Chapter 8 — Step 5: Determine When to Recognize Revenue

8.5 Measuring Progress for Revenue Recognized Over Time

ASC 606-10

25-31 For each performance obligation satisfied over time in accordance with paragraphs 606-10-25-27 through 25-29, an entity shall recognize revenue over time by measuring the progress toward complete satisfaction of that performance obligation. The objective when measuring progress is to depict an entity’s performance in transferring control of goods or services promised to a customer (that is, the satisfaction of an entity’s performance obligation).

25-32 An entity shall apply a single method of measuring progress for each performance obligation satisfied over time, and the entity shall apply that method consistently to similar performance obligations and in similar circumstances. At the end of each reporting period, an entity shall remeasure its progress toward complete satisfaction of a performance obligation satisfied over time.

After determining that a performance obligation is satisfied over time, an entity must determine the appropriate method for depicting that performance over time — that is, how far complete the entity’s progress is as of any given reporting period. This method is described in the revenue standard as the entity’s measure of progress.

For example, if a contract requires a calendar-year reporting entity to perform a daily cleaning service for 12 months beginning on January 1, the entity may, depending on the facts and circumstances, measure progress in any of the following ways:

Based on days passed (i.e., time elapsed) — For example, as of March 31, 90 days have passed, so the entity’s performance is 25 percent complete.
Based on costs incurred — For example, as of March 31, the entity has incurred $300,000 of the expected costs of $1 million, so the entity’s performance is 30 percent complete.
Based on labor hours — For example, as of March 31, the entity has incurred 260 hours of cleaning of the expected 1,100 hours for the full year. As a result, the entity’s performance is 24 percent complete.

8.5.1 Methods for Measuring Progress

ASC 606-10

Methods for Measuring Progress

25-33 Appropriate methods of measuring progress include output methods and input methods. Paragraphs 606-10-55-16 through 55-21 provide guidance for using output methods and input methods to measure an entity’s progress toward complete satisfaction of a performance obligation. In determining the appropriate method for measuring progress, an entity shall consider the nature of the good or service that the entity promised to transfer to the customer.

When a performance obligation is satisfied over time, an entity must select a measure of progress (e.g., time elapsed, labor hours, costs incurred) to depict its progress toward complete satisfaction of that obligation.

In accordance with ASC 606-10-25-33, appropriate methods of measuring progress include:

Output methods — ASC 606-10-55-17 states that output methods “recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract.” These methods include “surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered.” (See Section 8.5.8.)
Input methods — ASC 606-10-55-20 states that input methods “recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation.” (See Section 8.5.9.)

In discussing the selection of a measure of progress, paragraph BC164 of ASU 2014-09 states:

The [FASB and IASB] decided that, conceptually, an output measure is the most faithful depiction of an entity’s performance because it directly measures the value of the goods or services transferred to the customer. However, the Boards observed that it would be appropriate for an entity to use an input method if that method would be less costly and would provide a reasonable proxy for measuring progress.

The above statement from paragraph BC164 of ASU 2014-09 does not mean that it is preferable for an entity to use an output method when measuring progress toward complete satisfaction of a performance obligation. As stated in paragraph BC159 of ASU 2014-09, an entity does not have a free choice in selecting an appropriate method of measuring progress toward complete satisfaction of a performance obligation but should exercise judgment in identifying a method that fulfills the stated objective in ASC 606-10-25-31 of depicting an entity’s performance in transferring control of goods or services promised to a customer (i.e., the satisfaction of the performance obligation).

Neither an input method nor an output method is preferred since each has benefits and disadvantages that will make it more or less appropriate to the facts and circumstances of each contract. While an output method is, as stated in paragraph BC164, conceptually preferable in a general sense, an appropriate measure of output will not always be directly observable; and sometimes, an apparent measure of output will not in fact provide an appropriate measure of an entity’s performance. Information needed to apply an input method is more likely to be available to an entity without undue cost, but care should be taken to ensure that any measure of an entity’s inputs used is reflective of the transfer of control of goods or services to the customer.

