In step two of the new revenue recognition standard, an entity is required to identify all of the performance obligations promised in a contract with a customer. In many cases, the performance obligations are readily apparent in the contract. In other cases, promises implicit in the contract may qualify as performance obligations. One type of promise mentioned explicitly in the standard is the obligation to stand ready to provide a good or service. There has been significant discussion about when these promises constitute a performance obligation, as well as the appropriate pattern of recognition for revenue related to these obligations (for information on patterns of revenue recognition, see step five of The Five-Step Method).
Accounting Standards Codification (ASC) 606-10-25-18 provides a list of 10 examples of goods or services that might be promised to a customer (explicitly or implicitly). Paragraph 18(e) reads:
Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use as and when the customer decides.
When an entity has entered into a contract to “provide a service of standing ready to provide goods or services,” it should assess the following two factors to determine the pattern of revenue recognition:
- How the customer receives the benefits
- The nature of the entity’s performance
The standard provides the example of an entity that owns and manages a chain of health clubs (Example 18, ASC 606-10-55-184 through 55-186). The entity enters into a one-year contract with a customer to provide unlimited access to the health club facilities. In this example, the customer benefits from the entity’s service of making the health club available, and the customer’s use of the facilities does not affect the remaining goods and services that the entity has contracted to provide. The standard concludes that the entity should recognize revenue on a straight-line basis throughout the year.
Other fact patterns might not lead to straight-line or ratable recognition throughout the period of the contract, however. For example, if it is more likely that the entity will be required to stand ready and perform at certain points in the contract, then revenue should be allocated to the periods when the entity expects to be required to perform. An entity should consider which method of allocating revenue best reflects the satisfaction of the performance obligations in the contract. It may be useful to consult the guidance on Input and Output Methods to assist in determining how revenue should be allocated across the life of the contract (for more information, see Input Versus Output Methods).
The Transition Resource Group (TRG) memo on stand-ready obligations gives the example of a company that contracts to clear the snow off of the runways of an airport for a year. Assume in addition to these facts that the airport provided consideration of $1,200 for this service. Although the airport does receive some benefit from the promise of standing ready to clear the snow from the runways, the airport is receiving more benefits during the winter months when it is more likely to snow. Additionally, during these months the company is more likely to be obligated to perform. For these reasons, the company could conclude that it is appropriate to allocate significantly more revenue to the winter months. For example, the company might allocate $300 per month to December through February, and only $33 per month to the other months of the year.
Diversity in thought
In the TRG memo on stand-ready obligations, the Financial Accounting Standards Board (FASB) staff describes four types of scenarios that respondents thought would qualify as stand-ready obligations. The four types of scenarios are:
- Type A – The entity has control over when the goods or services are delivered, but needs to develop those goods or services further. For example, unspecified software upgrades.
- Type B – Neither the entity nor the customer has control over the delivery of the obligation. For example, a company promises to remove snow from an airport’s runways for a fixed yearly fee.
- Type C – The customer has control over the delivery of the goods or services. Certain maintenance arrangements would fall into this category.
- Type D – The entity is obligated to make a good or service continually available, as is the case with health club chains.
The health club example discussed above falls under Type D. As discussed, the revenue in this case should be recognized straight-line over the contract. The other types of stand-ready obligations are not addressed in the new standard. For these other types of stand-ready obligations, stakeholders were concerned about how to apply the standard. Stakeholders raised two key questions:
- How often should stand-ready obligations be accounted for separately (i.e., how often will they be distinct)?
- When stand-ready obligations are distinct, when is it appropriate to recognize revenue on a straight-line basis?
As these discussions are interrelated, they will be presented together in the following section.
When is it appropriate for an entity to recognize revenue for a stand-ready obligation?
View A. Revenue associated with stand-ready obligations should be recognized on a straight-line basis. Proponents of this view note that a stand-ready obligation requires providing a service of standing ready to provide goods or services to a customer. In a stand-ready obligation of either type B or C, the customer benefits from the assurance that the goods or services will be available, not solely from the actual delivery of the goods or services.
