Step 2 of Accounting Standards Codification (ASC) 606 requires entities to identify separate performance obligations once a contract has been identified. An entity should account for a good or service as a separate performance obligation if the good or service meets the criteria to be distinct and separately identifiable.
To be distinct, a good or service must meet two criteria:
- It must be capable of being distinct, and
- It must be separately identifiable or “distinct within the context of the contract”
An entity should consider each promise to deliver a good or service in a contract in light of these two criteria. The first criterion (capable of being distinct) is similar to the notion of standalone value under ASC 605. If a good or service is capable of being distinct, a customer should be able to benefit from the good or service on its own, or in combination with other resources the customer has readily at hand.
The second criterion, however, or the requirement of a good or service being “distinct within the context of the contract,” is a new concept and early interpretation of the guidance has varied. The underlying concept in determining whether a good or service is separately identifiable is the notion of “separable risks”. Separable risks relates to whether or not the risks associated with the obligation to transfer a good or service are separate from the risks associated with the transfer of other goods or services in the contract. However, in spite of the conceptual influence of separable risks to the criterion of goods or services being distinct within the context of the contract, the FASB decided not to include the idea of separable risks explicitly within ASC 606. Rather, ASC 606 emphasizes that entities should evaluate if promised goods or services represent individual promises or inputs making up a combined output or outputs.
Both approaches should be considered when applying the separately identifiable principle. Accordingly, the standard (ASC 606-10-25-21) puts forth three factors that may indicate goods or services are not separately identifiable, and would therefore be combined as one performance obligation:
- The entity provides a significant service of integrating the good or service with other goods or services in the contract.
- The good or service significantly modifies or customizes another good or service in the contract
- The good or service is highly dependent on, or highly interrelated with, other goods or services in the contract.
The factors above are not an exhaustive list and should not be used as criteria. Additionally, the FASB has stated that determining whether a good or service is separately identifiable will require judgment, taking into account all of the facts and circumstances.
Note that judgment is required in reaching conclusions about the factors described above. For example, in order for a good or service not to be distinct within the context of the contract it must significantly modify another good or service in the contract. Just because a good or service modifies another good or service does not automatically mean it is not distinct. An entity must determine whether or not the modification that occurs is significant. Similarly, a good or service may be distinct in the contract while still being interrelated with another good or service in a contract, provided it is not highly interrelated. Some analyses will be relatively straightforward, while others will require significant judgment with strong arguments for either view.
Diversity in Thought
Since the new standard was issued, different views have arisen in several key areas. This article will focus on a few of the most significant areas of disagreement around the three factors in ASC 606-10-25-21, including customer motivation and product customization.
Diversity around factor 21(a) – Customer motivation
It is unclear what role customer motivation should play in determining whether a good or service is distinct in the context of the contract. Two main views have emerged. Some believe that customer motivation is important to understanding the concept of separable risks (View A). In their view, knowledge of a customer’s motivation can be used to determine the level of both integration and interrelation (factors 21(a) and 21(c)) of goods and services within a contract. Other stakeholders believe that customer motivation should not be taken into consideration (View B), because of the difficulty of identifying a customer’s motivation and the concern that such an approach could lead to different treatments for economically similar transactions.
View A. One of the most frequent examples used to demonstrate the distinct within the context of the contract principle is building a house. Each of the different materials and services that go into completing a house may be capable of being distinct as they deliver economic benefit to the customer. Carried to an extreme, even one brick laid on top of the existing bricks could be capable of being distinct. However, due to the level of integration the goods and services undergo in the process of building a home, the individual promises are not separable in the overall transaction. The house is viewed as a combined output of a bundle of goods and services or separate inputs. Certain stakeholders have interpreted examples used to demonstrate the input in a combined output principle (606-10-25-21[a]) to indicate that the motivation and viewpoint of the customer should be part of the distinct analysis. The customer has contracted to have a home built—not to have a collection of bricks, wood, nails, and services delivered. Proponents of this viewpoint point to the fact that it is unlikely the customer will view the separate materials and services as separate obligations in the contract; instead, they will just look at the final output. The example of building a house could be used as an analogy in many transactions for determining the output a customer is expecting to receive. Although the guidance does not specifically direct entities to put themselves in the shoes of the customer, it does allow the consideration of all facts and circumstances in exercising judgment. In certain circumstances, the motivation of the customer may be reasonably and readily determinable, and View A would deem that information as part of relevant facts and circumstances to include in the analysis.
View B. Other stakeholders have voiced a different point of view, arguing that customer’s motivations should not be taken into consideration when determining any of the separately identifiable factors. Proponents of this viewpoint often cite BC101 where the FASB observes that it would be difficult if not impossible for an entity to know the customer’s intentions in a given contract. Furthermore, if customer motivation was given significant weight in analyzing a factor, different accounting treatment for economically similar transactions could follow. The language of factor 21(a) states that the good or service is used as an input in delivering or producing “the combined output specified by the customer.” View B stakeholders will observe that customer specifications of combined output are different from assumed customer perception of combined output. The combined output is a house not because that is the final, combined deliverable in the eyes of the customer, but rather because the customer specified the particulars of the house at contract inception.
