As you probably know, the effective date of the highly anticipated revenue recognition standard, ASC 606, is just around the corner. For public entities, the effective date is for fiscal years beginning after December 15, 2017. For everyone else, there is an additional year to get ready, with an effective date of fiscal years beginning after December 15, 2018.
In our previous articles, we’ve covered the first four steps in the five-step revenue recognition model – identifying the contract, identifying performance obligations in the contract, determining the transaction price and allocating the transaction price. This article focuses on the final step of the model – Recognizing Revenue When (or as) Performance Obligations are Satisfied.
When to recognize revenue
ASC 606 states that revenue should be recognized when (or as) an entity satisfies a performance obligation by transferring a promised good or service to a customer. Generally, satisfaction of a performance obligation occurs when (or as) control of the goods or services is transferred to the customer. Control can be defined as the ability to direct the use of an asset and to obtain substantially all of the remaining benefits from the asset. Control also includes the ability to prevent another entity from directing the use of and obtaining the benefits from an asset. Common examples of obtaining control include:
- The ability to use the asset to produce goods or to provide services;
- The ability to use the asset to enhance the value of other assets;
- The ability to use the asset to settle liabilities or reduce expenses;
- The ability to sell or exchange the asset; and
- The ability to pledge the asset to secure a debt liability.
For each separate performance obligation, entities will need to determine whether the performance obligation is satisfied by transferring the control of goods or services over time. If the performance obligation is not satisfied over time, then it is satisfied at a point in time.
Performance Obligations Satisfied Over Time
Revenue should be recognized over time if one of the following criteria is met to indicate transfer of control:
- The customer simultaneously receives and consumes the economic benefits provided by the entity’s performance.
- The entity’s performance creates or enhances an asset controlled by the customer.
- The entity’s performance does not create an asset for which the entity has an alternative use, and the entity has an enforceable right to payment for performance completed to date. It is important to note that the right to payment for performance completed to date does not have to be for a fixed amount. At all times during the contract, the entity must be entitled to an amount that at least compensates them for the performance completed to date if the contract were to terminate early for any reason other than failure to perform by the entity. Further, legal determinations may be necessary to determine whether a right to payment is enforceable.
Criterion 1 – Simultaneous receipt and consumption
The simultaneous receipt and consumption criterion is intended to capture most basic service arrangements. Common examples include routine or recurring services, such as cleaning and payroll services. In other situations, the determination of whether there is simultaneous receipt and consumption will not be as straightforward. In those cases, a performance obligation would be satisfied over time if another entity would not need to substantially re-perform the work already completed to date to fulfill the remaining performance obligation. In making the determination as to whether another entity would need to re-perform the work completed to date, the following items are considered:
- Potential contractual restrictions or practical limitations that would otherwise prevent transferring the remaining performance obligation should be disregarded.
- The presumption should be made that another entity fulfilling the remaining performance obligation would not have the benefit of any asset that is presently controlled by the vendor and that would remain controlled by the vendor if the performance obligation were transferred.
Criterion 2 – Creation or enhancement of an asset controlled by the customer
This criterion is most likely to be relevant when an asset is being constructed on a customer’s premises. The following items should be considered when determining whether or not the customer has control of the asset that is being created or enhanced:
- Is there a present right to payment for the asset?
- Who has legal title to the asset?
- Has physical possession of the asset been transferred?
- Have the significant risks and rewards of ownership been transferred?
- Has there been acceptance of the asset by the customer?
The above criterion is similar to existing U.S. GAAP’s percentage of completion method for construction contractors (i.e., that there is a continuous sale and that the customer controls the work in progress).
Criterion 3 – Alternative Use
An alternative use does not exist if the entity is unable (either contractually or practically) during the creation of the asset, to readily direct it to another use. For example, standard inventory items can be easily redirected to other customers, and the production process itself would not transfer control to a customer. Further, if there is not a substantive cost on rework or no substantial loss on sale of the asset to another customer, then there is no practical restriction preventing the redirection of the specific asset being produced. Thus, in these situations, an alternative use would exist. The assessment regarding alternative use is made only at contract inception or modification and will require judgment after considering all the applicable facts and circumstances.
Recognizing Revenue over Time
Once it is determined that a contract meets one of the three criterion to recognize revenue over time, revenue should be recognized over time by measuring the progress toward complete satisfaction of the performance obligation. The method used must reflect the pattern of how the goods or services are transferred to the customer. Methods may be based on outputs (results, milestones, units produced, etc.) or based on inputs (resources consumed, labor hours, costs incurred, etc.), whichever is the more appropriate method. Judgement will be needed to determine which method better depicts an entity’s performance in transferring control of the promised goods or services. Further, only one method per performance obligation can be used, and that method must be applied consistently to similar performance obligations and in similar circumstances. Any subsequent change in the method used is considered a change in estimate.
If an entity is not able to reasonably measure its’ progress toward satisfaction of the performance obligation but expects to recover costs, the entity can recognize revenue only to the extent of costs incurred.
Performance Obligations Satisfied at a Point in Time
When the criteria to recognize revenue over time are not met, then revenue should be recognized at a point in time (the point when control is transferred). To determine the point in time at which the customer obtains control of a promised asset and the entity satisfies a performance obligation, the guidance on control in ASC 606 should be considered. The following may be indicators that control has been transferred:
- The entity has a present right to payment of the asset
- The customer has legal title to the asset
- The entity has transferred physical possession of the asset
- Significant risks and rewards of ownership have been transferred
- The customer has accepted the asset
Whether control is transferred over time or at a point in time is an area that may result in changes in revenue recognition as compared to current guidance. It will be important for management to assess when performance obligations are truly satisfied. Controls will likely need to be designed over the process of assessing when control has transferred and obligations have been satisfied. Further, judgment will be required to determine the best method to measure progress towards complete satisfaction of the performance obligation. Now is the time to review your contracts and determine the appropriate method to recognize revenue. As always, please reach out to your local Warren Averett advisor for further guidance on implementing the new revenue recognition standard.