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Revenue Recognition Serial Part 6: Step 5 - Recognizing Revenue as or When Performance Obligations are Satisfied

June 14, 2016

Once entities allocate the transaction price, they can then move to the fifth and final step of the new revenue recognition standard: recognizing revenue.

Step 5 requires entities to recognize the consideration given for an asset when or as the performance obligation has been satisfied. This point occurs when the customer receives control of the good or service.

Under the standard, control is defined as the customer's ability to have direct use of an asset and reap substantially all of its benefits. Common signs of control include:

  • The entity providing the asset to the customer has a right to payment;
  • The legal title of the asset has been transferred to the customer;
  • The customer has physical control of the asset;
  • The customer is responsible for the asset's risks; and
  • The customer has accepted the asset.

How and when entities recognize revenue, however, depends on the nature of the performance obligation. At inception of the contract, entities determine whether performance obligations are satisfied over time or at a point in time.

Things to Consider

  • Similar to current guidance, revenue is recognized over time or at a point in time. Determining when to recognize revenue will require the use of judgment.
  • Unlike existing guidance, revenue is recognized based on the transfer of control. Existing guidance places an emphasis of risk and rewards of ownership, which is one indicator to consider if control has been transferred.
  • Evaluating when revenue is recognized and on what basis to recognize revenue will require an understanding of the contractual arrangements of an entity. Consider engaging legal expertise to review the existing terms of contracts and whether changes may be warranted.
  • All entities will need to re-evaluate their pattern of revenue recognition. Entities that currently have specialized guidance, such as the software industry and contractors may experience a greater degree of change and should carefully evaluate the new guidance to determine differences that may exist under the new guidance.

Performance Obligations Satisfied Over Time

Performance obligations meeting any one of three criteria are recognized over time; all other revenue from contacts with customers are recognized at a point in time.

Customers gain control of an asset over time if one of the following applies:

  • The customer has a right to the benefits provided by the contract as the provider of the good or service fulfills the contract;
  • The entity providing the good or service modifies an asset (work-in-progress) that the customer controls; or
  • The providing entity does not have an alternate use for the asset being created or transferred, and it has a right to payment for the asset.

The first over time recognition criterion will frequently apply in service contracts where the customer benefits from the service as it is performed. For example, a company performing a facility cleaning service would recognize revenue over time as it performs the cleaning. The cleaning service qualifies for over time recognition because the benefits of cleaning are received by the customer in the form of cleaned areas as the entity performs it. The customer's receipt of benefit is further illustrated by considering that if the service provider ceases cleaning part way through the service, the portion of the facility that was already cleaned would not need to be cleaned by someone else.

The second criterion for over time revenue recognition will be commonly applied in the construction industry. For example, a contractor enters into a contract with its customer to build a warehouse. The warehouse will be constructed on land already owned by the customer. As the contractor erects the warehouse, it is modifying the land that is controlled by the customer. Therefore, the contractor recognizes revenue over time.

The third criterion for over time revenue recognition will be commonly applied in the service industry when the customer does not receive a benefit as the performance occurs, but the performance cannot be redirected to another use. Similarly, this criterion may apply when performing specialized manufacturing where the product being manufactured cannot be repurposed or redirected. In either instance, it will be critical under this criterion to understand the contractual rights of the entity providing the good or service because revenue would only be eligible for recognition if the entity is entitled to payment for the work it performed at the time revenue is recognized. For example, a manufacturer of servos enters into a contract with a defense contractor to build a unique part used in the manufacturing of a tank. Under the contract, the manufacturer is prohibited from reselling or repurposing the servos, however, it is entitled to payment for the portion of work performed. In the event of cancellation by the customer, the contractual terms entitle the manufacturer to payment for work-in-process as well as finished but not yet delivered servos. As a result, the manufacturer meets both criteria and recognizes revenue as the production of servos occurs.

Methods of Recognizing Revenue Over Time

An entity should select either an output or input method for recognizing revenue over time by considering the nature of the good or service that is transferred to the customer. When choosing the most appropriate method, consider what would most faithfully depict the value transferred to the customer.

When entities satisfy performance obligations over time, they must recognize revenue in a way that reflects the transfer of control to the customer. This requires entities to measure their progress toward satisfying the performance obligation. There are two methods for measuring progress, the output method and the input method.

The output method recognizes revenue by directly measuring the value of the good or service that has been transferred to the customer in proportion to the total value of the good or service to be transferred to the customer. Common output based measures include:

 

  • Amount (units) produced
  • Amount (units) delivered
  • Milestones reached
  • Survey of performance completed
  • Appraisal of performance completed, and
  • Time elapsed

When using an output measure, it is important to consider whether the measure selected would inaccurately exclude goods or services that have not been transferred to the control of the customer.

In some instances, it is necessary to adjust input methods because they may include costs or other units of measure that are not representative of the value transferred to the customer. Two types of adjustments to cost-based input methods are given in Topic 606:

  • Costs incurred do not contribute to satisfying a performance obligation. Examples include waste materials, labor hours incurred on rework and other similar inefficient usage of resources, and
  • Costs incurred that are not proportionate to the progress made in satisfying the performance obligation. For example, materials purchased and delivered to be used in constructing an asset for a customer that have not yet been used (also known as uninstalled materials).

