
Example 5-14
Entity X sells long-life LED lightbulbs
to customers with a two-year contractual warranty
period. Entity X also has a customary business practice
of providing its customers with a replacement lightbulb
free of charge if a defective lightbulb is returned
within three years of the date of purchase.
In accordance with ASC 606-10-55-32 and
ASC 606-10-55-34, the practice of replacement in the
third year is not considered an additional service
(i.e., it is not a separate performance obligation) and
therefore should not be accounted for as a service-type
warranty. Entity X concludes that the practice of
replacement in the third year should be accounted for as
an assurance-type warranty, and is not a separate
performance obligation, because X is only guaranteeing
that the lightbulb will function as intended. Therefore,
X accounts for the warranty in accordance with ASC
460-10.
Footnotes
13
Quoted from Implementation Q&A 17.
5.6 Nonrefundable Up-Front Fees
ASC 606-10
55-50 In some contracts, an entity charges a customer a nonrefundable upfront fee at or near contract
inception. Examples include joining fees in health club membership contracts, activation fees in
telecommunication contracts, setup fees in some services contracts, and initial fees in some supply contracts.
55-51 To identify performance obligations in such contracts, an entity should assess whether the fee relates
to the transfer of a promised good or service. In many cases, even though a nonrefundable upfront fee relates
to an activity that the entity is required to undertake at or near contract inception to fulfill the contract, that
activity does not result in the transfer of a promised good or service to the customer (see paragraph 606-10-
25-17). Instead, the upfront fee is an advance payment for future goods or services and, therefore, would be
recognized as revenue when those future goods or services are provided. The revenue recognition period
would extend beyond the initial contractual period if the entity grants the customer the option to renew the
contract and that option provides the customer with a material right as described in paragraph 606-10-55-42.
55-52 If the nonrefundable upfront fee relates to a good or service, the entity should evaluate whether to
account for the good or service as a separate performance obligation in accordance with paragraphs 606-10-
25-14 through 25-22.
55-53 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.
Nonrefundable up-front fees are payments made by customers at the start of a
contract for various reasons. The revenue standard cites health club membership
fees, activation fees in telecommunication contracts, and set-up fees as examples of
nonrefundable up-front fees. Entities need to assess nonrefundable up-front fees to
determine whether the fees (1) are for goods or services provided at contract
inception or (2) provide the customer with an option for additional goods or
services that gives rise to a material right (a performance obligation).
Example 53 in ASC 606 illustrates the application of the revenue standard’s
guidance on nonrefundable up-front fees.
ASC 606-10
Example 53 — Nonrefundable Upfront Fees
55-358 An entity enters into a contract with a customer for one year of transaction processing services. The
entity’s contracts have standard terms that are the same for all customers. The contract requires the customer
to pay an upfront fee to set up the customer on the entity’s systems and processes. The fee is a nominal
amount and is nonrefundable. The customer can renew the contract each year without paying an additional
fee.
55-359 The entity’s setup
activities do not transfer a good or service to the customer
and, therefore, do not give rise to a performance
obligation.
55-360 The entity concludes that the renewal option does not provide a material right to the customer that
it would not receive without entering into that contract (see paragraph 606-10-55-42). The upfront fee is, in
effect, an advance payment for the future transaction processing services. Consequently, the entity determines
the transaction price, which includes the nonrefundable upfront fee, and recognizes revenue for the
transaction processing services as those services are provided in accordance with paragraph 606-10-55-51.
The example below illustrates how an entity would determine the
period over which to recognize a nonrefundable up-front fee.
Example 5-15
Entity X agrees to provide a customer with
services on a monthly basis at a price of $400 per month,
payable at the start of each month. At the outset, X also
charges the customer a one-time, nonrefundable up-front fee
of $50, for which no separate goods or services are
transferred. The customer can cancel the contract at any
time without penalty, but it will not be entitled to any
refund of amounts already paid. Entity X’s average customer
life is two years.
