Explain and illustrate how a company should recognize revenue for a contract that includes multiple performance obligations, giving a fictional example.

When a company enters into a contract that includes multiple performance obligations, it must allocate the total transaction price to each performance obligation based on its standalone selling price. Revenue recognition should then occur as each performance obligation is satisfied.

For example, let's say a company, ABC Corp, enters into a contract with a customer to provide software installation, training, and ongoing technical support services. The total transaction price for the contract is $10,000.

ABC Corp determines that the standalone selling prices for each performance obligation are as follows:
- Software installation: $3,000
- Training: $2,000
- Technical support: $5,000

ABC Corp would allocate the total transaction price of $10,000 to each performance obligation based on their standalone selling prices. Revenue recognition would then occur as follows:
- $3,000 would be recognized when the software installation is completed
- $2,000 would be recognized when the training services are provided
- $5,000 would be recognized over the period of the technical support services

By recognizing revenue for each performance obligation as it is satisfied, ABC Corp is able to accurately reflect the value of the services provided to the customer and comply with accounting standards for revenue recognition.

Revenue Recognition for Contracts with Multiple Performance Obligations

In accordance with accounting standards (e.g., IFRS 15, ASC 606), companies must recognize revenue for contracts that include multiple performance obligations (i.e., distinct goods or services within a contract) based on their relative standalone selling prices.

Steps for Revenue Recognition:

1. Identify the Performance Obligations: Determine the distinct goods or services within the contract that are substantially independent of each other.
2. Allocate Contract Price: Allocate the total contract price to each performance obligation based on its standalone selling price or a surrogate measure thereof.
3. Recognize Revenue: Recognize revenue as each performance obligation is satisfied over time.

Fictional Example:

Company: Smart Solutions

Contract: A contract with a customer to purchase a custom software package and provide ongoing support services for one year.

Performance Obligations:

- Software Package: $40,000
- Support Services: $10,000

Allocation of Contract Price:

Assuming the standalone selling price of the software package is $50,000 and the annual support services fee is $12,000:

- Software Package: $40,000 / $50,000 - $50,000 = $40,000
- Support Services: $10,000 / $12,000 - $50,000 = $10,000

Revenue Recognition Schedule:

- Software Package: Revenue of $40,000 recognized upon delivery and acceptance of the software.
- Support Services: Revenue of $10,000 recognized evenly over the one-year support period ($1,000 per month).

Timeline:

- Month 1:
- Deliver and accept software: Recognize $40,000 revenue for the software package.
- Provide monthly support: Recognize $1,000 revenue for support services.
- Month 2:
- Provide monthly support: Recognize $1,000 revenue for support services.
- Month 3:
- Provide monthly support: Recognize $1,000 revenue for support services.
- Month 12:
- Provide final monthly support: Recognize $1,000 revenue for support services.

By following these steps, Smart Solutions will accurately recognize revenue for the multiple performance obligations in the contract over the period in which they are satisfied.