Considerations that may be relevant to the selection of a measure of progress include the following:

An output method would not provide a faithful depiction of the entity’s performance if the output selected fails to measure some of the goods or services transferred to the customer. For example, a units-of-delivery or a units-of-production method may sometimes understate an entity’s performance by excluding work in progress that is controlled by the customer. (See paragraph BC165 of ASU 2014-09.)
An input method may better reflect progress toward complete satisfaction of a performance obligation over time when (1) the performance obligation consists of a series of distinct goods or services that meets the criteria in ASC 606-10-25-14(b) to be treated as a single performance obligation and (2) the effort required to create and deliver the first units is greater than the effort to create the subsequent units because of the effect of a “learning curve” of efficiencies realized over time. (See paragraph BC314 of ASU 2014-09.)
An entity applying an input method must exclude from its measure of progress the costs incurred that (1) do not contribute to the entity’s progress in satisfying a performance obligation (e.g., the costs of unexpected amounts of wasted materials) and (2) are not proportionate to the entity’s progress in satisfying the performance obligation (e.g., the cost of obtaining goods from a vendor that accounts for most of the product’s cost). (See ASC 606-10-55-21.)

8.5.2 Whether Control of a Good or Service Can Be Transferred at Discrete Points in Time When the Underlying Performance Obligation Is Satisfied Over Time

As discussed above, if the entity meets one of the three criteria in ASC 606-10-25-27, it recognizes revenue over time by using either an output method or an input method to measure its progress toward complete satisfaction of the performance obligation. While the revenue standard does not prescribe which method to use, the entity should select an approach that faithfully depicts its performance in transferring control of goods or services promised to a customer.

At the TRG’s April 2016 meeting, the TRG discussed two views articulated by stakeholders on whether an entity that is performing over time can transfer control of a good or service underlying a performance obligation at discrete points in time:

View A — Satisfaction of any of the requirements for recognition over time implies that control does not transfer at discrete points in time. Therefore, an entity’s use of an appropriate measure of progress should not result in its recognition of a material asset (e.g., work in progress) for performance the entity has completed. Proponents of View A point to paragraphs BC125, BC128, BC130, BC131, BC135, and BC142 of ASU 2014-09, which clarify that control of any asset (such as work in progress) transfers to the customer as progress is made.
View B — Satisfaction of any of the criteria for recognition over time does not preclude transfer of control at discrete points in time. The use of an appropriate measure of progress could therefore result in the recognition of a material asset for performance under a contract. Proponents of View B emphasized that ASC 606-10-25-27(c) specifically “contemplates transfer of control at discrete points in time.” They also noted that the term “could” in paragraph BC135 of ASU 2014-09 implies that in certain circumstances, the customer may not control the asset as performance occurs. In addition, proponents of View B indicated that “if control can never transfer at discrete points in time, certain methods of progress referenced in the new revenue standard [e.g., milestones2] rarely would be permissible.”3

The FASB staff believes (as discussed in Implementation Q&A 51) that View B is inconsistent with the revenue standard but that View A is appropriate. The staff reiterates that paragraphs BC125, BC128, BC130, BC131, BC135, and BC142 of ASU 2014-09 clarify that when an entity satisfies any of the three criteria for recognizing revenue over time, the entity’s performance is an asset that the customer controls. The staff also indicates that in accordance with paragraph BC135 of ASU 2014-09, an entity would consider whether it has a right to payment in determining whether the customer controls an asset. Therefore, in the staff’s view, control “does not transfer at discrete points in time,” and “an appropriate measure of progress should not result in an entity recognizing a material asset that results from the entity’s performance (for example, work in process).”4

The FASB staff also notes that (1) View A does not prohibit an entity from recognizing revenue over time if there is a period during which the entity does not perform any activities toward satisfying its performance obligation (i.e., if there is a break in the period of performance) and (2) although Example 27 in the revenue standard refers to milestone payments, the standard does not conclude that milestones are the appropriate measure of progress. Therefore, entities must use judgment in selecting an appropriate measure of progress.

Certain TRG members questioned the FASB staff’s view that there could be times when an entity may recognize an immaterial asset (e.g., work in progress) under a recognition-over-time model because the entity’s selected measure of progress may not perfectly match its performance. Specifically, they cited ASC 340-40-25-8, which requires an entity to recognize costs related to satisfied and partially satisfied performance obligations as expenses when they are incurred.

