Identifying performance obligations is the second step in the new revenue model. Listen in to hear how to take that one small step, in what’s going to be a giant leap of implementation. Hear PwC’s Michele Marino define what a performance obligation is, the criteria for determining whether goods or services in a contract should be accounted for separately or as a group, and share an example of applying the guidance.
Hi, I’m Michele Marino.
When assessing contracts under the new revenue standard, a key aspect is determining whether the goods or services provided are individual promises to perform, or if they should be grouped together. Getting this determination correct is critical because it impacts when and how revenue is recognized.
Identifying performance obligations is the second step of the revenue model. In this video I’ll define what a performance obligation is, the criteria for determining when goods or services in a contract should be accounted for separately or as a group, and I’ll share an example of applying the guidance.
A performance obligation is a promise to provide a “distinct” good or service to a customer. This is the unit of account for applying the new revenue standard.
When there are multiple promises in a contract, companies will need to determine whether those goods or services are distinct, and therefore separate performance obligations. Goods and services that aren’t distinct are bundled together with other goods or services in a contract until a single performance obligation is achieved.
There are two criteria for a good or service to be considered distinct, and both of those criteria must be met. The good or service must be capable of being distinct, and it must be distinct in the context of the contract. The first criterion is easier to meet, and it acts as an initial screen. The second is more subjective, and it’s likely you’ll spend most of your time on that one. Let’s go through each of these in more detail.
First, a good or service is “capable of being distinct” if the customer can benefit from that good or service either on its own or with other resources that are readily available.
A customer can benefit from a good or service if it can be used, consumed, or sold for an amount greater than scrap value. A good or service that cannot be used on its own, but can be used with other readily available resources, would also meet this criterion, because the customer has the ability to benefit from it.
A customer is typically able to benefit from a good or service on its own when a company regularly sells that good or service on a standalone basis.
This criterion establishes the baseline level of economic substance a good or service must have to be considered distinct.
Now second, a good or service must also be separately identifiable from other promises in the contract. This is commonly referred to as being “distinct in the context of the contract.”
This criterion requires more judgement than the first. The objective is to determine whether the nature of a company’s promise is to transfer individual goods or services to the customer, or to transfer a combined item, to which those individual goods and services are an input.
There are three factors to consider when making this assessment:
It’s important to recognize that these factors aren’t an exhaustive list and they shouldn’t be used as a checklist. These factors are intended to help determine whether an entity’s performance in transferring multiple goods or services is, in effect, fulfilling a single promise to a customer.
Let’s walk through an example. Assume you sell a washing machine to a customer, and offer them “free” installation. You need to determine whether the contract contains a single performance obligation for the installed washing machine, or separate performance obligations for the washing machine and the installation service. Assume the washing machine is functional without any customization or modification, and that the installation could be performed by several service providers.
Thinking through the first criterion, you would likely conclude that the washing machine and installation are capable of being distinct. The customer can benefit from the washing machine on its own because it could get another company to perform the installation, or perhaps the customer could even install the machine themselves. Additionally, the customer could sell the machine to another party. The customer can also benefit from the subsequent installation services together with the washing machine, which it has already obtained.
Thinking through the second criterion, you would also likely conclude that the washing machine and installation are separately identifiable because they are not inputs into a combined item. You can fulfill the promise to transfer the washing machine and perform the installation service separately, and you aren’t providing any significant integration, modification or customization services.
So in this example, you would have two performance obligations and revenue would be recognized separately; once for the washing machine and then again at installation.
Now, compare this to a situation where you enter into a contract to build a house for a customer. There are many things that go into building a house, for example, there’s nails, lumber, sheetrock, labor. Many of these items are capable of being distinct. But, the customer isn’t purchasing these individual items. Those items would be viewed as inputs used to create the house (or the output) requested by the customer, and there is a significant service of integrating those various goods and services into the home. This would be an example of bundling multiple goods and services into one performance obligation.
While those are the core criteria, companies must consider the terms of their contracts and all other relevant facts, including the economic substance of a transaction, to make this assessment. Determining when goods or services need to be combined into a single performance obligation, and when they should be accounted for separately, will often require significant judgement.
The specific questions and level of complexity will vary by industry. However, the core principle is the same and this assessment must be made based on the facts and circumstances in each arrangement.