Step 2 Identify the performance obligations in the contract

Step 2 Identify the performance obligations in the contract

– is the second step in IFRS 15 Revenue from contracts with customers. IFRS 15 The revenue recognition standard provides a single comprehensive standard that applies to nearly all industries and has changed revenue recognition quite significant. Step 2 Identify the performance obligations in the contract

IFRS 15 introduced a five step process for recognising revenue, as follows:Step 2 Identify the performance obligations in the contract

    1. Identify the contract with the customer
    2. Identify the performance obligations in the contract
    3. Determine the transaction price for the contract
    4. Allocate the transaction price to each specific performance obligation
    5. Recognise the revenue when the entity satisfies each performance obligation

INTRO – Step 2 Identify the performance obligations in the contract – The process of identifying performance obligations requires an entity to determine whether it promises to transfer either goods or services that are distinct, or a series of distinct goods or services that meet certain conditions. These promises may not be limited to those explicitly included in written contracts. IFRS 15 provides indicators to help determine when the ‘distinct’ criteria are met.

A ‘performance obligation’ is the unit of account for revenue recognition. An entity assesses the goods or services promised in a contract with a customer and identifies as a performance obligation either a: [IFRS 15.22–23, IFRS 15.26]

  • good or service (or a bundle of goods or services) that is distinct (see distinct goods and services below); or
  • series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (i.e. each distinct good or service in the series is satisfied over time, and the same method is used to measure progress) (see Series of distinct goods or services below).

This includes an assessment of implied promises and administrative tasks (see implied promises and administrative tasks below).

1. Distinct goods or services

A single contract may contain promises to deliver to the customer more than one good or service. At contract inception, an entity evaluates the promised goods or services to determine which goods or services (or bundle of goods or services) are distinct and therefore constitute performance obligations. [IFRS 15.22]

A good or service is distinct if both of the following criteria are met. [IFRS 15.27]

Step 2 Identify the performance obligations in the contract

Further explanations: [IFRS 15.28]

1. Good or service is capable of being distinct

A customer can benefit from a good or service if it can be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits.

A customer can benefit from a good or service on its own or in conjunction with:

  • other readily available resources that are sold separately by the entity, or by another entity; or
  • resources that the customer has already obtained from the entity – e.g. a good or service delivered up-front – or from other transactions or events.

The fact that a good or service is regularly sold separately by the entity is an indicator that the customer can benefit from a good or service on its own or with other readily available resources.

2. Distinct within the context of the contract

The objective when assessing whether an entity’s promises to transfer goods or services are distinct within the context of the contract is to determine whether the nature of the promise is to transfer each of those goods or services individually, or whether the promise is to transfer a combined item or items to which the promised goods or services are inputs.

IFRS 15 provides the following indicators to assist in evaluating whether two or more promises to transfer goods or services to a customer are not separately identifiable:

  • The entity provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. This occurs when the entity is using the goods or services as inputs to produce or deliver the output or outputs specified by the customer. A combined output (or outputs) might include more than one phase, element, or unit.
  • One or more of the goods or services significantly modifies or customizes, or is significantly modified or customized by, one or more of the other goods or services promised in the contract.
  • The goods or services are highly interdependent or highly interrelated, such that each of the goods or services is significantly affected by one or more of the other goods or services.

The list of indicators in IFRS 15 is not exhaustive.

If a promised good or service is determined not to be distinct, then an entity continues to combine it with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, this results in the entity accounting for all of the goods or services promised in a contract as a single performance obligation.

For guidance and discussion on determining whether the promise to transfer a license along with other goods or services is distinct, see determine whether a license is distinct in link.

Worked example – Single performance obligation in a contract

IFRS 15.IE45–IE48 Example 10

Construction Company C enters into a contract with Customer D to design and build a hospital. Construction Company C is responsible for the overall management of the project and identifies goods and services to be provided – including engineering, site clearance, foundation, procurement, construction, piping and wiring, installation of equipment, and finishing.

Construction Company C identifies goods and services that will be provided during the hospital construction that might otherwise benefit Customer D on its own. For example, if each construction material is sold separately by other entities, then it could be resold for more than scrap value by Customer D. It also could be sold together with other readily available resources such as additional materials or the services of another contractor.

