ASC 606 Revenue Recognition Series: Recognizing Revenue when Performance Obligations are Satisfied (Part VI)

The fifth and final step in ASC 606: Revenue from Contracts with Customers (ASC 606) is to recognize revenue when or as the performance obligations are satisfied. Performance obligations are satisfied when control of the good or service has been transferred to the customer. This differs from the current revenue recognition standard, in which the transfer of risks and rewards triggers revenue recognition. Under the new standard, once the customer has control or, in other words, is able to direct the use of a good or service as well as obtain substantially all of the benefits from it, revenue should be recognized.

Recognition of revenue is driven by satisfaction of the performance obligation, using one of two methods: revenue is either recognized over time or at a point in time.

Satisfaction Over Time

Entities often promise to stand ready to provide goods and services or continuously provide goods and services that the customer receives and consumes at the same time. In these cases, the entity is satisfying the performance obligation and should recognize revenue over time. While this determination seems straight forward, in some contracts it is not. ASC 606 provides three situations in which performance obligations are satisfied over time. The entity must meet the criteria in at least one of the following situations. These are as follows:

Situation I: To determine whether a customer can receive and consume the benefits simultaneously, one can consider whether a different entity could (hypothetically) take over the contract at any point in time and fulfill the performance obligation without having to substantially reperform the work that was already performed. When considering this, there is no need to address the practical considerations of a new entity taking over for the original entity.

Example I: Examples of this type of situation can occur with a recurring service contract, such as monthly journal entry processing services, weekly staffing for support services, and continuous web hosting services. For example, an office has contracted to have a cleaning service come each night for two years to clean the office. At any point during the two years, a new cleaning service can take over the performance obligation without needing to substantially reperform the cleaning services already provided. As such, the customer simultaneously receives and consumes the benefit of the cleaning services and revenue should be recognized over time.

Situation II: The entity’s progress towards satisfying the performance obligation creates or enhances an asset that the customer has full control over.

Example II: The best example of this is a construction company. If a builder enters into a contract with a family to build them a home and the contract states that the customer owns all of the work in progress, the performance obligation would be satisfied over time, per the above criteria.

Situation III: The entity’s progress towards satisfaction does not create an asset that has any alternative use to the entity and the entity has a right to payment for progress made to date. In order to assess “alternative use”, the entity should consider whether the asset being created has any legal, contractual, or practical limitations (i.e. asset is very specialized or highly customized) on redirecting the asset. Additionally, the contract must state that the entity has the right to receive payment for all progress to date, and that payment is considered sufficient compensation for the entity’s performance to date.

Example III: Let’s consider a software company that is developing a tailored module of software meant to work seamlessly with a customer’s existing framework. Because the software being developed is so specialized, it is presumed that the software has no alternative use to the entity. The contract also must have an enforceable right for payment related to the work incurred to date. In this case, the revenue should be recognized over time.

Once the entity has determined that a performance obligation will be satisfied over time, the entity must decide how to measure its progress so that it can accurately depict the transfer of control of the good or service and recognize revenue. A single method of measurement must be chosen that best depicts a reasonable and reliable measure of progress. This can be done by using either an input or an output method of measurement.

Output methods rely on the value transferred to the customer to date to measure progress. For instance, an output method is based on drivers such as units completed, milestones reached, surveys or appraisals of results achieved, or the amount of time that has passed since the start of the contract. When selecting what output to use as measurement, the entity should choose the output that best illustrates the amount of progress toward satisfaction of the underlying performance obligation. For example, consider a customer contracting with a hosting provider for a one year contract. The hosting services are continuously provided and consumed by the customer. The entity determines that the services provided are substantially the same each day. Each day (unit of time) of providing the service is determined to be a reasonable and reliable measure of progress in satisfaction of the performance obligation. Consider an annual contract for $100,000 where the service provider has provided the hosting service for 30 days. The entity could recognize $8,219 ((30/365) X $100,000) of revenue.

