Judgement needed to identify performance obligations under IFRS 15

In the April 2018 edition of Accounting News we discussed the five step model for revenue recognition introduced by IFRS 15 Revenue from Contracts with Customers:

Step 1 Identify the contract(s) with the customer
Step 2 Identify the performance obligations in the contract
Step 3 Determine the transaction price
Step 4 Allocate the transaction price to the performance obligations
Step 5 Recognise revenue when a performance obligation is satisfied

In the May and June 2018 editions of Accounting News we examined the first step of that five step process in greater depth and in the July 2018 edition we started to look at the complexities of the second step.  In this article, we look at some common situations in which it can be difficult to identify performance obligations.

What is a performance obligation?

A contract with a customer includes promises to transfer goods or services to the customer. If those goods or services are distinct, they are separate performance obligations and are accounted for separately.

A good or service that is promised to a customer is distinct if the following two criteria are both met:

  • The customer can benefit from the good or service either on its own, or together with other resources that are readily available to the customer, and
  • The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. 

In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable, the objective is to determine whether the nature of the promise in the contract is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs.  This assessment is done from the perspective of the customer.

If a promised good or service is not distinct, the entity must combine that good or service with other promised goods or services until it identifies a bundle of goods and/or services that is distinct.  Promises are not separately identifiable (i.e. they must be bundled) if any of the following circumstances exist:

  • The seller does a significant amount of work to integrate the good or service with other goods or services promised in the contract
  • One or more of the goods or services provided by the seller significantly modifies or customises, or is significantly modified or customised by, other goods or services promised in the contract, or
  • Goods or services provided are highly interdependent or interrelated.

The following decision tree summarises the process that an entity should work through to determine whether goods or services provided in a contract are distinct (and are therefore performance obligations):

Distinct decision tree

In determining whether a performance obligation is ‘distinct’, there are many judgement calls that need to be made along the way. The following examples demonstrate the identification of performance obligations in practice.

Example 1: Offering free goods or services (sports bag with a gym membership)

Company A is a gym that is offering a free sports bag to every new member who signs up for a 12-month contract.  The sports bag is also available for sale separately at the gym. 

To determine whether the sports bag and gym membership are distinct goods and services (and thereby performance obligations), we need to work through the decision tree above:

Question (from the decision tree above) Answer
  1. Can the customer benefit from the good or service, either on its own, or with other readily available resources?
Yes (the gym membership and the sports bag can be used separately from each other)
  1. Does the entity provide a significant service of integrating the goods or services?
No (the gym membership and the sports bag remain separate)
  1. Does one or more of the goods or services significantly modify or customise (or become significantly modified or customised by) the other goods or services?
No (the gym membership and the sports bag remain separate)
  1. Are the goods or services highly interdependent or highly interrelated?
No (the gym membership and the sports bag can be used separately from each other)

In this fact pattern, it is fairly obvious that the gym membership and the sports bag are distinct, and therefore constitute two performance obligations.  This means that the revenue from each is recognised when, or as, the performance obligation is satisfied.  However, in practice, more judgement is required when transactions become more complicated. Refer expanded fact pattern in Example 1A below.

Example 1A: Charging a sign-on fee to join a gym

In order to become a member of Gym Co, customers need to enter into a 24-month contract. The contract price is $100 per month plus a $200 sign-on fee to cover Gym Co’s administration costs of signing up a new customer. In return, customers have 24/7 access to the gym, and also receive three complimentary (free) personal training sessions.

Answering the questions in the above decision tree regarding the free personal training sessions, we can conclude fairly easily that those are distinct performance obligations because the member can benefit from the personal training sessions with other readily available resources (i.e. access to the gym is necessary to be able to use the personal trainer, and the member has access to the gym via the gym contract). The free personal training sessions are also separately identifiable from the other services in the contract (there is no significant integration, nor modification to the services of accessing the gym and vice versa, and the two services are not highly interdependent or interrelated).

However, judgement will need to be applied to decide whether the sign-on services and access to the gym are distinct, and the again, the best way to do this is to use the decision tree above.

Question (from the decision tree above) Answer
  1. Can the customer benefit from the good or service, either on its own, or with other readily available resources?
No. The member gets no benefit from being ‘signed on’ to the gym’s computer system. Gym Co does not sell ‘sign on’ fees separately which indicates that the customer would not be able to benefit from the services on its own or with other readily available resources.
  1. Does the entity provide a significant service of integrating the goods or services?
No need to assess as good or service is automatically not distinct
  1. Does one or more of the goods or services significantly modify or customise (or become significantly modified or customised by) the other goods or services?
  1. Are the goods or services highly interdependent or highly interrelated?

