Authored by: Philip Santarelli
So far in our series, we have discussed four of the five elements of revenue recognition. We have identified a contract, determined the performance obligations, estimated the transaction price, and allocated that transaction price to the various performance obligations. In this article we examine the final element, recognizing revenue as the entity satisfies the performance obligations.
ASC 606 states the following:
An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.1
A key concept in the determination of “transfer” is that the customer obtains control of the asset, and of course, the entity itself must make a determination as to when it believes its customer obtains control. Control of an asset is demonstrated when an entity has the ability to direct and realize all of the remaining benefits associated with the use of the asset. This concept also covers the benefit of services provided to an entity, even though the benefit may be only momentary. Some indicators (but not the only) of control passing to the customer are:
- Using the asset to produce goods or provide services (including public services)
- Using the asset to enhance the value of other assets
- Using the asset to settle liabilities or reduce expenses
- Selling or exchanging the asset
- Pledging the asset to secure a loan
- Holding the asset
Control passes to a customer in one of two ways: either at a point time or over time. Both concepts are discussed below.
Performance obligations satisfied at a point in time
This concept is the most basic and applies to many revenue transactions in retail, wholesale, manufacturing, food and beverage, real estate, and other industries. Basically, an entity transfers an asset or service to a customer, thereby completing the performance obligation. However, determining whether control has passed to the customer is not always simple. ASC 606 includes several indicators of the transfer of control, which include, but are not limited to, the following:
- The entity has a present right to payment for the asset—If a customer presently is obliged to pay for an asset, then that may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset in exchange.
- The customer has legal title to the asset—Legal title may indicate which party to a contract has the ability to direct the use of, and obtain substantially all of the remaining benefits from, an asset or to restrict the access of other entities to those benefits. Therefore, the transfer of legal title of an asset may indicate that the customer has obtained control of the asset. If an entity retains legal title solely as protection against the customer’s failure to pay, those rights of the entity would not preclude the customer from obtaining control of an asset.
- The entity has transferred physical possession of the asset—The customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits. However, physical possession may not coincide with control of an asset. For example, in some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset that the entity controls. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls. Paragraphs 606-10-55-66 through 55-78, 606-10-55-79 through 55-80, and 606-10-55-81 through 55-84 provide guidance on accounting for repurchase agreements, consignment arrangements, and bill-and-hold arrangements, respectively.
- The customer has the significant risks and rewards of ownership of the asset—The transfer of the significant risks and rewards of ownership of an asset to the customer may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. However, when evaluating the risks and rewards of ownership of a promised asset, an entity shall exclude any risks that give rise to a separate performance obligation in addition to the performance obligation to transfer the asset. For example, an entity may have transferred control of an asset to a customer but not yet satisfied an additional performance obligation to provide maintenance services related to the transferred asset.
- The customer has accepted the asset—The customer’s acceptance of an asset may indicate that it has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. To evaluate the effect of a contractual customer acceptance clause on when control of an asset is transferred, an entity shall consider the guidance in paragraphs 606-10-55-85 through 55-88.2
This is not an all-inclusive list and an entity may determine that specific facts and circumstances enable the conclusion that control has passed to the customer. For example, the existence of a customer acceptance clause in a contract does not necessarily preclude the recognition of revenue for a particular performance obligation until the customer formally accepts the good or service. If the entity can objectively determine that the agreed-upon specifications have been satisfied, the entity may be able to recognize revenue for that particular performance obligation prior to receiving confirmation of the customer’s acceptance.
It is also notable that these indicators provide more indicators of revenue recognition than the current GAAP, which relies on a transfer of risk and reward model for recognition.
Although reasonably straightforward, there may be situations (such as with synthetic shipping terms) that need to be reassessed as to the timing of revenue recognition.
Performance obligations satisfied over time
More complex judgments will be necessary when recognizing revenue from performance obligations satisfied over time. This concept will be commonly applied by contractors, service entities, and professional organizations. It may also include manufacturing for certain specialized products made to customer specifications without alternative uses, such as seen in government contracting.
The standard provides that revenue is recognized over time if any of the following criteria are met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (see paragraphs 606-10-55-5 through 55-6).
- The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced (see paragraph 606-10-55-7).
