A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. It is a key concept in revenue recognition, as a company must identify the distinct performance obligations in a contract and allocate the transaction price to each one in order to determine when to recognize revenue.
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A company must identify all distinct performance obligations in a contract and allocate the transaction price to each one.
Revenue is recognized when (or as) the company satisfies a performance obligation by transferring a promised good or service to a customer.
The timing of revenue recognition depends on whether the performance obligation is satisfied over time or at a point in time.
Factors that determine whether a performance obligation is satisfied over time include the customer's simultaneous receipt and consumption of the benefit, the company's creation or enhancement of an asset that the customer controls, and the company's right to payment for performance completed to date.
If a performance obligation is not satisfied over time, it is satisfied at a point in time, which is typically when the customer obtains control of the good or service.
Review Questions
Explain how the concept of a performance obligation is central to a company's recognition of revenue.
The identification and allocation of distinct performance obligations is a critical step in the revenue recognition process. A company must first identify all of the promises to transfer goods or services to the customer that are contained in the contract. These distinct performance obligations represent the unit of account for revenue recognition. The company then allocates the total transaction price to each performance obligation based on their relative standalone selling prices. Revenue is then recognized as each performance obligation is satisfied, either over time or at a point in time, depending on the nature of the obligation.
Describe the factors that determine whether a performance obligation is satisfied over time or at a point in time.
There are three main factors that determine whether a performance obligation is satisfied over time or at a point in time: 1) whether the customer simultaneously receives and consumes the benefits provided by the company's performance as the company performs, 2) whether the company's performance creates or enhances an asset that the customer controls as the asset is created or enhanced, and 3) whether the company has a right to payment for performance completed to date. If any of these criteria are met, the performance obligation is satisfied over time. Otherwise, it is satisfied at a point in time, typically when the customer obtains control of the good or service.
Analyze how the identification and measurement of distinct performance obligations impacts a company's financial reporting.
The identification and measurement of distinct performance obligations is critical to a company's financial reporting, as it directly determines the timing and amount of revenue recognized. If a company fails to properly identify all distinct performance obligations in a contract, it may recognize revenue prematurely or fail to recognize revenue for certain promised goods or services. Additionally, the allocation of the transaction price to each distinct performance obligation based on standalone selling prices impacts the amount of revenue recognized for each obligation. This, in turn, affects the company's reported revenue, gross profit, and other key financial metrics that are closely watched by investors, analysts, and other stakeholders. Proper accounting for performance obligations is therefore essential for a company to provide an accurate and faithful representation of its financial performance.
The accounting process of determining when a company should record revenue from the sale of its products or services.
Transaction Price: The amount of consideration a company expects to be entitled to in exchange for transferring promised goods or services to a customer.
Distinct Performance Obligation: A promise to transfer a good or service that is separately identifiable from other promises in the contract.