In some arrangements, an entity performs activities that transfer control of goods or services to a customer prior to having a formalized contract with the customer that meets the requirements listed under Step 1: Identify the contract with a customer. Revenue for these partially completed performance obligations cannot be recognized until the contract is established. There is some debate about how revenue in these situations should be recognized.
This article outlines two potential revenue recognition patterns for partially satisfied performance obligations at contract inception and demonstrates how revenue would be recognized under the method we believe is most appropriate. The article also discusses how to account for the costs resulting from activities performed prior to contract inception that relate to the transfer of a good or service to a customer.
The date at which contract criteria (established in Step 1) are met is referred to as the “contract establishment date” (CED). Activities performed by an entity before the CED are referred to as “pre-CED activities.” Three primary types of pre-CED activities exist:
- Administrative activities that do not result in transferring control of goods or services to a customer or fulfilling the anticipated contract
- Activities, such as set-up costs, to fulfill an anticipated contract that do not result in transferring control of goods or services to the customer
- Activities that transfer control of goods or services to a customer at or subsequent to the CED
The first two types of activities do not transfer goods or services to a customer and should not have any revenue allocated to them. This article deals with the accounting treatment for the third type of pre-CED activities. Below are examples from the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) Transition Resource Group (TRG) Memo No. 33 that illustrate the issue:
Example 1- Contract Manufacturer
A manufacturer enters into a long-term contract with a customer to manufacture a highly customized good. The customer issues purchase orders for 30 days of supply on a rolling calendar basis (that is, every 30 days a new purchase order is issued). Purchase orders are non-cancellable and the manufacturer has a contractual right to payment for all work in process for goods once an order is received. The manufacturer will pre-assemble some goods in order to meet the anticipated demand from the customer based on a non-binding forecast provided by the customer. At the time the customer issues a purchase order, the manufacturer has some goods on hand that are completed and others that are partially completed.The entity has determined that each customized good represents a performance obligation satisfied over time because the customized goods have no alternative use and the manufacturer has an enforceable right to payment once it receives the purchase order (Accounting Standards Codification (ASC) 606-10-25-27(c)).
Example 2- Real Estate Developer
An entity begins constructing an apartment building and pre-sells 60% of the units. In this particular territory, the contracts satisfy the criteria for a performance obligation satisfied over time in accordance with ASC 606-10-25-27(c).
The remaining 40% of the units are constructed for inventory. After construction of the common areas and the shells of all the rooms have been completed, the entity enters into a new contract with a customer to sell one of the remaining units on the same terms as the original contracts. Thus, at inception of the new contract, a portion of the new customer’s unit is already constructed.
The preferred method of revenue recognition includes a cumulative catch-up adjustment in which the entity recognizes revenue for the portion of the good or service which has been transferred to the customer. In the first example, this is the inventory that has been created in anticipation of the contract. In the second example, it is the percentage of the contracted-for apartment that is completed at the CED. In the Real Estate Developer example, after the catch-up adjustment, the amount of revenue recognized for the new contract would be the same percentage of total revenue as the original contracts. As an illustration, imagine the real estate company in the second example determines that when the remaining 40% of the units are sold (the CED), the company has completed 30% of each unit. If the total transaction price for those 40% of the units is $10,000,000. The company would recognize $3,000,000 at the CED. The remaining $7,000,000 would be recognized over time.
The treatment of the costs incurred to perform these pre-CED activities that transfer a good or service to the customer is another issue resulting from such situations. The method we believe to be the most preferred is to capitalize such costs as costs to fulfill an anticipated contract. The costs are then immediately expensed at the CED if they relate to performance obligations that have been transferred to the customer. This would be the case in both of the examples given above.
Diversity in Thought
The TRG discussed this issue in their March 30 meeting. In the memo that addressed this topic, two issues were presented and discussed.
- Issue 1: How should revenue arising from pre-CED activities be recognized?
- Issue 2: How should an entity account for fulfillment costs incurred prior to the CED?
View A. This view supports the cumulative catch-up method as outlined above. Proponents of this view believe that it is most consistent with the new standard’s goal to depict the transfer of goods and services. The cumulative catch-up method reflects that, as of the CED, control of some of the goods or services has already passed to the customer.
View B. This view states that an entity should recognize revenue on a prospective basis. An entity should begin measuring progress toward completion of performance obligations only after the CED, ignoring pre-CED activities performed. Proponents of View B argue that paragraph 16 (ASC 606-10-25-8), which references transferring ‘goods or services in the future,’ suggests that the board intended revenue recognition to be on a prospective basis from the CED. They believe a catch-up adjustment is inconsistent with recognizing revenue over time.
We agree with the FASB staff that View A best reflects the transfer of control of goods or services to the customer. View B does not depict the transfer of control as accurately as View A. While proponents of View B reference the phrase ‘goods or services in the future,’ we believe the board intended the phrase to apply specifically to contract liabilities (the context in which it is used) and not to situations discussed in this article. Additionally, we do not believe that a catch-up adjustment is inconsistent with recognizing revenue over time. In the examples above, a portion of the goods or services are transferred to the customer at the CED, while the rest is transferred over time. Consequently, the recognition of revenue should depict some immediate transfer and the rest over time.
View A. Costs are capitalized as costs to fulfill an anticipated contract. These costs are immediately expensed at the CED if they relate to goods or services already transferred to the customer. Any remaining asset is amortized over the period over which the goods or services to which the asset relates are transferred to the customer (e.g. a capitalized commission cost would still be amortized over the entire contract period).