TRG members indicated that an asset could result from activities that are not specific to the customer contract (i.e., the creation of general inventory). They reiterated the importance of understanding the differences between costs associated with the development of an asset that transfers to a customer as it is created and costs to develop assets for general inventory (i.e., before the asset undergoes modifications that are specific to the customer). One TRG member discussed an example that involved large, complex, and customized assets. He noted that activities can be performed to assemble parts, for example, and that such costs may represent inventory (and thus an asset) because the assets are interchangeable for use in more than one customer contract.

Because control of the related good or service cannot be transferred at discrete points in time if a performance obligation meets one of the criteria in ASC 606-10-25-27, the measure of progress selected for such a performance obligation should be consistent with the pattern of transfer of control of the good or service over time and should not result in the recognition of work in progress (or a similar asset) as the entity performs work between discrete points of revenue recognition (see Example 13-2).

ASC 606-10-25-27 does not, however, require an entity’s performance over time to be continuous and uninterrupted. Accordingly, a gap in the entity’s performance (e.g., if the entity does not perform any activities toward satisfying the performance obligation in a particular financial reporting period) does not in itself prevent the entity from recognizing revenue over time. In addition, as discussed in Section 13.3.3.2, it will typically be appropriate for the entity to continue to recognize any incurred contract-fulfillment costs related to future performance as assets, such as inventories and other assets that have not yet been used in the contract and are still controlled by the entity.

The above issues are addressed in Implementation Q&A 51 (compiled from previously issued TRG Agenda Papers 53 and 55). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

8.5.3 Use of a Multiple Attribution Approach (as Compared With a Single Method for Measuring Progress)

For performance obligations meeting the requirements for revenue recognition over time, the entity must select a method for measuring progress toward satisfaction of the performance obligation.

Although the revenue standard indicates that an entity should apply a single method to measure progress for each performance obligation satisfied over time, stakeholders have questioned whether an entity may apply more than one method to measure progress toward satisfaction of a performance obligation that contains multiple goods and services bundled and recognized over time. Examples of such circumstances include the following:

A cloud computing company provides hosting services to its customers for specified periods that begin once certain up-front implementation activities are completed. The customer cannot access the services in the hosting arrangement until the implementation activities are complete (and no other vendor can perform the implementation). Therefore, the hosting services are combined with the up-front activities to be one performance obligation.
A license is provided to a customer at contract inception. However, there is also a service associated with the license that is not considered to be distinct. Therefore, the service is combined with the license to be one performance obligation.
A franchisor enters into a license agreement with a new franchisee for a specified number of years with a promise to also provide a fixed number of hours of consulting services in the first year of the agreement. The license is to be satisfied over time. Because both promises in the arrangement are highly interrelated, the license is combined with the consulting services into one performance obligation.

Stakeholders questioned whether it would be acceptable to apply two different methods for measuring progress even though the contract has only one performance obligation.

The FASB staff notes that the revenue standard clearly indicates that “using multiple methods of measuring progress for the same performance obligation would not be appropriate.”5 Accordingly, the staff concludes that an entity should use a single measure of progress for each performance obligation identified in the contract.

In addition, the FASB staff observes that selecting a common measure of progress may be challenging when a single performance obligation contains more than one good or service or has multiple payment streams, although it emphasizes that the selection is not a free choice. Further, the staff notes that while a common measure of progress that does not depict the economics of the contract may indicate that the arrangement contains more than one performance obligation, it is not determinative. However, a reexamination may suggest that the contract includes more performance obligations than were initially identified.

The above issues are addressed in Implementation Q&As 47 and 48 (compiled from previously issued TRG Agenda Papers 41 and 44). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

8.5.4 Use of Different Methods of Measuring Performance to Date to Determine Whether a Performance Obligation Is Satisfied Over Time and to Measure Progress Toward Satisfaction of That Performance Obligation

In some circumstances, an entity will need to identity a suitable method for measuring “performance completed to date” to determine whether the criterion in ASC 606-10-25-27(c) is met (see ASC 606-10-25-29 and ASC 606-10-55-11 for additional guidance). Further, once it has been determined that a performance obligation is satisfied over time, ASC 606-10-25-31 requires an entity to “recognize revenue over time by measuring the progress toward complete satisfaction of that performance obligation.” For measuring both performance completed to date under ASC 606-10-25-27(c) (to determine whether revenue should be recognized over time) and progress toward complete satisfaction of a performance obligation under ASC 606-10-25-31, the method selected should faithfully depict an entity’s performance in transferring control of goods or services promised to a customer. However, there is no requirement for the same method to be used for both purposes.

