How do you apply the five-step model to service contracts?

1 Identify the contract

The first step in the process is to identify the contract with the customer, which is an agreement that creates enforceable rights and obligations for both parties. This contract can be written, oral, or implied by customary business practices, but it must include certain criteria, such as approval from both parties, identifiable terms and conditions including payment terms, commercial substance meaning it affects the risks, timing or amount of future cash flows, and a probability of collection of the consideration. In our example, the web hosting company has a contract with each client that signs up for a plan, either online or by phone. This contract outlines the plan features such as storage space, bandwidth, uptime and support as well as the monthly fee and billing cycle. The company has a successful track record of collecting payments from its clients and has no reason to doubt their creditworthiness.

2 Identify the performance obligations

The second step is to identify the performance obligations in the contract, which are the promises to transfer distinct goods or services to the customer. A good or service is distinct if it is separately identifiable from other items in the contract and if the customer can benefit from it on its own or with other resources that are readily available.

In our example, the web hosting company has one main performance obligation in each contract: to provide web hosting services according to the plan features. This is a distinct service because it is clearly defined and separate from other services that the company may offer, such as domain registration or web design. The customer can benefit from the web hosting service by using it to host their website and access it online.

3 Determine the transaction price

The third step is to determine the transaction price, which is the amount of consideration that the provider expects to receive in exchange for transferring the goods or services to the customer. The transaction price may include fixed or variable components, such as discounts, rebates, incentives, or penalties, and may be affected by factors such as the time value of money, non-cash considerations, or uncertainty.

In our example, the web hosting company has a fixed transaction price for each contract, which is the monthly fee that the client agrees to pay for the chosen plan. The company does not offer any discounts, rebates, incentives, or penalties to its clients, and does not accept any non-cash considerations or face any uncertainty in collecting the payments.

4 Allocate the transaction price

The fourth step is to allocate the transaction price to the performance obligations in the contract, based on their relative stand-alone selling prices. The stand-alone selling price is the price at which the provider would sell a good or service separately to a customer. The best evidence of the stand-alone selling price is the observable price of a good or service when the provider sells it separately in similar circumstances and to similar customers. If the observable price is not available, the provider may use other methods, such as adjusted market assessment, expected cost plus margin, or residual approach, to estimate the stand-alone selling price.

In our example, the web hosting company has only one performance obligation in each contract, so there is no need to allocate the transaction price. The transaction price equals the stand-alone selling price of the web hosting service.

5 Recognize revenue

The fifth and final step is to recognize revenue when or as the provider satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when the customer obtains control of it, which means that the customer has the ability and right to direct the use of and obtain the benefits from the good or service.

In our example, the web hosting company satisfies its performance obligation over time, as it provides the web hosting service continuously throughout the contract period. The customer obtains control of the service as it receives and consumes the benefits of hosting their website online. Therefore, the company recognizes revenue over time, using a method that best reflects the pattern of transfer of the service to the customer. One possible method is to recognize revenue on a straight-line basis, based on the monthly fee and the number of days in each month.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?