Diversity around factors 21(b) and 21(c) – Product Customization
A specialized product manufacturer contracts with a mining company to deliver five pieces of customized mining equipment to be used in the mining company’s fracking operations. The mining company has previously collaborated with a product design firm to produce finalized design specifications and manufacturing instructions, which will be given to the manufacturer as part of the contract. The manufacturer will assemble and deliver the products over a 24 month period.
Whenever a contract involves the delivery of a series of customized products to a customer, the presence of a number of factors may make the analysis of whether each product is distinct within the context of the contract less straightforward. Differing viewpoints of the implications of the presence of implied services or promises or a learning curve may complicate the identification of separate performance obligations.
Implied Services. Many stakeholders have observed that even when the design work of a customized product has been performed by the customer or a third party, facts and circumstances may exist that would make products not separately identifiable from one another. For instance, in the case of the Example above, if the equipment has never been manufactured before and the manufacturing process is new and uncertain, it is possible that some level of rework and redesign services are implied in the contract. In process of carrying out manufacturing for the first product, the manufacturer may make mistakes, improvements, or other changes to the design or manufacturing process as they perform the work. These changes will in turn benefit the manufacturing of products 2 through 5. Further retooling and redesign may be done in connection with the manufacturing of the second product and so forth all the way to the completion of the fifth and final product.
Do the benefits to the latter products gained from retooling and redesign work on the earlier products constitute significant modification or customization per ASC 606-10-25-21(b)? Or does this particular form of manufacturing make all the products highly interrelated per ASC 606-10-25-21(c)? Many stakeholders have interpreted the guidance to mean that a scenario in which rework and redesign were an implied part of the contract would prevent each individual product as being accounted for as distinct. The rework and redesign services as described here seem to cause an interrelation of the different units being produced, effectively meeting factor 21(c). This would result in deferred revenue in the case of the manufacturer.
Learning Curve. Significant judgment will often be necessary in assessing the interrelatedness of products and the degree of modification/customization present. For a manufacturer, the presence of a learning curve in producing units is similar to the scenario of rework and redesign given above. In most manufacturing scenarios, the cost per unit will decrease as aggregate unit production increases as the company learns and becomes more efficient in producing the product. Does the fact that later units produced will cost less as a result of learning from earlier units result in the products being highly interrelated?
In assessing both the effect of implied design work and that of a learning curve, taking a step back and viewing the overall promises contracted for may be helpful. In the underlying economics of the transaction, what is the customer actually contracting for? In a scenario where the manufacturer does redesign work and modifies the manufacturing process, it may be implied that the result of that work will be passed along to the customer in the end. Indeed there may be an inherent “promise” that the customer is contracting with the manufacturer to learn and work out the details of its product that will be in turn given back to the customer and used for years to come. In the case of a learning curve, those same promises might not exist. Although the manufacturer will see costs decrease and greater efficiencies as a result of producing more units, in some cases those services or benefits may not be passed along to the customer.
In their Oct. 31, 2014 meeting, members of the Transition Resource Group (TRG) emphasized the importance of considering the overall contract and not basing the distinct analysis on one factor in isolation. Just because a manufacturer completes redesign work does not necessarily mean products are not distinct. In this case and in all cases, all facts and circumstances should be considered.
Changes from 605
The requirement that a performance obligation be capable of being distinct will not be a major change from the old standard. A good or service being distinct replaces the notion of a good or service having standalone value in ASC 605. On the other hand, the concept of distinct within the context of the contract is unique to ASC 606. Overall, in most industries it is expected that many goods and services that did not have standalone value under ASC 605 will be treated as distinct under ASC 606.
Entities must take steps to ensure the proper controls are in place to assess the distinctness of each good or service in contracts it enters into with customers. Conclusions reached under ASC 606 will often be different than those under ASC 605 and may lead to a different recognition pattern for certain goods and services.
This issue was identified by the TRG as a hot topic and was discussed at its October 31, 2014 meeting. Most of the issues discussed were not fully resolved, and the FASB instructed the staff to perform additional research and outreach. An update on this research is scheduled at the January 26, 2015 meeting of the TRG, and a further update will be scheduled in future. This article will continue to be revised as these new updates come available.
Accounting Standards Update (ASU) 2016-10, issued by the Financial Accounting Standards Board (FASB) in April 2016, addresses the subject of this article. ASU 2016-10 seeks to clarify the separately identifiable principle and expand examples on the subject. The changes made to ASC 606 as a result of this update are reflected in the article above. The TRG has yet to release further discussion on the topic.
- ASC 606-10-25-18 to 25-22
- ASU 2014-09: “Revenue from Contracts with Customers.” BC101.
- ASU 2016-10: “Identifying Performance Obligations and Licensing.”
- Deloitte, “A Roadmap to Applying the New Revenue Recognition Standard.” February 2015. Section 6.3.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” October 2018. Section 4.2.1.
- FASB TRG Memo 9: “Distinct in the Context of the Contract.” 31 October 2014.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 5.2.1.
- PWC, “Revenue from contracts with customers.” August 2016. Section 3.3.