Identifying performance obligations can become difficult when dealing with large, multifaceted
, contracts. For example, Service Corporation International (SCI) had to produce an extensive analysis to explain the performance obligations associated with producing gravestones. SCI described why certain gravestone production events are considered immaterial within contracts. This analysis allows SCI to minimize the work involved in accounting for the different sections of their contracts.
Identifying Promised Goods and Services
Goods or services are considered “promised” when the customer has a valid expectation to receive them (ASC 606-10-25-16). Therefore, a guiding principle in identifying promised goods or services is to analyze the contract from the perspective of the customer. If analysis of the contract leads an entity to believe that a customer sees something as part of the negotiated agreement, either explicitly or implicitly, then that item is considered a promised good or service.
Illustrative Example – Customer Perspective
Penny Corporation has engaged Bond Corporation to create a special tool to machine engine valves. The machine is intended to lower variable costs and reduce defects by operating within tighter tolerances. The resulting valve is superior to any other manufacturer’s valve-train products. As Bond is building the machine, after the contract is signed, it decides to include a vacuum system to continuously remove steel shavings from the work surface. The vacuum system was not part of the machine specifications originally contracted for and is intended to show Penny, which is Bond’s newest and largest client, that Bond is willing to go the “extra mile” to maintain their business. Adding design elements like this is not standard operating procedure and is very rarely done.
Bond Corporation determines that Penny believes it is only paying explicitly for the originally contracted machine and not for the vacuum system. Further, because this is not standard operating protocol, Bond determines Penny does not believe it is implicitly paying for the extra item. Analyzing from the customer perspective leads Bond to conclude that the vacuum system is not a promised good or service.
Entities are not required to identify performance obligations for promised goods or services that are immaterial in the context of the contract with the customer (ASC 606-10-25-16A). Therefore, revenue may be recognized as material performance obligations are delivered without regard to the transfer of such immaterial promises. The concept of “immaterial in the context of the contract” is not applicable for customer options to acquire additional goods or services.
Evertec Inc. is a data processing entity based in Puerto Rico, Central America, and the Caribbean. Evertec is currently the largest PIN code facilitator, meaning that when a customer swipes a debit card and types in their PIN, Evertec validates that pin.
The SEC questioned why Evertec had two different policies of materiality within the revenue recognition disclosures, which were published in the 2018 10-K. Evertec responded to the SEC’s question by breaking down the quantitative and qualitative factors used in identifying materiality in contracts.
The first threshold (20%) relates to management’s analysis of future purchase options within contracts and is rarely used by Evertec.
The second threshold (10%) relates to whether promises in the contract are considered material and is reevaluated on a much more continuous basis.
Management’s policy states that (i) promises with a standalone selling price (“SSP”) equal to or lower than 5% of the total contract value (“TCV”) are considered immaterial promises, and (ii) requires Management to evaluate promises with a SSP greater than 5% and equal to or lower than 10% considering qualitative factors to determine whether they are a immaterial promises; and (iii) states that promises with a SSP above 10% of TCV are considered material promises.
Evertec further reasons through the method it used to reach the above conclusion.
As set forth in ASC 606-10-25-16A, the Company is not required to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer, or immaterial promises.
Qualitatively, Management analyzes the type of promises included in the contract and to determine whether they would be immaterial from the customer’s perspective. Promises analyzed and considered qualitatively immaterial are typically simple installations, set-ups, and trainings.
Evertec uses specific percentages as its materiality threshold for a variety of transactions, and the SEC accepted this analysis due to Evertec’s qualitative reasoning. These numbers do not universally constitute materiality thresholds, but the analysis provided was sufficient for the SEC’s review because of the reasoning behind it. (September 2019 letter to the SEC)
Illustrative Example – Immateriality
Assume the same facts as the customer perspective example. As part of the agreement, Bond Corporation has agreed to offer one day of training to employees tasked with running the machine. However, because the machine is highly automated, the training is brief and mostly addresses setup, maintenance, and safety. Bond has also developed a manual for using the machine. The value of the manual and the training is about $5,000. Because the machine is highly specialized, the overall transaction price of the contract is $5 million.
