Revenue can be recognized either over a period of time or at a point in time, depending on when a performance obligation is fulfilled. 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” (ASC 606-10-25-27). Therefore, before recognizing any revenue, an entity should establish when control over a promised good or service is transferred to a customer.
Determining If Control Is Transferred Over Time
An entity must consider three criteria to determine whether control over an asset is transferred over time. If any one of these criteria is met, then the entity should recognize revenue over time (ASC 606-10-25-27, emphasis added):
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- 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.
- 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 A: Customer Simultaneously Receives and Consumes the Benefits
The first criterion applies to many service providers. In a typical service contract, the entity does not create a tangible asset for which it can transfer control to the customer. Instead, the customer automatically consumes the benefits of the service as the entity provides that service. If the determination is not clear, the service provider should consider a hypothetical situation where the entity stopped providing the service partway through. If another provider would not need to substantially re-perform the work already completed, then the customer is assumed to receive and consume the benefit as the service provider performs an obligation.
Example A – Hypothetical Situation Test for a Shipping Contract
Mover Company 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.
Mover considers if the other shipper would need to redo a substantial amount of the work that Mover performed (e.g., go back to Point A and restart from there). Because another shipper would not need to reperform transportation already completed, Mover determines that the customer is receiving the benefit as Mover performs the delivery. Therefore, this contract falls under criterion A, and revenue would be recognized over time.
Parsons Corp. (2019 SEC Correspondence): Inspection Services
While many service contracts do fall under the first criterion, the inspection services at Parsons Corp. do not. “The Company has contracts in which it performs vehicle inspection services on behalf of the customer in order to ensure vehicles are in compliance with emissions regulations.
The Company does not recognize revenue over time for its inspection services because none of the criteria outlined in ASC 606-10-25-27 are met:
- The customer does not simultaneously receive and consume the benefits of the inspection service. There is no benefit to a partially inspected vehicle. The customer only receives a benefit from a fully inspected vehicle.
- The inspection services do not create or enhance an asset.
- There is no alternative use for the inspection service as the service is specific to each vehicle.
- The Company does not have a present right to payment until the inspection service is complete.
Since the criteria for recognizing revenue over time has not been met, the Company concluded that revenue for vehicle inspection services should be recognized at a point in time” (April 2019 letter to the SEC, emphasis added).
Cheetah Mobile, Inc. (2019 SEC Correspondence): Term-Based Licenses
Cheetah Mobile’s term-based licenses are standard service contracts that fit neatly under the first criterion. “The revenue generated from the term-based licenses primarily represents a membership fee for a mobile phone community platform hosted by the Company, which the customers can access on an as-needed basis for information sharing during the contract period. … As the customer simultaneously receives and consumes the benefits of the Company’s performance of providing access throughout the contract period, the Company concludes that the performance obligation is satisfied over time in accordance with 606-10-25-27[a].” (December 2019 letter to the SEC)
Criterion B: Customer Controls the Asset
The second criterion applies to contracts where the entity creates a work-in-process asset as it performs its obligation, either by creating a new asset for the customer or enhancing an asset the customer already owns. To determine if the customer controls the asset during the creation or enhancement process, the entity should consider the key indicators of transfer of control found in ASC 606-10-25-30:
- The entity has a present right to payment for the asset.
- The customer has legal title to the asset.
- The entity has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
The presence of these indicators does not guarantee that the customer has control of the asset, and other factors can and should be considered. 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, a customer has the physical possession of an asset, but the seller still retains control. These indicators are discussed in more depth in Determining the Transfer of Control.
Example B – Control Transfer for an Office Building Renovation
FixIt Corporation 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, but FixIt has physical possession during the renovation period.
Although FixIt has physical possession of the building during the renovation, the customer still has all of the risks and rewards of owning the building. Should any natural disasters damage the building, the customer would incur a loss. If the value of the location of the building increases dramatically during the renovation period, the customer would receive the benefit of the increased value. The customer’s legal title to the building as well as the outstanding loan on the building indicate that the customer has control of the building. Because so many of these indicators point to the customer retaining control of the building, FixIt’s contract likely meets the second criterion, and it should recognize revenue over time.