However, Construction Company C notes that the goods and services to be provided under the contract are not separately identifiable from the other promises in the contract. Instead, Construction Company C is providing a significant integration service by combining all of the goods and services in the contract into the combined item for which Customer D has contracted – i.e. the hospital.

Therefore, Construction Company C concludes that the second criterion is not met and that the individual activities are not distinct and therefore are not separate performance obligations. Therefore, it accounts for the bundle of goods and services to construct the hospital as a single performance obligation.

Worked example – Multiple performance obligations in a contract

Telco T has a contract with Customer R that includes the delivery of a handset and two years of voice and data services.

The handset can be used by a customer to perform certain functions – e.g. calendar, contacts list, email, internet access, accessing apps via Wi-Fi and to play music or games.

Additionally, there is evidence of customers reselling the handset on an online auction site and recapturing a portion of the selling price of the phone. Telco T also regularly sells its voice and data services separately to customers, through renewals or sales to customers who acquire handsets from an alternative vendor – e.g. a retailer.

Telco T concludes that the handset and the wireless services are two separate performance obligations based on the following evaluation.

Assessment of the two criteria: [IFRS 15.27]

1. Handset is capable of being distinct

  • Customer R can benefit from the handset either on its own – i.e. because the handset has stand-alone functionalities and can be resold for more than scrap value and has substantive, although diminished, functionality that is separate from Telco T’s network – or together with its wireless services that are readily available to Customer R, because Telco T sells those services separately.
  • Customer R can benefit from the wireless services in conjunction with readily available resources – i.e. either the handset is already delivered at the time of the contract set-up, could be purchased from alternative retail vendors, or the wireless service could be used with a different handset.

2. Distinct within the contract

  • The handset and the wireless services are separable in this contract because they are not inputs to a single asset – i.e. a combined output – which demonstrates that Telco T is not providing a significant integration service.
  • Neither the hand set nor the wireless service significantly modifies or customizes the other.
  • Customer R could purchase the handset and the voice/data services from different parties – e.g. Customer R could purchase the handset from a retailer – therefore providing evidence that the handset and voice/data services are not highly dependent on, or highly interrelated with, each other.

Applying the indicators will require judgment

IFRS 15 does not include a hierarchy or weighting of the indicators of whether a good or service is separately identifiable from other promised goods or services within the context of the contract. An entity evaluates the specific facts and circumstances of the contract to determine how much emphasis to place on each indicator.

Certain indicators may provide more compelling evidence in the separability analysis than others in different scenarios or types of contracts. For example, factors such as the degree of customization, complexity, customer’s motivation for purchasing goods/services, contractual restrictions, and the functionality of individual goods/services may have differing effects on the distinct analysis for different types of contracts.

In addition, the relative strength of an indicator, in light of the specific facts and circumstances of a contract, may lead an entity to conclude that two or more promised goods or services are not separable from each other within the context of the contract. This may occur even if the other two indicators might suggest separation.

To assist an entity in applying the indicators, IFRS 15 includes many examples illustrating their application. The following table summarizes them: [IFRS 15.IE45–IE65A, links are in the table below]

IFRS 15 Example #

Description of scenario

Conclusion

10A

Entity provides a significant integration service for a building construction and delivers a single output to the customer

Single performance obligation

10B

Entity provides a significant integration service and delivers multiple complex and specialized items as single outputs to the customer

Single performance obligation

11A

Entity provides the customer with software, installation, unspecified upgrades and telephone support from which it can benefit separately

Multiple performance obligations

11B

Entity provides the customer with installation services that involve significant customization of the underlying software

Single performance obligation

11C & 11D

Entity provides customer with equipment and a separately identifiable installation service; customer required to use entity’s installation service in 11D

Multiple performance obligations

11E

Entity provides the customer with equipment and proprietary consumables that are separately identifiable

Multiple performance obligations

12A

Entity provides the customer with a good and an explicit promise to provide a service to the customer’s customer who purchases the good

Multiple performance obligations

12B

Entity provides the customer with a good and an implicit promise to provide a service to the customer’s customer who purchases the good

Multiple performance obligations

12C

Entity provides a customer’s customer with a service that is not part of its promise to the customer

Single performance obligation (service is not a performance obligation of the contract)

Applying Criterion 2 requires an entity to assess if there is a transformative relationship between the two items being analysed

[IFRS 15.BC116K]

The Board noted that the evaluation of whether an entity’s promise to transfer a good of service is separately identifiable from other promises in the contract considers the relationship between the various goods and services within the contract in the context of the process of fulfilling the contract. An entity should consider the level of integration, interrelation, or interdependence among promises to transfer goods or services in evaluation whether the goods or services are distinct.