For the latter category of adjustments, revenue may be recognized up to the amount of the cost incurred if the uninstalled material identified at contract inception meets the following conditions:

  • Uninstalled material is not a distinct good,
  • The entity expects the customer to obtain control of the good significantly prior to receiving the services related to the good,
  • Cost of the uninstalled material is significant to the total costs related to the performance obligation, and
  • The entity acting as a principal obtains the good but is not significantly involved in its design or manufacturing.

The overall objective when adjusting the input measure is to best depict the entity's progress in satisfying the performance obligation.

For example, assume an entity provides services related to the management of employee health insurance and care. The entity is engaged through a fixed price contract with a customer to provide on-site screening to evaluate risk factors of employees at the customer's many locations. The entity considers electing two output methods: the delivery of the report of overall employee health for each location to the customer or the number of employees for which screening has been completed. In evaluating these two options, the entity considers that under the first method, the report may not be prepared until several weeks after screening has been conducted, and the customer receives benefits as each employee's screening is completed. If the output method based on the generation of the report were used, the entity would not recognize revenue related to screenings conducted before a period end that did not have the final report issued until after period end. Therefore, the entity concludes that measurement on an output measure based on the issuance of a report would not be appropriate and determines that the only reasonable output based measure is the one based on the number of employees screened.

An entity may also consider input methods to measure revenue recognized over time. Input measures focus on the effort expended by the entity in fulfilling a performance obligation to a customer. In many situations, input methods will be easier to use because the value of the effort put into creating the good or service transferred to the customer is more readily available than the value of the output that was transferred to the customer. When input measures are used, consideration should be given to the risk that the input measure selected would measure inputs that do not relate to the transfer of a good or service to a customer. It may be necessary for an entity to exclude certain inputs from the measurement. Common forms of input measures include:

  • Labor hours
  • Machine hours
  • Costs incurred (cost-to-cost), and
  • Time elapsed

Continuing the example above, the entity also considers input methods to measure its performance related to its on-site screening service with a customer. It identifies labor hours incurred to perform the on-site screenings as a potential input method. In considering labor hours incurred, the entity identifies that the screening process includes using supplies such as disposable test kits with a significant cost-per-use. It concludes that measuring based simply on labor hours would not accurately reflect the value of the service performed because of the additional costs that are incurred for each screening. Therefore, the entity concludes that labor hours alone would not be an appropriate measure, rather it could use total costs computed based on the cost of labor hours and the cost of the supplies used for each screening.

If neither an input nor an output method appears to fit the performance obligation or significant uncertainty about the measurement exists, then revenue should not be recognized until the progress can be measured. If this occurs, it may be appropriate to recognize revenue up to the amount of cost incurred if the entity can determine that a loss will not be incurred.

Having identified two different potential measures, an output measure based on the number of employees screened and an input measure based on total costs, the entity now considers its ability to generate information about the number of employees screened and the total number of employees expected to be screened under the contract and also the total costs incurred for services performed compared to the total amount of costs expected to be incurred. After evaluating these, it determines that it will be able to more accurately generate information about the number of employees screened and the total number of employees expected to be screened to measure progress consistently over time and concludes that the output measure is most appropriate.

The guidance for over time recognition of revenue also includes a practical expedient that if the entity has a right to consideration equal to the value to the customer of the entity's performance to date, the entity may recognize revenue at the amount it has the right to invoice. One situation this practical expedient may be used is a service provider that bills a fixed hourly rate.

The overall objective when selecting a method to recognize over time revenue is to best measure the progress in satisfying a performance obligation. In accomplishing this objective, the guidance does not create a preference between output or input methods. However, whichever method is selected should be used for similar arrangements under similar circumstances.

Performance Obligations Measured at a Point in Time

The transfer of control occurs when the customer obtains the ability to direct the use of, and obtain substantially all of the remaining benefits goods or services of the performance obligation.

Entities recognize revenue at a point in time when their performance obligation does not meet the criteria to be measured over time and control of the asset has been transferred to the customer. To determine at which point in time to recognize revenue, entities must consider factors that indicate control of a good or service has transferred. Topic 606 provides five indicators—right to payment, legal title, physical possession, liability for risks and rewards and acceptance of the asset—that might indicate control has been transferred, but other indicators may apply.

No single indicator is considered determinative that a transfer of control has occurred; rather the intent is that consideration is given to all relevant indicators in concluding the control has transferred to the customer. In addition, the indicators might be given different weightings depending on the qualitative analysis of the arrangement. Due to this, each indicator must be considered carefully in deciding whether transfer of control has occurred:

A contractual right to payment may indicate that the customer has received control and has now agreed to pay for the good or service. In some instances, however, the contractual right to payment may occur prior to satisfying a performance obligation, such as when prepayment is required under the contract before performance occurs.

The transfer of legal title often indicates that control of the good or service has also transferred; however, in some instances the seller may retain title as a form of security interest even though control has transferred to the customer.