Criterion C: No Alternative Use and Enforceable Right to Payment
This last criterion was designed by the FASB to capture cases that did not fit cleanly under the other two criteria but still show a transfer of control over time (ASU 2014-09, BC132). These situations may include contracts where the entity provides goods or services that are specifically tailored to one customer. Unlike the other criteria, this criterion has two requirements that an entity must meet to demonstrate that control is transferred to the customer over time. First, the asset must have no alternative use to the entity. Second, the entity must have an enforceable right to payment.
No 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 and is only reassessed if a modification substantially changes the performance obligations in the contract.
The entity should consider whether the asset is designed and produced to fit unique customer specifications by evaluating whether (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 to a different customer at a significant loss. This situation often arises with highly customized assets. The entity should complete this evaluation based on the asset’s expected final form, not the asset’s form while in production.
Example C – Practical Limitation with Consulting Services
Advice Company 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—Advice would not likely be able to sell this deliverable to another customer without a significant amount of rework. Thus, this consulting deliverable does not have an alternative use.
In some contracts, the customer has a right to a specific asset, indicating that the entity may not be able to sell the asset to another customer. To provide evidence for the asset having no alternative use, contractual restrictions must be substantive. Substantive contractual restrictions require that an asset not be fundamentally interchangeable with other assets that the entity owns. Additionally, the entity should not be able to transfer that asset to another customer without incurring significant loss or breaching the contract with the customer.
Example D – Contractual Restrictions
Non-substantive – Interchangeable Consumer Products
TV Manufacturing Company has a contract with a customer to sell a TV. The contract provides the customer with the right to a certain model of TV with certain specifications. However, the contract does not guarantee the specific TV unit that the customer identified. TV Manufacturing 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 TV Manufacturing has on hand. The contract does not indicate that control of the TV is transferred to the customer. Thus, it does not meet the third criterion, and TV Manufacturing should not recognize revenue as the TV units are built.
Substantive – Building a House
In contrast, Home Builder Company has a contract to build a house for the Smith family. The house is similar to many of the houses in the area; however, the contract guarantees a specific house on a specific lot to the Smith family. Even though Home Builder owns the land during construction, Smith family has the contractual right to the home once completed and Home Builder is restricted from selling it to anyone else. In this situation, the contractual restriction is substantial because the house is not interchangeable with other houses that Home Builder sells, and Home Builder would incur a loss by breaching the contract if it were to transfer the house to another customer. Revenue should be recognized over time, assuming Home Builder has an enforceable right to payment for any work done.
Enforceable Right to Payment
In order to meet the requirements for revenue recognition over time, the entity must also have an enforceable right to payment from the customer for its performance to date if the contract is terminated. The right to payment is an important indicator that the customer is receiving benefit from the seller’s performance and, thus, control is transferred to the customer.
The enforceable amount needs to “approximate the selling price of the goods or services transferred to date” (ASC 606-10-55-11). The payment amount does not have to give the entity the same profit margin as expected on the whole contract, but it should be a reasonable proportion of the expected profit margin or a reasonable return based on the cost of capital for the contract.
The right to payment needs to be enforceable; the entity must be entitled to receive payment if the customer terminates the contract for reasons other than the entity’s failure to perform as promised. 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.
The enforceability of the right to payment depends on the contract as well as the laws in the jurisdiction. In some situations, the laws may not uphold the contract agreement even if the contract payment terms require the customer to pay a reasonable amount upon termination. In these cases, the right to payment would be unenforceable. In contrast, the laws in some jurisdictions may require the customer to pay a reasonable amount to the seller even if a contract does not outline a right to payment upon termination and would establish an enforceable right to payment.
Example E – No Alternative Use and an Enforceable Right to Payment with a Customized Asset
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.
The contract does not specifically 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 laws of its jurisdiction.