The Board also observed that an entity should not merely evaluate whether one item, by its nature, depends on the other (i.e. whether the items have a functional relationship). Instead, an entity should evaluate whether there is a transformative relationship between the two items in the process of fulfilling the contract.

A change in practice for the software industry

In Example 11A of IFRS 15, post-contract customer support (PCS) that includes both technical support and unspecified software upgrades provided on a when-and-if available basis comprises two separate performance obligations. [IFRS 15.IE49–IE58 Example 11A]

Additionally, in that example the two performance obligations are distinct from the software license, which is also a separate performance obligation.

Goods or services promised to a customer’s customer may be a performance obligation

In some industries, a manufacturer may promise goods or services as sales incentives to the end customers of its customer to encourage the sale of its products through the distribution channel. IFRS 15 requires an entity to evaluate the promise to the customer’s customer to determine whether it is a performance obligation in the contract with the customer.

Examples of these circumstance are an auto manufacturer that offers free maintenance services to customers who purchase cars from dealerships, a software provider that implicitly offers customer support or updates to end users of its software and a consumer goods company that provides mail-in offers for free goods to end customers.

These promises may be made explicitly in the contract with the customer or implied by an entity’s customary business practices, published policies, or specific statements. For more discussion on implied promises, see implied promises and administrative tasks below.

Contractual restrictions may not be determinative

Contracts between an entity and a customer often include contractual limitations or prohibitions. These may include prohibitions on reselling a good in the contract to a third party, or restrictions on using certain readily available resources – e.g. the contract may require a customer to purchase complementary services from the entity in conjunction with its purchase of a good or license.

In Example 11D of IFRS 15, the customer is contractually required to use the seller’s installation service to install the purchased good. The example notes that the contractual restriction does not affect the assessment of whether the installation services are considered distinct. Instead, the entity applies Criterion 1 and Criterion 2 to assess whether the installation services are distinct. By applying these criteria, Example 11D illustrates that substantive contractual provisions alone do not lead to a conclusion that the goods and services are not distinct. [IFRS 15.IE58E–IE58F Example 11D]

A contractual restriction on the customer’s ability to resell a good – e.g. to protect an entity’s intellectual property – may prohibit an entity from concluding that the customer can benefit from a good or service, on the basis of the customer not being able to resell the good for more than scrap value in an available market. [IFRS 15.BC100]

However, if the customer can benefit from the good (e.g. telephone support) together with other readily available resources (e.g. a software license), even if the contract restricts the customer’s access to those resources (by requiring the customer to use the entity’s products or services), then the entity may conclude that the good or service has benefits to the customer, and that the customer could purchase or not purchase the entity’s products or services without significantly affecting that good.

2. Implied promises and administrative tasks

Promises to transfer a good or service can be explicitly stated in the contract, or be implicit based on established business practices or published policies that create a valid expectation that the entity will transfer the good or service to the customer. [IFRS 15.24–25]

Conversely, administrative tasks do not transfer a good or service to the customer and are not performance obligations – e.g. administrative tasks to set up a contract.

Worked example – Implied promise to reseller’s customers

Software Company K enters into a contract with Reseller D, who then sells software products to end users. Software Company K has a customary business practice of providing free telephone support to end users without involving the reseller, and both expect Software Company K to continue to provide this support.

In evaluating whether the telephone support is a separate performance obligation, Software Company K notes that:

  • Reseller D and the end customers are not related parties – and, as such, these contracts will not be combined; and
  • the promise to provide telephone support free of charge to end users is considered a service that meets the definition of a performance obligation when control of the software product transfers to Reseller D.

As a result, Software Company K accounts for the telephone support as a separate performance obligation in the transaction with the reseller.

Worked example – Implied performance obligation – Pre- and post-sale incentives

Car Manufacturer N has an historical practice of offering free maintenance services – e.g. oil changes and tire rotation – for two years to the end customers of dealers who purchase its vehicles. However, the two-years free maintenance is not explicitly stated in the contract with its dealers, but it is typically stated in Car Manufacturer N’s advertisements for the vehicles.

