The identification of performance obligation(s) represents 1 of 5 steps in the revenue recognition process as outlined in ASC 606. This can be considered the most significant step in the process as the determination has a significant influence on 2 subsequent steps.
Revenue recognition under ASC 606 consists of the following 5 steps:
- Identify the contract
- Identify the performance obligation(s)
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue when (or as) each performance obligation is satisfied.
A contract has been defined as an agreement between two or more parties that create enforceable rights and obligations. Once a contract has been identified, management should consider if it consists of one or multiple performance obligations. A performance obligation is a promise made to a customer to transfer a good or service that is distinct, or a series of goods or services that follow the same pattern of transfer to the customer. The important distinction when analyzing the contract is whether the goods and services (performance obligations) are distinct and identifiable.
If multiple performance obligations exist, the allocation and recognition (steps 4 and 5) of the transaction price could be impacted. An example of such contract could be a design, build, and maintain job. In this example the contract calls for the design, build, and subsequent maintenance of the end deliverable (roadway, ventilation, infrastructure, etc.). In these situations, the design and build aspect can be considered one performance obligation as both aspects are not distinct from one another, and both are needed to complete the deliverable.
However, the maintenance aspect of the contract could be considered a separate performance obligation. When contracts include these activities, it is critical to understand the nature of the maintenance being offered. If maintenance is related to an assurance type warranty an additional performance obligation does not exist. Assurance type warranties are not distinct from the build aspect of the job, as they provide assurance that the end deliverable meets the specifications as outlined in the contract. However, if the maintenance relates to a service warranty, or maintenance contract following the build, a separate performance obligation exists. This maintenance work is a distinct and identifiable service offered to the customer that can be differentiated from the design build aspect of the job.
Under ASC 606, these projects should be accounted for separately. Management should allocate the transaction price in the contract between the identified performance obligations. Once allocated, management should recognize costs and revenue separately based on the progress made towards each performance obligation. By doing so management will be able to avoid the misstating revenue and have a more precise presentation of job progress and profitability.