Although the goods are mostly interchangeable with other units that Vendor A produces, the asset is customized in its final form, so the contractual restriction is considered substantive and the asset is determined to have no alternative use to Vendor A. Because the laws of the jurisdiction require the DOD to pay for the goods if the contract is terminated for reasons other than Vendor A failing to perform the contractual obligations, Vendor A also has an enforceable right to payment. Because both the requirements of the third criterion are met, the revenue from this contract should be recognized over time.
Cimpress plc (2019 SEC Correspondence): No Enforceable Right to Payment
Our products are customized for each individual customer with no alternative use except to be delivered to that specific customer; however, we do not have an enforceable right to payment prior to delivering the items to the customer based on the terms and conditions of our arrangements with customers and therefore we recognize revenue at a point in time. (July 2019 letter to the SEC)
Kaman Corp. (2018 SEC Correspondence): Minimal Rework Costs
[For its contracts with customers for the sale of K-MAX® aircraft,] the Company … evaluated criterion c) with respect to over time revenue recognition. In each of the Company’s contracts for the manufacture and sale of K-MAX® aircraft, the Company receives a nominal deposit from the customer during the production phase of this aircraft, which does not represent a significant portion of the total purchase price of the aircraft. The balance of purchase price of each aircraft is due and payable upon delivery of the completed aircraft to the customer, and our contracts with customers do not provide an enforceable right to payment for performance completed to date during the production of each aircraft. Accordingly, we determined that we did not meet the right to payment criteria noted above with respect to over time revenue recognition.
Additionally, in evaluating the criteria for no alternative use, we noted that the customization of the aircraft typically reflects certain additional equipment and services, but minimal customization to the underlying base aircraft. This would allow the aircraft to be redirected to another customer contract with minimal cost of re-work. Moreover, we are not restricted contractually from redirecting the aircraft to another customer. Accordingly, we determined the production of each aircraft also represented an asset with alternative use to the entity based on the criteria noted in ASC 606-10-25-28.
As a result of this analysis, the Company determined we would recognize revenue at a point in time under ASC 606 for each of our K-MAX® contracts. (September 2018 letter to the SEC)
WABCO Holdings, Inc. (2018 SEC Correspondence): Alternative Use Depending on Jurisdiction
The revenue from the customized OEM serial production contracts is recognized at a point in time as the underlying contracts did not meet both conditions for over time recognition in ASC 606-10-25-27[c]. Most of the Company’s products can be sold in the aftermarket. Certain OEM contracts have contractual limitations that limit the Company’s ability to resell the produced parts during serial production to parties other than the OEM but in the European Union such limitations are not enforceable and therefore these parts are still considered to have an alternative use. In other jurisdictions these contractual limitations are enforceable under the respective laws which cause the parts in these regions to have no alternative use.
However, based on discussions held with legal counsel, in absence of a termination clause or provision within the Purchase Order or Electronic Data Interchange (EDI), we would likely only be able to receive reimbursement of actual costs (versus actual costs plus a margin) incurred up to the termination date. As we did not have any contracts with no alternative use and a termination clause or provision that would allow for recovery including a margin, we concluded we did not have any OEM contracts that met the over-time criteria. (May 2018 letter to the SEC)
Recognizing revenue over time under ASC 606 centers around three criteria that determine how control of the good or service is transferred to the customer. The entity must determine if (1) the customer simultaneously receives and consumes the benefit, (2) the customer controls the asset as the entity does its work, or (3) the asset has no alternative use to the entity and the entity has an enforceable right to payment for work completed to date. If at least one of these criteria are met, the entity must recognize revenue for that performance obligation over time.
- ASC 606-10-25-24 to 25-30, 55-4 to 55-15
- ASU 2014-09: “Revenue from Contracts with Customers.” BC124-BC152.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” January 2020. Section 7.1.
- KPMG, Handbook: “Revenue Recognition.” December 2019. Section 7.3.
- PwC, “Revenue from contracts with customers.” March 2020. Section 6.3.