Identifying performance obligations can become difficult when dealing with large, multifaceted, contracts. This is why many companies often produce an extensive analysis to explain and identify the performance obligations associated with certain goods and services. Understanding how to correctly identify promised goods and services is a crucial step in the revenue recognition process.
Identifying Promised Goods and Services
Customer Perspective
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.
Immateriality
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.
Actual Company Example - Fanhua Inc. Immaterial Services Implicit In The Contract
Fanhua Inc. is one of the largest technology and insurance agency groups in China, connecting
approximately 12 million individuals to over 100 of their insurance company partners. As part of the Company’s business, they will often promise post-sale services in their contracts with their customers.
The SEC contacted Fanhua to better understand how the company recognizes revenue with regard to these post-sale services, and more specifically, why it identifies the post-sale services as immaterial seeing that its obligation to provide these services can be up to the 20 year renewal terms.
In the letter to the SEC, Fanhua explained, “With regard to the conclusion that the post-sale services are immaterial in the context of the contract, it is based on 1) the nature of the work required to perform; 2) the reason for deferral of renewal commission payments by the insurance companies; and 3) the cost and time required to complete such service.”
Additionally, Fanhua provided a few reasons how it arrived at this conclusion (February 2021 letter to the SEC):
- With regard to ASC 606-10-25-17, none of its post-sale activities on their own would result in a transfer of a good or service to the insurance company.
- When the insurance policies are sold, “the Company does not have any ongoing obligation to provide additional selling or remarketing services to insurance companies to secure policy renewals.”
- It determined that the expected costs from the post-sale services are “qualitatively and quantitatively insignificant and administrative in nature.”
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.
Actual Company Example - CSX Corp. Immaterial Services Implicit In The Contract
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.
Implicit Promises
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.
Fulfillment Activities
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, for most businesses, setup activities may be ignored in the context of identifying promised goods and services and recognizing revenue (ASC 606-10-25-17). However, effective December 16, 2020, non-public franchisors that enter into a franchise agreement may account for certain pre-opening services as being distinct from the franchise license. These exceptions can be found in the transitional guidance and are referenced in ASC 606-10-25-18C.
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.
Actual Company Example - Materion Corp. Fulfillment Activities In Contract
Materion Corp. (Materion) is a multinational company specializing in high-performance engineered materials. They are a global supplier of specialty materials including alloys, beryllium products, composite/clad metals, thin film deposition materials, and precision optics.
The Company had recently entered into an investment and master supply agreement with a customer that has provided prepayments to Materion to procure equipment and manufacture product for the customer. At the end of the contract, Materion will retain the equipment.
The SEC asked Materion to explain how they determined if the pre-production activities represented a promised good or service or fulfillment activities.
In response to the SEC, Materion explained that the pre-production activities represented a fulfillment activity because control of the facility and equipment does not transfer to the customer. Here is Materions analysis (April 2022 letter to the SEC):
The Investment Agreement and the Supply Agreement require Materion to both install equipment to establish the necessary infrastructure and to ship commercial product to authorized buyers. The establishment of the infrastructure and procurement of the equipment is concluded to be a pre-production activity that is not a promised good or service to the customer but is considered a fulfillment activity because control of the facility and equipment does not transfer to the customer (ASC 606-10-25-17)
Marketing Incentives
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.
Conclusion
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.
Resources Consulted
