In step 5 of the revenue model, companies recognize revenue when (or as) performance obligations are satisfied. An entity must assess whether revenue should be recognized over time or at a point in time. This can include assessing whether the customer controls an asset as it is created or enhanced. For revenue recognized over time, an entity must choose either an input method or an output method to measure progress. These three topics are each covered separately in the following articles: Revenue Recognition Over Time, Determining the Transfer of Control, and Input Versus Output Methods. This article provides a comprehensive example to illustrate the recognition of revenue over time for a product or asset.
E-Vehicle is a manufacturer of Electric Vehicles for fleet customers. They have two models of a delivery van, one with a 50-mile range (the E-van) and another with a 200-mile range (the LE-van). They recently entered a contract with RxRunner (a medical courier company) to provide 50 E-vans and 50 LE-vans.
RxRunner provides courier services for medicine, medical documentation, and small medical equipment. All 100 vans will be customized with a vehicle wrap advertising RxRunner. In addition, the LE-vans will be outfitted with a refrigerated medicine compartment to keep medicine at a proper temperature during longer deliveries. This refrigeration compartment will create a larger load on the vehicles battery, which will necessitate the installation of larger batteries. E-Vehicle has not sold any vans to medical courier companies previously, and is unaware of any similar potential customers. The larger batteries and refrigeration equipment will significantly reduce the interior storage capacity of the van.
The contract provides E-Vehicle the unilateral right to terminate the contract to protect them in case of supply chain failures by their vendors, and E-Vehicle is only entitled to payment for vehicles already delivered should they exercise this right. Alternatively, if RxRunner cancels the contract then E-Vehicle is entitled to payment for all vans already delivered, as well as compensation to cover costs and a reasonable profit for any partially completed LE-vans. In the past, E-Vehicle has not elected to enforce a similar right to payment when a customer cancels a contract. Additionally, the agreed-upon billing schedule only provides for payment with the delivery of every 10th E-van and every 10th LE-van.
The manufacturing process involves E-Vehicle purchasing a van chassis and body (all components aside from the drivetrain) for each E-Van and LE-van. This is purchased from a large US automaker (US Motors) for $20,000 per vehicle. Then E-Vehicle installs its own proprietary drivetrain. The primary components of this drivetrain are an electric motor and a battery pack. To prevent overheating, the vehicle requires installation of a vented cooling system for the battery. Additionally, regenerative brakes are installed to conserve energy that would otherwise be lost during braking. As a final step, any contract-specific modifications are made to the vehicles. Until this point, the vehicles are interchangeable and could easily be directed to any customer.
E-Vehicle has assessed steps 1-4 of the revenue model, and has identified the following performance obligations along with their allocated portion of the transaction price, and their expected cost.
E-Vehicle needs to determine if they should recognize revenue over time or at a point in time. If recognizing revenue over time is appropriate, they must decide whether using an input method or an output method to measure progress is appropriate.
Revenue Recognition over Time
If a performance obligation meets any of the three criteria for revenue recognition over time then it must recognize revenue over time. Otherwise, revenue will be recognized at a point in time. E-Vehicle considers the three criteria in Accounting Standards Codification (ASC) 606-10-25-27 to determine whether it should recognize revenue over time:
- A) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- B) 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.
- C) The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
The Financial Accounting Standards Board (FASB) clarified that criterion A is generally not intended to apply to contracts where an entity’s progress results in an asset, but rather is intended for service-type contracts (BC 125, 128). Because the benefits of E-Vehicle’s performance are not simultaneously received and consumed and this contract results in the creation of an asset, this criterion is not satisfied.
From the background information provided, there is no indication that E-Vehicle is creating or enhancing an asset that the customer controls in the course of manufacturing the vans. Consequently, criterion B is not met. In a different circumstance, this criterion could be met provided the indicators of the transfer of control in ASC 606-10-25-30 demonstrate that the customer controls the asset.
Criterion C is useful in some situations where the first two criteria are difficult to apply. This criterion may be used for either goods or services that are specific to a customer. To meet this criteria the asset created must (1) not have a feasible alternative use, and (2) the entity must be entitled to payment. These elements of this criterion are each addressed separately below.
E-Vans: Does the asset have an alternative use?