Proponents of this view would also argue that obligations of type A are providing assurance to customers against obsolescence of their goods or services (particularly for intellectual property licenses). Inasmuch as these stakeholders believe that the customer benefits from each of these obligations, they would argue that these obligations are distinct, and should be accounted for separately. Furthermore, since the benefit received by the customer is a function of time, stand-ready obligations should be recognized on a straight-line basis over the period of time that the company is obligated to stand ready. Proponents of this view would apply the treatment recommended in Example 18 for all four types of stand-ready obligations.
View B. Revenue associated with many stand-ready obligations will not be recognized on a straight-line basis. Proponents of this view argue that few performance obligations will primarily constitute a stand-ready obligation. Although the customer does receive benefit from the assurance that the goods and services will be available when they need them, most stand-ready obligations will likely be difficult to separate from the delivery of the underlying goods and services. In cases where the two performance obligations are not distinct, the straight-line method of recognition would likely not be representative of the actual transfer of benefits to the customer. Even in cases where the stand-ready obligation is distinct, it would be inappropriate to default to a straight-line pattern of recognition for a stand-ready obligation unless that pattern best reflected the pattern of transfer of benefits.
In discussion at the TRG, the majority of TRG members agreed more strongly with view B. One particular weakness that was noted in these deliberations is the fact that applying view A would lead to a significant increase in performance obligations that the Board did not intend to create, as was reaffirmed by a board member present at the TRG meeting. Additionally, the treatment in view A of accounting for many stand-ready obligations as distinct would sometimes run afoul of the guidance on distinctness both inside and outside of the contract (for more information about distinct performance obligations, see Distinct within the Context of the Contract).
Furthermore, there was some discussion that similar performance obligations could reasonably be accounted for differently. For example, some TRG members expressed the view that unspecified upgrades, or when-and-if available upgrades, for software could be accounted for differently according to the facts and circumstances of the entity. For example, if a software company knows that it intends to release major updates, then straight-line recognition would be less appropriate, and more revenue should be allocated to the periods where the new release is being developed. However, if that company was instead periodically providing bug fixes and incremental improvements, straight-line recognition might be appropriate.
Comparison to 605
Stand-ready obligations were not specifically addressed under ASC 605, but some of the transactions that stakeholders identified as potentially including stand-ready obligations did have related guidance. Accounting for Type D performance obligations will likely remain relatively unchanged, as revenue from these kinds of membership services was already recognized ratably over the life of the contract.
On the other hand, the accounting for software contracts including unspecified upgrades is likely to change significantly. In software contracts under ASC 985-605, companies were required to have standalone sales for every deliverable in a contract in order to allocate revenue; if any deliverable did not have standalone sales, then revenue from the whole contract would be deferred until the last deliverable was delivered. In contracts with postcontract customer support (PCS), which included when-and-if available upgrades, this often meant that the revenue was recognized ratably throughout the period where PCS was being provided. This led to significant deferral of revenue in software companies. While the when-and-if available upgrades might still be recognized ratably, the fact that they could now be distinct will require much earlier revenue recognition for other obligations included in the contract.
Stand-ready obligations are a new concept in ASC 606. However, they will not necessarily result in different accounting treatments in all cases. In many cases, entities may decide that the stand-ready obligation is not distinct, and therefore will not allocate any revenue to it. In situations where a stand-ready obligation is distinct, the entity will need to exercise judgment in determining whether the customer benefits equally from having the contract in place throughout the life of the contract, or whether the customer benefits more at certain periods or points during the contract. Revenue will need to be recognized accordingly. While many companies will have to adjust their accounting slightly, we expect that this could be a more significant change for software companies.
- ASC 606-10-25-18; ASC 606-10-55-184 to 55-186.
- FASB & IASB, TRG Memo 16: “Stand-ready obligations.” 26 January 2015.
- Deloitte, TRG Snapshot: “Joint Meeting on Revenue.” October 2014. Topic 5 “Stand-Ready Obligations.”
- EY, To The Point: “TRG Revenue Recognition.” January 2015. Appendix “Stand-Ready Obligations.”
- PWC, “TRG Third Meeting on Revenue Recognition.” January 2015. Paragraph 23 “Stand-Ready Performance Obligations”.