But in determining an appropriate method for measuring progress under ASC 606-10-25-31, entities should be aware that ASC 606-10-25-32 requires them to apply the same method to all similar performance obligations in similar circumstances.

Example 8-5

Entity A enters into a contract with Customer B under which A will construct a large item of specialized equipment on its own premises and then deliver the equipment and transfer title to B after construction is completed. The specialized equipment is only suitable for this particular customer (i.e., it has no alternative use). In addition, the specialized equipment is subject to certain regulations that require third-party appraisals to be performed throughout the construction of the equipment. The objective of the appraisals is to assess the entity’s construction progress and ensure that the equipment is built in accordance with published regulations. The results of the periodic appraisals are provided to the customer, and a final appraisal is performed shortly before the equipment is delivered to the customer.

Entity A concludes that it qualifies to recognize revenue over time under ASC 606-10-25-27(c) by using a cost-based input method because if the customer cancels the contract, the customer must reimburse the costs incurred by the entity to the date of cancellation and pay a 5 percent margin on those costs (which is considered to be a reasonable margin).

However, in measuring the progress toward satisfaction of similar performance obligations in other contracts, A uses an output method based on third-party appraisals completed to date. This method is determined to faithfully depict progress toward satisfaction of the performance obligation in the contract with B. Because ASC 606-10-25-32 requires an entity to apply the same method of measuring progress to similar performance obligations in similar circumstances, A uses this appraisal-based output method to measure the revenue to be recognized in each reporting period from its contract with B despite using a cost-based measure of progress to determine whether it met the criterion in ASC 606-10-25-27(c).

8.5.5 Application of the Method for Measuring Progress

ASC 606-10

25-34 When applying a method for measuring progress, an entity shall exclude from the measure of progress any goods or services for which the entity does not transfer control to a customer. Conversely, an entity shall include in the measure of progress any goods or services for which the entity does transfer control to a customer when satisfying that performance obligation.

Under the control principle of the revenue standard, it would not be appropriate for an entity to recognize revenue for any progress made or activities performed that do not transfer control to the customer. Rather, the entity should use judgment to determine which activities are included in the promised goods or services to the customer and select a method for measuring progress toward transferring the goods or services to the customer.

This concept is also aligned with principal-versus-agent considerations in that if the entity does not transfer control to the customer but coordinates the transfer directly to the customer from a third party (i.e., the entity does not control the good or service before it is transferred to the customer), it would be inappropriate to include the component part in the measure of progress, and revenue should therefore be adjusted accordingly. See Chapter 10 for further discussion of principal-versus-agent considerations.

8.5.6 Subsequent Measurement of an Entity’s Measure of Progress

ASC 606-10

25-35 As circumstances change over time, an entity shall update its measure of progress to reflect any changes in the outcome of the performance obligation. Such changes to an entity’s measure of progress shall be accounted for as a change in accounting estimate in accordance with Subtopic 250-10 on accounting changes and error corrections.

It is common for estimates related to an entity’s level of progress to change as the entity fulfills its promise to the customer. As a result, such estimates of an entity’s measure of progress should be updated on the basis of the most current information available to the entity. Consideration should be given to subsequent measurement to the extent that there are any changes in the outcome of the performance obligation. Such changes should be accounted for in a manner consistent with the guidance on accounting changes in ASC 250, which states that a “change in accounting estimate shall be accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both.” Accordingly, a change in the entity’s estimated measure of progress should be accounted for prospectively (i.e., prior periods are not restated, but there could be a cumulative-effect adjustment to revenue in the current period). Because the change represents a change in accounting estimate rather than any change in the scope or price of the contract, the guidance in the revenue standard on contract modifications (discussed in Chapter 9) would not apply. In addition, since this estimate is related to an entity’s recognition of revenue rather than measurement of revenue, the guidance on accounting for changes in the estimate of variable consideration (discussed in Chapter 7) would not apply.

Example 8-6

Entity A enters into a contract to construct a building in exchange for a fixed price of $2 million. Entity A concludes that it has a single performance obligation and that one of the criteria for recognizing revenue over time is met. In addition, A concludes that an input method is the most appropriate method for measuring its progress toward complete satisfaction. Accordingly, A measures its progress on the basis of costs incurred to date as compared with total expected costs.

