Revenue can be recognized either over a period of time or at a point in time, depending on when a performance obligation is fulfilled in a contract. Per Accounting Standards Codifications (ASC) 606-10-25-27, if an “entity transfers control of a good or a service over time,” then that entity “satisfies the performance obligation and recognizes revenue over time.” Therefore, before recognizing any revenue, an entity should determine when control over a promised good or service (that is, an asset) is transferred to a customer, whether it is transferred over time or at a point in time.
This article discusses the steps in determining if a company can recognize revenue over time under the new standard and the differences between current practice and ASC 606 on revenue recognition over time.
ASC 606-10-25-27 requires an entity meeting at least one of the three criteria in order to demonstrate that control over an asset is transferred over time. If one of the criteria is met, then the entity should recognize revenue over time. The three criteria in ASC 606-10-25-27 are listed below:
- “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)
According to the Financial Accounting Standards Board (FASB), Criterion 1 is mainly for services that are consumed by customers continuously over a period of time. However, many service providers may have difficulty in determining whether or not their customers consume benefits as they perform each obligation; this is due to the subjectivity in determining what the “benefits” are. To address this issue, the new standard requires the service provider to assess, in a hypothetical situation, if another provider would need to substantially re-perform the work completed to date. If another provider does not need to substantially re-perform the work done, then the original service provider should establish that control is transferred over time; consequently, the customer is assumed to receive and consume the benefit as the service provider performs an obligation.
For example, Mover Company (“Mover”) has a contract with a customer to ship goods from Point A to Point B. Mover uses a hypothetical situation to assess if its customer receives benefit as it performs the promised delivery.
In that hypothetical situation, Mover stops at a point between Points A and B. The customer cancels the contract and hires another shipper to complete the delivery to Point B. Does the other shipper need to redo a substantial amount of work that Mover performed (e.g., go back to Point A and restart from there)? In this case, it is unlikely that another shipper would need to do that; therefore, Mover may assume that the customer is receiving the benefit as it performs the delivery.
This criterion is most similar to the percentage-of-completion method used by construction-type companies under current practice. A key factor to consider for this criterion is ASC 606-10-25-30’s indicators of transfer of control. While all three criteria should consider ASC 606-10-25-30 in assessing if the customer has control of an asset, Criterion 2 requires more emphasis on this matter.
Indicators that suggest the customer has control over the asset include: the customer having an obligation to pay, physical possession of the asset, legal title of the asset, and risks and rewards of ownership of the asset; however, these are not the only indicators, nor do these indicators guarantee that the customer has control of the asset. For example, in a bill-and-hold arrangement, the seller may have physical possession of the asset that a customer controls; conversely, in a consignment arrangement, although a customer has the physical possession of an asset, the seller still retains control of the asset.
In contrast to the indicators discussed above, indicators that signify that control has not been transferred may include the following: the customer having no obligation to pay, no physical possession of the asset, no legal title of the asset, and no risks and rewards of ownership of the asset. Therefore, to determine if the customer has control of the asset, the seller should also consider indicators that suggest control of the asset is not transferred to the customer.
For example, FixIt Corporation (“FixIt”) has a contract to renovate a customer’s office building. The customer retains the legal title of the building and owes an outstanding loan on the building; FixIt has the physical possession during the renovation period.
Although FixIt has the physical possession of the building during the renovation, the customer still has all of the risks and the rewards of owning the building. Should any natural disasters damage the building, the customer would incur a loss. Conversely, should the value of the location of the building increase dramatically during the renovation period, the customer would receive benefit of the increased value. Additionally, the legal title also indicates that the customer has control of the building. Further, the customer’s outstanding loan on the building signifies that it has control of the building. In this case, FixIt’s contract with this customer may meet Criterion 2, thus it should recognize revenue over time.
In the FASB’s Basis for Conclusion, the FASB observed that for some performance obligations, it is unclear if the customer has control over the asset that is built or enhanced as the entity performs the obligations. Criterion 3 is designed to offer more guidance for such situation as discussed above.
ASC 606-10-25-27 includes Criterion 3 mainly for entities that provide services or goods that are specifically tailored to one customer. This criterion has two requirements that an entity must meet to demonstrate that control is transferred to the customer over time as the entity fulfills an obligation. First, the asset must not have an alternative use to the entity. Second, the entity must have an enforceable right to payment.
