Step 2 of the revenue recognition model requires entities to determine whether a promised good or service is distinct (Accounting Standards Codification (ASC) 606-10-25-14). Distinct goods and services are considered separate performance obligations for recognizing revenue. This article presents a series of cases to illustrate the process of identifying distinct goods and services within a contract. This process includes analyzing the following criteria required for a good or service to be considered distinct:
Capable of Being Distinct. For a good or service to be considered distinct, it must first be deemed as capable of being distinct, which is similar to the notion of standalone value under ASC 605. Entities must consider whether the customer can benefit from the good or service on its own or together with other readily available resources.
Distinct within the Context of the Contract. The next step to determine whether a particular good or service is distinct is to evaluate whether it is separately identifiable from other promised goods or services in the contract (distinct within the context of the contract). In other words, entities must determine whether the nature of the contract is to transfer each good or service individually or, instead, as a combined output to the customer. To assist in making this determination, ASC 606-10-25-21 provides a list of potential factors that would indicate that a promised good or service is separately identifiable. The following summarizes these factors:
- Significant integration service. This factor considers whether the vendor is providing a significant service of combining promised goods or services into a combined output. If this is the case, the individual goods or services of a contract are not distinct because they represent inputs to a combined output contracted by the customer.
- Significant modification or customization. This factor considers whether goods or services in a contract significantly change other goods or services, which may indicate that the entity is not providing a distinct promise.
- Highly interdependent or interrelated. This factor considers whether goods or services significantly affect each other in such a way that the entity could not transfer these goods or services independently.
These factors are not exhaustive and the existence of a single factor is not determinative; thus, all the facts and circumstances should be considered.
The foregoing criteria are examined at greater length in the article, Distinct within the Context of the Contract.
Case 1: Home Security Equipment, Installation, and Monitoring
LiveSafe Security (LSS) is a leader in the residential security industry. LSS offers a variety of tiered packages to residential homeowners. Tiered packages differ in the quality and amount of security equipment included. In addition to the packages, customers must select monitoring services with periods of 1, 3, or 5 years. Customers cannot purchase the security equipment from LSS without also subscribing to LSS’s monitoring service. Without LSS’s security monitoring, the equipment remains partially functional; however, security compromises are not electronically reported to LSS. For example, door detectors will still beep and the internal alarm will sound if doors are opened after the house is locked down, but LSS will not monitor such occurrences.
LSS can typically install a system and start monitoring services within one week of a sale. Third-parties routinely perform similar installation services, but they typically take twice as long. At the conclusion of the contract term, LSS customers often continue business with LSS by purchasing additional years of monitoring sold on a standalone basis. However, other security companies can provide monitoring services using the LSS equipment.
Recently, LSS sold its standard package to a homeowner. The contract includes the following promised goods and services:
- Home security equipment, including motion sensor lights, door and window detectors, and a touchscreen control panel
- Equipment installation
- Three years of 24/7 security monitoring
Capable of Being Distinct – LSS begins its analysis by considering if the goods and services of the contract are capable of being distinct. The security equipment appears to be distinct because the customer can use the equipment by installing it themselves and hiring another monitoring service, even though initially, all customers must subscribe to LSS’s monitoring services. Further, the security equipment, without monitoring, maintains basic functionalities that provide benefits to the customer.
Both equipment installation and security monitoring are sold separately through a third-party or on a renewal basis, also indicating that these services are distinct. Further, the customer can derive a benefit from the monitoring service because it can be used with the delivered equipment, which is a readily available resource. Given this analysis, each feature in the contract above is capable of being distinct.
Distinct within the Context of the Contract – Next, LSS must analyze if the promised goods or services are distinct within the context of the contract using the three factors in ASC 606-10-25-21. These factors are not exhaustive and the existence of a single factor is not determinative; thus, all the facts and circumstances should be considered.
