By nature of their business, service organizations may face challenges with their determination of when revenue from contracts should be recognized under ASC Topic 606, Revenue from Contracts with Customers (ASC Topic 606). In addition to the obvious accounting issues associated with timing of revenue recognition, this determination will also impact their financial statement disclosure requirements as it relates to revenue recognition.
The following provides a closer look why service organizations may find the determination of timing of revenue recognition challenging. Some illustrative examples are also included that may provide additional insight into revenue recognition application to common service organization arrangements.
Under ASC Topic 606, organizations recognize revenue in one of two ways: at a point in time or over time. Entities recognize revenue over time if the performance obligations in the contract meet one of three criteria:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as performed
- The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced
- The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date
If none of the three criteria is met, the entity recognizes the revenue at a point in time.
Private organizations must also make the following disclosures with respect to timing of their revenue recognition:
- Revenue that qualifies for point-in-time recognition must be presented separately from revenue that qualifies for over-time recognition
- Explanation of judgments and changes in judgments used in determining the timing of performance obligation satisfaction
- The methods used to recognize revenue that qualifies for over-time recognition (ex., output methods or input methods) and how those methods were applied
What Makes Revenue Recognition Timing Difficult for Service Organizations
In many service contracts, an organization’s performance creates an asset only for a short amount of time because the customer simultaneously receives and consumes that asset. These performance obligations often result in revenue qualifying for over-time recognition. It’s important to note that the length of time that the customer uses the asset will never be the determining factor with respect to over-time versus point-in-time revenue recognition. So even when a performance obligation is created and used for only a few minutes, it may still technically meet one of the three criteria for over-time recognition.
Discerning between over-time versus point-in-time recognition is difficult in part, because it is not always clear whether the customer simultaneously receives and consumes the benefit of the entity’s performance. The FASB provided implementation guidance in ASC Topic 606 to assist in this assessment, clarifying that a performance obligation is satisfied over time if (disregarding potential contractual restrictions or practical limitations) another entity would not need to substantially reperform the work that the entity has completed to date in order to fulfill the remaining performance obligation.
Illustrative Example: Transaction Processing Services
Processing a transaction is nearly instantaneous; but since the customer simultaneously receives and consumes the benefits as the processing of each transaction takes place, the organization providing the transaction processing would apply over-time recognition.
In an arrangement to process a series of transactions, the service organization accounts for its transaction processing services as a single performance obligation in accordance with the series accounting guidance. The performance obligation is still satisfied over time because the customer simultaneously receives and consumes the benefits of the entity’s performance in processing each transaction as and when each transaction is processed. This conclusion is supported by the notion that another entity would not need to reperform transactions processed to date (disregarding any practical or contractual limitations).
Illustrative Example: Services Involving a Final Report
Conversely, if the service organization produces a final report of findings upon conclusion of the service it provides, the service arrangement does not meet the first criterion for over-time recognition; the customer does not receive the benefit of the service until the service organization finalizes the report. Therefore, the service organization would need to look at the other two criteria to determine whether over-time recognition applies.
In this example, the arrangement likely qualifies for over-time recognition under the third criterion: The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date. The report and any progress made on that report is likely highly specific to the customer and could not be used for another customer’s report.
Illustrative Example: Assessing Additional Revenue Streams
Service organizations may have various types of revenue streams where the customer simultaneously receives and consumes the benefit associated with the performance, supporting over-time recognition. Consider the following additional examples.
Company A has two revenue streams:
- Process training in which it provides one-hour training sessions for employees to learn how to process accounts payable
- A cloud-based software solution in which customers use its purchasing and payables platform through a web-based application
Company A concludes that both of the above services are recognized over time. The customer in each scenario receives and consumes the benefits provided by the Company A’s performance as Company A performs the service:
- The timing and amount of recognition for the training is the same whether it is accounted for at a point in time or over time (the service occurs within a single day), but the organization recognizes revenue from the training service over time because the employee receiving the training learns throughout the one-hour course.
- Cloud-based software solutions that do not provide the customer the ability to obtain control of a software license are considered a service versus a license of software. These solutions allow customers to access the software over a period of time and therefore Company A recognizes revenue over time.
The over-time conclusion is generally NOT affected by “use-it-or-lose-it” type contract clauses. For example, if Company A sells 50 prepaid training hours that must be used within 12 months, and any unused training hours expire after the 12-month period lapses, Company A still recognizes the performance obligation over time. Company A would also apply the concept of breakage and potentially recognize an estimate of the hours that will ultimately not be used (using an appropriate measurement method) recognized over the appropriate period.
Careful Analysis Needed
When determining whether over time recognition applies, service organizations should consider all relevant facts and circumstances, including the inherent characteristics of the good or service, the contract terms, and information about how the good or service is transferred or delivered.
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Published on January 08, 2020