In revenue recognition guidance under Topic 605, the recognition of revenue at a point in-time occurred when risk and reward of ownership was transferred to the customer. The new guidance in Topic 606 emphasizes the transfer of control. The concept of control under Topic 606 includes multiple indicators including risk and reward. As a result, evaluations of when control has transferred might result in the same conclusion as when risk and reward transferred under prior guidance.

Physical possession of an asset may indicate that the possessor has control, but exceptions may exist for a variety of reasons, including bill-and-hold arrangements, repurchase agreements and consignment sales arrangements.

Transferring the risk and reward associated with a good or service often indicates that control has also transferred. When analyzing risk and reward, it is important to exclude risks associated with separate performance obligations.

Whether a customer has accepted the good or service is often a powerful indicator that control of the good or service has transferred. Particularly in situations where the customer is entitled to trial or evaluation of a good or service, the control cannot have transferred until either acceptance occurs or the trial period lapses.

Special Considerations: Bill-and-Hold, Consignment Sales, and Repurchase Agreements

Three special types of transactions that are discussed in Topic 606 are bill-and-hold, consignment sales and repurchase agreements. These types of transactions have unique characteristics that affect when control has transferred and thus when an entity is able to recognize revenue.

Bill-and-Hold

Topic 606 provides guidance on bill-and-hold transactions that is different than the existing guidance issued by the staff of the Securities and Exchange Commission (SEC). Under the new guidance, an arrangement where control of a product has been transferred to the customer but is still in physical possession of the entity, may be accounted for as a bill-and-hold arrangement if it meets four criteria:

  • The reason for the transaction to be structured as a bill-and-hold must be substantive, such as a customer request,
  • The product must be identified separately for the customer,
  • The product must be ready for physical transfer to the customer, and
  • The entity cannot have the ability to use the product or direct it to another customer.

Consignment Sales

Consignment sales occur when a customer has obtained physical possession of a good but control has not been transferred. Consignment sales most often occur when a middleman, such as a dealer exists between the selling entity and the end user of a product. Various indicators should be considered to conclude whether revenue recognition should be deferred due to a sale being on consignment, including the following:

  • The evaluation of the indicators that control has been transferred show that control will not be transferred until a future event occurs. Future events that may cause a sale to be conditional include sale to a dealers customer or a specified amount of time lapsing.
  • The selling entity can redirect the product sold to a party other than the dealer, such as another dealer or a customer.
  • The selling entity is not entitled to full payment for the product. For example, the dealer might pay a deposit for the product with the remaining payment only due upon the dealer's sale to its customer.

Repurchase agreements

In some scenarios, contracts may include provisions that allow the entity performing the service to repurchase the asset or a substantially similar asset, from the customer. The agreement likely falls into one of three categories: a forward, or an obligation to repurchase the asset; a call option, the right to purchase an asset; or a put option, an entity's obligation to repurchase the asset from the customer upon request.

When forward and call options exist, control has not been transferred, as the entity providing the asset or service still has a say in how it is used. It also has a say in how to obtain the benefits of the asset. In these cases, entities should account for the options in one of two ways: as a lease or as a financing arrangement. Entities account for the options as a lease if they consider the time value of money—that is, they repurchase the item for less than the original selling price and if the option is not part of a sale-leaseback transaction. Alternatively, entities account for the option as a financing arrangement if they pay an amount equal to or greater than the original selling price for the asset or it is part of a sale-leaseback transaction.

For put options, an entity considers at contract inception whether the customer has a significant economic incentive to put the asset to the entity. Factors to consider include the length of time that the repurchase price exists and whether the repurchase price is expected to be greater than the market value of the asset at the time the repurchase price can be exercised.

The amount of the repurchase price and the nature of the transaction determine how to account for the transaction. If considering the time value of money, that is, the repurchase price is less than the original selling price of the asset, the transaction is part of a sale-leaseback, and a significant economic incentive exists for the customer to exercise the put option. The transaction would then be accounted for as a financing arrangement. If the same transaction is not part of a sale-leaseback transaction, it would be accounted for as a lease. On the other hand, if a significant economic incentive for the customer to exercise the put option does not exist, the transaction would be accounted for as a sale with a right of return.

Alternatively, the repurchase price might be greater than the original selling price. If that is the case and the repurchase price is also expected to be greater than the value of the asset at the time of repurchase, the transaction would be a financing arrangement. Lastly, if the repurchase price is greater than the original selling price but less than the expected value of the asset at the time of repurchase, then the transaction would be accounted for as a sale with a right of return.

For More Information

If you have specific comments, concerns or questions, please contact James Comito, Brad Hale or Mark Winiarski of MHM's Professional Standards Group. James can be reached at jcomito@cbiz.com or 858.795.2029. Brad can be reached at bhale@cbiz.com or 727.572.1400. Mark can be reached at mwiniarski@cbiz.com or 816.945.5614.


» Up Next

Recognizing revenue for the license of intellectual property has special considerations within the new guidance. In our next revenue recognition serial, we will explore how licensing is evaluated under the revenue recognition guidance in more detail.

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