At their joint meetings this year, the FASB and IASB (the “boards”) reached a number of tentative decisions related to the joint revenue recognition project. These decisions address many of the concerns identified by constituents (see Deloitte’s December 9, 2010, Heads Up on constituents’ views about the revenue project). Note that all such decisions are subject to change before any standard becomes final.

Since the end of the comment letter period on their exposure draft (ED) on revenue recognition, the boards have focused primarily on five topics: (1) separation of performance obligations; (2) transfer of control; (3) contract combination, segmentation, and modification; (4) onerous performance obligations; and (5) warranties. The boards have also made a few tentative decisions on other aspects of the ED.

Separation of Performance Obligations

The ED proposes that a good or service would be accounted for as a separate performance obligation if it is deemed “distinct” (i.e., sold separately or could be sold separately because it has a distinct function and profit margin). At the February 17 meeting, the boards modified the criteria entities use to separate performance obligations as follows:

1. An entity should account for a bundle of promised goods or services as one performance obligation if the entity provides a service of integrating those goods or services into a single item that the entity provides to the customer.

2. An entity should account for a promised good or service as a separate performance obligation if:

a. The pattern of transfer of the good or service is different from the pattern of transfer of other promised goods or services in the contract, and

b. The good or service has a distinct function.

3. A good or service has a distinct function if either:

a. The entity regularly sells the good or service separately, or

b. The customer can use the good or service either on its own or together with resources that are readily available to the customer.

In addition, the boards decided to delete the word “enforceable” from the definition of a performance obligation, thereby potentially including those that are not legally enforceable (e.g., free when-and-if-available software upgrades that an entity has a history of providing to customers).

Transfer of Control

The ED indicates that an entity would use the concept of “control” to determine when a good or service has transferred to a customer (and thus, when revenue is recognized). It lists indicators for use in analyzing the transfer of control and specifies that control can be continuously transferred. The boards tentatively decided to (1) slightly modify the proposed indicators of when a customer obtains control of a good and (2) provide additional guidance on the continuous transfer of control for a service (including how an entity should measure its progress toward completion of a performance obligation that is continuously satisfied). If a contract includes obligations to transfer both goods and services that do not meet the separate performance obligation criteria, an entity would account for a bundle in accordance with the guidance on transfer of control for services.

Control of a Good

The boards tentatively decided to carry forward most of the proposed guidance in the ED. However, they also decided to (1) describe the concept of control instead of define it, (2) remove the indicator of control that states that “the design or function of the good or service is customer-specific,” and (3) add “risks and rewards of ownership” as an indicator of control.

Control of a Service and Measurement Toward Completion

For an entity to recognize revenue for a service, it first must conclude that a performance obligation is continuously satisfied, and then it must select a method to measure progress toward completion. At the February 17 meeting, the boards tentatively decided that an entity satisfies a performance obligation continuously if at least one of the following two criteria is met:

1. The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
2. The entity’s performance does not create an asset with alternative use to the entity and at least one of the following is met:
   1. The customer receives a benefit as the entity performs each task, or
   2. Another entity would not need to reperform the task(s) performed to date if that other entity were to fulfil the remaining obligation to the customer, or
   3. The entity has a right to payment for performance to date even if the customer could cancel the contract for convenience.

The boards also decided that the final standard should (1) “[e]mphasize that the objective of measuring progress is to faithfully depict the entity’s performance ([i.e., the] pattern of transfer of goods or services to a customer)” and (2) clarify the ED’s descriptions of input and output methods. Finally, when an entity that is using the input method to measure progress toward completion purchases goods that are transferred to the customer at a different time from related services (e.g., materials that are controlled by the customer before installation by the entity), the entity should recognize revenue for the transfer of those goods in an amount equal to their costs.

Contract Combination, Segmentation, and Modification

Contract Combination

At the February 17 meeting, the boards also tentatively decided to modify the ED’s indicators for contract combinations, noting that an entity should combine two or more contracts that are entered into at or near the same time with the same customer (or related entities) if one or more of the following criteria are met:

1. The contracts are negotiated as a package with a single commercial objective.
2. The amount of consideration in one contract depends on the other contract.
3. The goods and services in the contracts are interrelated in terms of design, technology, or function.

