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Dissecting the New Revenue Recognition Guidance: Step 2 of the Five-Step Framework

August 10, 2018

Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as amended, creates a five-step framework for entities to determine when and how much revenue should be recognized. The first article in the ‘Dissecting the New Revenue Recognition Guidance’ series discusses step 1, identifying the contract(s) with customers. This article focuses on step 2, identifying the performance obligations in the contract.

Step 2: Identify the Performance Obligations in the Contract

After analyzing the entity’s agreement with a customer and determining that a contract exists, the next step is for the entity to determine the separate performance obligations within that contract.

The entity needs to assess the goods or services promised in the contract and identify as a performance obligation each promise to transfer to the customer that is distinct or each series of distinct goods or services.

A good or service is determined to be distinct if both of the following criteria are met:

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

Example 1

A homebuilder enters into an agreement to build a house for a customer and concludes a contract exists. The homebuilder analyzes the contract to determine the separate performance obligations within the contract. Do such items as the roof, attached garage, and plumbing qualify as separate performance obligations?

The answer in this case would be no. These items are not distinct to the customer. For example, what use would the customer have for a roof if there was no foundation or walls to support it? The house is considered the distinct good based on the facts provided above.

Example 2

The homebuilder in the first example determined that the house is a distinct good and should be identified as one performance obligation. However, what if as a part of the same contract, the homebuilder includes free landscaping services for one year?

In this scenario, the landscaping portion would be considered a separate performance obligation within the contract.

Other Common Considerations in Identifying Separate Performance Obligations

Free Services or Products

In the second example above, the homebuilder offered the landscaping services as “free” to the customer. These services are not, however, free to the homebuilder and should be treated as a separate obligation of the contract.

Series of Goods or Services

For a series of goods or services that are substantially the same and have the same pattern of transfer to the customer, the entity is required to treat the series as a single performance obligation. For example, a builder who constructs apartment buildings has a contract to install five units at the complex. All of the units to be installed are substantially identical and have the same standard terms of transfer to the owner. In this scenario, the builder would combine all of the revenues and costs to be earned from this contract and treat the series of units as a single performance obligation.


The nature of a warranty can be either for assurance that a product will function as intended or service related. Generally, warranties in which the customer has the option to purchase or extend a warranty for over a year (depending on industry practice) are considered service-type warranties and should be treated as separate performance obligations.

What Should Entities Do Now?

Entities should be analyzing current agreements with customers and determining where contracts exist and what potential performance obligations are inherent in those contracts. Review contract language in detail and determine which contracts contain unique attributes and set policies to account for those instances. Design controls that will properly account for these transactions and test the controls in place prior to implementation to ensure they are functioning as designed and prior to the implementation date.

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