Input methods seek to measure the entities efforts in satisfaction of the underlying performance obligation. Input measures could be based on labor hours, materials consumed, costs incurred, the passage of time, or various other measurements of resources used. The appropriate measure of progress would utilize a fraction of the total amount expected to be used or consumed. This ensures that revenue is recognized proportionate to the resources expended to date. For example, an input method might be used by a machine shop contracted to produce 100 gears for a customer, for a total price of $100,000. If the machine shop can reasonably predict, based on historical data, that each gear will take two machine hours to finish, machine hours could be used as an input to measure satisfaction of the performance obligation. Assume the machine shop estimates 200 hours to complete the contract. At the end of the period, 50 machine hours had been incurred on the contract. The machine shop would recognize $25,000 ((50/200) X $100,000) as revenue.

A practical expedient is available which allows an entity to recognize revenue in the amount to which the entity has a right to invoice. The right to invoice should correspond directly with the value provided to the customer for the entity’s performance completed to date.

If no reasonable and reliable measure of progress can be made, revenue is generally recognized to the extent of costs incurred until a reasonable method can be determined.

ASC 606 also notes that users should remeasure their progress toward satisfaction of a performance obligation at the end of each reporting period. If the user finds that that an estimate has changed, such as machine hours, the user should adjust the progress toward performance obligation satisfaction and revenue recognition accordingly. While the standard requires re-measurement and allows for adjustments, it does not allow for a change from an output to input method, or vice versa. This determination is made at contract inception and cannot be changed after that point.

Satisfaction at a Point in Time

Any performance obligations that are not satisfied over time, are deemed to be satisfied at a point in time. At the point in time the obligation is satisfied, the transaction price allocated to that performance obligation should be recognized as revenue.

While there are many considerations in determining the point in time at which control transfers, several potential indicators are:

1. The entity has a right to payment from the customer for the satisfaction of the performance obligation.
2. The customer has title to the transferred asset.
3. The customer has physical possession of the asset.
4. The risks and rewards of ownership have transferred to the customer.
5. The customer has accepted the asset.

This is not an all-inclusive list, as there may be other facts and circumstances that indicate when control has transferred.

Customer acceptance clauses in contracts present a unique issue in determining when the performance obligation has been satisfied. These clauses should be carefully considered when going through the revenue recognition process. Acceptance clauses allow for a customer to essentially terminate a contract, or obligate the vendor to do additional work to fix something. When there is a customer acceptance clause, the customer must confirm they’ve accepted the final delivery in order for the performance obligation to be met. These customer acceptance clauses generally will have a period of time attached to them. For example, a customer could have one month after delivery to accept or reject a good. The lag between delivery and customer acceptance can cause delays in the entity’s ability to recognize revenue. Whenever a customer acceptance clause is present, entities should carefully consider and analyze it to determine the point in time in which the performance obligation was satisfied.

Consignments & Bill and Hold Arrangements

Consignment arrangements occur when an entity delivers goods to another party, who, in turn, has agreed to sell the goods to an end customer. Under ASC 606, revenue is typically not recorded for goods on consignment, which is consistent with the current standard. This is because consigned goods are generally still controlled by the entity, and not by the consignor. Additionally, the entity  could elect to take the good out of consignment and the consignor wouldn’t be required to pay for the good until the final sale to the customer. Revenue from consignment arrangements should typically be recognized once the products are sold to the end customers, consistent with when the entity relinquishes control.

In a bill and hold arrangement an entity sends a bill to the end customer for the final product, but the customer requests that the product be held by the entity until a later date. The entity must determine when control of the asset has transferred to the customer. If the customer has full control to direct the use of and receive the benefits from the asset, even though they have elected not to take physical possession of it, the entity could determine that control has passed, and recognize revenue even though the asset is still held by them. It is important to note that classification as a bill and hold transaction is primarily driven by a  customer request for the entity to hold onto the goods.

Read the whole Revenue Recognition blog series from the beginning, starting with Part I. Continue with Part II, Part III, Part IV, and Part V.

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