The period over which the up-front fee
should be recognized depends on whether the up-front fee
provides the customer with a material right with respect to
renewing X’s services. In determining whether the up-front
fee provides the customer with such a material right, X
should consider both quantitative and qualitative factors
(e.g., the renewal price compared with the price a new
customer would pay or the price paid for services already
transferred, inclusive of the nonrefundable up-front
fee).
If X concludes that the up-front fee does
provide a material right, that fee should be recognized over
the service period during which the customer is expected to
benefit from not having to pay a further up-front fee upon
renewal of service.
If X concludes that the up-front fee does
not provide the customer with a material right, the entire
transaction price of $450 (which comprises the minimum
one-month service fee and the up-front fee) is viewed as
advance payment for the promised services (i.e., the first
month only) and should be recognized over the first month
during which the services are provided.
The above issue is addressed in Implementation Q&A 52 (compiled from
previously issued TRG Agenda Papers 18, 25, 32, and 34). For additional information and Deloitte’s
summary of issues discussed in the Implementation Q&As, see Appendix C.
Refer to Section 8.9.4 for
additional discussion of the accounting for nonrefundable up-front fees.
5.6.1 Termination Clauses and Nonrefundable Up-Front Fees in Software Arrangements
Under some software arrangements, the customer must pay a nonrefundable up-front
fee. ASC 606 requires entities to consider whether the fee is (1) associated
with the transfer of promised goods or services or (2) an advance payment for
future goods or services.14 In addition, some software arrangements give the customer the right to
terminate the contract at the customer’s convenience. For example, an
arrangement for a one-year term license and PCS may contain a provision that
allows the customer to terminate the contract after a 30-day notice period. If
the customer can terminate a contract without having to pay a substantive
penalty, generally only the noncancelable portion of the contract (e.g., the
initial 30 days) is accounted for under ASC 606, even if the customer is
unlikely to exercise its termination right.
Questions have arisen in practice regarding how to account for nonrefundable
up-front fees associated with a software arrangement that contains a termination
provision. The examples below illustrate this scenario and discuss the
accounting considerations.
Example 5-16
All Fees Are Nonrefundable
A vendor sells a one-year term-based license with PCS for
an up-front nonrefundable fee of $1.25 million. The
stand-alone selling prices of the license and PCS are $1
million and $250,000, respectively. The vendor’s
customer has the right to terminate the arrangement at
its convenience at the end of each month without paying
any penalty. If the customer terminates, it loses the
right to use the software and receive support. The
customer also has the right to renew the contract
annually for the same fee.
Under the assumption that the license is distinct from
the PCS, the vendor has two performance obligations: (1)
a one-year term license and (2) one year of PCS. While
the customer has the right to terminate the contract at
the end of each month without paying the vendor a
penalty, the customer has, in substance, paid up front
for all the goods and services in the contract — the
one-year term license and one year of PCS. That is,
while a termination provision is treated similarly to a
renewal option, there is no incremental fee to “renew”
(i.e., not terminate) the contract each month, nor is
there a refundable payment for termination. Therefore,
the nonrefundable up-front fee is payment for the term
license and PCS for the full year. In addition, the
contract does not give the customer a material right
since the annual renewal provision is priced at the
stand-alone selling prices of the term license and
PCS.
Example 5-17
Nonrefundable License Fees and Pro Rata Refund for
PCS
A vendor sells a one-year term-based license with PCS for
an up-front fee of $1.25 million. The stand-alone
selling prices of the license and PCS are $1 million and
$250,000, respectively. The vendor’s customer has the
right to terminate the arrangement at its convenience at
the end of each month without paying any penalty. If the
customer terminates, it loses the right to receive
support and $1 million of the up-front fee. However, the
customer receives a pro rata refund for the PCS
($250,000) and retains the software license for the
remainder of the year. The customer also has the right
to renew the contract annually for the same fee.