- Significant integration service. LSS is not providing a service of integration. For example, the control of the security equipment, equipment installation, and security monitoring are transferred to the customer in a sequence; e.g. the equipment gives the customer substantial features before the start of the monitoring term. Further, while the installation is, by nature, an integrative service, it does not alter the equipment or monitoring in a way that indicates that LSS is providing a single deliverable. Thus, the promised goods and services do not appear to be separate inputs to a combined output in this arrangement.
- Significant modification or customization. The above goods or services do not significantly modify or customize one another. For example, the installation does not alter the equipment.
- Highly interdependent or interrelated. In this case, the customer can benefit from the security monitoring only after obtaining the security equipment and installation is required for the equipment to provide its intended functionality. However, this does not necessarily mean the equipment and monitoring significantly affect one another according to this factor. LSS must consider whether it could fulfill its promises to provide security equipment, installation, and monitoring separately. Although this customer is unable to purchase security equipment without also purchasing some period of security monitoring per company policy, LSS could fulfill its promise to provide these obligations separately. For example, LSS can deliver the equipment without monitoring and monitoring is available on a renewal basis subsequent to the contract. Further, the equipment maintains some significant functionality without the monitoring. As such, the equipment and monitoring do not significantly affect one another. Similarly, the installation is not highly interdependent with the other contract features. LSS can deliver the other performance obligations even if the customer uses a third-party for installation.
As described in the accounting analysis above, each promised good or service in the contract is capable of being distinct and distinct within the context of the contract. As a result, LSS should complete the 5-step revenue model using the following performance obligations:
- Home security equipment
- Equipment installation
- Three years of 24/7 security monitoring
Case 2: Landscaping Services
Commercial Green Landscaping (CG) is a landscaping company operating in 32 national markets that specializes in landscape installations for SMB (small- and medium-sized business) commercial properties. Typical landscape installations begin with customers selecting landscapes from pre-designed blueprints provided by CG. Once a customer has selected a blueprint, CG may make some minor changes to accommodate the customer’s unique commercial property layout. Recently, CG contracted with a small business to install a landscape based on a pre-designed blueprint. The contract contains the following items:
- Land gradation
- Irrigation system installation
- Sod installation
- Plants and shrubbery, including 12 trees and 36 bushes
- Cement curbing and landscaping rocks
The project is estimated to be completed in three months. The contract items above are occasionally provided by CG separately. Third parties routinely provide these same services on a standalone basis.
Capable of Being Distinct – CG begins its analysis by considering if the goods and services of the contract are capable of being distinct. Generally, the fact that a good or service is sold on a standalone basis, either by the entity or third-parties, is evidence that customers can benefit from goods or services separately. In this case, the customer owns the property to be landscaped and could purchase the contract services separately from CG or other vendors. Therefore, the promised goods and services are capable of being distinct.
Distinct within the Context of the Contract – Next, CG must analyze if the promised goods or services are distinct within the context of the contract using the three factors in ASC 606-10-25-21. These factors are not exhaustive and the existence of a single factor is not determinative; thus, all the facts and circumstances should be considered.
- Significant integration service. At the inception of the contract, the customer contracted with CG to install a landscape that met the specifications of the chosen blueprint. The individual services included in the contract essentially become required inputs to achieve the specified design. In this way, CG provides a significant integration service of combining the land gradation, irrigation system, etc. into the output of a landscaped property that meets the customer’s desired output as specified in the original contract and blueprint.
- Significant modification or customization. The contract services do not significantly modify or customize one another. For example, the irrigation system installation does not customize or modify the land gradation or other landscaping items.
- Highly interdependent or interrelated. The different landscaping elements are often interrelated, in that these elements work together to accomplish a practical outcome. For example, land gradation and irrigation systems support sod installation, maintenance, and use. However, these items are not highly interdependent or interrelated for the purposes of being distinct within the context of the contract. This is because CG could transfer each contract service independently without significantly affecting the other, in spite of the sequential nature of landscaping services (i.e., an irrigation system is typically installed before the sod). Further, CG provides these services separately.