- The entity’s performance does not create an asset with an alternative use to the entity (see paragraph 606-10-25-28), and the entity has an enforceable right to payment for performance completed to date (see paragraph 606-10-25-29).3
The following paragraphs discuss each criterion in more detail.
Criterion (a) – simultaneous receipt and consumption of benefits
The first criterion would typically be applied in many recurring service arrangements. For example, an entity contracts with a cleaning service to have its offices cleaned every working day for a period of one year. This is accounted for as a single performance obligation as it meets one of the definitions of a performance obligation: “A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.” Since another entity would not need to re-perform the cleaning services that the entity has provided at any point in time, is an indicator that the customer simultaneously receives and consumes the benefits. The entity recognizes revenue over time as the performance obligation is satisfied.
Criterion (b) – creation or enhancement of an asset that the customer controls
The second criterion would be most applicable to contractor-type activities, such as when an entity agrees to construct an asset and the customer controls the asset as it is created or enhanced. One example would be a contractor constructing a building on land owned by its customer. Here as the building is erected the customer receives and controls the benefit, such that if the entity failed to complete the job, another entity would most likely not need to re-perform the work already provided.
Criterion (c) – creation of an asset with no alternative use and enforceable right to payment for progress
The third criterion would be applicable to many entities that provide customized products or services. As stated in the criterion description above, (i) the entity’s performance does not create an asset with an alternative use to the entity; and (ii) the entity has an enforceable right to payment for performance to date.
In order for an entity to determine if it is not creating an asset with an alternative use, it should consider whether it is contractually prohibited from redirecting the use of the asset or if there are practical limitations in transferring the asset readily for alternative uses. Practical limitations in the transfer of the asset for an alternative use might include the entity suffering significant economic consequences in order to effect such a transfer, such as significant rework or the necessity to sell the asset at a loss. Accordingly, assets with specific design elements or assets in remote locations may be subject to the practical limitations.
Some examples of contracts that do not create assets with alternative uses to the entity may be design services provided by an engineering firm, a contract to build a custom ocean liner to the customer’s specifications, or legal or accounting services related to the customer. There are many other examples, and it is important to note the assessment of whether an asset has an alternative use must be made at contract inception.
When the entity assesses the enforceable right to payment, it must consider contract terms as well as legal issues. While the standard does not require the right to full payment at all times during the performance period, the right to payment must be at least enough to compensate the entity for its performance to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised. Such compensation is meant to be the cost incurred by the entity to date, plus a reasonable profit margin. As stated in the standard with respect to profit margin, the entity should be entitled to compensation for either of the following amounts:
- A proportion of the expected profit margin in the contract that reasonably reflects the extent of the entity’s performance under the contract before termination by the customer (or another party)
- A reasonable return on the entity’s cost of capital for similar contracts (or the entity’s typical operating margin for similar contracts) if the contract-specific margin is higher than the return the entity usually generates from similar contracts.4
Determining this enforceable right to payment will be complex and subject to significant judgments.
Example: Application of criterion (c)
An entity enters into a contract to construct a specialized machine. The contract requires an upfront payment of 10% of the total, regular progress payment totaling 50% through the construction period and a final payment 40% upon delivery and acceptance by the customer. The payments are non-refundable. If the contract is terminated by the customer the entity is entitled to retain any payments made to date. The entity is not entitled to any further compensation from the customer.
At the inception of the contract, the entity assess its rights to payment and determines that despite the fact that the payments are not refundable, these payments do not meet the requirement that the cumulative amount does not at all times during the contract represent an amount to compensate the entity for performance to date. As such, even though the asset does not have readily alternative use to the entity, because of the lack of an enforceable right to payment for performance to date, the entity cannot recognize performance over time. Instead, the entity must recognize revenue upon delivery and acceptance of the machine by the customer. That is, at a point in time.5
Measuring progress toward completion
In order to recognize revenue over time, an entity must measure its progress towards completion of the obligation. The objective is that the measure of progress should “depict an entity’s performance in transferring control of goods or services promised to the customer…” The measure used should be consistent with measures used by the entity for similar performance obligations and consistently used throughout the completion of the promise.