Alternative Use. To assess if an asset has an alternative use, the entity should consider practical limitations as well as contractual restrictions. This assessment should be made at the inception of the contract; nevertheless, should a modification in the contract arises at a future date and that modification substantially changes the performance obligation in the contract, then the entity should make a subsequent assessment.
Practical Limitations. In considering practical limitations of directing an asset to another use, the entity should consider whether the asset is designed and produced to fit unique specifications of the customer. This could be determined by evaluating whether or not (a) the entity would incur a significant cost to rework the asset for a different purpose or (b) the entity would only be able to sell the asset at a significant loss. Moreover, an entity should complete this evaluation based on the asset’s expected final form, not the asset’s form while in production.
For example, Advice Company (“Advice”) has a contract with a customer to provide consulting services in the form of a deliverable at the end of the contract. The product, in its completed final form, is unique to this customer; therefore, it’s highly unlikely that Advice would be able to sell this deliverable to another customer without a significant amount of rework. Advice can ascertain that the consulting deliverable does not have an alternative use.
Contractual Restrictions. Practical limitations may not always be a viable method to prove that an asset has no alternative use; hence, contractual restrictions may be more relevant than practical limitations (e.g. some real estate contracts). Criterion 3 requires the contractual restrictions be substantive. It means that an asset must not be fundamentally interchangeable with other assets that the vendor owns; additionally, the vendor should not be able to transfer that asset to another customer without incurring significant loss or breaching the contract with the customer.
For example, BuySell Company (“BuySell”) has a contract with a customer to sell a TV. The contract provides the customer with the right to a TV with certain specifications and model; however, the contract does not guarantee the specific TV unit that the customer identified. BuySell can redirect that unit to another customer for little or no cost. In this case, the contractual restriction is not substantive because the unit that the customer chose is interchangeable with other TV units that BuySell has on hand. The contract does not indicate that the control of the TV is transferred to the customer, thus it does not meet Criterion 3.
In contrast, Realtor Company (“Realtor”) has a contract to sell a house to the Smith family. The house is similar to many of the houses in the area; however, the contract guarantees a specific house to the Smith family. If Realtor sells this house to another customer, then the Smith family is entitled to a penalty payment from Realtor for breaching the contract. In this situation, the contractual restriction is substantial because the house is not interchangeable with other houses that Realtor sells; additionally, Realtor would incur a loss by breaching the contract if it were to transfer the house to another customer.
Right to Payment. ASC 606-10-25-29 states that the seller should assess whether it is entitled to payment from the customer for its performance to date if the contract is terminated. Since the seller is creating an asset that has no alternative use to the seller, the seller is creating the asset on behalf of the customer. Therefore, the seller’s right to payment indicates that the customer is receiving benefit from the seller’s performance, hence control is transferred to the customer.
The amount of the payment does not have to be equal to the contract’s profit margin, but it should be a reasonable proportion of the seller’s expected profit margin or a reasonable return based on the cost of capital for the contract. It is important to note, however, that the amount is not the settlement amount from negotiating with the customer.
The right to payment should also be “enforceable.” An “enforceable” right to payment means that the seller is entitled to receive payment if the customer terminates the contract for reasons other than the seller’s failure to perform as promised. The enforceability depends on the contract as well as the laws in the jurisdiction. In some situations, although the contract payment terms may require the customer to pay a reasonable amount upon termination, the laws may not uphold the contract agreement, thus the right to payment is not enforceable.
In contrast, in some jurisdictions, even if a contract does not outline a right to payment upon termination, the laws would require the customer to pay a reasonable amount to the seller, establishing an enforceable right to payment. When considering the existence of an enforceable right to payment, a seller does not need to consider the probability of actually exercising such right, the seller only needs to possess an enforceable right.
Comparison To 605
ASC 606-10-25-27’s three criteria could change the timing of revenue recognition for many companies. This section compares the three criteria to current practice, and identifies some industries that could be affected extensively by this new standard.
Currently, service-type companies may recognize revenue over time using four different methods based on different sets of criteria. In contrast, Criterion 1 requires the service provider to identify a performance obligation in the contract, and to recognize revenue only when an obligation is satisfied. This requirement follows the 5-step model in the new standard—the service provider transfers control over the asset (in this case, the service) to the customer as the provider fulfills the obligation. To help service providers to determine that control over the asset is transferred, Criterion 1 requires a service provider to use a hypothetical situation to determine if the customer receives benefit as the service is provided.
