When to Recognize Revenue
Accounting Standards Codification (ASC) 606 states that revenue should be recognized when the seller satisfies their performance obligations. Generally, this occurs when (or as) control of goods or services is transferred to customers. Control can be defined as having autonomy over the use and benefits of an asset and preventing others from using and obtaining benefits from the asset. Common examples of obtaining control include the ability to:
- use the asset to produce goods or to provide services;
- use the asset to enhance the value of other assets;
- use the asset to settle liabilities or reduce expenses;
- sell or exchange the asset; and
- pledge the asset to secure a debt liability.
Each performance obligation requires the determination of whether it is satisfied by transferring the control of goods or services over time or at a point in time.
Performance Obligations Satisfied Over Time
Revenue is recognized over time if one of the following conditions is met:
- The customer simultaneously receives and consumes the economic benefits of the provided asset as the entity performs;
- The seller’s performance creates or enhances an asset controlled by the customer as the asset is created or enhanced; or
- The seller’s performance creates an asset with no alternative use, and the seller has an enforceable right to payment for performance completed to date.
Criterion 1 – Simultaneous Receipt and Consumption
The simultaneous receipt and consumption criterion is intended to capture most basic service arrangements. Common examples include cleaning and payroll services. In other situations, the determination of whether there is simultaneous receipt and consumption may not be as straightforward. In such cases, a performance obligation is satisfied over time if there is no need to redo completed work to satisfy the remaining performance obligation. In making this determination, the following factors are considered:
- Contractual restrictions or practical limitations in transferring the remaining performance obligation should be disregarded
- The presumption should be made that another provider would not have the benefit of any asset presently controlled by the vendor
Criterion 2 – Creation or Enhancement of an Asset Controlled by the Customer
This criterion is applicable when an asset is being constructed on a customer’s premises. The following items help determine whether the customer has gained control of the asset:
- Is there a present right to payment for the asset?
- Who has the 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?
Criterion 3 – Alternative Use
An alternative use does not exist if the provider is unable (either contractually or practically) to readily direct an asset to another use. If there is not a substantive cost for rework or no substantial loss on the sale of the asset to another customer, then there is no practical restriction preventing the redirection of the specific asset being produced. Thus, in this situation, an alternative use would exist.
Recognizing Revenue Over Time
If a contract meets one of the three criteria to recognize revenue over time, revenue should be based on the completed progress of the performance obligation. Applicable methods may be based on outputs (results, milestones, units produced, etc.) or based on inputs (resources consumed, labor hours, costs incurred, etc.). Judgment is needed to determine which method better reflects the transfer of promised goods or services. One method per performance obligation is used and must be applied consistently to similar performance obligations.
A seller can only recognize revenue covering costs incurred if it cannot measure its completed progress of a performance obligation.
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 when the customer obtains control of a promised asset, guidance in the ASC 606 should be considered. The following may be indicators that control has been transferred:
- The seller has a present right to payment.
- The customer has legal title to the asset.
- The seller has transferred physical possession.
- 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. It is important for management to assess when performance obligations are satisfied. Further, judgment is required to determine which method best measures the progress of the performance obligation.
This article was originally written and published on November 30, 2017, and was most recently updated and revised on March 9, 2020