This article helps entities properly recognize revenue for installation and implementation services. It specifically answers three questions that arise in the revenue recognition of these contracts:
- Is the installation distinct from the product?
- Is revenue for this installation recognized over time or at a point in time?
- What is the measure of progress that an entity should use if an entity recognizes revenue over time?
This issue is particularly relevant to entities in the hardware and software industry, but it can also be applied to other integration services. This guidance can substantially impact revenue for these entities.
Is the Installation Distinct from the Product?
Accounting Standards Codification (ASC) 606-10-25-19 outlines two criteria, both of which must be met for the installation to qualify as distinct: (1) the installation is capable of being distinct and (2) the installation is distinct within the context of the contract.
1. Capable of Being Distinct
Installation services are “capable of being distinct” from the other products in the contract if the customer can benefit from the installation either on its own or with other resources that the customer has readily available. This definition means that an installation service is capable of being distinct if the installation could be used, consumed, or sold for an amount greater than scrap value. An entity should ask, “Does our company sell this installation on a standalone basis?” or “Do any other companies sell this installation as a standalone service?” If the entity can answer yes to either of these questions it is indicative that the customer can benefit from the installation on its own or with other readily available resources. As a result, the installation is capable of being distinct.
2. Distinct within the Context of the Contract
The key determinant that the installation is “distinct within the context of the contract” is that the installation is separately identifiable from the other promises in the contract. Although the installation could be capable of being distinct (meeting criterion 1), the entity must now determine that the installation is distinct from the other goods in this particular transaction. ASC 606-10-25-21 outlines three factors that must be considered. These factors indicate that the installation is distinct within the context of the contract.
- The entity does not provide a significant service of integrating the good or service with other goods or services in the contract.
- The good or service does not significantly modify or customize another good or service in the contract.
- The good or service is not highly dependent on, or highly interrelated with, other goods or services in the contract.
These three factors are not mutually exclusive, and the Boards noted that more than one of these factors can apply to a contract with a customer. The Boards developed the three factors because each one is more applicable to a different industry. The most important factors to consider for the software industry are factors 1 and 2.
If an installation involves a significant service of integration (factor 1), then the risks of transferring the other goods in the contract are inseparable, and the installation is not distinct within the context of the contract. In this case, the entity is using the installation as an input to create a combined output that is specified in the contract. For example, an entity could be contracted to deliver a fully integrated system to the customer. The installation could be considered an input along with the hardware and software to produce the output of the fully integrated system.
Factor 1 specifies that the entity does not perform a significant integration service, because the Boards did not intend for this factor to be applied to less complex integration services (e.g., a simple installation of software that does not require significant modification). If the risks that the entity assumes in integrating the promised goods are negligible, then the entity should use factors 2 and 3 to determine whether the installation is distinct within the context of the contract.
The Boards developed factor 2 to provide additional clarification for software-type contracts. This requirement is that the installation does not significantly modify or customize another good in the contract. In the software industry, the notion of separable risks might be best approached by assessing whether the installation service significantly modifies another good. An entity may promise to deliver software that must be customized to fit into the customer’s existing system. In those situations, the seller is not only providing software, but it is using that software as an input to deliver a fully integrated system (the combined output) to the customer. If the installation requires the entity to significantly modify the customer’s existing system, then the entity would conclude that the promise to transfer the software and the promise to install the software are not separately identifiable. Therefore, the installation would not be distinct from the software within the context of the contract.
To determine whether an installation service is distinct within the context of the contract the entity should ask questions like, “Is the installation an input for a combined output?” or “Will the installation significantly modify or customize other hardware or software in the contract?” If the entity answers yes to these questions then the installation service typically is not distinct within the context of the contract.
Example 1 – Simple Installation
Software4U is a company that provides software for small to mid-sized businesses. Software4U enters into a contract with StartUp Company to transfer a software license and provide installation for its latest edition of Essential Software 2015. Software4U sells the installation on a standalone basis, and similar installations are performed by other entities for the same software.
A description of the installation is as follows:
The technician unpacks the software and plugs it in to each computer at StartUp Company. The technician then changes the on-screen display for each type of user – a different display is used for finance and accounting, marketing, inventory management, and information technology. The installation requires this configuration of the software, but it does not significantly modify the software.
Is the installation distinct from the software license?
Analysis: Yes, the installation is distinct from the software license. First, the products are capable of being distinct. The customer can benefit from the installation together with the software license, which is readily available through other providers. In addition, Software4U sells the installation separately, and other entities can perform the same service.
Second, the promise of the installation is separately identifiable from the promise to transfer the license. The installation requires some configuration, but it does not significantly modify or customize the software. The software and the installation are separate outputs rather than inputs used to produce a combined output. Also, the installation is not highly dependent on, or interrelated with the software. The installation is both capable of being distinct, and distinct within the context of the contract.
