In many contracts, revenue1 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 Revenue from Contracts with Customers 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 a contract and determining when to recognize revenue– the input method and the output method. While both of these methods are acceptable, they are not interchangeable. The method chosen must be appropriate for the circumstances of the contract. These methods are currently used extensively in construction- and production-type contracts to measure progress and revenue earned, but will soon 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 hardwood dining room table, board-feet of hardwood consumed by the project would be an input measure.
While both methods may be acceptable in certain circumstances, the input and output methods can differ significantly in application and can result in 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 where the input method is preferable (ASU 2014-09 Basis for Conclusions (BC) 164). When weighing the input and output methods, management should be sure to choose the method that best reflects the substantive transfer of goods or services to the customer (ASU 2014-09 BC159). In certain situations, neither the input method nor the output method are appropriate.
Outputs are the result of inputs and processes in a business and are goods or services finished and transferred to the customer. 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 through 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.
Example – Output Method
Imagine that demand spikes in Atlanta for Chicago-style pizzas – the real ones actually made in Chicago. In fact, there is so much demand, that the Chicago-style pizza restaurants all get together and contract with Old Elgin Eastern Railways to build a railroad from Chicago to Atlanta. Outputs could be measured by how many railroad ties or feet of iron have been laid, how many spikes have been driven, or how many cities have been connected to the line. Old Elgin Eastern should choose the output measure that correlates most closely with actual substantive progress toward completion of the contract. If Old Elgin Eastern were to recognize revenue based on how many railroad ties have been laid, it would estimate how many railroad ties are needed to complete the line from Chicago to Atlanta. If 20 million railroad ties are needed, and the contract value is $20 million, then Elgin would recognize $1 in revenue for each railroad tie laid until the railroad is finished.
The input method is a more indirect measure of fulfillment of a performance obligation. Inputs are measured by determining how much effort has been put into satisfying a contract. The input method is implemented by first estimating the inputs required in order to satisfy a performance obligation. The entity then compares efforts expended to date with the estimated inputs needed to satisfy the performance obligation (see ASC 606-10-55-20 through 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 all input measures.
Example – Input Method
If Old Elgin Eastern were using the input method for the railroad contract, it might use tons of iron rails or pig iron consumed, labor hours consumed, palettes of railroad ties consumed, or total costs they have been incurred in satisfying the contract to measure progress toward completion. The measure Old Elgin chooses should correlate as closely as possible with the actual substantive progress toward completion.
Deciding on 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 that the entity enters into.
The output method is most often used in 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 in which outputs are not necessarily apparent. A project in which there is a substantial amount of work-in-progress is another example of a circumstance in which the output method may not accurately depict performance.
Using a special output measure – the amount that an entity has the right to invoice its customer – may be appropriate in certain circumstances. 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. 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).
Example – Choosing a Method: A Practical Expedient
Old Elgin Eastern won a bid to build a rail line for Eau Claire Freight. The contract states that Old Elgin has the right to bill Eau Claire $10 for each railroad tie laid. Old Elgin customarily bills its clients at the end of every month. At the end of the month, 200,000 railroad ties have been laid and Old Elgin invoices Eau Claire for $2 million. Because Old Elgin has a contractual right to bill Eau Claire an amount that directly corresponds with actual performance of the contract, it may elect to apply the practical expedient and measure progress by the amount which it has the right to bill Eau Claire. Consequently, Old Elgin should recognize revenue in the amount that it has the right to bill for, which, in this case is $2 million.
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 common in 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 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.
Example – Choosing a Method
Crosby Designs contracts for office furniture with a local carpenter, the legendary Whitestone Co. The contract states that Crosby obtains control over the furniture once it enters finished goods. In this circumstance, Whitestone Co. would be unable to use certain output measures, such as units delivered, because they would fail to measure some furniture for which control has already transferred to Crosby. The units delivered output method would not be truly representative of progress made, control transferred, and revenue earned. Whitestone Co. will need to choose a different method in order to more effectively measure progress on the contract.
In some situations, the costs to obtain information about outputs may outweigh the benefits that it would provide to stakeholders. In other situations, determining outputs may even be impossible because they are not directly observable. In either case, the input method should be used.
Example – Choosing a Method
Cox Law contracts with Kempton Corporation to represent them in a civil suit. This involves consulting with Kempton Corporation, attempting settlement for Kempton Corporation, and representing them in court, if necessary. Because they are the best, Cox requires payment based on hours billed regardless of the outcome of the suit. Because Cox’s outputs are difficult or costly (if not impossible) to determine and measure, it should use an input method, such as costs incurred or hours billed, to measure contractual progress and recognize revenue.
When the Input and Output Methods are Inappropriate
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 beginning 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. 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 occur:
- 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 through 98.
Comparison to ASC 605
Knowing the following key differences concerning when to recognize revenue is important to a successful understanding of and transition to ASC 606:
- Timing of Revenue Recognition
- Control vs. Risks & Rewards of Ownership
The current revenue recognition standard is a smattering of industry-specific guidance. The new standard consolidates revenue guidance across most industries. This means that all entities with performance obligations that are satisfied over time, regardless of industry, will be required to select the revenue recognition method that best depicts the entity’s performance in transferring the goods or services to their customer.
Timing of Revenue Recognition
The new standard outlines three criteria that improve upon the distinction between contracts satisfied at one point in time and those satisfied over time (ASC 606-10-25-27). These new criteria require that companies think differently about when to recognize revenue in contracts with customers. Under ASC 605, immediate recognition of revenue on some contracts may be appropriate. Under ASC 606, however, the same contract may meet one of these criteria and require revenue recognition over time. The opposite scenario is also possible.
A common practice under current guidance is to recognize certain types of revenue on a straightline basis over the life of the contract. Under the new standard, accounting for contracts may become more complex. Instead of recognizing revenue on a straightline basis, entities must follow the method that best depicts their performance in transferring the goods or services. This means that, under ASC 606, companies that currently utilize the straightline method of revenue recognition must not only choose a method, but put in place processes to track progress using the chosen method going forward. Reevaluation of the timing of revenue recognition for contracts with customers may be necessary.
Control vs. Risks and Rewards of Ownership
A key issue for recognizing revenue is determining exactly when the contracted goods or services pass to the customer. The new standard shifts the focus surrounding this issue from the “risks and rewards of ownership” to when control is passed to a customer. Control is defined under the new standard as “…the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.” In other words, in determining when goods and services are transferred to the customer, entities must now assess whether control has passed to the customer rather than merely the “risks and rewards of ownership” (ASC 606-10-25-25). This new terminology may affect the timing of revenue recognition.
Under ASC 605, only construction- and production-type contracts explicitly utilize the input and output methods. Under the new standard, performance obligations that are satisfied over time, across all industries, will use the input and output methods.
Because the differences between these two methods (and even between measures used in each method) can result in material differences in the timing of revenue recognition, careful, objective judgment is required in deciding which method and measure to apply. While the output method is generally more closely correlated with substantive contract performance than the input method, there are many circumstances where the input method is more appropriate. 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.
In some cases, where collectability of contract consideration is in doubt, neither the input method nor output method is appropriate and other measures must be taken. Whatever method and measure is chosen, it 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, 25-27, 25-31; ASC 606-10-55-17 to 21, 55-95 to 55-98
- ASU 2014-09: “Basis for Conclusions.” BC 159, BC 164, and BC 167.
- KPMG, Issues-in-Depth: “Revenue from Contracts with Customers.” May 2016. Section 5.5.3 “Measuring progress toward complete satisfaction of a performance obligation.”