Through careful consideration, Bond has decided on a materiality threshold of one percent. Because $5,000 is below the materiality threshold at one-tenth of a percent of the overall transaction price, it is considered immaterial in the context of the contract and should be disregarded in identifying promised goods and services. In other words, the manual and training should not preclude Bond from recognizing the full $5 million in revenue once the machine is delivered.
CSX is one of the largest transportation suppliers in the United States, managing tracks that serve two-thirds of the U.S. population. The company also occasionally works with other carriers to fulfill additional contracts. The SEC contacted CSX to better understand how the company recognizes revenue from these other-carrier transactions.
In its response to the SEC, CSX defined its role in each of its contracted relationships. As part of an implicit promise in the contracts, the company often coordinated with third party companies when creating invoices/bids to find the best price and route for CSX customers.
In the letter to the SEC, CSX concluded, “The promise to arrange shipment and consolidate billing is immaterial in the context of the contract.”
CSX offered a few reasons why it arrived at this decision (September 2018 letter to the SEC):
- Consolidation of billing doesn’t provide a material benefit or right to the customer as administrative in nature.
- When quantitatively determining whether this promise was material in the context of the contract, CSX looked at a theoretical cost plus margin approach and determined the value to be inconsequential, as the time it takes to procure prices and consolidate billing takes less than an hour to complete, as compared to the value of the freight movement using that route in a service agreement.
- CSX does not analyze and develop the rates for the participating carriers and only receives a rate quote once the participating carrier performs their own rate analysis.
In many cases, contracts are straightforward and explicitly state the promised goods or services. However, the standard is clear that promised goods or services are not limited to what is explicitly outlined in the contract (ASC 606-10-25-16). If the customer has a valid expectation to receive control of a good or service, then a performance obligation exists even if it is not explicit in the contract. Promises can be implicit in the contract or implied-in-fact through customary business practices.
Illustrative Example – Implicit Promises
Conrad Corporation has a contract with Profuria Chemical Corporation to manufacture custom, automated production equipment. The equipment will enable Profuria to produce the chemicals used in etching silicon wafers. The chemicals will subsequently be sold to microchip manufacturers. A critical part of Conrad’s business model is providing better customer service than all its competitors.
While not explicitly stated in the contract, Conrad customarily sends technicians once a month for one year after installation of new machinery to ensure that the machinery is functioning properly. Profuria agreed to a contract with Conrad—and even paid a premium—because of this superior customer service. Because Profuria can reasonably expect that Conrad Corporation will send technicians once a month for a year, the technician visits qualify as a promised service. Furthermore, Profuria paid a premium in anticipation of Conrad’s excellent quality and customer service. Consequently, the technician visits should be included in Conrad’s list of promised goods or services, and the company should consider whether these visits represent a distinct performance obligation.
Administrative tasks and setup activities are often necessary to facilitate a contract. While these activities are necessary to ultimately transfer goods and services to the customer, they do not qualify as promised goods or services because they do not directly transfer a good or service to the customer. Consequently, setup activities may be ignored in the context of identifying promised goods and services and recognizing revenue (ASC 606-10-25-17).
ASC 606 provides further guidance for shipping and handling activities performed before or after the customer obtains control of a promised good. When these activities are performed before a customer takes control of the good, the activities are considered fulfillment activities and not a promised service to the customer. However, when such activities are performed subsequent to a customer obtaining control of the good, the entity may elect to treat shipping and handling as either fulfillment activities or promised services as a matter of accounting policy to be applied consistently across all similar transactions. The costs related to these activities should be accrued if revenue is recognized for the services. Entities must disclose any accounting policy election regarding shipping and handling activities.
Performance obligations with multiple goods or services may include promises that should be accounted for as fulfillment costs rather than promised goods or services. For example, a Software-as-a-Service company may provide a license and implementation services to customers. If the company concludes that these two services should be combined into a single performance obligation and that the implementation does not transfer a service to the customer, the implementation service should be treated as a fulfillment cost.
Illustrative Example – Setup Activities
DuPage LightCraft, an aircraft parts manufacturer, signed a contract with Kankakee Corporation, a metals broker, for eleven five-pound ingots of refined rhodium worth $1 million. DuPage plans on using this rhodium to manufacture turbine engine components. Before it delivers the rhodium, Kankakee must complete special insurance paperwork and file specific documentation with the government. Kankakee has engaged a local law firm to complete this paperwork. Because these costs merely facilitate the transaction and do not deliver any additional goods or services to DuPage, they are considered setup activities and are not considered performance obligations.