Example 2 – Significant Integration
SoftwareCo provides specialized software and installation services for companies in Silicon Valley. SoftwareCo enters into a contract with XYZ, Inc. to transfer a software license and provide installation for this software. The installation requirements of XYZ are such that the software will be substantially customized. SoftwareCo will add significant new functionality enabling the software to function with other computer systems that XYZ owns. This customized installation is provided by other entities in the area.
Is the installation distinct from the software license?
Analysis: No, the installation is not distinct from the software license. Since SoftwareCo provides a significant service of integrating the software with XYZ’s other systems, the installation is not distinct within the context of the contract. SoftwareCo is using the installation and the software license as inputs to produce a combined output; that is, a fully integrated system to XYZ. Although the installation service can be provided by other entities, SoftwareCo concludes that, within the context of this contract, the promise to transfer the installation service is not distinct from the promise to transfer the software license.
In other words, XYZ has contracted to receive customized software and the promise to transfer this product is not complete without both the software license and the installation service. Therefore, the installation is not distinct from the software license, and SoftwareCo would count the customized installation service and the software license as one performance obligation.
In general, a simple installation may often be distinct from the product, while a significant integration or customization is likely not distinct from the product. The issue becomes less clear when the installation provided is somewhere in between a simple installation and a significant integration. An installation may need some degree of implementation and configuration, but the entity must determine whether the installation provides a significant implementation, and whether the configuration significantly modifies or customizes the other products in the contract. This will be the key factor that determines whether the installation is distinct from the product.
Is Revenue Recognized Over Time or at a Point in Time?
Often, entities will transfer goods for a contract and recognize revenue for other components of the same contract over time. An example of this might be maintenance over a 12-month period. On other occasions, revenue recognition takes place at one point in time, like a vendor selling a bottle of water. The next determination that an entity should make is whether to recognize revenue over time or at a point in time. ASC 606-10-25-27 outlines the criteria entities should use to make the proper assessment. If one of the following criteria is met, then the entity should recognize revenue for the installation over time.
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. (Criterion 1)
- 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. (Criterion 2)
- 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 3)
Criterion 1. When a customer simultaneously receives and consumes the benefits provided, this indicates that the product is a service that is fulfilled little by little. For example, in a cleaning service the customer receives and consumes the benefits of a clean office as it is being cleaned. If the cleaner cleans only half of the office, the customer has already consumed the benefit of that half of the office being clean, so the cleaner should recognize that portion of the revenue. In a simple installation, the same principle applies. An entity could attach the customer’s computers to the main server, configure the interface of each user, and activate the software being installed. Each step of the installation performance obligation is received and consumed simultaneously. As a result, revenue would be recognized over time.
For more complex installations an entity may not be able to readily identify whether the customer simultaneously receives and consumes the benefit of the performance obligation. In these cases, the performance obligation is satisfied over time if an entity determines that another entity would not have to “substantially reperform” the work if that entity were to fulfill the remainder of the performance obligation (ASC 606-10-55-6).
For example, Installer Company enters into a contract with a customer to provide a complex integration of software and hardware. Installer Co. uses a hypothetical situation to assess whether the performance obligation is satisfied over time. In the hypothetical situation, Installer Co. stops the integration halfway to completion. If another company can pick up where Installer Co. left off, and complete the remaining 50% of the installation without any re-work, then the performance obligation is satisfied over time. If another company would have to re-work the first half of the installation in order to complete it, then the performance obligation is satisfied at a point in time.
Criterion 2. The second criterion to determine whether an installation is transferred over time is that the customer controls the asset that is being created or enhanced. If the customer is in control of the asset, then the customer is receiving benefit little by little as the asset is enhanced (resulting in revenue recognition over time).
For instance, if a customer had a giant gumball machine in its possession, and the vendor was filling it with gumballs little by little, then the customer could enjoy the benefits of the gumball machine each day. As a result, the performance obligation is satisfied over time and the vendor would recognize revenue over time. On the other hand, if the vendor had the gumball machine in its possession as it was filling it then the customer could not enjoy the benefits of the gumball machine until the machine was transferred into the possession of the customer. In this case the performance obligation of transferring the gumball machine full of gumballs would be satisfied at a point in time – after the filling is complete.
In many cases, installation will take place on the premises of the customer, and this will satisfy the criteria that the customer is in possession of the asset being enhanced or created. Alternatively, if the installation is performed on the entity’s premises rather than the customer’s then the installation piece of the performance obligation is not transferred over time.
Criterion 3. The third criterion is two-fold: first, that the entity’s performance does not create an asset with alternative use, and second, that the entity has an enforceable right to payment. If the asset has no alternative use, then it is specifically tailored to that customer. If the vendor also has a right to payment for that asset for performance completed to date, then the vendor should recognize revenue over time.