At contract inception, A estimates that it will incur total costs of $900,000. After A incurs actual costs of $450,000, its estimate of total costs changes from $900,000 to $800,000. This change represents a change in accounting estimate and should be accounted for as follows:

Amount of revenue recognized to date — ($450,000 ÷ $900,000) × $2 million = $1 million.
Amount of revenue that should be recognized on the basis of the new estimate — ($450,000 ÷ $800,000) × $2 million = $1.125 million.
Amount of revenue recognized upon change in estimate — $1.125 million − $1 million = $125,000.

8.5.7 Reasonable Measure of Progress

ASC 606-10

Reasonable Measures of Progress

25-36 An entity shall recognize revenue for a performance obligation satisfied over time only if the entity can reasonably measure its progress toward complete satisfaction of the performance obligation. An entity would not be able to reasonably measure its progress toward complete satisfaction of a performance obligation if it lacks reliable information that would be required to apply an appropriate method of measuring progress.

25-37 In some circumstances (for example, in the early stages of a contract), an entity may not be able to reasonably measure the outcome of a performance obligation, but the entity expects to recover the costs incurred in satisfying the performance obligation. In those circumstances, the entity shall recognize revenue only to the extent of the costs incurred until such time that it can reasonably measure the outcome of the performance obligation.

As discussed in Section 8.5.1, the revenue standard requires an entity to select the method that faithfully depicts its progress toward completion. However, in some circumstances, an entity may not be able to reasonably measure progress toward completion.

During the development of the revenue standard, feedback considered by the FASB and IASB suggested that recognizing revenue solely on the basis of costs incurred (resulting in zero margin being recognized) is a widely understood and reasonable practice. As a result, the boards agreed that this is an important recognition practice and decided to incorporate the concept into the revenue standard. Specifically, the boards concluded that if an entity cannot reasonably measure progress but still expects to recover the costs incurred to satisfy the performance obligation, the entity should recognize revenue for its progress in satisfying the performance obligation by recognizing revenue in the amount of the costs incurred. However, this would only be appropriate if the entity cannot reasonably measure its progress, or until the entity is able to reasonably measure progress. In addition, an entity may need to evaluate whether it is required to recognize losses in its financial statements before those losses are incurred. Refer to Chapter 13 for considerations related to onerous performance obligations and recognition of such losses.

Importantly, this evaluation is separate from estimating and constraining variable consideration. Therefore, in long-term contracts, there are typically at least two key estimates made at contract inception and reassessed during the contract: (1) the entity’s current measure of progress and, separately, (2) the entity’s current estimate of any variable consideration (see Chapter 6 for further discussion).

The example below illustrates a situation in which progress toward complete satisfaction of a performance obligation cannot be reasonably measured.

Example 8-7

A contractor enters into a building contract with fixed consideration of $1,000. The contract is expected to take three years to complete and satisfies one of the criteria in ASC 606-10-25-27 for revenue to be recognized over time. At the end of year 1, management is unable to reasonably measure its progress toward complete satisfaction of the performance obligation (e.g., because it cannot reasonably measure total costs under the contract). Taking into account the progress to date and future expectations, management expects that total contract costs will not exceed total contract revenues. Costs of $100 have been incurred in year 1.

In this example, since the contractor is not able to reasonably measure the progress relative to the work performed to date but expects that costs are recoverable, only revenue of $100 should be recognized in year 1. Therefore, in year 1, revenue and costs of services of $100 are recognized, resulting in no profit margin.

8.5.8 Output Methods

The revenue standard outlines two types of methods for measuring progress: output methods and input methods. As stated in ASC 606-10-55-17, output methods “recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract.” Examples of output methods include surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units delivered or produced. Value to the customer should be an objective measure of the entity’s performance (i.e., the measure is directly observable, and information needed to apply the measure is readily available).

ASC 606-10

55-17 Output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract. Output methods include methods such as surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered. When an entity evaluates whether to apply an output method to measure its progress, the entity should consider whether the output selected would faithfully depict the entity’s performance toward complete satisfaction of the performance obligation. An output method would not provide a faithful depiction of the entity’s performance if the output selected would fail to measure some of the goods or services for which control has transferred to the customer. For example, output methods based on units produced or units delivered would not faithfully depict an entity’s performance in satisfying a performance obligation if, at the end of the reporting period, the entity’s performance has produced work in process or finished goods controlled by the customer that are not included in the measurement of the output.