Contract Segmentation

Under the ED, a contract is accounted for “as two or more contracts if the price of some goods or services in the contract is independent of the price of other goods or services in the contract.” The boards decided to eliminate this requirement, which would have effectively made all decisions about contract separation part of the process of identifying separate performance obligations.

Contract Modification

According to the ED, a contract modification is accounted for either (1) together with the original contract if the pricing in the new contract provides for a discount (resulting in a cumulative-effect adjustment as if the modified terms existed at contract inception) or (2) as a separate contract. The boards tentatively decided that an entity should account for a contract modification as a separate contract if it results “in the addition of a separate performance obligation at a price that is commensurate with that additional performance obligation”; however, they requested that the staffs further consider the criteria for when a contract modification is a separate contract on the basis of indicators tentatively decided upon for combining contracts. “Otherwise, the entity should reassess the performance obligations [in the contract] and reallocate the transaction price to each separate performance obligation.” The reallocation of the transaction price is slated to be part of the boards’ redeliberations later in March on the broader topic of transaction price allocation.

Onerous Performance Obligations

The boards modified the ED’s requirement that a contract loss must be recognized to the extent that the present value of the expected direct costs of satisfying a separate performance obligation exceeds the amount of the transaction price allocated to that obligation. The boards tentatively decided that (1) the unit of account for the onerous test should be at the contract level (i.e., the remaining performance obligations in the contract) and (2) the costs used in the onerous test and measurement of the onerous liability are either (a) the costs that related directly the contract (as proposed in the ED) or (b) if the contract is cancelled, the amount based on contractual cancellation terms or in accordance with other GAAP (i.e., ASC 450¹ or IAS 37²).

Warranties

The ED distinguishes between (1) warranties that provide coverage for defects existing when the product is transferred to the customer and (2) those that provide coverage for faults that arise after the product is transferred to the customer. At their February 1 meeting, the boards tentatively decided that some warranties should be accounted for as a warranty obligation (i.e., a cost accrual), which is consistent with current practice, and stated that a warranty is accounted for as a cost accrual:

1. If a customer has the option to purchase a warranty separately from the entity, the entity should account for the warranty as a separate performance obligation. Hence, the entity would allocate revenue to the warranty service.
2. If a customer does not have the option to purchase a warranty separately from the entity, the entity should account for the warranty as a cost accrual unless the warranty provides a service to the customer in addition to assurance that the entity’s past performance was as specified in the contract (in which case the entity would account for the warranty service as a separate performance obligation).

The boards also decided that they will develop implementation guidance on the exception in the second criterion (i.e., “the warranty provides a service to the customer in addition to assurance that the entity’s past performance was as specified in the contract”) and issue such guidance with the final standard.

Other Tentative Decisions

Costs of Obtaining a Contract

The ED states that costs of obtaining a contract are expensed when incurred. However, at their February 2 meeting, the boards modified this guidance and tentatively decided that:

1. An entity should recognize an asset for the incremental costs of obtaining a contract that the entity expects to recover. Incremental costs of obtaining a contract are costs that the entity would not have incurred if the contract had not been obtained.
2. An asset recognized for the costs of obtaining a contract should be presented separately on the statement of financial position and subsequently measured on a systematic basis consistent with the pattern of transfer of the goods or services to which the asset relates.

Breakage and Prepayments for Future Goods or Services

The ED did not specifically address how to recognize revenue for breakage on prepayments (or customers’ rights that are not exercised). The boards tentatively decided that if the amount of expected breakage can be reasonably estimated, it should be recognized as revenue in proportion to the pattern of rights exercised by the customer. Otherwise, the breakage should be recognized when the likelihood becomes remote that the customer will exercise its remaining rights.

[1] FASB Accounting Standards Codification Topic 450, Contingencies.

[2] IAS 37, Provisions, Contingent Liabilities and Contingent Assets.