When a good or service is not distinct, they should be combined with other promised goods or services until an entity identifies a bundle of goods or services that are distinct. In some cases, this would result in accounting for all the goods or services promised in a contract as a single performance obligation.
The contract with the customer
A contractor enters into a contract to build a hospital for a customer. The contractor is responsible for the overall management of the project and identifies various promised goods and services, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing.
Considerations in determining whether the goods and services are distinct:
The promised goods and services are capable of being distinct because the customer can benefit from the goods and services either on their own or together with other readily available resources. This is evidenced by the fact that the contractor’s competitors will regularly sell many of these goods and services separately to other customers. In addition, the customer could generate economic benefit from the individual goods and services by using, consuming, selling, or holding those goods or services.
The promises to transfer the goods and services are not separately identifiable as evidenced by the fact that the contractor provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.
Conclusion
The criterion has not been met for the goods and services to be considered distinct, and therefore the contractor will account for all of the goods and services in the contract as a single performance obligation. To put another way, the customer entered into a contract with the contractor to a hospital and without the engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing, the hospital could not have been built.
The contract
Merrill Corporation (Merrill) grants its customer Darren Partners (Darren) a three-year term license to anti-virus software and promises to provide Darren with when-and-if available updates to that software during the license period. Merrill frequently provides updates that are critical to the continued utility of the software. Without the updates, Darren’s ability to benefit from the software would decline significantly during the three-year arrangement.
Assessment considerations
Merrill considered whether the software and the updates are each promised goods or services in the contract and are each capable of being distinct because Darren can derive economic benefit from the software on its own throughout the license period (that is, without the updates the software would still provide its original functionality to Darren), while Darren can benefit from the updates together with the software license transferred at the outset of the contract.
Conclusion
Merrill concludes that its promise to transfer the software license and to provide the updates, when-and-if available, are not separately identifiable because the license and the updates are, in effect, inputs to a combined item (anti-virus protection) in the contract.
The updates significantly modify the functionality of the software (that is, they permit the software to protect Darren from a significant number of additional viruses that the software did not protect against previously) and are integral to maintaining the utility of the software license with Darren.
The license and updates fulfill a single promise (one performance obligation) to Darren in the contract (a promise to provide protection from computer viruses for three years).
Merrill will account for the software license and the when-and-if available updates as a single performance obligation because it has concluded that the nature of the combined good or service it promised to transfer to its customer Darren is computer virus protection for three years.
The following are some thoughts for management to consider when identifying performance obligations:
Performance obligations may be explicitly stated in the contract and/or may be implied based on customary business practices.
Do any of the contracts contain material rights to customers that need to be accounted for as separate performance obligation?
When identifying performance obligations have immaterial items been omitted? If there are immaterial items, how did management determine those items to be immaterial?
If transactions with customers involve shipping and handling activities, is management going to assess whether the shipping and handling activities represent a separate performance obligation to the customer?
Should management elect to not account for shipping and handling activities as separate performance obligations and, if so, has that election been properly disclosed in the notes to the financial statements?
How does management determine whether a promised good or service is distinct, particularly within the context of the contract?
If a series of goods or services is provided to a customer, should management treat that series of goods or services as separate performance obligations or should they be treated as a single performance obligation?
Has management established proper controls over the process used to identify performance obligations?
Unlike larger companies, many private companies do not have written contracts with their customers and therefore it may be a bit more difficult for these private companies to identify performance obligations because some promises to customers may be based on customary business practices established over the years. Although not all inclusive, these companies might want to consider the following:
As private companies identify the customary business practices they have established, they should consider documenting them in writing to assist in the assessment of separate performance obligations as well as establish an overall consistent policy.
When searching for customary business practices, consider reviewing notices posted at the business establishment such as, “We value our customers and provide training on all of our products free of charge.”
If a private company has a website, they should review its contents making sure they have not stated something on the website that might be considered a customary business practice.
Knowledge check
1 Which item below would not result in a separately identifiable promise by an entity to transfer goods to a customer?Assessing whether the customer can benefit from each good on its own.Determining whether the customer is able to benefit from the good in conjunction with other readily available resources.Determining whether the goods are interdependent and significantly impact each other.Determining