Therefore, the maintenance is treated as a separate performance obligation in the sale of the vehicle to the dealer. Revenue from the sale of the vehicle is recognized when control of the vehicle is transferred to the dealer. Revenue from the maintenance services is recognized as the maintenance services are provided to the retail customer.

However, if Car Manufacturer N does not have a customary business practice of offering free maintenance, and instead announces a maintenance program as a limited-period sales incentive after control of the vehicle has transferred to the dealer, then the free maintenance is not a separate performance obligation in the sale of the vehicle to the dealer. [IFRS 15.IE64–IE65 Example 12 – Case C]

In this case, Car Manufacturer N recognizes the full amount of revenue when control of the vehicle is transferred to the dealer. If Car Manufacturer N subsequently creates an obligation by announcing that it will provide incentives, then Car Manufacturer N will accrue as an expense its expected cost of providing maintenance services on the vehicles in the distribution channel – i.e. controlled by dealers – when the program is announced.

Determining whether a sales incentive to end customers was offered pre- or post-sale to the dealer will be challenging for some entities, especially for implied sales incentives in which the entity has a customary business practice of offering incentives or does so on a seasonal basis. The entity will need to assess whether the dealer and customer have a valid expectation that the entity will provide a free service.

Worked example – Administrative task – Registration of software keys

Software Company B licenses and transfers operating system software to Customer L. The operating system software will not function on Customer L’s computer hardware without a key provided by Software Company B. Customer L has to provide Software Company B with the serial number from the hardware to receive the key. If Customer L orders hardware from a different supplier and has not received the hardware when the operating system software is delivered, then it is still obliged to pay for the operating system software because payment is not contingent on delivery of the key.

In this example, the operating system software is ready for use by Customer L, and delivery of the key is contingent only on Customer L’s actions. As such, it is an administrative task that does not transfer a promised good or service and therefore is not considered to be a promised service in the contract. Assuming that all other revenue recognition criteria have been met – including Customer L obtaining control of the operating system software – Software Company B recognizes revenue on delivery of the operating system software. For discussion on the timing and pattern of recognition of licenses, see Timing and pattern of revenue recognition for licensing IP and other rights.

Only promises that transfer goods or services to the customer can be performance obligations

An entity does not account for a promise that does not transfer goods or services to the customer. For example, an entity’s promise to defend its patent, copyright, or trademark is not a performance obligation. [IFRS 15.BC93, BC411(b)]

Set-up activities as administrative task

A software-as-a-service (SaaS) provider may perform tasks that are necessary for the customer to access its web-based software application. These tasks range from a simple activation service in some situations to more complex up-front activities needed to allow the customer to access the SaaS services from the customer’s IT platform.

Generally, these types of set-up activities provide no incremental benefit to the customer and therefore constitute an administrative task. However, the necessity of completing these activities before the customer can begin accessing the underlying service may affect the timing of when revenue recognition may begin.

3. Series of distinct goods or services

A contract may contain promises to deliver a series of distinct goods or services that are substantially the same. At contract inception, an entity assesses the goods or services promised in the contract and determines whether the series of goods or services is a single performance obligation. [IFRS 15.22(b)]

This is the case when they meet the following criteria: [IFRS 15.23]

Series of distinct goods or services VS 2

Worked example – Series of distinct goods or services treated as a single performance obligation

Contract Manufacturer X agrees to produce 1,000 customized widgets for use by Customer A in its products. Contract Manufacturer X concludes that the widgets will transfer to Customer A over time because:

  • they have no alternative use to Contract Manufacturer X; and
  • Customer A is contractually obligated to pay Contract Manufacturer X for any finished or in-process widgets, including a reasonable margin, if Customer A terminates the contract for convenience.

Contract Manufacturer X already has the process in place to produce the widgets and is given the design by Customer A, such that Contract Manufacturer X does not expect to incur any significant learning curve or design and development costs. Contract Manufacturer X uses a method of measuring progress toward complete satisfaction of its manufacturing contracts that takes into account work in progress and finished goods controlled by Customer A.

Contract Manufacturer X concludes that each of the 1,000 widgets is distinct, because:

  • Customer A can use each widget on its own; and
  • each widget is separately identifiable from the others because one does not significantly affect, modify, or customize another.

