Revenue Recognition – Step 2: Identify the Performance Obligation in the Contract

As discussed in our initial installment in this series, in the upcoming changes to FASB Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, FASB provides a five-step framework for determining revenue recognition.

In our first installment, we discussed the initial stage, which is identifying the contract(s) with the customer.

The second step is identifying the performance obligations in the contract. Contracts may have multiple performance obligations, with those meeting the following two criteria recognizing revenue separately:

1. The good or service is capable of being distinct, meaning that a customer can benefit from the good or service on its own, or together with other resources readily available to the customer.
2. The good or service is distinct within the context of the contract, meaning the good or service is separately identifiable from other promises in the contract.

While it is not uncommon for a contract to contain a single clear performance obligation, such as a retailer selling a single product to a consumer, or wholesale and manufacturing companies delivering a specified product to a customer, there may be additional performance obligations not previously considered. For example, many entities have loyalty reward programs which may create additional performance obligations. When an individual picks up their morning bagel, and he or she uses a punch card allowing for a free bagel after purchasing five bagels, the entity may have a performance obligation to provide the sixth bagel for free. Another example is a “free oil changes for life” program provided by an auto dealership when a customer purchases a new vehicle. Each of those future oil changes represents a future performance obligation.

Performance obligations may become increasingly difficult to identify when multiple components or stages are not clearly articulated within a contract, or do not provide separate individual benefit to a customer. If performance obligations are not clearly defined, revenue may not be recognized until all aspects of the contract are fully satisfied. Identifying performance obligations is particularly essential to industries that currently use a percentage-of-completion or some other recognition method for which revenue is recognized over time or phases.

For example, a construction contractor enters into a contract to build a home. The contractor is responsible for design, site clearing, foundation, and construction of the home, and the contract only specifies an obligation for the delivery of the agreed-upon home. While the building materials used in the construction meet the first criterion (they are distinct and can be used on their own), the contract did not identify separate phases of the construction project. Accordingly, one promise of delivery is not separately identifiable from another. Therefore, the contractor will likely consider the contract to include a single performance obligation. In contrast, an entity may sell a product that comes with “free” maintenance services for the first two years. The separate maintenance service meets both criteria of a performance obligation; therefore, it will be considered a separate performance obligation for which revenue would be separately allocated and recognized.

Many industries, as well as entities within certain industries, have deliverable arrangements that are difficult to separately identify. All entities should take great care to identify all their explicit or implicit performance obligations.

Questions about this process? Contact your Eide Bailly representative today.

Catch up on this series!

Revenue Recognition – Step 1: Identify the Contracts with a Customer

Revenue Recognition – Step 2: Identify the Performance Obligation in the Contract

Revenue Recognition – Step 3: Determine the Transaction Price