So in this fact pattern, Gym Co would likely have two performance obligations:

  • Three complimentary personal training sessions
  • 24-month gym contract.

Example 2: Offering free goods or services (discount card for use with the next purchase)

Company B is a hardware store that is running a special deal under which it provides each customer who purchases more than $100 of paint a coupon for 30% off their next purchase, capped at $30. 

To determine whether the paint and the coupon are distinct goods and services (and thereby performance obligations), we work through the decision tree above:

Question (from the decision tree above) Answer
  1. Can the customer benefit from the good or service, either on its own, or with other readily available resources?
Yes (the paint and the coupon are used separately from each other)
  1. Does the entity provide a significant service of integrating the goods or services?
No (the paint and the coupon remain separate)
  1. Does one or more of the goods or services significantly modify or customise (or become significantly modified or customised by) the other goods or services?
No (the paint and the coupon remain separate)
  1. Are the goods or services highly interdependent or highly interrelated?
No (the paint and the coupon are used separately from each other)

The paint and the coupon constitute two performance obligations, and the revenue from each is recognised when, or as, the performance obligation is satisfied. 

Example 3:  Design and build services

Company C is a building company that has entered into a contract with Customer Z to design and, once the design has been approved, build a house on Customer Z’s land for $750,000.  Once the design has been completed and approved, Customer Z owns the plans.

To determine whether the design and the building are distinct goods and services (and thereby performance obligations), we work through the decision tree above:

Question (from the decision tree above) Answer
  1. Can the customer benefit from the good or service, either on its own, or with other readily available resources?
Yes, in theory Customer Z could use the design plans and engage another builder other than Company C to build Customer Z’s house
  1. Does the entity provide a significant service of integrating the goods or services?
No (the house will be constructed to the specifications in the design, but the design remains separate from the house)
  1. Does one or more of the goods or services significantly modify or customise (or become significantly modified or customised by) the other goods or services?
No (the house will be constructed to the specifications in the design, but the design remains separate from the house)
  1. Are the goods or services highly interdependent or highly interrelated?
No (the house will be constructed to the specifications in the design, but the design remains separate from the house)

Judgement is required to conclude whether the customer can benefit from the design plans on its own or with other available resources. Theoretically Customer Z can use the design plans it owns to engage another builder to build the house. Although the building contract is to design and build a completed house for $750,000, contractual limitations precluding Customer Z from engaging another builder are not taken into account when answering this question. This question is based on the characteristics of the good/services themselves and contractual restrictions are ignored. The design plans and construction services could therefore be identified as two distinct performance obligations.

Example 4: Software customisation

Company D is a software company that has entered into a contract with Customer Y to provide and install off-the-shelf software on Customer Y’s servers. 

The software requires significant customisation during the installation process (due to the need for it to interface with other customised software applications used by Company Y). 

There are a number of other software companies that could undertake the work necessary to install the software on Customer Y’s servers. 

To determine whether the software and the installation of that software are distinct goods and services (and thereby performance obligations), we need to work through the decision tree above:

Question (from the decision tree above) Answer
  1. Can the customer benefit from the good or service, either on its own, or with other readily available resources?
Yes (the software is off-the-shelf and there are other companies that have the ability to install it on Customer Y’s servers)
  1. Does the entity provide a significant service of integrating the goods or services?
Yes (Company D is using the off-the-shelf software and the installation service to deliver one output, which is a functional and integrated software system)  
  1. Does one or more of the goods or services significantly modify or customise (or become significantly modified or customised by) the other goods or services?
This question does not need to be considered (due to the yes answer to question 2); however, the answer to the question is yes, as the off-the-shelf software is significantly modified by the customisation work undertaken during the installation process
  1. Are the goods or services highly interdependent or highly interrelated?
This question does not need to be considered (due to the yes answer to question 2); however, the answer to the question is yes, as the off-the-shelf software cannot work without being installed

On that basis, the software and the installation service are one performance obligation. Again amending the fact pattern slightly could change the answer as to whether the software and installation services are distinct. The extent of work required by software companies to install software can vary significantly from one project to another. On the one end of the spectrum, a contract to supply standard off-the-shelf software and installation services could be considered two performance obligations (distinct) if the software is to be used independently by a customer, and requires no customisation at all. However, adding some customisation, or the necessity of specialist installation skills into the fact pattern requires further judgement and could reduce that to one, and have a significant impact on the timing of an entity’s revenue recognition.

Concluding thoughts

Determining the performance obligations in a contract with a customer requires the application of significant judgement.  For that reason, it is important that members of finance teams become familiar with the manner in which such judgements must be made, so that they can correctly identify the performance obligations within their company’s contracts with its customers. This will require the finance team to have a much greater understanding of the particular terms and conditions of contracts with customers than has been required in the past.