Under the assumption that the license is distinct from
the PCS, the vendor has two performance obligations: (1)
a one-year term license and (2) one month of PCS. The
contract terms are one year for the license and one
month for the PCS. While the customer has the right to
terminate the contract at the end of each month without
paying the vendor a penalty, the customer has, in
substance, paid up front for the one-year term license
since the fee for the license is nonrefundable and the
customer retains the right to use the license for the
entire year, even if the contract is terminated.
However, the termination provision is treated similarly
to a renewal option for PCS since there is a pro rata
refund for PCS. Therefore, the incremental fee to renew
the contract each month is for optional renewals of PCS
only. In addition, the contract does not give the
customer a material right since (1) the annual renewal
provision is priced at the stand-alone selling prices of
the term license and PCS and (2) the monthly renewal of
PCS is priced at the stand-alone selling price of
PCS.
Example 5-18
Nonrefundable License Fees and Pro Rata Refund for
Mandatory PCS
A vendor sells a one-year term-based license with PCS for
an up-front fee of $1.25 million. The stand-alone
selling prices of the license and PCS are $1 million and
$250,000, respectively. The vendor’s customer has the
right to terminate the arrangement at its convenience at
the end of each month without paying any penalty. If the
customer terminates, it loses the right to use the
software and receive support, but it receives a pro rata
refund that is based on the PCS fee stated in the
contract. The vendor intends to enforce compliance with
the requirement to relinquish the use of the term
license if PCS is not renewed. The stated fee for PCS
($250,000) is refundable, and the remainder of the
up-front payment for the license ($1 million) is
nonrefundable. The customer also has the right to renew
the contract annually for the same fee.
Under the assumption that the license is distinct from
the PCS, we believe that it may be reasonable to
conclude that the vendor has three performance
obligations: (1) a one-month term license, (2) one month
of PCS, and (3) a material right. If the termination
provision is substantive, the contract term is likely to
be one month (i.e., the enforceable rights and
obligations are likely to be limited to one month). The
customer has the right to terminate the contract at the
end of each month without paying the vendor a penalty.
While the customer does not receive a refund of the
up-front payment of $1 million and also loses the right
to use the software license in the event of a
termination, neither loss is considered a substantive
termination penalty. ASC 606 specifies that a
termination penalty compensates the other party. We do
not believe that the relinquishment of the software
would be considered a termination penalty because the
customer is not compensating the vendor for terminating
the contract. Because software licenses are typically
sold on a nonexclusive basis and can be replicated an
unlimited number of times at minimal or no cost, no
substantive asset is returned to the vendor (i.e., the
vendor does not receive a returned product that it can
resell or otherwise obtain economic value from). Such
licenses can be contrasted with exclusive licenses to
IP, which may have value if returned to a vendor. In
addition, we do not believe that the loss of the
up-front, nonrefundable payment is compensation to the
vendor because the initial contract already gave the
vendor the right to that payment (i.e., the vendor
retains the payment irrespective of whether the customer
cancels or renews the contract). Rather, the up-front
nonrefundable fee should be assessed under ASC
606-10-55-50 and 55-51.
The termination provision is treated similarly to a
renewal option since there is a pro rata refund for PCS
if the contract is terminated (which can also be viewed
as an incremental fee to renew). In deciding not to
terminate the contract (i.e., by renewing the contract),
the customer renews both the term license and PCS,
because if PCS is not renewed, the customer loses the
right to the license. Therefore, because of the
termination provision, the vendor might conclude that
present enforceable rights and obligations only exist
for a term license and PCS for one month.
