A search of the FASB’s entire codification of accounting standards reveals only 8 references to the term “performance obligation,” with no definition.  The term does not appear in any current concepts statements.  Given it’s prominence in the exposure draft on revenue recognition, I expect that the term will become ubiquitous as the FASB-IASB convergence process continues.

 The exposure draft of an accounting standards update of codification topic 605 presents the following revenue recognition model (par. IN9):  (a) identify the contract(s) with a customer; (b) identify the separate performance obligations in the contract; (c) determine the transaction price; (d) allocate the transaction price to the separate performance obligations; and (e) recognize revenue when the entity satisfies each performance obligation.

 The exposure draft defines performance obligation as “an enforceable promise (whether explicit or implicit) in a contract with a customer to transfer a good or service to the customer (par. IN12),” and already this definition is the subject of debate. During the comment period ending in October 2010, this joint project with the IASB generated 986 comments, mostly from North America, but also widely distributed from around the world and from many industries. Based on those comments, the boards currently plan to modify the definition by excluding the word “enforceable” and adding the following sentence: “Performance obligations include promises that are implied by an entity’s business practices, published policies, or specific statements if those promises create a valid expectation of the customer that the entity will perform (April 26, 2011 update).”

 The proposed revenue recognition standard will perhaps have its biggest impact on the construction industry, as the “percentage of completion” terminology and technique will disappear. In order to apply accounting resulting in similar revenue recognition timing as the percentage of completion method, the construction company will have to argue that the contract with the customer represents a service contract with continuous transfer of the service (as opposed to a contract for the production and transfer of goods). “Continuous transfer of service” is still a developing concept; however, it appears that criteria such as the customer controlling the asset “as it is created or enhanced,” the contractor having the right to receive payment at various stages, or the customer having a reasonable expectation that it could fire the contractor at various stages and not need to have work done to date re-performed will meet the “continuous transfer of service” test.

 The proposed standard also potentially affects many industries in relation to accounting for warranties and to uncertainty around collection from the customer. Under the proposed rules, many warranties will be accounted for as separate performance obligations and the reduction of income will be accounted for as deferred revenue as opposed to accrued expense. Similarly, at the initiation of a contract estimates of the effects of customer credit risk will be accounted for in contra-revenue accounts as opposed to bad debt expense.

The boards also have on their agendas a phase of the conceptual framework project titled “elements and recognition.”  It will be interesting to see if/how the performance obligation concept affects the definition of a liability. As of March 2010, in deliberating about the definition of a liability in the elements and recognition phase of the conceptual framework project, the boards concluded that “it is unclear how the definition applies to contractual obligations.”

To stay current on the development of the new revenue recognition model, click here for the exposure draft, click here for an analysis of comment letters, and click here for decisions since analysis of the comment letters.

Jeff Wilks and I will periodically post entries regarding revenue recognition and we would be happy to orient those posts towards any questions or comments you may have about the developing “revenue from contracts with customers” standard. Please respond to anything we write, post your own revenue recognition-related FASRI blog, or send either one of us an email, and we will keep the posts moving in a direction that responds to the interests and concerns of the academic community and hopefully provides good soil for nurturing useful input to standard setters from research and other contributions of the academic community. Our email addresses are pbshane@fasb.org or phil.shane@virginia.edu, and wilks@byu.edu.