Despite the fact that each widget is distinct, Contract Manufacturer X concludes that the 1,000 units are a single performance obligation because:

  • each widget will transfer to Customer A over time; and
  • Contract Manufacturer X uses the same method to measure progress toward complete satisfaction of the obligation to transfer each widget to Customer A.

Consequently, the transaction price for all 1,000 widgets is recognized over time using an appropriate measure of progress. This outcome may be different from the outcome of allocating a fixed amount to each widget if each one were a performance obligation.

Worked example – Distinct service periods within a long-term service contract

Cable Company R enters into a two-year service contract with Customer M to provide cable television service for a fixed fee of 100 per month. Cable Company R has concluded that its cable television service is satisfied over time because Customer M consumes and receives the benefit from the service as it is provided – e.g. customers generally benefit from each day that they have access to Cable Company R’s service.

Cable Company R determines that each increment of its service – e.g. day or month – is distinct because Customer M benefits from that period of service on its own. Additionally, each increment of service is separately identifiable from those preceding and following it – i.e. one service period does not significantly affect, modify, or customize another. However, Cable Company R concludes that its contract with Customer M is a single performance obligation to provide two years of cable television service because each of the distinct increments of service is satisfied over time. Also, Cable Company R uses the same measure of progress to recognize revenue on its cable television service regardless of the contract’s time period.

No exemption from applying the series guidance

If the series guidance requirements are met for a good or service, then that series is treated as a single performance obligation (i.e. the series guidance is not optional).

Accounting for a series is intended to provide a simplification of the model

The Board believes that accounting for a series of distinct goods or services as a single performance obligation if they are substantially the same and meet certain criteria generally simplifies the application of the model and promotes consistency in identifying performance obligations in a repetitive service arrangement. For example, without the guidance on the series of goods or services, an entity may need to allocate consideration to each hour or day of service in a cleaning service contract. [IFRS 15.BC113–BC114]

The Board also gave transaction processing and the delivery of electricity as examples of a series of goods or services.

However, in some cases applying the series guidance may complicate application of the model. For example, this may be the case for common transactions in certain industries (e.g. aerospace and defense) and other types of transactions that involve producing a relatively small number of products that meet the series guidance. For this reason, some stakeholders requested amendments to IFRS 15 to make application of the series guidance optional. The Boards declined to do so and reiterated that this guidance is not optional.

However, if the contract is modified then the entity considers the distinct goods or services, rather than the performance obligation. This in turn simplifies the accounting for the contract modification (see contract modifications in link).

Determining the nature of the entity’s promise to the customer is the first step in applying the series guidance

Determining the nature of the entity’s promise is the first step in determining whether the series guidance applies. For example, if the nature of the promise is the delivery of a specified quantity of a good or service, then the evaluation should consider whether each good or service is distinct and substantially the same.

Conversely, if the nature of the entity’s promise is to stand ready or to provide a single service for a period of time (i.e. there is not a specified quantity to be delivered), then the evaluation would likely focus on whether each time increment, rather than the underlying activities, is distinct and substantially the same.

Identifying distinct goods or services as a series may affect the allocation of variable consideration

Even if per-unit pricing is fixed, if the quantity related to a series is not specified, then it results in variable consideration (see Step 3 Determine the transaction price in the link). However, an entity is not required to allocate variable consideration across the distinct goods or services included in a series on a stand-alone selling price basis. Instead, it follows the general guidance in the standard on allocating variable consideration entirely to a performance obligation or a distinct good or service that forms part of a performance obligation (see Step 4 Allocate the transaction price to the performance obligations in the contract in the link). For example, this may be relevant if the goods or services in the series and any other performance obligations in the contract are priced at market rates.

Not necessary for goods or services to be provided consecutively

To apply the series guidance, it is not necessary that the goods be delivered or services performed consecutively over the contract period. There may be a gap or an overlap in delivery or performance, and this would not affect the assessment of whether the series guidance applies.

Although the Boards specifically contemplated a consecutively delivered contract (e.g. repetitive service arrangement), they did not make this distinction a criterion for applying the series guidance.

Once the performance obligations have been identified, then it is time to move to Step 3: Determining the transaction price.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Something else -   Contract assets and contract liabilities

Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract

Step 2 Identify the performance obligations in the contract

Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract

Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract

Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract

Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract Step 2 Identify the performance obligations in the contract

Leave a comment