The New Revenue Recognition Standard: Step 5 Recognize Revenue as the Performance Obligations are Satisfied
As mentioned in our previous blogs, on May 28th the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers: Topic 606 creating a whole new codification topic (ASC 606). The new standard ushers in a new era of revenue recognition by replacing thousands of pages of industry specific guidance with a single comprehensive standard applicable to virtually all industries, and will significantly change how we recognize revenue. ASU 2014-19 isn’t effective for private entities until reporting periods beginning after December 15, 2017, and will be effective for public entities a year earlier.
ASC 606 creates a five-step process for recognizing revenue. We’ve already covered the first four steps in our previous blogs. The fifth step is to recognize revenue as the performance obligations are satisfied.
Revenue allocated (Step 4) to a performance obligation should be recognized when the goods or services are transferred to the customer, which occurs when the customer has control of the asset or use of the service.
Control means the ability to direct the use of and obtain substantially all of the benefits from the asset or service. The following are some indicators that may, though not necessarily will be, indicators of control:
- The entity has a present right to payment for the asset.
- The customer has legal title to the asset – If an entity retains legal title solely as protection against the customer’s failure to pay, then those rights of the entity would not preclude the customer from obtaining control of an asset.
- The entity has transferred physical possession of the asset.
- The entity has the ability to prevent others from directing the use of, and obtaining the benefits from, the asset or service.
- The customer has the significant risks and rewards of ownership of the asset.
An entity should exclude any risks that give rise to a separate performance obligation. For example, if another performance obligation under the contract was to provide maintenance on a building, then the transfer of control for that building would exclude the consideration of risk of maintenance costs.
- The customer has accepted the asset.
The benefit means the potential cash inflows or savings in cash outflows. Common examples of benefits include:
- Using the asset to produce goods or provide services.
- Using the asset to enhance the value of other assets.
- Using the asset to settle liabilities or reduce expenses.
- Selling or exchanging the asset.
- Pledging the asset to secure a loan.
- Holding the asset.
Performance obligations can be satisfied, and thus revenue recognized over time or at a point in time. We’ve already discussed the criteria required to satisfy a performance obligation over time and thus recognize revenue over a period of time in our Step 2 blog. We’ve also stated that if a performance obligation doesn’t meet the criteria to be recognized over time, then it must be recognized at a point in time when control of the good or service is transferred. Most entities will desire to have their performance obligations satisfied over a period of time, as that will result in earlier revenue recognition. However, what we haven’t discussed is how to measure progress towards the completion of a performance obligation that is satisfied over time.
Measuring Progress Towards Completion
The principle objective is to recognize revenue in a pattern commensurate with the transfer of control to the customer. The method chosen to measure progress should be consistently applied to similar performance obligations under similar circumstances. There are two acceptable methods for measuring progress towards completion: output and input methods.
Output methods recognize revenue based on the value transferred to the customer relative to the remaining value to be transferred. For example, surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered. Importantly, output methods shouldn’t be used if they do not faithfully depict the entity’s performance. For example, an output method based on units delivered would not faithfully depict an entity’s performance if significant work in process exists and is controlled by the customer, but not captured in the measurement method.
Input methods recognize revenue based on the entity’s effort to satisfy the performance obligation relative to the total expected effort to satisfy the performance obligation. For example: resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used. However, wasted costs should not be included in estimating progress towards completion. If the entity’s efforts are expended evenly throughout the performance period, it may be appropriate to recognize revenue on a straight-line basis.
Measuring progress towards completion will require judgment and is not supposed to be an accounting policy choice. Rather, the method chosen should be the technique that most faithfully depicts the pattern of control transferred.
Measuring progress towards completion can be quite complex and judgmental, so let’s walk through a couple examples:
Assume that a construction contractor enters into an arrangement to build 100 miles of road for a local government for $100,000. If at period end the contractor has built 50 miles of road, and the effort required by the contractor and value delivered to the customer is consistent across each of the 100 miles, then an output method such as the number of miles built might be appropriate, and thus 50 percent or $50,000 should be recognized. Depending upon whether work in process is material and whether it is controlled by the customer might influence whether an output method is appropriate.
Let’s assume that another construction contractor enters into an arrangement to construct a building for $100,000 with an estimated cost to construct the building of $80,000. If at period end the contractor has incurred $40,000 in costs but of the $40,000 in costs $10,000 is wasted costs due to inefficiencies, then only 37.5 percent ($30K cost incurred over the $80K total expected costs) or $37,500 should be recognized as revenue.
However, let’s change the previous example and of the $40,000 in costs incurred as of period end, $10,000 is wasted costs and another $10,000 is for uninstalled materials purchased and delivered to the construction site, but not yet used in the construction. Should 37.5 percent or only 25 percent ($20K over the $80K total expected costs) of revenue be recognized? Again, judgment is required. If the $10,000 in uninstalled materials meets all of the below criteria then the related costs should be included in estimating progress towards completion:
- Good(s) are not distinct.
- The customer expected to obtain control of the good significantly before receiving the related service (e.g. integration of the good).
- The cost of the good is significant to the relative total cost of satisfying the performance obligation.
- The entity procures the good(s) from a third party and is not significantly involved in designing or manufacturing the good(s), but is still acting as principle (i.e. not an agent transaction).
As a practical expedient, if an entity has the right to consideration that corresponds directly with the value received by the customer (e.g. fixed hourly billing), then the entity may recognize revenue as the entity has a right to invoice. As you can see, measuring progress towards completion can be quite complex and judgmental.
This concludes our blog series covering the five steps in the new revenue recognition standard. In our next blog series we will discuss in-depth examples, special considerations, disclosure requirements and industry specific implications.