Published on: 17 Sep 2019 Show
BackgroundDid you know that the identification of performance obligations requires more judgment than most other aspects of the new revenue standard (i.e., the guidance in ASU 2014-09,1 as amended2) and that misidentification could result in a material misstatement of revenue? Although the concept of separating deliverables into separate units of accounting for recognizing revenue existed under legacy U.S. GAAP in ASC 605-25,3 the method for identifying a performance obligation is different under the new revenue standard. Under legacy U.S. GAAP, ASC 605-25 generally required an entity to identify units of accounting by determining whether the delivered item or items have stand-alone value to the customer.4 Typically, an entity applying legacy revenue guidance focused on whether the items were sold by the entity or other suppliers on a stand-alone basis. In contrast, an entity applying the new revenue standard is required to identify a performance obligation by determining whether a promised good or service is (1) capable of being distinct and (2) distinct within the context of the contract. If the promised good or service does not meet both of these requirements (collectively, the “‘distinct’ criteria”), it must be combined with other goods or services promised in the contract until there is a combination of goods or services that meets the requirements. Identifying Promised Goods or ServicesBefore evaluating the “distinct” criteria in ASC 606, an entity must first identify the goods or services promised in the contract. For some contracts, it will be easy to identify all promised goods or services because they are all specifically stated. However, an entity must also identify implied promises to the customer. Such implied promises do not need to be enforceable by law. Rather, if the customer has a reasonable expectation that the entity will transfer a good or service to the customer, that good or service represents an implied promise in the contract. Promises Versus ActivitiesThere is a difference between goods or services promised in the contract and activities that the entity needs to undertake to transfer the promised goods or services. Promised goods or services are goods or services that are transferred to the entity’s customer in accordance with the contract (i.e., goods or services that result in the customer’s obtaining control of an asset5). A good or service promised in the contract must be evaluated so that the entity can determine whether the good or service represents a distinct performance obligation. In contrast, an activity typically represents something that the entity is required to undertake before or in connection with fulfilling an obligation to transfer a good or service to the customer. Because the core principle of the new revenue standard is for an entity to recognize revenue when it transfers control of a good or service to a customer, it would be inappropriate for an entity to recognize revenue for the completion of an activity. Distinguishing between fulfillment activities and promises to transfer goods or services to a customer can sometimes require significant judgment. Consider Examples 1 and 2 below.
Applying the “Distinct” CriteriaFor an entity to account for goods or services promised in a contract with a customer as performance obligations, the entity must determine that the goods or services are both (1) capable of being distinct and (2) distinct within the context of the contract. Capable of Being DistinctUnder ASC 606-10-25-19(a), the first criterion for a promised good or service to be accounted for as a separate performance obligation is that the promised good or service is “capable of being distinct.” ASC 606-10-25-19(a) states that a good or service is capable of being distinct if 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.” Readily available resources could be resources that the customer is purchasing separately (including those that have already been transferred to the customer as part of the current contract or prior contracts). Generally, a good or service is capable of being distinct if the entity regularly sells the good or service separately. The “capable of being distinct” criterion is similar to the criterion in ASC 605-25 under legacy U.S. GAAP that required a deliverable to have stand-alone value to the customer to be considered a separate unit of accounting. However, evaluating whether a good or service has stand-alone value to the customer requires an entity to understand the customer’s intended use of the good or service, which may be difficult or impossible to determine in some situations. Consequently, when the FASB was developing the new revenue standard, it made a conscious decision not to use the same language as legacy U.S. GAAP to avoid implying that an entity must assess the customer’s intentions for the promised goods or services. Accordingly, the assessment of whether the customer can economically benefit from a good or service on its own should not be based on the customer’s intended use of the good or service. Rather, the assessment “should be based on the characteristics of the 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.” 6 As noted above, a strong indicator that a good or service is capable of being distinct is that the entity regularly sells the good or service separately. Distinct Within the Context of the ContractASC 606-10-25-19(b) provides that the second criterion for a promised good or service to be accounted for as a separate performance obligation is that the promised good or service is “distinct within the context of the contract” or “separately identifiable.” Unlike the “capable of being distinct” criterion, the “distinct within the context of the contract” criterion did not exist in legacy U.S. GAAP and introduces a different framework for evaluating the separation of elements in an arrangement. The FASB developed this criterion 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.” 7 This evaluation remains a challenging aspect of the new revenue standard, requiring an entity to use significant judgment to appropriately identify performance obligations. To help entities apply this new framework, the new revenue standard provides the following three indicators that a promised good or service is not separately identifiable, and therefore not distinct:
Other ExamplesIn some cases, identifying the performance obligations in a contract will be straightforward. In other cases, however, significant judgment will be needed for an entity to identify the performance obligations in a contract. The examples discussed below illustrate arrangements that may require entities to use significant judgment when identifying the performance obligations. Hybrid Cloud ArrangementsSoftware providers may offer hybrid solutions in which a customer may have the right to deploy the software (1) as either on-premise software or a cloud-based service (with the ability to switch from one to the other as needed) or (2) by using the on-premise software together with the cloud-based service. On-premise software is installed and runs on the customer’s computers and servers, whereas a cloud-based service involves software that is physically hosted on the software provider’s systems and accessed by the customer over the Internet. In arrangements involving these hybrid solutions, questions arise about how to identify the promises (and therefore the performance obligations) in the contract since some functionality is provided by the on-premise software while other functionality is provided by the cloud-based service.
