To continue the discussion of the ASC 606, Step 2 of the revenue recognition process requires examining what the seller has promised to do for the customer, and if there are multiple promises, whether these promises should be accounted for separately or combined. This examination determines the performance obligations which are the basis for the revenue recognition.
Performance obligations must meet both of the following criteria:
– Capable of being distinct: 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
– Distinct within the contract: The promise to transfer the good or service is identifiable as separate from other promises in the contract
The definition of distinct is from the customer’s perspective. The deliverable has to possess stand-alone value in the customer’s view. When a transaction is examined from the customer’s perspective, certain elements may be implied and create a customer expectation. Product upgrades are an element of a revenue transaction that may not have been treated as a separate performance obligation in the past but could meet the definition under ASC 606. If these upgrades are described as “if and when available” and the company has a history of providing upgrades, then these upgrades meet the definition of a performance obligation. Contrary to current US GAAP, identifying upgrades as a separate performance obligation may allow license revenue to be recognized at a point in time and upgrades to be recognized over time.
If a good or service does not meet the “distinct” definition above, then it should be combined with deliverables until an aggregation of a distinct good or service is met. This combination of deliverables will be treated as the performance obligation.
Obligations that are immaterial are not considered a separate performance obligation. This is an area of revenue recognition that has not changed from the current guidance. These immaterial items include:
– Implied warranties that are not specifically elected by the customer (bug fixes)
– Protective provisions in a contract, such as IP indemnification or promises to defend patents
– Marketing offers when they don’t constitute a material right
Options for additional goods and services may qualify as additional performance obligations. Examples of these customer options would be discounts on future goods or services, sales incentives, customer award credits, and contract renewals. These customer options would qualify as a performance obligation if the options provide material rights to the customers that they would not receive without entering into the contracts. Would the customer have the option if they did not enter into the current contract? When the option is independent, it is a marketing offer and not a material right. When the option to purchase additional goods or services constitutes a material right to the customer, the customer is in effect paying in advance for future goods and services. To make this a little clearer, consider this example:
A software company offers a discount on the 3rd year of maintenance if the customer renews for the 2nd and 3rd year at the same time. This discount on the 3rd year of maintenance is considered a material right that the customer would not have received if it had not entered into the contract. A portion of the transaction price for the contract should be allocated to the 3rd year discount option based on its relative standalone selling price.
It is time to take a fresh look at your contracts and consider what the customer is purchasing. Once the performance obligations are identified, Step 3 focuses on the transaction price being paid for these obligations. Stay tuned.