In many contracts, revenue is recognized at the point of sale because the contract with the customer is executed immediately. However, some contracts are executed over a period of time (see criteria in ASC 606-10-25-27). Accounting Standards Codification (ASC) 606 states that an “entity shall recognize revenue over time by measuring the progress toward complete satisfaction of that performance obligation” (ASC 605-10-25-31).
For all contracts that fall under this category, the codification outlines two acceptable methods for measuring progress toward the completion of the contract and determining when to recognize revenue: the input method and the output method. Although both of these methods are acceptable, they are not interchangeable. The method chosen must be appropriate for the circumstances of the contract. These methods were first used extensively in construction- and production-type contracts to measure progress and revenue earned, but after implementation of ASC 606 now apply to contracts across all industries.
The output method measures the results achieved and value transferred to a customer. For example, miles of railroad track completed is an output measure that informs the railroad company of its progress toward completion of the railroad line. In certain circumstances, a special output measure—a practical expedient that allows revenue recognition based on the amount for which an entity has the right to invoice—may be applied.
The input method measures the efforts or materials expended to satisfy the obligation. For example, in the construction of a building, construction materials consumed by the project would be an input measure.
Although both methods are acceptable in certain circumstances, the input and output methods can differ significantly in application. The result could be material differences in the timing of revenue recognition. Companies should carefully determine which method best reflects the economic substance of the transaction. According to the Financial Accounting Standards Board (FASB), the output method is often preferable due to its close correlation with substantive performance of a contract. However, there are circumstances in which the input method is preferable, such as in service contracts where value transferred is best represented by labor hours worked. (Accounting Standards Update (ASU 2014-09 BC164). When deciding between the input and output methods, management should choose the method that best reflects the substantive transfer of goods or services to the customer (ASU 2014-09 BC159).
In some situations, neither the input method nor the output method is appropriate. In such a case, two other options must be considered: recognizing revenue as invoiced and recognizing revenue only to the extent that recoverable costs have been incurred.
Outputs are goods or services finished and transferred to the customer. These outputs are the result of processes applied to inputs in a business. In other words, the output method measures results achieved. In order to implement the output method, an entity first estimates the amount of outputs needed to satisfy the contract. The entity then tracks the progress toward completion of the contract by measuring outputs to date relative to total estimated outputs needed to satisfy the performance obligation (see ASC 606-10-55-17 to 19). Many different measures can be used to quantify outputs and can easily be tailored to a contract. For example, tables completed, units delivered, houses erected, or miles of track laid are all output measures.
The input method is a more indirect measure of the fulfillment of a performance obligation. Inputs are measured by the amount of effort that has been put into satisfying a contract. The input method is implemented by first estimating the total inputs required to satisfy a performance obligation. The entity then compares efforts expended to date with the estimated total inputs needed to satisfy the performance obligation (see ASC 606-10-55-20 to 21). Many different measures can be used to quantify inputs and can easily be tailored to a contract. For example, hours of labor put into a project or tons of material consumed are both input measures.
In contrast with the output method, the input method is most often used in contracts in which the customer is entitled to goods or services that are not easily measured and observed. This is commonly used with service contracts where it is difficult to ascertain the value that has been transferred to the customer. In deciding whether or not the input method is the right method to use for a particular contract, it is important to note that the input method may not be correlated with the actual completion of the contract and transfer of control to the customer. For example, worker inefficiency, pilferage, or spoilage may make the input method unreliable as a measure of contract completion. If chosen, the input method must exclude those inputs which do not accurately depict an entity’s progress toward completion of a contract.
"As Invoiced" Method (Practical Expedient)
In some cases, an entity may have the contractual right to bill the customer based directly on value transferred to the customer. If this is the case, the entity may elect to recognize revenue in the amount that it has the right to invoice. This is often applied to service contracts in which the invoices to the customer align with the amount of value delivered. This method may not be used for the purpose of accelerating revenue recognition.
Choosing a Method
Choosing a method is not discretionary. The selected method must “faithfully depict the entity’s performance toward complete satisfaction of the performance obligation” (ASC 606-10-55-17). The method chosen must also be applied consistently across all similar contracts into which the entity enters.
The output method is most often used with contracts in which the customer is entitled to goods or services that are easily measured and observed. According to the FASB, the output method often—but not always—provides the “most faithful depiction of an entity’s performance because it directly measures the value of the goods or services transferred to the customer.” Even though the output method often correlates to substantive contract performance, it may not faithfully depict performance in some circumstances (ASU 2014-09 BC164). For example, the output method may be inappropriate if outputs are difficult to observe, as is often the case in service contracts. A project requiring a substantial amount of work-in-progress, such as building a house, is another situation in which the output method may not accurately depict performance.
Using the “as invoiced method”—the amount that an entity has the right to invoice its customer—may be appropriate in certain circumstances. Applying the practical expedient and using this output measure might be common in situations where the customer is invoiced a fixed amount for individual units delivered or hours of service rendered (ASU 2014-09 BC167 and ASC 606-10-55-18).
When the Input and Output Methods Are Both Unreliable
In some cases, neither the input method nor the output method may be a reliable measure of contract performance. This most often occurs during the first stages of a contract. If the progress on a contract cannot be reliably measured using one of the two methods, revenue may only be recognized to the extent that costs are incurred until measurement is possible. However, this can only be done if the costs incurred in performance of the contract obligations are expected to be recovered. If costs incurred aren’t expected to be recovered, the contract is outside the scope of ASC 606 (ASC 606-10-25-1) and revenue recognition is prohibited—even if consideration is received from the customer—until one of the following occurs:
- After reassessment, the contract is found to be within the scope of ASC 606-10-25-1, and costs are now likely to be recovered. Contracts that fail to fall within the scope of ASC 606-10-25-1 should be continually reevaluated (ASC 606-10-25-6).
- The contract is fully executed by the entity and all or substantially all of the consideration promised by the customer has been received and is nonrefundable (ASC 606-10-25-7).
- The contract has been terminated and any payments received from the customer are nonrefundable (ASC 606-10-25-7).
Until one of these situations occurs, any consideration received from the customer must be recognized as a liability. “The liability recognized represents the entity’s obligation to either transfer goods or services in the future or refund the consideration received” (ASC 606-10-25-8). For an illustration of revenue recognition when collectability of consideration is in question, see “Example 1 – Collectability of Consideration” in ASC 606-10-55-95 to 98.
The differences between the input and output methods (and even between measures used in each method) can result in material differences in the timing of revenue recognition. Therefore, careful and objective judgment is required when deciding which method and measure to apply. Although the output method is generally more closely correlated with substantive contract performance than the input method, there are many circumstances in which the input method is more appropriate. Sometimes the “as invoiced method,” a special output measure and practical expedient that allows revenue recognition based on the amount for which an entity has the right to invoice, may be applied.
Whatever method and measure are chosen, that method and measure must approximate the actual transfer of control of goods and services to the customer. For more assistance in making an informed decision between the input method and output method, see the attached flowchart.
Input vs. Output Flowchart
(Click image to enlarge)
- ASC 606-10-25-1, 25-6 to 25-8, 25-25 to 25-31, 55-17 to 21, 55-95 to 55-98
- ASU 2014-09: “Revenue from Contracts with Customers.” BC159, BC164, BC167.
- KPMG, Handbook: “Revenue Recognition.” May 2019. Section 7.4.2.
- PWC, Global Edition: “Revenue from Contracts with Customers.” August2019. Section 184.108.40.206.