No contractual limitations exist to prevent E-Vehicle from shipping the vans manufactured for this contract to another customer. However, the entity should consider potential practical limitations. A practical limitation exists if E-vehicle would incur significant economic losses to direct the asset to an alternative use (ASC 606-10-55-10). E-Vehicle should make this assessment at contract inception based on the good’s completed state. The fact that the vans are interchangeable until the modifications are performed as a final step is not a relevant consideration.
All of the vehicles will be customized with a vehicle wrap advertisement, but this could be removed without E-vehicle incurring significant economic losses. As this is the only customization for the 50 E-vans, these vans have an alternative use, and revenue should be recognized when they are delivered to RxRunner (i.e., at a point it time). Because these vans have an alternative use, it is not necessary to determine if E-Vehicle is entitled to payment.
LE-Vans: Does the asset have an alternative use?
For the 50 highly customized LE-vans, E-Vehicle must consider whether they would be able to sell the completed vans without significant rework and/or incurring a significant economic loss. E-vehicle first considers whether they have other potential customers for these 50 customized vans as completed, and determines that they do not. Because the vans have larger batteries and refrigeration equipment, they are uniquely suited for use as medical courier vans. Consequently, E-Vehicle determines that they could not sell the vans without removing the larger batteries and extra equipment (which would require significant rework) or by selling them at a significant loss. Therefore, the entity’s performance does not create an asset with an alternative use to the entity.
LE-Vans: Is E-Vehicle entitled to payment?
E-Vehicle’s payment schedule lags behind their performance of the contract, but this is not evidence against an enforceable right to payment for performance to date (ASC 606-10-55-11 through 15). E-Vehicle determines that if RxRunner cancels the contract they will be able to recover their costs as well as a reasonable return on capital. Although E-Vehicle has previously made a business decision not to enforce their right to payment in similar contracts, with the help of their legal counsel they determine based on legislation and legal precedent that they do in fact retain an enforceable right to payment. Consequently, E-Vehicle determines that revenue should be recognized over time for the 50 LE-vans.
Determining transfer of Control for Criterion B
Assume a similar contract and situation as provided in the facts above, with the following changes. The contract does not contain provisions to ensure that E-Vehicle is entitled to payment for performance completed to date. RxRunner can cancel the contract at any time for any reason. RxRunner pays in advance, but is entitled to a proportional refund at their discretion. E-Vehicle facilitates a transaction between RxRunner and US Motors for RxRunner’s purchase of 100 van chassis and bodies for $20,000 each. Subsequently, E-vehicle contracts to install their proprietary drivetrain into these shells. RxRunner purchases insurance to protect their assets. The vans are specifically identified by VIN, and can be picked up at any point in the installation process with payment for completion to date. Although RxRunner maintains title to the vans during the installation of the drivetrain, E-Vehicle maintains a mechanics lien whereby they are legally entitled to payment for performance through a security interest in the title. The modifications to the vans are the same, and the contract price and expected cost are similar (but reduced by $20,000 per van).
If E-Vehicle’s performance creates or enhances an asset that RxRunner controls then criterion B is met. Therefore, the key question is whether RxRunner is able to direct the use of, and obtain the benefits from the vans. This also includes the ability to prevent other entities from directing the use of the asset. To assist in making this determination, ASC 606-10-25-30 provides a non-comprehensive list of indicators of the transfer of control:
- The entity has a present right to payment.
- The customer has legal title to the asset.
- The entity has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
Although E-Vehicle does not have a contractual right to payment, through legal precedent in its jurisdiction E-Vehicle does have a mechanics lien representing a security interest in the vans. This gives them the ability to effectively ensure payment. RxRunner has the legal title to the asset, and has the significant risks and rewards of ownership as illustrated by their purchase of insurance. Although there is no evidence of a customer acceptance clause in this scenario, this indicator should be considered by entities where applicable. Although E-Vehicle maintains physical possession of the asset, this does not preclude the transfer of control (as illustrated by bill-and-hold transactions). E-Vehicle considers the indicators of the transfer of control, and determines that RxRunner maintains control of all 100 vans. Consequently, criterion B is met and E-Vehicle should recognize revenue over time.
Input vs. Output methods
After determining that revenue is recognized over time, E-Vehicle must determine whether to use an input method or an output method to measure progress and record revenue. The selected method should depict the entity’s progress in satisfying the performance obligation. Output methods generally better measure the value delivered to the customer, but may fail to faithfully depict the entity’s performance if there is a significant amount of work-in-process or finished goods that are controlled by the customer but excluded from the output measure. Additionally, depending on the situation, outputs may be difficult or costly to observe. Input measures should also be considered, as they may be more observable and provide a better measure of the entity’s progress. Ultimately whichever approach depicts the entity’s completion most faithfully should be used.