55-19 The disadvantages of output methods are that the outputs used to measure progress may not be directly observable and the information required to apply them may not be available to an entity without undue cost. Therefore, an input method may be necessary.

Paragraph BC164 of ASU 2014-09 states that the FASB and IASB “decided that, conceptually, an output measure is the most faithful depiction of an entity’s performance because it directly measures the value of the goods or services transferred to the customer.” That is, the boards did not state that an output method is the preferred method but instead indicated that in most cases, an output method would be the most appropriate method that is consistent with recognizing revenue as value is transferred to the customer. Some stakeholders argue that an output method is generally the most appropriate method. However, a drawback of using an output method is that there may not always be a directly observable or objectively determined output to reliably measure an entity’s progress, and it could fail to measure progress between directly observable or objectively determined outputs. As a result, the boards noted that there may be instances in which it would be appropriate for an entity to use an input method (i.e., if that method would be less costly and would provide a reasonable measure of progress).

In redeliberations of the revenue standard, some stakeholders requested that the boards provide more guidance on when units-of-delivery or units-of-production methods would be appropriate. Although such methods appear to be output methods, they do not always provide the most faithful depiction of the entity’s performance. That is, these methods may disregard an entity’s efforts that result in progress toward completion when performance is satisfied over time, which could be material to the contract or even the financial statements as a whole. In addition, units-of-production or units-of-delivery methods may not be appropriate in contracts that provide design and production services because the transfer of produced items may not correspond to the actual progress made on the entire contract.

Therefore, in the selection of an output method for measuring progress and the determination of whether a units-of-delivery or units-of-production method is appropriate, it is important for an entity to carefully consider (1) all of the facts and circumstances of the arrangement and (2) how value is transferred to the customer.

8.5.8.1 Invoice Practical Expedient for Measuring Progress

ASC 606-10

55-18 As a practical expedient, if an entity has a right to consideration from a customer in an amount that corresponds directly with the value to the customer of the entity’s performance completed to date (for example, a service contract in which an entity bills a fixed amount for each hour of service provided), the entity may recognize revenue in the amount to which the entity has a right to invoice.

The revenue standard provides a practical expedient in ASC 606-10-55-18 that can be applied to performance obligations that meet the criteria in ASC 606-10-25-27 to be satisfied over time. Most commonly referred to as the “invoice practical expedient,” this option allows an entity to recognize revenue in the amount of consideration to which the entity has the right to invoice when the amount that the entity has the right to invoice corresponds directly to the value transferred to the customer. That is, the invoice practical expedient cannot be applied in all circumstances because the right to invoice a certain amount does not always correspond to the progress toward satisfying the performance obligation. Therefore, an entity should demonstrate its ability to apply the invoice practical expedient to performance obligations satisfied over time. Because the purpose of the invoice practical expedient is to faithfully depict an entity’s measure of progress toward completion, the invoice practical expedient can only be applied to performance obligations satisfied over time (not at a point in time).

8.5.8.1.1 Using the Invoice Practical Expedient When the Unit Price or Rate Varies During the Contract Period

The option to apply the invoice practical expedient in ASC 606-10-55-18 is available only if the invoice amount represents the “amount that corresponds directly with the value to the customer of the entity’s performance completed to date (for example, a service contract in which an entity bills a fixed amount for each hour of service provided).”6

Stakeholders have questioned whether the invoice practical expedient may be used for contracts in which the unit price or rate varies during the contract period.

The FASB staff has noted that an entity must use judgment and that conclusions are likely to vary depending on the facts and circumstances. The staff believes that the invoice practical expedient could be used for both a contract in which the unit price varies during the contract period and a contract in which the rate varies during the contract period if the contracts’ respective price and rate changes reflect the “value to the customer of each incremental good or service that the entity transfers to the customer.”7

Connecting the Dots

In some industries, the price charged to the customer for each unit transferred may vary over the contract term. For example, a contract to supply electricity for several years may specify different unit prices each year depending on the forward market price of electricity at contract inception.

In this example, the contract to purchase electricity at prices that vary over the term of the contract depending on the forward market price of electricity at contract inception would qualify for the practical expedient because the rates per unit generally correlate to the value to the customer of the entity’s provision of each unit of electricity.

