The second stop on our journey to revenue recognition is to determine what we are required to do for our customer, our performance obligations.
This is an important stop for us. This is the this stop where we identify what we need to do in order to earn revenue from the customer.
We will start with the technical definition based upon our authoritative guidance (the ASC 606 – Revenue from Contracts with Customers, “ASC 606”, that is) first, and then break it down and simplify it. Let’s go!
What Are Performance Obligations?
The ASC 606 defines a performance obligation to be “a promise in a contract with a customer to transfer either a good or service that is distinct or a series of goods or services that are substantially the same to the customer.”
The thing to remember here is that we may have more than one type of good or service that will be transferred to our customer as part of our agreement with them. Each distinct (that is different) type of good or service that is transferred to the customer as part of our agreement is its own performance obligation.
What we need to do now is identify each of the different types of goods and/or services that we are delivering to our customer (our performance obligations). Let’s take a look at a few examples.
Example 1 – Simple Retail Sale
Let’s say you are a designer jeans retail store. You purchase your inventory of designer jeans from your favorite wholesaler, price them (with your customary markup), and put them on the display shelves to sell to customers. Your ordinary course of business, the reason you exist, is to sell designer jeans at a profit. In this example, your performance obligation is to deliver designer jeans to customers.
Example 2 – Continuous Delivery & Receipt
In this example, you are a cell phone provider. You enter into a contract with your customer to provide cell phone service for two years and agree to deliver and charge your customer for this service monthly. In this example your performance obligation is 24 months of uninterrupted cell phone service. Although you have 24 months of service to deliver, they are all pretty much the same service rather than separate, distinctly different services. In this case you have a series of distinct services that are, for all intents and purposes, the same service (cell phone service) delivered to the customer the same pattern (monthly). This series of 24 months of cell phone service is therefore considered one performance obligation.
Example 3 – Multiple Deliverables
This time you are a software company that has developed a unique software solution for companies to help them manage their data centers more efficiently. You sign contracts with your customers to provide them with the software and install the software on their servers. In addition, you provide a one-year warranty to your customer and also sign them up for one year of software maintenance which includes upgrades.
This case is not as straightforward as the previous two examples, although there could be more complexities, for illustration purposes, we’ll keep it simple. In these types of instances I would highly recommend working closely with your CPA to ensure proper revenue recognition.
By way of example, we’ll say that we’ve got four distinct goods and services to provide to our customer, the software, professional services to install the software, warranty on the software and the one-year maintenance services. Each of these services/goods is different and distinct from the other. This is probably the most complex and difficult type of contract to have to deal with, but it is also not uncommon.
What Are Your Performance Obligations?
When you are thinking about what your performance obligations are, just simply think about what it is you’ve agreed to provide to your customer.
Take an inventory, a simple list, of what you have agreed to sell to your customer, including the services that you have agreed to provide, which could be outside the written contract, but are part of your customary practices. Group the goods/services together that are similar, then separate the remaining goods and services into their distinct deliverables. You have now identified your performance obligations.
Thank you for traveling down the revenue recognition road with me again to our second stop.
Keep going and read on. Read the next post in the Road to Revenue Series: The Transaction Price.
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