Chapter 8 — Step 5: Determine When to Recognize Revenue

8.3 Two Models for Revenue Recognition — Based on Control

At contract inception, an entity must determine whether the performance obligation meets the criteria for revenue to be recognized over time (see Sections 8.4 and 8.5); if the performance obligation does not meet those criteria, revenue must be recognized at a point in time (see Section 8.6). That is, the entity must carefully evaluate how and when control is transferred to the customer. While generally speaking, goods are transferred at a point in time and services are transferred over time, this is not the case in all circumstances.

Connecting the Dots

Step-by-Step Approach

When entities think about revenue recognition, it may seem natural or logical to jump directly to determining when revenue can be recognized in step 5. However, understanding the nature of the arrangement and identified promised goods or services in step 2 is critical to determining when transfer of control occurs in step 5. As discussed in Section 8.1.1, applying the steps sequentially is important because the assessment of whether revenue should be recognized over time or at a point in time should be performed at the individual performance obligation level rather than at the overall contract level.

For example, suppose that an entity sells a product with a multiyear warranty to a customer. Without identifying and assessing the nature of the promised goods and services in the contract, the entity may incorrectly assume that it should recognize all of the revenue when the product is transferred to the customer. However, upon assessing the nature of the promised goods and services in the contract, the entity determines that the multiyear warranty represents a service-type warranty (rather than an assurance-type warranty). In this situation, the contract would include two performance obligations: (1) the product and (2) the service-type warranty. In accordance with step 4 (see Chapter 7) revenue should be allocated to the product and the service-type warranty. The revenue allocated to the product would generally be recognized at the point in time when control is transferred (see Section 8.6), and the revenue allocated to the service-type warranty should be recognized over the multiyear warranty period (see Sections 8.4 and 8.5). See Section 5.5 for additional information on determining whether a warranty represents a distinct service in the contract.

Assessing the Nature of the Promise

Identifying the nature of the arrangement and the promised goods or services may be challenging in many instances, such as in certain types of stand-ready obligations or when an entity is acting as an agent. For example, in an arrangement in which a price comparison Web site (the entity) allows its users (customers) to select services from a wide range of providers (e.g., hotels, airlines) and make purchases through the site, stakeholders have questioned whether revenue should be recognized before the user executes a purchase (e.g., selects and books a hotel room or flight). That is, when an entity acts as an agent, it could be thought of as providing a service throughout a certain period of effort, or it could instead be viewed as performing a single act of matching the buyer with a provider (when the agent finds a buyer). The entity earns a commission for acting as a broker; however, the entity is also providing a service of price comparisons and in essence is creating a lead for the provider. Stakeholders have therefore questioned whether revenue should be recognized before the customer makes a purchase through the site since some views indicate that value is being transferred to the user over time before the execution of a purchase through the site. In light of this, the entity should first assess the nature of its promise in the contract to understand whether its promise is fulfilled at a point in time or over time so that it can appropriately recognize revenue. For additional discussion, see Section 8.9.5.

Sections 8.3.1 through 8.3.4 illustrate how an entity must carefully assess the terms of the arrangement and not just assess whether it is providing a good or a service to properly determine when control is transferred to the customer.

8.3.1 When Revenue Recognition Over Time Is Appropriate for Goods (e.g., Contract Manufacturing)

An entity that is delivering goods (e.g., a contract manufacturer) should carefully analyze the contractual arrangement in accordance with the three criteria in ASC 606-10-25-27 to determine whether the promise in the contract to construct and transfer goods to the customer is a performance obligation that will be satisfied over time or at a point in time.

If an entity’s obligation to produce a customized product meets one of the criteria in ASC 606-10-25-27 for revenue recognition over time (e.g., the entity’s performance does not create an asset with an alternative use, and the entity has an enforceable right to payment for performance completed to date), revenue related to that product would be recognized as the product is produced, not when the product is delivered to the customer.