The functionality of on-premise software and a cloud-based service in a hybrid software arrangement can vary between offerings to customers and between entities. Significant judgment is required for an entity to identify performance obligations when some functionality is provided by the on-premise software while other functionally is accessible only through the cloud-based service. When identifying performance obligations in this type of hybrid software arrangement, an entity may consider the following:
Equipment and InstallationEntities should not assume that equipment and installation always represent distinct performance obligations (or should always be combined into a single performance obligation). The determination of whether equipment and installation represent distinct performance obligations requires careful analysis of the nature of the equipment and installation promised to the customer and how the two promises affect each other. Example 11, Case C, in ASC 6068 illustrates a situation in which equipment and installation are distinct within the context of the contract and therefore are separate performance obligations. This conclusion is based on the following facts:
Although the fact that the installation could be performed by several alternative service providers supports the conclusion that the equipment and the installation are distinct, this factor is not determinative. Similarly, the fact that installation is only provided by the entity does not in and of itself suggest that the equipment and the installation are not distinct. It is important for an entity to consider why the installation is or is not available from alternative providers to determine whether the installation is distinct within the context of the contract. In a manner consistent with the indicators in ASC 606-10-25-21, an entity should consider the following:
Where to Find Additional InformationFor more in-depth discussion and analysis of the identification of performance obligations, as well as discussions of other topics related to the new revenue standard, refer to Deloitte’s A Roadmap to Applying the New Revenue Recognition Standard. If you have questions about the new revenue standard or need assistance with interpreting its requirements, please contact any of the following Deloitte professionals:
____________________ 1FASB Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers (Topic 606). 2For a full list of final ASUs issued by the FASB to amend and clarify the guidance in ASU 2014-09, see Section 19.2.2 of Deloitte’s A Roadmap to Applying the New Revenue Recognition Standard. The guidance in ASU 2014-09, as amended, is codified primarily in FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers, and Subtopic 340-40, Other Assets and Deferred Costs — Contracts With Customers. 3FASB Accounting Standards Codification Subtopic 605-25, Revenue Recognition — Multiple-Element Arrangements. 4ASC 605-25-25-5 provides that for a delivered item in an arrangement with multiple deliverables to be a separate unit of accounting, (1) the item must have stand-alone value and (2) “[i]f the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item or items [must be] considered probable and substantially in the control of the vendor.” 5As noted in paragraph BC125 of ASU 2014-09, typical service contracts create an asset only momentarily since the asset is simultaneously received and consumed by the customer. 6Quoted from paragraph BC100 of ASU 2014-09. 7Quoted from paragraph BC103 of ASU 2014-09. 8ASC 606-10-55-150A through 55-150D. Download
How should performance obligations determine revenue recognition?Performance Obligations Satisfied at a Point in Time. The seller has a present right to payment.. The customer has legal title to the asset.. The seller has transferred physical possession.. Significant risks and rewards of ownership have been transferred.. The customer has accepted the asset.. What criteria determine whether a company can recognize revenue over time?Revenue can be recognized either over a period of time or at a point in time, depending on when a performance obligation is fulfilled. If an “entity transfers control of a good or a service over time,” then that entity “satisfies the performance obligation and recognizes revenue over time” (ASC 606-10-25-27).
What are the criteria for determining if a performance obligation exist?For an entity to account for goods or services promised in a contract with a customer as performance obligations, the entity must determine that the goods or services are both (1) capable of being distinct and (2) distinct within the context of the contract.
What criteria must be met for revenue to be recognized?In this instance, revenue is recognized when all four of the traditional revenue recognition criteria are met: (1) the price can be determined, (2) collection is probable, (3) there is persuasive evidence of an arrangement, and (4) delivery has occurred.
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