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.
Emergent BioSolutions Inc. (Emergent) is a worldwide developer and manufacturer of
protections against public health threats such as vaccines and therapeutics. In a letter dated
August 18, 2021, the SEC sent Emergent the following request:
Please provide revised disclosure to be included in future filings of the method used to
recognize the technology transfer and stand-ready performance obligations, and why the
methods used provide a faithful depiction of the transfer of goods and services. Refer to
In its response, Emergent highlighted that it performs contract development and manufacturing
(CDMO) services for third parties. These contracts include pharmaceutical product process
development, drug substance manufacturing, drug product manufacturing, and many other
services. Although many of Emergent’s contracts vary in duration, activities, and number of
performance obligations, each contract may include any combination of the following
performance obligations: drug substance and drug product manufacturing, technology transfer
activities, and suite reservations.
For the drug substance and drug product manufacturing performance obligations, revenue is
recognized over time because the company’s performance does not create an asset with an
alternative use. Additionally, Emergent has an enforceable right to payment for performance
completed as work is performed. The company uses an input method to measure progress toward
the satisfaction of related performance obligations based upon costs incurred by the company as
a percentage of total costs to complete the contract. Emergent believes that this accounting
treatment for recognizing revenue best depicts the transfer of control of goods and services
promised to its customers.
Emergent uses a similar approach to recognizing revenue when it determines technology transfer
activities are a separate performance obligation. In these instances, revenue is recognized over
time as the service is provided as there is no alternative future use to the company for the asset
created, and the company has an enforceable right to payment for performance completed as of
that date. Emergent measures progress toward completion based on an input method using costs
incurred to date as a percentage of total costs to complete the technology transfer activities
(September 2021 letter to the SEC).
Aridis Pharmaceuticals, Inc. (Aridis) is a biopharmaceutical company focused on developing innovative therapies for infectious diseases. Ardis has been contracted to work with the Cystic Fibrosis Foundation (CFF) to research and develop AR-501, an inhaled formula developed to treat chronic lung infections in cystic fibrosis patients. In response to an SEC comment letter dated October 15, 2020, Aridis outlined its reasoning for recognizing revenue for the CFF contract using the input method:
As there are significant internal and external costs associated with each of the distinct goods and services, we concluded the input method using total costs incurred is the most appropriate method to recognize revenue. This is because the research and development activities are advanced with both efforts by the Company’s own employees as well as the use of the outside resources.
Because Aridis incurred significant costs in conjunction with completing the performance obligations outlined in its agreement with CFF, the company determined that the input method is the most appropriate way to recognize revenue over the contract period (February 2021 letter to the SEC).
In 2019, the SEC requested more information from Spark Therapeutics (a gene therapy company) about the timing of its revenue recognition. Spark explained its use of the output method to recognize revenue for a supply agreement for vials. Spark’s analysis is as follows:
Pursuant to ASC 606-10-25-27, an entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if certain criteria are met. The agreements with Novartis met these criteria. When a performance obligation is satisfied over time, an entity must select a measure of progress to depict its progress toward complete satisfaction of that obligation. The Company considered agenda paper no. 41 from the FASB’s July 13, 2015, Transition Research Group, or TRG, meeting, in which TRG members agreed that when an entity has determined that a combined performance obligation is satisfied over time, the entity has to select a single measure of progress that faithfully depicts the entity’s performance in transferring the goods or services. For example, using different measures of progress for different non-distinct goods or services in the combined performance obligation would be inappropriate because doing so ignores the unit of accounting that has been identified under the standard (i.e., the single combined performance obligation) and recognizes revenue in a way that overrides the separation and allocation guidance in the standard. The Company considered this guidance and determined that under ASC 606-10-55-17 an outputs method of expected vials to be produced during the contract term of the Supply Agreement was most appropriate to recognize revenue. Since the Company has not yet begun producing vials for Novartis, no revenue has been recognized through September 30, 2018. (January 2019)
Example: Output Method
Imagine that demand spikes in Atlanta, Georgia 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.Imagine that demand spikes in Atlanta, Georgia 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 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.
Example: Input Method
If Old Elgin Eastern were using the input method for the railroad contract, it might measure progress toward completion using tons of iron rails or pig iron consumed, labor hours consumed, palettes of railroad ties consumed, or total costs that have been incurred in satisfying the contract. The measure Old Elgin chooses should correlate as closely as possible with the actual substantive progress toward completion.
Example: Input Method Used When Outputs are Difficult to Measure
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 such a measure ignores furniture completed for which, under the terms of the contract, 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: Input Method Used When Outputs are Costly or Impossible to Measure
Cox Law contracts with Kempton Corporation to represent them in a civil suit. These legal services involve consulting with Kempton Corporation, attempting settlement for Kempton Corporation, and representing them in court, if necessary. 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, Cox should use an input method, such as costs incurred or hours billed, to measure contractual progress and to recognize revenue.
“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.
Example: As Invoiced Method
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 for which it has the right to bill which, in this case is $2 million.
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.