Revenue can be recognized either over a period of time or at a point in time, depending on when a performance obligation is fulfilled. If an “entity transfers control of a good or a service over time,” then that entity “satisfies the performance obligation and recognizes revenue over time” (ASC 606-10-25-27). Therefore, before recognizing any revenue, an entity should establish when control over a promised good or service is transferred to a customer.
Determining If Control Is Transferred Over Time
An entity must consider three criteria to determine whether control over an asset is transferred over time. If any one of these criteria is met, then the entity should recognize revenue over time (ASC 606-10-25-27, emphasis added):
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- 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.
- 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.
Criterion A: Customer Simultaneously Receives and Consumes the Benefits
The first criterion applies to many service providers. In a typical service contract, the entity does not create a tangible asset for which it can transfer control to the customer. Instead, the customer automatically consumes the benefits of the service as the entity provides that service. If the determination is not clear, the service provider should consider a hypothetical situation where the entity stopped providing the service partway through. If another provider would not need to substantially re-perform the work already completed, then the customer is assumed to receive and consume the benefit as the service provider performs an obligation.
Criterion B: Customer Controls the Asset
The second criterion applies to contracts where the entity creates a work-in-process asset as it performs its obligation, either by creating a new asset for the customer or enhancing an asset the customer already owns. To determine if the customer controls the asset during the creation or enhancement process, the entity should consider the key indicators of transfer of control found in ASC 606-10-25-30:
- The entity has a present right to payment for the asset.
- 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.
The presence of these indicators does not guarantee that the customer has control of the asset, and other factors can and should be considered. For example, in a bill-and-hold arrangement, the seller may have physical possession of the asset that a customer controls; conversely, in a consignment arrangement, a customer has the physical possession of an asset, but the seller still retains control. These indicators are discussed in more depth in Determining the Transfer of Control.
Criterion C: No Alternative Use and Enforceable Right to Payment
This last criterion was designed by the FASB to capture cases that did not fit cleanly under the other two criteria but still show a transfer of control over time (ASU 2014-09, BC132). These situations may include contracts where the entity provides goods or services that are specifically tailored to one customer. Unlike the other criteria, this criterion has two requirements that an entity must meet to demonstrate that control is transferred to the customer over time. First, the asset must have no alternative use to the entity. Second, the entity must have an enforceable right to payment.
No Alternative Use
To assess if an asset has an alternative use, the entity should consider practical limitations as well as contractual restrictions. This assessment should be made at the inception of the contract and is only reassessed if a modification substantially changes the performance obligations in the contract.
The entity should consider whether the asset is designed and produced to fit unique customer specifications by evaluating whether (a) the entity would incur a significant cost to rework the asset for a different purpose or (b) the entity would only be able to sell the asset to a different customer at a significant loss. This situation often arises with highly customized assets. The entity should complete this evaluation based on the asset’s expected final form, not the asset’s form while in production.
In some contracts, the customer has a right to a specific asset, indicating that the entity may not be able to sell the asset to another customer. To provide evidence for the asset having no alternative use, contractual restrictions must be substantive. Substantive contractual restrictions require that an asset not be fundamentally interchangeable with other assets that the entity owns. Additionally, the entity should not be able to transfer that asset to another customer without incurring significant loss or breaching the contract with the customer.
Enforceable Right to Payment
In order to meet the requirements for revenue recognition over time, the entity must also have an enforceable right to payment from the customer for its performance to date if the contract is terminated. The right to payment is an important indicator that the customer is receiving benefit from the seller’s performance and, thus, control is transferred to the customer.
The enforceable amount needs to “approximate the selling price of the goods or services transferred to date” (ASC 606-10-55-11). The payment amount does not have to give the entity the same profit margin as expected on the whole contract, but it should be a reasonable proportion of the expected profit margin or a reasonable return based on the cost of capital for the contract.
The right to payment needs to be enforceable; the entity must be entitled to receive payment if the customer terminates the contract for reasons other than the entity’s failure to perform as promised. When considering the existence of an enforceable right to payment, a seller does not need to consider the probability of actually exercising such right; the seller only needs to possess an enforceable right.
The enforceability of the right to payment depends on the contract as well as the laws in the jurisdiction. In some situations, the laws may not uphold the contract agreement even if the contract payment terms require the customer to pay a reasonable amount upon termination. In these cases, the right to payment would be unenforceable. In contrast, the laws in some jurisdictions may require the customer to pay a reasonable amount to the seller even if a contract does not outline a right to payment upon termination and would establish an enforceable right to payment.
Recognizing revenue over time under ASC 606 centers around three criteria that determine how control of the good or service is transferred to the customer. The entity must determine if (1) the customer simultaneously receives and consumes the benefit, (2) the customer controls the asset as the entity does its work, or (3) the asset has no alternative use to the entity and the entity has an enforceable right to payment for work completed to date. If at least one of these criteria are met, the entity must recognize revenue for that performance obligation over time.
- ASC 606-10-25-24 to 25-30, 55-4 to 55-15
- ASU 2014-09: "Revenue from Contracts with Customers." BC124-BC152.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” January 2020. Section 7.1.
- KPMG, Handbook: “Revenue Recognition.” December 2019. Section 7.3.
- PwC, “Revenue from contracts with customers.” March 2020. Section 6.3.