Proponents of this view point to ASC 340-40-25-8, which states that an entity will recognize costs to fulfill a contract as an expense when incurred if they relate to satisfied (or partially-satisfied) performance obligations. Because a performance obligation is not created until the CED, no costs should be expensed until then. Proponents of this view also note the guidance states that capitalized costs to fulfill a contract “shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates” (ASC 340-40-35-1). Consequently, if some of the goods or services are transferred at the CED, the related capitalized costs should be expensed at the same time.
View B. Costs are capitalized as costs to fulfill an anticipated contract, and amortized as the entity transfers the remaining goods or services under the contract. This view is coupled with View B of Issue 1 because costs are amortized on a prospective basis. Proponents of View B argue a performance obligation can only comprise remaining activities after the CED, in other words, there is no immediate transfer at the CED.
View C. Costs cannot be capitalized as costs to fulfill an anticipated contract because they relate to progress made prior to obtaining the contract and not to satisfying performance obligations in the future. Such costs should be expensed as incurred unless they qualify for capitalization under other guidance (for example, inventory). Proponents of this view believe that such costs would likely not qualify for capitalization because the costs will not be used to satisfy performance obligations in the future as is required in ASC 340-40-25-5(b). They believe the costs do no relate to future performance and therefore should be expensed immediately. However, the FASB staff notes that because a performance obligation is not created until the CED, a performance obligation cannot be considered satisfied prior to the CED.
Most members of the TRG concluded that View A under both issues represents the most appropriate accounting. The determining factor between the views is whether or not the performance obligations within a contract where the 3rd type of pre-CED activities occur are the same as in an identical contract where no pre-CED activities have occurred. If there is no difference in the performance obligations, then View A is most appropriate. However, proponents of View B say that the performance obligations do change and that the performance obligations in the contract are only made up of work that is remaining. Our view is that the performance of pre-CED activities do not change the performance obligation of the contract and that the cumulative catch-up method is appropriate.
Comparison to 605
Under 605, it is unclear how companies are accounting for this type of situation. Based on our analysis, it seems very reasonable that a company could reach the conclusion that a cumulative catch-up as part of the percentage-of-completion method is most appropriate. Securities and Exchange Commission (SEC) guidance found in ASC 605-10-S99-1 states revenue is generally realized or realizable when four criteria are met:
- Persuasive evidence of an arrangement
- Delivery has occurred or services are rendered
- Price is fixed or determinable
- Collectability is assured
The primary issue in this analysis is determining whether delivery has occurred. If the arrangement qualified for recognition over time, this requirement is met for the portion of the goods or services already completed. It appears companies are able to arrive at the ‘cumulative catch-up’ method under both ASC 605 and 606. However, there could be circumstances where other conclusions are reached under 605. Below are two examples from comment letters to the SEC describing how similar situations are accounted for.
“For the products mentioned above, sometimes we will build them in anticipation of an order and we may not have a contract with a customer. In these instances, we do not recognize revenue under the percentage of completion method. Rather, we will build up the inventory balance as the equipment is constructed and revenue is recognized at the time title passes to the customer.” (Forum Energy Technologies, Inc. 10-21-2011)
“In certain instances where revenue is recognized under the guidance of ASC 605-35, when our customers have requested that we commence work prior to receipt of the contract award and funding and we have incurred costs related to that specific anticipated contract, and we believe recoverability of the costs is probable, we may defer those costs incurred until the associated contract has been awarded and funded by the customer in accordance with ASC 605-35-25-41…A portion of our fixed price completion contracts are within the scope of Topic 605-35. For these contracts, revenue is recognized using the percentage-of-completion method based on the ratio of total costs incurred to date compared to estimated total costs to complete the contract. Estimates of costs to complete include material, direct labor, overhead, and allowable indirect expenses for our government contracts. These cost estimates are reviewed and, if necessary, revised monthly on a contract-by-contract basis. If, as a result of this review, we determine that a loss on a contract is probable, then the full amount of estimated loss is charged to operations in the period it is determined that it is probable a loss will be realized from the full performance of the contract.” (Kratos Defense & Security Solutions 10-26-2012)
In both of the above examples, the company defers costs incurred prior to CED and recognizes both the costs and the revenue after the CED. The first company recognizes the revenue as title passes. The second company arrives at a similar answer by deferring those costs and then including them in the percentage of completion calculation after the CED. The company accurately measures progress made to date by including the costs incurred prior to the CED in both the total estimated costs and costs incurred to date, leading to recognition of the revenue related to those costs.
When companies have partially-completed performance obligations at the CED, a cumulative catch-up adjustment for the completed portion followed by ratable recognition for the remaining portion may be the most appropriate accounting treatment. Although other views have been expressed to the Boards, most TRG members agree that a cumulative catch-up is appropriate.
- FASB & IASB, TRG Memo 33: “Partially Satisfied Performance Obligations.” 30 March 2015
- Forum Energy Technologies, INC. response to SEC comment letter, dated October 21, 2011. Written by James L. McCulloch Senior Vice President of Forum Energy Technologies.
- Kratos Defense & Security Solutions, INC. response to SEC comment letter, dated October 26, 2012. Written by Deanna H. Lund CFO of Kratos Defense & Security Solutions.