The above issue is addressed in Implementation Q&A 46 (compiled from previously issued TRG Agenda Papers 40 and 44). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

8.5.8.1.2 Applying the Invoice Practical Expedient to Contracts With Up-Front Consideration or Back-End Fees

An entity is not necessarily precluded from applying the invoice practical expedient in ASC 606-10-55-18 when a contract contains nonrefundable up-front consideration or back-end fees. However, the entity will need to use judgment in determining whether the amount invoiced for goods or services reasonably represents the value to the customer of the entity’s performance completed to date.

When the entity makes this assessment, an analysis of the significance of the up-front or back-end fees relative to the other consideration in the arrangement is likely to be important.

8.5.9 Input Methods

Input methods recognize revenue on the basis of an entity’s efforts or inputs toward satisfying a performance obligation. Examples include resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used.

ASC 606-10

55-20 Input methods recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation. If the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on a straight-line basis.

A common input method is the “cost-to-cost” method, as implied by the use of the term “costs incurred” in ASC 606-10-55-20 as an example of a basis for measuring progress. When applying the cost-to-cost method, an entity uses costs incurred as compared with total estimated costs. Types of costs that an entity may consider when applying the cost-to-cost method include direct labor, direct materials, subcontractor costs, and other costs incurred that are related to the entity’s performance under a contract. In addition, while certain overhead costs may be appropriate for consideration under the cost-to-cost method, an entity should use judgment to include only allocated costs (in measuring progress) that actually contribute to the transfer of control to the customer of the performance obligation(s). For example, it would generally not be appropriate for an entity to include general and administrative costs or sales and marketing costs in measuring the progress toward satisfying a performance obligation unless (1) those costs are directly chargeable to the customer and (2) including such costs faithfully depicts the entity’s progress toward satisfying the performance obligation. In making this distinction, entities may refer to ASC 340-40-25-7, which includes types of costs that are directly related to a contract.

8.5.9.1 Inefficiencies and Wasted Materials

ASC 606-10

55-21 A shortcoming of input methods is that there may not be a direct relationship between an entity’s inputs and the transfer of control of goods or services to a customer. Therefore, an entity should exclude from an input method the effects of any inputs that, in accordance with the objective of measuring progress in paragraph 606-10-25-31, do not depict the entity’s performance in transferring control of goods or services to the customer. For instance, when using a cost-based input method, an adjustment to the measure of progress may be required in the following circumstances:

When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation. For example, an entity would not recognize revenue on the basis of costs incurred that are attributable to significant inefficiencies in the entity’s performance that were not reflected in the price of the contract (for example, the costs of unexpected amounts of wasted materials, labor, or other resources that were incurred to satisfy the performance obligation). . . .

While an entity may conclude that an input method is the most appropriate method to measure progress of a contract (e.g., cost-to-cost method), there may be instances or anomalies in which costs incurred are attributable to inefficiencies or wasted materials and do not contribute to the satisfaction of the performance obligation. In these circumstances, an entity should exclude such factors that do not accurately depict the entity’s progress toward satisfying the performance obligation.

In early drafts of the revenue standard, the FASB and IASB proposed requiring an entity to exclude inefficiencies and wasted materials from any input measure (i.e., a cost-to-cost measure). However, many comment letter respondents explained that often there is an “expected” level of inefficiency or waste factored into a project from the outset and that separately, circumstances involving “unexpected” inefficiencies or waste may occur once a project has commenced. Those comment letter respondents requested further clarification from the boards regarding the amounts that should be excluded from any measure of progress. However, instead of providing additional detailed guidance on “expected” versus “unexpected” inefficiencies, the boards ultimately decided to emphasize the objective of measuring progress toward complete satisfaction of the performance obligation to depict an entity’s performance in the contract. That is, when an input method is used, it should be adjusted if it is not truly depicting the measure of progress.

In many construction and manufacturing contracts, some level of wastage is normal and unavoidable as part of the construction or manufacturing process. Expected levels of such wastage will be forecasted in an entity’s budgets and estimates and included in contract costs. However, there may be circumstances in which an entity experiences significant unexpected levels of wasted materials, labor, or other resources.

ASC 606 contains specific guidance on accounting for costs of fulfilling a contract. ASC 340-40-25- 8(b) specifies that costs of wasted materials, labor, or other resources to fulfill a contract that are not reflected in the price of the contract should be recognized as expenses when incurred.