Criterion 2 is most similar to the current practice percentage-of-completion method for construction- and production- type companies. Under the current standard, a company may recognize revenue over a period of time if the company, in essence, has agreed to sell the rights of work-in-progress inventory to the customer as the work is being performed. In that case, the customer and the seller, in effect, enter into a continuous sale that occurs as the company builds or creates the asset. The rationale behind the percentage-of-completion method is similar to Criterion 2—control of an asset should be in the customer’s hands as the company builds or improves that asset.
Criterion 3 could allow companies that produce customer-specified products or services to recognize revenue over time. For instance, under current practice, manufacturing companies that construct goods to customers’ specifications generally treat these arrangements as product sales, hence revenue is recognized when the completed goods are shipped or delivered to the customers. Under Criterion 3, these manufacturing companies may recognize revenue over time as the goods are produced to the customer’s specifications. This is conditional on whether they can provide evidence that the goods they produce have no alternative use and that they have enforceable rights to payments from customers.
Currently, the Codification includes industry-specific guidance on revenue treatment for real estate sales. Under ASC 606, the guidance is much less prescriptive on the amount of down payment and the seller’s continuing involvement during the sales process; therefore, revenue from real estate sales may be recognized earlier than what is currently allowed if a contract meets Criterion 3. On the other hand, for transactions that involve certain apartment developments, revenue may be recognized under the percentage-of-completion method in the current guidance; however, many of these contracts may not meet any of the three criteria, thus delay recognition of the revenue to a later date.
Software revenue recognition may also be affected by the new guidance on recognizing revenue over time. Under ASC 606, the specific guidance on software revenue recognition is placed under Licensing. For more information on this topic, refer to Licenses for Intellectual Property.
Vendor A currently recognizes revenue over time from its fixed-price contracts via percentage-of-completion methods. For contracts in which goods are produced and delivered in a continuous or a sequential process, revenue is recognized as units are delivered. For contracts in which units are not produced or delivered in a continuous or a sequential process, or under which a small number of units are produced, revenue is recognized by using cost-to-cost method.
Assuming that the Department of Defense (“the DOD”) has ordered several anti-submarine warfare systems from Vendor A. These systems are largely the same as other units that Vendor A produces for other customers during the building process, but the contract guarantees the DOD the specific units that it has selected because the DOD requires a custom-built component to be installed in the units as the final step in the building process.
During production, Vendor A retains the units in its production facility. Also, Vendor A bears the loss should any damages occur to these units during production. On the other hand, the DOD has the legal title to the units during and after production. The contract does not require the DOD to pay for the ordered goods if the contract is terminated before completion. However, unless Vendor A fails to complete the performance obligations, the DOD is legally bound to pay for these goods regardless of the contract clause under the jurisdiction it operates under.
Under the new standard, Vendor A should consider Criterions 2 and 3. To satisfy Criterion 2, Vendor A should refer to ASC 606-10-25-30’s indicators of control to assess whether the DOD has control over the anti-submarine warfare systems as Vendor A builds them. In this situation, Vendor A has physical possession of the goods and retains the risks and rewards of the goods while in production.
In contrast, the DOD has the title of the goods. Since it is unclear whether the DOD has control of the goods during production, Vendor A should consider Criterion 3. Criterion 3 requires Vendor A to determine if the goods have no alternative use and to determine if Vendor A has an enforceable right to payment. Although the goods are mostly interchangeable with other units that Vendor A produces, the contractual restriction is considered substantial because the DOD requires a specific component installed in these units. Because the DOD is required to pay for the goods if the contract is terminated for reasons other than Vendor A failing to perform the contractual obligations, Vendor A has an enforceable right to payment. Based on this analysis, Vendor A meets Criterion 3 and should recognize revenue from this contract over time.
Recognizing revenue over time under ASC 606 is considerably different from the current practice. The introduction of the three criteria impacts the timing of revenue recognition. The three criteria are more inclusive of companies that are currently relying on industry-specific guidance. Furthermore, some companies may begin revenue recognition earlier than before, while some may delay revenue recognition. In the end, the three criteria are designed to provide more guidance on recognizing revenue over time and to consolidate separate industry-specific guidance in one place.
- ASC 606-10-25-24 to 25-25, 25-27 to 25-30.
- ASU 2014-09: “Basis for Conclusions.” BC 124-BC 152.
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised August 2017. Section 7.1 “Performance obligations satisfied over time.”
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 5.5.2 “Performance obligations satisfied over time.”
- PWC, “Revenue from contracts with customers.” August 2016. Section 6.3 “Performance obligations satisfied over time.”