Step 2: performance obligations, the distinct test and the series guidance

• List the promised goods and services in a contract, including implied promises
• Apply the capable-of-being-distinct and separately-identifiable criteria
• Use the immaterial-promise and shipping and handling options from ASU 2016-10
• Determine when a series of distinct goods or services is a single performance obligation

Start with the promises

A contract usually lists what the entity will deliver, but promises can also be implied by customary business practice, published policies or specific statements that create a valid customer expectation. Free installation that sales staff always include, or a help desk the company advertises to every buyer, can be a promise even if the contract is silent.

Activities that do not transfer anything to the customer are not promises. Setup tasks a service provider performs internally to start a contract are fulfillment activities, not a performance obligation.

ASU 2016-10 added two simplifications:

• Immaterial promises (606-10-25-16A). An entity is not required to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract. If revenue is recognized before those items are delivered, accrue their cost. The exemption does not apply to a customer option that gives a material right (606-10-25-16B).
• Shipping and handling (606-10-25-18B). If shipping and handling happens after the customer obtains control of the good, the entity may elect to treat it as a fulfillment activity rather than a separate service. The election is applied consistently to similar transactions and disclosed as a policy.

The two-part distinct test

Under 606-10-25-19, a good or service is distinct if both criteria are met:

1. Capable of being distinct. The customer can benefit from it on its own or with other readily available resources. A readily available resource is one sold separately (by the entity or another entity), or one the customer has already obtained from the entity or from other transactions or events (606-10-25-20).
2. Distinct within the context of the contract. The promise is separately identifiable from other promises in the contract.

ASU 2016-10 reframed the second criterion around one question: is the nature of the promise to transfer each item individually, or to transfer a combined item to which the promised items are inputs? Indicators that promises are not separately identifiable include:

• the entity provides a significant service of integrating the items into a combined output the customer contracted for;
• one item significantly modifies or customizes another; and
• the items are highly interdependent or highly interrelated, so each significantly affects the other.

Items that fail the test are combined with other promises until the bundle is distinct.

The series guidance

Under 606-10-25-14(b) and 606-10-25-15, a series of distinct goods or services that are substantially the same and have the same pattern of transfer is a single performance obligation. Same pattern means each distinct item would be satisfied over time and the same measure of progress would apply to each.

The series is not an option; when the criteria are met, it applies. It matters in three places:

• Modifications. Because each period is distinct, a modification of a series is usually prospective rather than a catch-up.
• Variable consideration. A variable fee (such as a usage fee) can be allocated entirely to the distinct period it relates to when the 606-10-32-40 criteria are met.
• Stand-ready services. Monthly hosting, cleaning, payroll processing and similar services are common series.

Material rights

A customer option to buy more goods or services is a performance obligation only if it gives a material right the customer would not receive without entering into the contract, such as a discount incremental to the range normally given to that class of customer. Lesson 13 covers the measurement.

Documentation habits

Write down every promise you considered, including the ones you rejected and why. Reviewers and inspectors test the list as often as the conclusion. Use the five-step memo template and the SaaS multi-element guide for common patterns.

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