Common ASC 606 Issues: Industrial Products & Manufacturing Industry

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every industry, and the industrial products and manufacturing (IP&M) industry is no exception. The large, long-term contracts with varying price levels that are common in the IP&M industry pose some of the most difficult issues for the new standard. Due to various contractual incentives and unique manufacturing agreements that may be involved in a single contract, application of the five-step revenue-recognition model can be particularly complicated.

In this article, we provide a brief explanation of the key issues the IP&M industry faces when applying ASC 606, drawing on the following helpful guides published by the major accounting firms:

We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics. See our RevenueHub article, The Five-Step Method, for more general information.

The following are the issues that companies in the IP&M industry commonly face:

1. Contract combinations

In the manufacturing industry, entities often have multiple contracts with the same client to produce different goods or components. According to ASC 606-10-25-9, an entity is required to combine contracts entered into “at or near the same time” with the same customer if at least one of the following criteria is met:

  1. The contracts are negotiated as a package with a single commercial objective.
  2. The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
  3. The goods or services promised in the contracts…are a single performance obligation.

In some industries, the application of these criteria is relatively simple, but the long-term, complex nature of most IP&M contracts can make contract combination assessments less clear. To appreciate why this is the case, one must understand that IP&M contracts take a long time to formulate and to execute—the process of finding an appropriate supplier and agreeing to contractual terms can often take more than one year. As a result, it may be difficult to determine if contracts are entered into “at or near the same time” relative to normal schedules. This determination requires judgement.

Further, IP&M entities must evaluate their contracts with the same customer to determine if combination is required under the new standard. If the entity finds that multiple contracts do need to be combined, the combined contracts will be treated as one contract.

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2. Contract modifications and change orders

Manufacturing contracts are frequently modified to adjust for the changing needs and specifications of the customer. These contract modifications, or change orders—which can be approved in writing, orally, or based on customary practices—can either be treated as a separate contract or an adjustment to the original contract. If a change order results in an additional, distinct performance obligation and is priced at the standalone selling price (SSP), it should be accounted for as a separate contract.

However, if the goods are not distinct and or the price is different than the SSP, the change order is treated as a modification of the original contract—in effect, the old contract is terminated and a new contract with the modifications is created. The new, adjusted contract price will be allocated to the remaining units prospectively as the contract obligations are satisfied.

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3. Volume rebates and volume discounts (variable consideration)

Volume rebates—in which the manufacturer gives the customer a percentage rebate if a certain sales threshold is met—are very common in the manufacturing industry. Under ASC 606, these rebates are variable considerations, and the manufacturing entity should recognize the rebate to the extent that it is not probable that a significant reversal in revenue will occur. A volume discount may function like a volume rebate if it is retroactive—meaning that the discount is awarded in the contract only if a certain volume of units is sold; the accounting for this discount would be the same as that for a volume rebate.

Comparatively, a volume discount may only apply to future purchases after a certain volume of goods have been sold. These prospective discounts represent an option for the customer, which constitutes a material right and therefore an additional performance obligation. ASC 606 allows for a practical expedient for estimating the value of the SSP of the new material right if the material right is for the purchase of goods similar to the original goods.

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4. Allocating transaction price (with variable consideration)

Like all other industries, IP&M companies should allocate the contractual transaction price to separate performance obligations on the basis of relative standalone selling prices (SSP). This process is relatively straightforward but can be complicated by a discount or variable consideration. The entity must determine whether the discount or variable consideration relates to all performance obligations or just some.

ASC 606-10-32-37 provides three criteria for assessing if an entity should allocate a discount entirely to one or more, but not all, performance obligations: (a) the entity regularly sells each distinct good or service on a standalone basis, (b) the entity also regularly sells a bundle of the distinct goods or services on a standalone basis at a discount, or (c) the regular discount from part (b) is substantially the same as the discount in the contract. Because bulk discounts are very common in the IP&M industry, it will likely be appropriate for entities to allocate discounts to one or more, but not all, performance obligations due to criterion (b) above. However, entities will still need to carefully evaluate their contracts to determine the appropriate allocation methodology for the discount.

Comparatively, ASC 606-10-32-40 gives two criteria that must be met to allocate the variable consideration to one or more, but not all, performance obligations: (a) the terms of the variable payment relate specifically to the entity’s efforts to satisfy the performance obligation, and (b) allocating the variable consideration entirely to the performance obligation is consistent with the amount to which the entity expects to be entitled in exchange for transferring the promised good or service to the customer.

These new criteria for discounts and variable considerations eliminate the contingent revenue cap that exists under ASC 605-25-30-5. This revenue cap dictates that the “amount allocable to the delivered unit or units of accounting is limited to the amount that is not contingent upon the delivery of additional items.” Thus, this change within ASC 606 will likely have a significant impact on companies in the manufacturing industry, as it will allow for earlier recognition of revenue, even with the presence of some uncertainty.

5. Transfer of control

IP&M entities need to evaluate their contracts to determine if control of the goods produced is transferred over time or at a single point in time. ASC 606-10-25-27 provides three criteria to determine if transfer of control happens 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 that the customer controls, or (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.