The entity’s performance does not create an asset with alternative use “if the entity is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use” (ASC 606-10-25-28). Does the contract specify restrictions stating that the customer cannot use the product that has been installed? Is the customer limited practically from using the system or the asset being installed in another way? If so, then the installation satisfies the first part of criterion 3: the entity’s performance does not create an asset with alternative use.
To satisfy the second part of criterion 3 the entity must have an enforceable right to payment. The right to payment need not be a fixed amount. However, the entity must be entitled at all times to consideration that at least compensates for the work that has been performed to date. When evaluating the existence of an enforceable right to payment the entity must consider the terms set out in the contract as well as legislation or any legal precedent that could override the contractual terms.
If the installation does not satisfy any of these criteria, then revenue is not recognized over time. Revenue is instead recognized at one point in time. For more details on recognizing revenue over time, see Revenue Recognition Over Time.
What is the Measure of Progress?
For installation services that will be recognized over time, the next question is how the entity will measure progress towards complete satisfaction of the performance obligation. This question is especially applicable to significant integrations and customizations that might take weeks or months to complete. An entity must have a plan to measure progress as it fulfills its performance obligation to deliver the completed, integrated system. Two methods exist to measure progress, the “output method” and the “input method.” The entity must choose the method that most accurately depicts the entity’s progress towards complete satisfaction of the performance obligation.
To use the output method, entities recognize revenue based on the value that the entity has transferred to the customer to date relative to the remaining value that will be transferred in the installation. Entities could use such measures as performance completed to date, milestones reached, or time elapsed, to compare the current value that has been transferred to the total value of the installation that will be transferred in the future. If an output fails to measure the transfer of the installation performance obligation then it is not a faithful depiction of progress made, and another output should be chosen.
If outputs are not directly observable, or if the information required to apply the output is not available without undue cost, then the input method may be necessary to measure progress. In contrast to the output method (which measures value delivered) the input method recognizes revenue based on efforts expended (the inputs) by the entity toward the satisfaction of the performance obligation. The entity can use such measures as resources consumed, labor hours used, or machine hours used. Entities can recognize revenue on a straight-line basis if inputs are expended evenly throughout the installation process. Again, the key requirement is that the input faithfully depicts the satisfaction of the installation’s performance obligation.
The entity should decide whether the output or input method best depicts the installation that is taking place. Once the selection has been made, the entity may not change the method of measuring progress. The entity should use the same method and measures of progress for similar performance obligations in similar circumstances.
Comparison to 605
The guidance for installation and implementation services differs from the previous guidance in a few ways. First, the requirement to determine whether the installation is distinct within the context of the contract is unique to the new standard. This replaces the concept of standalone value that was used under ASC 605. The conclusions entities reach on whether installations are distinct from the product may be different than in the previous standard.
Second, entities must now consider the three criteria listed to determine whether revenue will be recognized over time or at a point in time. Under ASC 605, entities could use one of four different methods to recognize revenue over time using different criteria.
Third, under the previous guidance it was fairly common to recognize certain types of revenue on a straight-line basis over the life of the contract. Instead of following a straight-line method, entities should now choose the measure that faithfully depicts the satisfaction of the installation performance obligation.
All of these points notwithstanding, many companies will conclude that revenue recognition is the same under ASC 606 as it was under ASC 605. The analysis will certainly change, but the end result may not be different from current practice. Any potential change will depend on the facts and circumstances of each transaction.
To determine revenue recognition for installation and implementation services, an entity must determine if the installation is capable of being distinct, and if the installation is distinct within the context of the contract. Next, the entity must determine whether revenue should be recognized over time or at a point in time. This determination depends on three criteria: (1) the entity does not provide a significant service of integrating the installation, (2) the installation does not significantly modify or customize the other goods in the contract, and (3) the installation is not highly dependent on, or highly interrelated with, other goods in the contract. Finally, the entity must choose whether the output or the input method faithfully depicts the satisfaction of the performance obligation and recognize revenue accordingly.
- ASC 606-10-25-19 through 25-22, ASC 606-10-25-27 through 25-30, ASC 606-10-55-5 through 55-6, ASC 606-10-55-16 through 55-21, ASC 606-10-55-141 through 150
- ASU 2014-09 “Basis for Conclusions” BC103, BC106-BC112
- Deloitte, Revenue From Contracts with Customers: “A Roadmap to Applying the Guidance in ASU 2014-09.” Revised February 2015. Section 6.3 “Distinct Goods or Services.”
- EY, Financial Reporting Development: “Revenue from Contracts with Customers.” Revised August 2017. Section 7.1 “Performance obligations satisfied over time.”
- KPMG, Issues in Depth: “Revenue from Contracts with Customers.” May 2016. Section 5.2.1 “Distinct goods or services.”
- PWC, “Revenue from Contracts with Customers.” August 2016. Section 3.3.2 “Good or services is separately identifiable from other promises in the contract.”