As described in the accounting analysis above, each promised good or service in the contract is capable of being distinct. However, due to the significant service of integration, the contract items are not distinct within the context of the contract. As such, CG will complete the 5-step revenue model using one performance obligation.
Case 3: Software License and Installation
Track-to-Perform, Inc. (TPI) is a software company that specializes in financial planning and analysis tools for small businesses. The company offers a standard software program for various license durations. The standard program allows businesses to set departmental budgets and prepare financial reports and visualizations. TPI also offers installation services. These typically include customizing the program’s aesthetics from pre-made templates to match a customer’s preference. In other cases, larger customers may require additional installation services such as integrating the software program with the customers’ financial databases and other company systems. These additional installation services are performed by a professional services team within the company because the integration alters the software to create custom functionalities. TPI routinely sells software licenses separately and third-parties can perform the integration services. However, only TPI can alter the aesthetics of the program.
Recently, TPI entered a contract with a professional services firm to provide the following:
- Two-year software license
- Professional installation services
The contracted installation services are scheduled to take a month to complete. The services include customizing the software program’s color schemes to match the customer’s branding (“aesthetic installation”) and a full integration with the customer’s other systems, e.g., HR, sales, etc. (“integration installation”). TPI’s installation team has determined that the software itself will require significant modification to accommodate the integration. During the installation period, the customer does not have access to the software program.
Capable of Being Distinct – TPI begins its analysis by considering if the goods and services of the contract are capable of being distinct. TPI routinely sells the software license and aesthetic customization on a standalone basis and third-party vendors often perform the integration installation contracted by the customer. Further, the customer can benefit from the installation services with the software license, which is a readily available resource once delivered. Given this analysis, each of the promised goods or services is capable of being distinct.
Distinct within the Context of the Contract – Next, TPI must analyze if the promised goods or services are distinct within the context of the contract using the three factors in ASC 606-10-25-21. These factors are not exhaustive and the existence of a single factor is not determinative; thus, all the facts and circumstances should be considered.
- Significant integration service. TPI’s professional installation services, specifically the integration installation, create certain functionality essential to the customer’s intended use of the software. Therefore, without the integration installation, the software would not meet the customer’s needs. Further, the customer does not have access to the software during the installation period. As such, the software license and the installation are inputs to create a combined output of an integrated software system. In this case, TPI is performing a significant integration service.
- Significant modification or customization. The professional installation services customize the software in two ways: (1) aesthetics and (2) integration. In this case, the aesthetic customizations are not significant. These changes alter the appearance of the program, but do not affect the core functionalities of the software or the customer’s ability to derive value from the software. However, the modifications made to the software as part of the integration installation are significant. TPI’s professional services team must modify the software’s code to create custom functionalities to connect with other systems. Therefore, the integration services significantly modify the software license.
- Highly interdependent or interrelated. In this case, the customer can purchase the software without the professional installation. This is because the integration installation is available through a third-party. While the aesthetic installation is only provided by TPI, this service does not affect the customer’s intended use of the software. As such, the software and professional installation are not highly interdependent.
As described in the accounting analysis above, each promised good or service in the contract is capable of being distinct. However, due to the significant service of integration, the software license and installation are not distinct within the context of the contract. Thus one performance obligation exists in this contract.
The process of determining whether goods or services in a contract are distinct performance obligations is complex. Companies should note that this is an area that requires significant judgment and should consider all the facts and circumstances of the contract. After the determination has been made, the distinct performance obligations will then be used to complete the 5-step process.
- ASC 606-10-25-19 to 25-22, 55-137 to 55-150K
- ASU 2014-09 “Revenue from Contracts with Customers.” BC102-BC112.
- EY, Financial Reporting Developments: “Revenue from contracts with customers.” October 2018. Section 4.2.1.
- KPMG, Handbook: “Revenue Recognition.” November 2018. Section 4.4.
- PWC, “Revenue from contracts with customers.” September 2018. Section 3.4.