If an industrial products and manufacturing entity produces a component that could be sold to many different customers, it may be inappropriate to recognize revenue over time, because the customer may not substantively control the good until it is delivered. Therefore, revenue recognition over time is more likely for contract manufacturers who create custom goods for a specific customer and those that are contractually restricted from redirecting goods to any other customer. This is a very important determination in the manufacturing industry because of the large scale of many IP&M contracts.

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6. Measuring progress for performance obligations satisfied over time

Industrial products and manufacturing companies have two general options to measure the progress of performance obligations satisfied over time: input methods and output methods. Input methods recognize revenue based on the manufacturing entity’s actual efforts or inputs to satisfy the obligation—such as resources consumed, labor hours expended, or costs incurred—relative to the total expected inputs. Output methods recognize revenue on the basis of direct measurements of the value added to the customer—such as units produced or delivered.

Due to the nature of many manufacturing contracts, in which many identical goods are produced, it may be tempting to use the output method; however, manufacturing entities need to verify that their chosen method best represents the transfer of control to the customer, not just the transfer of goods. For example, if a contract manufacturer has goods that have not yet been delivered, but that have no alternative use to the entity, control may be effectively transferred even before the physical transport has occurred.

Additionally, under ASC 606, the gross profit method specified in ASC 605-35—in which revenue was measured in reference to cost plus profit—will no longer be an acceptable measure of progress. The progress must be based on actual inputs or outputs.

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7. Bill-and-hold arrangements

Bill-and-hold arrangements are relatively common for industrial products and manufacturing entities. Under these agreements, the entity bills its customer for a product(s), but “holds” the product until a later date (e.g., the goods are stored in the factory before shipping). The new guidance in ASC 606-10-55-83 provides four criteria to determine when an entity has effectively transferred control to the customer in a bill-and-hold arrangement:

  1. The reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement).
  2. The product must be identified separately as belonging to the customer.
  3. The product currently must be ready for physical transfer to the customer.
  4. The entity cannot have the ability to use the product or to direct it to another customer.

Manufacturing entities must be careful to verify that all these criteria are met before they recognize revenue in these situations.

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8. Contract costs

Under the new standard, companies will be required to capitalize and amortize incremental costs the entity incurred to obtain (e.g., sales commissions) and fulfill a contract. The costs of obtaining a contract are recognized as an asset if the entity expects to recover them. There is a practical expedient that allows entities to immediately expense the costs if they would have been fully amortized in one year or less.

The entity should only capitalize and amortize the costs to fulfill a contract if (1) the costs relate directly to a specific contract, (2) the costs generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) the entity expects to recover the costs. The incremental costs to obtain and/or fulfill a contract that are capitalized by the entity should be amortized as the entity transfers the goods or services designated in the contract to the customer.

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9. Shipping arrangements

Due to the large scale of many orders in the industrial product and manufacturing industry, shipping terms are a major concern. Many entities ship goods under “FOB shipping point” terms, which means that the goods are “free on board”—control has transferred to the customer when the goods are shipped. However, despite this formal designation as FOB, many entities in the industry also have implicit (or explicit) arrangements with their customers to bear the risk of loss or damage to the product when it is in transit. These arrangements are called “synthetic FOB destination shipping terms,” because, despite the name, the risk is still with the seller.

Under ASC 605, revenue recognition was focused on the transfer of risks and rewards, but under the new standard, ASC 606, the focus is on the transfer of control. Therefore, as entities evaluate their shipping terms, they need to understand when control of the goods is substantively transferred. If the customer has the ability to sell the goods or redirect them to another source when they are in transit, control may have transferred to the customer already.

Even if the customer does control the goods while in transit, an industrial products and manufacturing entity will need to evaluate the arrangement to determine if a separate obligation exists in addition to providing the actual goods. For example, if the manufacturing entity takes on the risk of loss during transit (i.e., purchases insurance to cover such loss), it may need to recognize a new, separate contract with the customer.

10. Warranties

Companies often offer product warranties to provide customer assurance in the event of a product failure. Sometimes, these warranties are extended as part of the product purchase (standard warranty), but, at other times, customers may purchase a separate warranty for additional protection. Warranties are very common in the IP&M industry, as well as other post-delivery obligations such as installation or training.

The treatment for standard warranties under ASC 606 is very similar to that in ASC 605. However, under ASC 606, warranties that are sold separately (such as an extended warranty) are separate performance obligations and should be accounted for at their standalone selling price (SSP)—not necessarily the contractual price. Thus, for example, when a manufacturing entity sells goods with an extended warranty, the company needs to allocate the bundled transaction price to each performance obligations based on their SSPs.

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Practitioners in the industrial products and manufacturing industry need to carefully analyze their contracts to determine how to apply the principles in ASC 606. Although many elements of their revenue recognition arrangements will be similar to the treatment under ASC 605, special note should be taken regarding the nuanced changes and issues identified in this article. See our other RevenueHub articles for more information about ASC 606 issues in other industries.


Author Chapman Ellsworth

Chapman was born and raised in Boise, ID. He is studying accounting and chemistry, and will join L.E.K. Consulting after graduation. Chapman loves pick-up sports, playing the viola, and getting his heart broken by the Arizona Diamondbacks.

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