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Focus on Revenue Recognition: Step 2

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Once you have identified an in-scope contract, you are ready to identify the performance obligations in the contract. Most contracts explicitly state the promised goods and/or services to be transferred to the customer.
April 23, 2018

This RubinBrown Focus on Revenue Recognition is the third in a series of articles on the new accounting guidance for revenue recognition. In this series, we will explore different aspects of the new standard. Please contact a member of your RubinBrown team for more information and ways that we may be able to help you.

The core principle of the new standard is to recognize revenue from customers in a way that reflects the entity’s transfer of promised goods and services at an amount that represents the consideration that the entity expects to receive in exchange for those goods and services. The new revenue recognition model uses five steps to achieve this principle:

  1. Identify the contract with the customer.
  2. Identify the performance obligations within the contract.
  3. Determine the overall transaction price of the contract.
  4. Allocate the transaction price between the identified performance obligations.
  5. Recognize revenue as performance obligations are satisfied.

Step 2 – Overview

Identify promised goods and services

Once you have identified an in-scope contract, you are ready to identify the performance obligations in the contract. Most contracts explicitly state the promised goods and/or services to be transferred to the customer. However, the standard requires an entity to consider any promises to the customer that are implied by customary business practice, published policy or in any way that gives a customer a reasonable expectation that the entity will provide goods or services that are not stated in the contract. Promises that are immaterial in the context of the contract do not need to be assessed any further. Additionally, promised goods and services do not include activities that an entity must perform in order to fulfill the contract unless they actually transfer a good or service. This would be internal, administrative type activities performed by the entity to set up the customer or the contract.

The standard provides a list of common promised goods and services (606-10-25-18). This list is consistent with legacy GAAP, with a few notable exceptions. The first of these is the promise to stand ready. In a stand-ready obligation, the promise is that the customer will have access to a good or service, not that the entity will transfer the underlying good or service itself. Some examples of stand-ready obligations include: when-and-if-available software updates, snow removal services provided for a fixed fee, periodic when-and-if needed maintenance agreements and continuous availability, like a health club membership. Another change from legacy GAAP is that incidental goods and services and certain marketing incentives will need to be evaluated to determine if they are performance obligations. Any “free” goods or services provided to customers will likely be performance obligations. Additionally, any options to purchase additional goods or services will need to be evaluated to determine whether the option provides a material right to the customer. If it does, it is a performance obligation. These options must be evaluated regardless of whether they are immaterial within the context of the contract.

Determining performance obligations

A performance obligation is a good or service (or a bundle of goods or services) that is distinct or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. Under the new standard a promise is a performance obligation if it is both capable of being distinct and distinct within the context of the contract. To be capable of being distinct, the customer must be able to benefit from the promised good or service as it is sold or together with other resources generally available to the customer. This assessment should be based on the characteristics of the goods and services themselves and not on the intended use by the customer. A promise is separately identifiable, or distinct within the context of the contract, if the customer can benefit from it without the other promised goods and services in the contract. Indicators that a promise is not separately identifiable include: the provision of significant integration services, one promise significantly customizes one or more of the other promises in the contract and each of the promised goods and services is affected by another in such away the entity cannot transfer each promise independently. This assessment should consider whether the customer can obtain the intended benefit from the goods and services separately or if part of the value is inherent in the combination.

While this determination will require a significant amount of judgement, generally speaking, if the promised goods and services are available to be sold separately they are capable of being distinct. In determining whether the promises are separately identifiable, the key point of consideration is if the goods and services significantly affect each other, meaning there needs to be a 2-way dependency. For example, if the agreement provides the right to use a highly specialized process and training that goes along with it, those would likely depend on one another as the customer cannot obtain the benefit of the rights to the process without the training and the training is of no benefit without access to the process. On the other hand, if one of the promised services is general IT setup that isn’t specific to the specialized process, it may not have the two-way dependency and could be a separate performance obligation.

In certain circumstances, a bundle of goods and services that an entity has determined to be distinct may still be treated as a single performance obligation if they meet the series criteria. A bundle of goods and services is a series if they are substantially the same and have the same pattern of transfer to the customer. The same pattern of transfer means that each distinct good or service in the bundle meets the criteria to be treated as a performance obligation satisfied over time and would have the same measure of progress toward satisfaction of the performance obligation. This determination is especially important in contracts with variable consideration, expected modifications or changes in the transaction price.

The performance obligations that are identified in this step are the foundation of the rest of the revenue recognition process. It is important to note that the standard specifically states that this determination is contract specific. Different bundling of goods and service can result in different determinations of whether something is distinct which could result in different treatment for the same goods and services.

Final Thoughts

We have found that some entities will have to apply significant judgment in both identifying performance obligations as well as determining whether there are significant integration services in the contract. In our next article, we will continue to explore some of the more technical aspects of Step 2.


Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

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