Assume the initial case facts. E-vehicle has determined that it will recognize revenue at a point in time (when each van is delivered) for the 50 E-vans, and will recognize revenue over time for the 50 LE-vans.
E-Vehicle takes a job-shop approach to manufacturing vehicles, with several mechanics working on a single vehicle. The process takes approximately 2 hours for a team of mechanics, and vehicles are completed one at a time. Because of an efficient scheduling and manufacturing process, work-in-process inventory at the end of any day is negligible.
In this situation an output method is most appropriate, as this will reflect E-Vehicle’s economic performance. Because there is negligible work-in-process inventory, E-Vehicle determines that they will recognize revenue with the completion of each custom LE-Van. To determine the portion of the transaction price that E-Vehicle should recognize, they divide the $3,750,000 transaction price by the 50 vans and recognize $75,000 of revenue with the completion of each vehicle.
Assume now that E-Vehicle uses an assembly line approach to manufacturing their vehicles. This approach includes dozens of production steps. There are several general phases of production, and within each phase there are several sub-phases. Consequently, at any point several vehicles will be at various sub-phases of production. The following table details the hours and costs required for each step, the percentage of total hours and costs, and the proportion of the transaction price that E-Vehicle is entitled to for a vehicle in a given stage of completion. (Percentages are rounded.)
Under this manufacturing method, E-Vehicles has significant work-in-process, and at any given point vehicles can be at one of a number of sub-phases. Consequently, E-Vehicle’s process is not directly measurable, and evaluating the progress based on an output measure would likely be difficult and costly. Consequently, E-Vehicle decides that it should use an input method. E-Vehicle notes that the number of hours closely reflects the vehicle completion, and the costs incurred do not. Therefore it decides to recognize revenue based on the number of hours spent. To the extent that an unexpected amount of labor is wasted, (for example, a strike or bottleneck causes an increase in labor hours) revenue should not be recognized for that input (606-10-55-21A).
Similarly, if E-vehicle determines that a cost-based input method should be used then it must exclude costs for the purchase of the vehicle chassis and body, as this cost does not contribute to the entity’s progress. Consequently, the percentage of completion should be recalculated as follows.
By ignoring the costs that do not reflect the satisfaction of a performance obligation, the costs now more appropriately reflect vehicle completion.
Comparison to ASC 605
ASC 606-10-25-27 provides three different criteria that a transaction could meet to qualify for revenue recognition over time; Criterion B and C are most suitable for products like the vans discussed in this case. Criterion B is similar to concepts found in ASC 605, Revenue Recognition, including construction- and production-type contracts where an entity may recognize revenue if it effectively agrees to a continuous sale of work-in-process inventory.
On the other hand, Criterion C will likely lead to the acceleration of revenue recognition for manufacturing companies that produce products to customer specifications. These arrangements are generally treated as product sales under ASC 605; under ASC 606, they qualify for recognition over time if the asset manufactured has no alternative use and the entity is entitled to payment. Perhaps the largest change to ASC 605 is the consolidation of guidance along with the elimination of industry-specific guidance. One relevant example is the elimination of prescriptive requirements for down payments for real estate sales.
Once an entity determines that revenue will be recognized over time, it must determine how to measure its progress towards the satisfaction of performance obligations. Under ASC 605, revenue recognized over time was often done on a straight-line basis. However, under ASC 606 an entity is required to use whatever method depicts performance most faithfully. Output measures are often preferable, but input measures should also be considered if using output measures would entail undue cost.
Two of the three criteria in ASC 606-10-25-27 are used to determine whether revenue should be recognized over time for the production of assets. Criterion B depends on whether the customer controls an asset as it is created or enhanced, while Criterion C depends both on the right to payment and on whether an asset has an alternative use. Upon determining that revenue will be recognized over time, an entity must determine which method of measuring progress to use. Either an output or an input method can be used depending on which method most faithfully represents the satisfaction of performance obligations.
- ASC 606-10-25-27 to 29, 55-11 to 21
- EY, Financial Reporting Developments: "Revenue from contracts with customers." August 2017. Section 7.
- EY, Financial Reporting Developments: "The New Revenue Recognition Standard-Construction & Engineering." September 2014. Section 6.
- PWC, "Revenue from contracts with customers." August 2016. Section 6.3.