In evaluating whether the up-front, nonrefundable fee is
either (1) a payment for the transfer of promised goods
or services in the initial contract or (2) an advance
payment for future goods or services, the vendor should
determine whether a material right has been provided for
the monthly renewals.15 If the contract is renewed, the incremental fee
(i.e., the refundable portion) is only associated with
the stated PCS fee. In effect, the customer obtains
control of both a term license and PCS by only paying
the fee for PCS. Since the monthly renewal is priced at
a significant and incremental discount to the price that
would be charged to similarly situated customers (i.e.,
the term license and PCS are not renewed at their
stand-alone selling prices), the customer receives a
material right. That material right would be accounted
for as a performance obligation that is recognized with
the renewals of the term license and PCS. If the
practical alternative in ASC 606-10-55-45 is elected,
the transaction price would be allocated to the renewals
of the term license and PCS by reference to the renewals
expected to be provided and the corresponding expected
consideration. If renewals are expected over the entire
stated term (i.e., one year), the entire contractually
stated fee (i.e., $1.25 million) would be allocated
evenly to each monthly term license and PCS. The amount
associated with each month (approximately $104,000)
would then be allocated to the one-month term license
and PCS and recognized when the customer obtains control
of the term license (at a point in time at the beginning
of each month) and as PCS is provided (ratably over the
month) on the basis of their relative stand-alone
selling prices.
For a vendor to conclude that a termination provision
affects the contract term, the provision must be
substantive (i.e., the customer is making a purchasing
decision to renew or terminate the contract). In
determining whether the termination/renewal provision is
substantive, the vendor should consider quantitative and
qualitative factors. For example, the amount subject to
refund must be substantive relative to the total
contract fee. Further, there should be a business
purpose for the provision, and the vendor must intend to
enforce the requirement to relinquish the use of the
term license if PCS is not renewed. The factors to
consider and the relevance of those factors will depend
on the specific facts and circumstances of each
arrangement, and the use of significant judgment may be
required. Companies are therefore encouraged to consult
with their accounting advisers and auditors.
Example 5-19
Nonrefundable License Fees and Nonsubstantive Pro Rata
Refund for Mandatory PCS
A vendor sells a one-year term-based license with PCS for
an up-front fee of $1.25 million. The stand-alone
selling prices of the license and PCS are $1 million and
$250,000, respectively. The vendor’s customer has the
right to terminate the arrangement at its convenience at
the end of each month without paying any penalty. If the
customer terminates, it loses the right to use the
software and receive support, but it receives a pro rata
refund for PCS. The vendor intends to enforce compliance
with the requirement to relinquish the use of the term
license if PCS is not renewed. The stated fee for PCS is
$50,000, and the remainder of the up-front payment ($1.2
million) is nonrefundable. The customer also has the
right to renew the contract annually for the same
fee.
Under the assumption that the license is distinct from
the PCS, we believe that it is reasonable to conclude
that the vendor has two performance obligations: (1) a
one-year license and (2) one year of PCS. The contract
term is likely to be one year (i.e., the enforceable
rights and obligations are likely to be for the full
stated term). The customer has the right to terminate
the contract at the end of each month without paying the
vendor a penalty. While the customer does not receive a
refund related to the up-front payment of $1.2 million
and also loses the right to use the software license in
the event of a termination, neither loss is a
substantive termination penalty. However, unlike the
termination provision in Example 5-18, the provision in this
scenario is not likely to be considered substantive
since the amount subject to refund is only $50,000.
In evaluating whether the up-front nonrefundable fee is
either (1) a payment for the transfer of promised goods
or services in the initial contract or (2) an advance
payment for future goods or services, the vendor would
consider that substantially all of the total contract
fee is the up-front nonrefundable fee. The customer has
the right to terminate the contract at the end of each
month without paying the vendor a penalty; however, the
customer has, in substance, substantially paid up front
for all the stated goods and services in the contract —
the one-year term license and one year of PCS. That is,
while a termination provision is treated similarly to a
renewal option, there is no substantive incremental fee
to “renew” the contract (i.e., there is no substantive
refundable payment for terminating the contract).
Therefore, as in Example
5-16, the nonrefundable up-front fee (in
addition to the nonsubstantive refundable payment) is
considered an up-front payment for the term license and
PCS for the full year. In addition, the contract does
not give the customer a material right since the annual
renewal provision is priced at the stand-alone selling
prices of the term license and PCS.