The New Revenue Recognition Standard — Step 2: Identify the Performance Obligations
As mentioned in our previous blog, on May 28th the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers: Topic 606. The new standard creates a whole new codification topic (ASC 606) and ushers in a new era of revenue recognition by replacing hundreds of pages of industry specific guidance with a single comprehensive standard applicable to virtually all industries, and will significantly change how we recognize revenue. ASU 2014-09 isn’t effective for private entities until reporting periods beginning after December 15, 2017, but will be effective for public entities a year earlier.
ASC 606 creates a five-step process for recognizing revenue. We’ve already covered the first step in a previous blog. The second step is to identify the performance obligations.
Under ASC 606, a performance obligation is defined as a promise to transfer a good or service. A performance obligation can be explicitly stated in the contract or it can be implied. For example, implied by customary business practices or published policies outside of the contract. Activities undertaken to fulfill a contract are not considered a performance obligation unless those activities transfer a good or service to a customer. For example, administrative tasks might be performed but that does not constitute a performance obligation because no good or service is transferred to the customer.
The transaction price (determined in Step 3) will be allocated (determined in Step 4) to the different performance obligations. So identifying performance obligations is important because it will have a significant impact on when and how much revenue will be recognized.
A performance obligation shall be allocated a portion of the transaction price if either of the following is true:
a. The good or service (or a bundle of goods or services) is distinct; or
b. The good or service is part of a series of distinct goods or services that are substantially the same, and have the same pattern of transfer to the customer.
A good or service is distinct if both of the following are met:
a. The customer can benefit from the good or service either on its own or together with other resources readily available to the customer. Resources are readily available to the customer if it is sold separately (by any entity) or is a resource that the customer already has (before entering into the contract or already transferred as a result of the contract). A good indicator that a customer can benefit from the good or service on its own would be if the entity regularly sells the good or service separately.
b. The promise to transfer the good or service is separately identifiable from other promises in the contract. Some factors to consider when determining if a good or service is separately identifiable would be:
- The entity doesn’t provide integration services for that good or service with other goods or services promised in the contract;
- The good or service doesn’t significantly alter other goods or services promised; and
- The customer could decide to not purchase the good or service, and it would not significantly affect the other goods or services promised in the contract.
For example, the construction of a building requires the transfer of building supplies and the service of integrating each of the goods to create a building. Under ASC 606, entities should look at performance obligations from the perspective of the customer. In this example, and for many construction contractors, from the customer’s perspective the customer likely isn’t purchasing an individual good but rather the building. So there would likely only be one performance obligation. However, as we will learn in Step 5: Recognize Revenue When (or As) the Performance Obligation Is Satisfied, some performance obligations can be recognized over a period of time and thus revenue does not necessarily have to be deferred just because there is only one performance obligation.
If a good or service is not distinct, then it should be combined with other goods and services until a bundle of goods or services are distinct.
A series of distinct goods or services has the same pattern of transfer if both of the following are met:
a. Each distinct good or service in the series would meet the criteria to be a performance obligation satisfied over time, which will be described below.
b. The same method would be used to measure progress toward completion for each distinct good or service in the series which will also be described below.
Satisfying Performance Obligations
Revenue allocated (Step 4) to a performance obligation should be recognized when the goods or services are transferred to the customer, which occurs when the customer has control of the asset or use of the service.
Performance obligations can be satisfied, and thus revenue recognized over time or at a point in time.
Performance obligations are satisfied over time if one of the following criteria is met:
- The customer simultaneously receives and consumes the benefit as the entity performs.
- The performance creates or enhances an asset that the customer controls.
- The asset created has no alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. Interestingly, unlike criteria “b” above, for this criteria the entity should consider any substantive contractual restrictions or practical limitations on the entity’s ability to readily direct that asset for another use. The possibility of the contract with the customer being terminated should not be considered relevant.
Measuring Progress Towards Completion
The principle objective is to recognize revenue in a pattern commensurate with the transfer of control to the customer. The method chosen to measure progress should be consistently applied to similar performance obligations and circumstances. There are two acceptable methods for measuring progress: Output and input methods.
Output methods recognize revenue based on the value transferred to the customer relative to the remaining value to be transferred. For example: surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered. Importantly, output methods shouldn’t be used if they do not faithfully depict the entity’s performance. For example, an output method based on units delivered would not faithfully depict an entity’s performance if significant work in process exists and is not captured in the measurement method.
Input methods recognize revenue based on the entity’s effort to satisfy the performance obligation relative to the total expected effort to satisfy the performance obligation. For example: resources consumed, labor hours expended, costs incurred, time elapsed or machine hours used. If the entity’s efforts are expended evenly throughout the performance period, it may be appropriate to recognize revenue on a straight-line basis.
As a practical expedient, if an entity has the right to consideration that corresponds directly with the value received by the customer (e.g. fixed hourly billing), then the entity may recognize revenue as the entity has a right to invoice.
If an entity concludes that a performance obligation is not satisfied over time, then the performance obligation, and thus revenue recognized, should be considered satisfied at a point in time when control is transferred.
Once the entity has completed Step 2 and identified the performance obligations, then the entity must move onto Step 3: Determining the Transaction Price, which will be the subject of our next in depth blog.