Service Corporation International (SCI) is North America’s largest cemetery and cremation services company. SCI’s contracts fall into two main categories: preneed contracts (comprised of personalized and planned funeral services for people who have not yet passed), and immediate contracts (for unexpected deaths). The SEC followed up on SCI’s role in finalizing the grave marker, storage, and implementation to see if those were separate performance obligations for preneed contracts.
SCI clarified, “The marker cannot be used or directed to a different customer, as it has been personalized to the customer’s specific design specifications.” When the marker is completed, the remaining promises are immaterial. Here is SCI’s analysis:
The personalized marker merchandise consists of bronze plaques that are cast with the customer’s name, date of birth, and other customized designs, such as quotes and pictures. Once completed, the personalized marker is stored or delivered based on the customer’s direction in the contract. The markers are small (generally, 1″ by 24″ by 12-14″), so each marker does not take up a significant amount of physical space, are made of durable products designed for outdoor use, do not have significant risk of damage or destruction, and are currently stored in areas with relatively low real estate values. At the time of need, the prefabricated year scroll is attached to the marker and the marker is sealed and polished. The prefabricated year scrolls are generally mass-produced and attaching the scroll, sealing, and polishing the marker requires approximately ninety minutes of labor. Additionally, the customer perceives control of the marker has transferred to them upon receipt of the title.
ASC 606 requires the analysis of immaterial performance obligations to be done per individual contract as shown in the analysis above. SCI specifically found that “the promises represent 1-2% of the total consideration in a preneed contract.” Based on the quantitative and qualitative analysis, SCI deemed these contracts immaterial. (December 2018 letter to the SEC)
Sometimes, an entity will provide incentives to “sweeten” a contract. These marketing incentives typically create a liability or an expense incidental to the contract. To be considered marketing incentives, the promised goods or services must be provided “independently of the contract they were designed to secure.” In other words, if the customer pays for a something—even implicitly—it is not a marketing incentive, but part of the contract as a promised good or service. Examples of marketing incentives include customer loyalty points or “free” cell phones provided by a wireless carrier designed to entice a customer to sign a contract (ASC 606-10-25-17) (KPMG Issues-In-Depth – Revenue from Contracts with Customers).
Illustrative Example – Marketing Incentives
Brythia Corporation develops tactical weapons systems for law enforcement and military application. Recently, Brythia made an agreement with the Chicago Police Department (CPD) to deliver 1,000 specially outfitted and engraved Beretta 92 FS sidearms and 500 specially outfitted and engraved Mossberg M590 shotguns.
At the time that CPD ordered the firearms, Brythia was running a special promotion—for orders over 500 firearms, complimentary gun racks and maintenance for one year would be provided. Brythia provides these complimentary goods and services free of charge and does not include the price of these items in the contract price in any way. As a result, the gun racks and maintenance are independent of the contract that they were designed to secure, qualify as marketing incentives, and should be expensed.
Identifying promised goods and services is an important step in the revenue recognition process. ASC 606 outlines terminology and concepts as well as important distinctions between promised goods or services, administrative tasks, and marketing incentives. ASC 606 also instructs entities that materiality in the context of the contract should be considered in assessing performance obligations for revenue recognition purposes.
- ASC 606-10-25-16 to 25-17
- ASU 2014-09: “Revenue from Contracts with Customers.” BC90.
- ASU 2016-10: “Identifying Performance Obligations and Licensing.”
- FASB & IASB Tentative Board Decisions: “Revenue Recognition—Licenses and Identifying Performance Obligations.” 18 February 2015.
- FASB TRG Memo 41: “Measuring progress when multiple goods or services are included in a single performance obligation.” 13 July 2015.
- SEC Staff Accounting Bulletin Topic 13.
- KPMG, Issues In-Depth: “Revenue from Contracts with Customers.” May 2016. Section 5.2.
- KPMG, Revenue Recognition Handbook. December 2019. Section 4.3