{"id":1891,"date":"2017-06-26T12:07:46","date_gmt":"2017-06-26T19:07:46","guid":{"rendered":"http:\/\/www.projectp.com\/ppblog\/?p=1891"},"modified":"2022-11-21T09:55:42","modified_gmt":"2022-11-21T17:55:42","slug":"step-2-identify-performance-obligations-revenue-recognition-standards","status":"publish","type":"post","link":"https:\/\/www.projectp.com\/ppblog\/2017\/06\/26\/step-2-identify-performance-obligations-revenue-recognition-standards\/","title":{"rendered":"Step 2: Identify Performance Obligations – Revenue Recognition Standards"},"content":{"rendered":"

This paper is part of the blog series on the impact of ASC 606 and how using Oracle Projects can facilitate compliance with the new revenue recognition standards.\u00a0 Previous posts on this subject covered an\u00a0Overview of ASC 606<\/a> and Step 1: Identify the Contract with the Customer<\/a>.\u00a0 This paper addresses Step 2: Identify the Performance Obligations in the Contract.<\/p>\n

\"ASC<\/a><\/p>\n

This step requires an entity to identify all the distinct performance obligations in a contract or arrangement.<\/p>\n

A performance obligation (commonly referred to as deliverables) is a promise to transfer goods or services to a customer.\u00a0 A good or service is distinct when the customer can benefit from said good or service on its own or with resources the customer already has. The good or service can be transferred to the customer independent of other performance obligations in the contract.\u00a0 Goods and services that are not distinct should be combined with other goods or services until the whole group is distinct.<\/p>\n

In addition to performance obligations explicitly outlined in a contract, obligations that a customer may expect because of an established business history must be examined.\u00a0 For example, if a vendor has always provided free shipping to a customer, and the customer expects the goods to be shipped for free, the shipping would represent a performance obligation even though it is not explicitly stated in the contract.<\/p>\n

How to Determine When a Good or Service is Distinct<\/span><\/h3>\n

To be distinct, a good or service must meet two criteria:<\/p>\n

    \n
  1. It must be capable of being distinct, and<\/li>\n
  2. It must be separately identifiable.<\/li>\n<\/ol>\n

    The first criterion is similar to the standalone value defined initially in ASC 605.\u00a0 The customer should be able to benefit from the good or service on its own or in combination with other resources it has on hand.<\/p>\n

    The second criterion is a new concept.\u00a0 The underlying concept in determining whether a good or service is separately identifiable is the notion of \u201cseparable risks.\u201d\u00a0 Separable risks relate to whether the risk associated with the obligation to transfer the goods\/services is separate from the risk associated with transferring other goods\/services.\u00a0 Interpretation of this concept has varied, and the Board decided that entities should evaluate if promised goods\/services represent individual promises or inputs in making up a combined output.<\/p>\n

    The Standard puts forth three factors that may indicate when goods\/services are not separately identifiable and should be combined as one performance obligation:<\/p>\n

      \n
    1. The entity provides a significant service of integrating the good\/service with other goods\/services in the contract<\/li>\n
    2. The good\/service significantly modifies or customizes another good or service in the contract<\/li>\n
    3. The good\/service is highly interrelated or dependent upon another good or service in the contract.<\/li>\n<\/ol>\n

      These factors should not be used exclusively to determine if they are separable, and the Board requires judgment by the entity of all facts and circumstances within the contract.<\/p>\n

      Factors Affecting an Entity\u2019s Evaluation of Performance Obligations<\/span><\/h3>\n

      Principal vs. Agent<\/strong><\/p>\n

      If other parties provide goods or services to an entity\u2019s customer, the entity must determine whether its performance obligation is to provide the goods\/services themselves (Principal) or to arrange for another party to provide the goods\/services (Agent).\u00a0 This will determine the amount of revenue that the entity can recognize.\u00a0 If the entity is the principal, it will recognize the gross amount received from the customer. However, if the entity is the agent, it can only recognize the fee or commission received for facilitating the sale.\u00a0 This identification is critical to correctly recognizing revenue in these situations.<\/p>\n

      Warranties<\/strong><\/p>\n

      The new standard now distinguishes two different types of warranties which are accounted for differently.\u00a0 An Assurance-Type Warranty guarantees that the good\/service functions as promised and is not a distinct performance obligation.\u00a0 A Service-Type Warranty provides benefits beyond what the Assurance Warranty offers and would create a distinct performance obligation.<\/p>\n

      Customer Options for Additional Goods or Services<\/strong><\/p>\n

      This would pertain to options like customer loyalty points or discounted contract renewals.\u00a0 A distinct performance obligation is created if the option provides a material right to the customer.\u00a0 A material right is not clearly defined but must be more than the standard discount available.<\/p>\n

      Nonrefundable Upfront Fees<\/strong><\/p>\n

      This is similar to a customer option.\u00a0 For example, a customer signs up for a martial arts class with a one-year contract, and an upfront fee is charged.\u00a0 That fee is not required when the customer renews his contract.\u00a0 Because the second year is being purchased at a \u201cdiscount,\u201d a material right is created and should be accounted for as a distinct performance obligation.<\/p>\n

      Stand-Ready Obligations<\/strong><\/p>\n

      This can happen either through contract specifications or customary business practices.\u00a0 This happens when an entity is required to have services ready whenever a customer decides to use them.\u00a0 An example would be a 24-hour health club.\u00a0 Revenue received is recognized over the period an entity offers the stand-ready service.<\/p>\n

      Rights of Return<\/strong><\/p>\n

      A right of return obligates a customer to accept the product should it be returned.\u00a0 This adds variability to the transaction price and should be considered when evaluating variable consideration.<\/p>\n

      Using Oracle Projects to Meet The Objectives of Step 2 of ASC 606<\/h2>\n

      In our previous paper, we described three types of contracts typical to service delivery organizations:<\/p>\n

      Service Contracts based on selling hours (Time & Expense-\u201cT&E\u201d)<\/span>: In this scenario, the delivery organization contracts to provide a specified number of hours of specialized resources that will deliver to the client\u2019s requirements. There are no specific deliverables listed in the contract. These contracts are slowly disappearing as clients demand more specifics before signing contracts.<\/p>\n