Similar to existing GAAP, the standard permits the use of output or input measures of progress. The determination of which to use should be based on the nature of the goods or services being transferred. In the case of a construction project, an input measure such as cost to date as compared to total estimated cost might be an appropriate method. For a contract to deliver a distinct set of similar services over a period of time, such as the cleaning contract noted above, an output method based on the number of cleanings provided to date would be more appropriate.
The measure of progress should be reasonable. If the entity does not have sufficient information to reasonably measure progress, such as not having a reliable estimate of total costs to complete a project, it should defer recognition until more reliable information is determined.
Output methods include methods such as units produced, milestones reached, surveys of performance to date, etc. In evaluating whether to apply an output method to measure progress, an entity should consider whether using the output selected is a faithful depiction of the entity’s performance to date in meeting the obligation. One example of an output measure that might not provide a faithful depiction
would be a situation where only using delivered units as a measure of progress may ignore work in progress or finished goods that are controlled by the customer (based on contract terms) but not yet delivered.
When using an input method there is an inherent limitation on its usefulness as there may not be a direct relationship between an entity’s input method and the delivery of goods or services to its customer. For example, when using a cost-based input method, an adjustment to the measure of progress may be required in the following circumstances:
- When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation. For example, an entity would not recognize revenue on the basis of costs incurred that are attributable to significant inefficiencies in the entity’s performance that were not reflected in the price of the contract (for example, the costs of unexpected amounts of wasted materials, labor, or other resources that were incurred to satisfy the performance obligation).
- When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation. In those circumstances, the best depiction of the entity’s performance may be to adjust the input method to recognize revenue only to the extent of that cost incurred. For example, a faithful depiction of an entity’s performance might be to recognize revenue at an amount equal to the cost of a good used to satisfy a performance obligation if the entity expects at contract inception that all of the following conditions would be met:
- The good is not distinct.
- The customer is expected to obtain control of the good significantly before receiving services related to the good.
- The cost of the transferred good is significant relative to the total expected costs to completely satisfy the performance obligation.
- The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good (but the entity is acting as a principal in accordance with paragraphs 606-10-55-36 through 55-40).6
One typical example from the construction industry would be uninstalled materials. Although the advance purchase of construction materials leads to a cost input and is part of the total costs expected to be incurred, merely purchasing the materials does not faithfully represent the entity’s progress towards fulfilling its performance obligations and, therefore, should not be included in the calculation of measuring progress towards completion.
Example: Adjustment to cost-based input method
An entity contracts to renovate a building including the installation of new elevators. The entity estimates the following with respect to the contract:
|Total expected costs||$4,000,00|
The entity purchases the elevators and they are delivered to the site six months before they will be installed. The entity uses an input method based on cost to measure progress towards completion. At the end of the reporting period, the entity has incurred other costs of $500,000; it determines its progress towards completion as 20% (500,000/2,500,000).
The entity calculates revenue to be recognized as 20% * $3,500,000 ($5,000,000-1,500,000) = $700,000 + $1,500,000 = $2,200,000. Its cost of goods sold is $500,000 + $1,500,000 = $2,000,000 for a profit to date of $200,000.7
In the foregoing example, the entity concluded that including the costs to procure the elevators in the measure of progress would overstate the extent of the entity’s performance. Consequently, the entity adjusted its measure of progress to exclude the costs to procure the elevators from the measure of costs incurred and from the transaction price. The entity recognizes revenue for the transfer of the elevators in an amount equal to the costs to procure the elevators (that is, at a zero margin).
This example simply illustrates the need to regularly evaluate estimates and adjust accounting accordingly if warrant.
The process towards recognizing revenue through applying the five elements is now completed. During these last five articles, we have demonstrated that most entities will encounter significantly more complexities in recognizing revenue than under current GAAP. These include the application of more management judgments than previously required. In many cases, the amount billed will not be equal to the amount of revenue recognized. Management will need to establish appropriate processes and internal controls over financial reporting (ICFR) to ensure that the integrity of its financial reporting is maintained.
The time to start analyzing contracts and revenue streams is now as the effective date, especially for public entities, is less than 18 months away.
In upcoming articles, we will explore the new disclosures (which are extensive), specialized topics such as cost capitalization, and finish with transition methods.
For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, contact our team.
1 ASC 606-10-25-23
2 ASC 606-10-25-30
3 ASC 606-10-25-27
4 ASC 606-10-55-11