For example, an entity that has a contract with an original equipment manufacturer (OEM) to produce a customized part for the OEM’s product would meet the criteria for revenue recognition over time if the customized part has no alternative use other than as a part for the OEM’s product and the entity has an enforceable right to payment for performance completed to date “at all times throughout the duration of the contract.” ASC 606-10-25-28 and 25-29 as well as ASC 606-10-55-8 through 55-15 provide detailed guidance on whether an asset has an alternative use to the entity and whether an entity has an enforceable right to payment for performance completed to date. An entity would need to carefully analyze the contractual arrangements and the specific facts and circumstances to determine whether those criteria are met.

If it concludes that revenue should be recognized over time, the entity would then be required to select a method of recognizing revenue over time that faithfully depicts the entity’s performance to date for producing the product. Therefore, contract revenue should be recognized as the entity performs (i.e., as the product is produced) rather than when the product is delivered to the customer.

8.3.2 When Revenue Recognition Over Time Is Appropriate for Services (e.g., Construction)

An entity that provides a service (e.g., under a construction contract) cannot assume that it can recognize revenue over time. Rather, the entity needs to assess whether the criteria outlined in ASC 606-10-25-27 are met.

Specifically, ASC 606-10-25-27 requires one of the following criteria to be met for revenue to be recognized over time:

The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs . . . .
The entity’s performance creates or enhances an asset (for example, work in process) 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.

The assessment should be made at contract inception. If a performance obligation does not meet any of the criteria in ASC 606-10-25-27, the entity should recognize revenue at a point in time rather than over time.

The entity should carefully analyze the terms of the contractual arrangement(s) in accordance with the requirements in ASC 606-10-25-27 to determine whether the performance obligation is satisfied over time or at a particular point in time. The criteria in ASC 606-10-25-27 are discussed in further detail in Section 8.4.

8.3.3 Whether an Entity Is Free to Choose Whether to Recognize Revenue Over Time or at a Point in Time

The decision of whether to recognize revenue over time or at a point in time is not a free choice. At contract inception, an entity must carefully evaluate whether the performance obligation meets any of the three criteria in ASC 606-10-25-27 for revenue recognition over time. If one or more of the criteria are met, the performance obligation must be recognized over time. However, if none of the criteria are met, the entity should recognize revenue at a point in time.

Accordingly, it would not be appropriate to recognize revenue at a point in time if one of the three criteria in ASC 606-10-15-27 is met.

8.3.4 Recognizing Revenue Over Time or at a Point in Time — Production of Customized Goods

An entity that sells products or goods cannot presume that it can recognize revenue at a point in time since it will be required to recognize revenue over time if one of the criteria in ASC 606-10-25-27 is met. In the FASB staff’s view, revenue from certain contracts with customers (e.g., contracts for the production of customized goods) may need to be recognized over time under the revenue standard because (1) the goods or services being provided may have no alternative use to the entity and (2) the entity may have an enforceable right to payment. To illustrate, the FASB staff cites the following fact pattern:1

An entity has contracted with a customer to provide a manufacturing service in which it will produce 1,000 units of a product per month for a 2-year period. The service will be performed evenly over the 2-year period with no breaks in production. The units produced under this service arrangement are substantially the same and are manufactured to the specifications of the customer. The entity does not incur significant upfront costs to develop the production process. Assume that its service of producing each unit is a distinct service in accordance with the criteria in paragraph 606-10-25-19. Additionally, the service is accounted for as a performance obligation satisfied over time in accordance with paragraph 606-10-25-27 because the units are manufactured specific to the customer (such that the entity’s performance does not create an asset with alternative use to the entity), and if the contract were to be cancelled, the entity has an enforceable right to payment (cost plus a reasonable profit margin). Therefore, the criteria in paragraph 606-10-25-15 have both been met.

The FASB staff cautions that while the example is not meant to illustrate that revenue from contracts for customized goods should always be recognized over time, an entity should not presume that it would continue to recognize revenue from such contracts at a point in time under the revenue standard. Rather, the entity would need to assess the criteria in ASC 606-10-25-27 to determine whether it should recognize revenue over time. If none of those criteria are met, the entity should recognize revenue at a point in time.

The above issue is addressed in Implementation Q&A 54 (compiled from previously issued TRG Agenda Papers 56 and 60). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

Footnotes

Quoted from Q&A 54 of the FASB staff’s Revenue Recognition Implementation Q&As (the “Implementation Q&As”).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.