Abnormal waste costs do not represent additional progress toward satisfaction of an entity’s performance obligation and, if revenue is being recognized over time, should be excluded from the measurement of such progress. If the entity is using costs incurred to date as an input method to measure progress toward complete satisfaction of its performance obligation, it should be careful to ensure that revenue attributed to work carried out is not increased to offset additional costs incurred when abnormal or excessive costs arise as a result of inefficiency or error. In particular, ASC 606-10-55-21(a) states that when using a cost-based input method, entities may be required to adjust the measure of progress when costs are incurred that are “attributable to significant inefficiencies in the entity’s performance that were not reflected in the price of the contract.”

8.5.9.2 Uninstalled Materials

ASC 606-10

b. When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation. In those circumstances, the best depiction of the entity’s performance may be to adjust the input method to recognize revenue only to the extent of that cost incurred. For example, a faithful depiction of an entity’s performance might be to recognize revenue at an amount equal to the cost of a good used to satisfy a performance obligation if the entity expects at contract inception that all of the following conditions would be met:

1. The good is not distinct.

2. The customer is expected to obtain control of the good significantly before receiving services related to the good.

3. The cost of the transferred good is significant relative to the total expected costs to completely satisfy the performance obligation.

4. The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good (but the entity is acting as a principal in accordance with paragraphs 606-10- 55-36 through 55-40).

There may be instances in which an entity is acting as a principal and promises to deliver a good and a service that are not distinct from each other, but the good is transferred before the service is provided. For example, this could occur when a piece of equipment is transferred to the customer, but the entity has also promised to install the equipment or the piece of equipment is a component part of an overall highly customized project being provided to the customer. In these types of circumstances, a strict, literal interpretation of an input method to measure progress may not be appropriate, and the entity may need to carefully consider its actual progress toward completion. To assist in the interpretation of the revenue standard’s general guidance on input methods in these circumstances, the boards provided additional guidance (see ASC 606-10-55-21(b), reproduced above) and included an example illustrating the treatment of uninstalled materials (see Example 19, reproduced below).

Through both the additional guidance and the example, the boards clarified that the adjustment to the input method for uninstalled materials was to ensure that the input method is consistent with the objective of measuring progress toward complete satisfaction of a performance obligation.

In the scenario described above (the promised delivery and installation of equipment), it would be inappropriate to continue recognizing the equipment as inventory after delivery but before installation. Rather, the entity should recognize revenue for the entity’s performance (i.e., for the delivery of the equipment) in accordance with the core principle of the standard. However, the boards acknowledged that an entity may have difficulty determining the amount of revenue to recognize for the delivery of the equipment when the delivery is not distinct from the installation. For example, if the entity were to use a cost-to-cost method to measure progress, resulting in recognition of a contract-wide profit margin for the delivery of the equipment, the entity’s performance could consequently be overstated, resulting in an overstatement of revenue. Another option would be for the entity to estimate a profit margin (which differs from the contract-wide profit margin); however, this approach would be complex and could result in the recognition of too much revenue for the transfer of goods or services that are not distinct. Ultimately, the boards decided that in certain circumstances, an entity should only recognize revenue in the amount of the cost of those goods that have been transferred to the customer (and not include any amount of profit margins). This adjustment is necessary if delivery of the uninstalled good does not depict the entity’s performance. This adjustment to the cost-to-cost measure of progress is most appropriate for scenarios in which the goods (e.g., the equipment) compose a large portion of the total cost of the contract, and it ensures that the input method meets the objective of measuring progress to depict the entity’s performance.

In addition, the boards also clarified that if an entity selects an input method, (e.g., the cost-to-cost method), it would need to adjust the measure of progress if including some of the costs incurred would not truly depict the entity’s performance in the contract.

ASC 606-10

Example 19 — Uninstalled Materials

55-187 In November 20X2, an entity contracts with a customer to refurbish a 3-story building and install new elevators for total consideration of $5 million. The promised refurbishment service, including the installation of elevators, is a single performance obligation satisfied over time. Total expected costs are $4 million, including $1.5 million for the elevators. The entity determines that it acts as a principal in accordance with paragraphs 606-10-55-36 through 55-40 because it obtains control of the elevators before they are transferred to the customer.

55-188 A summary of the transaction price and expected costs is as follows:

55-189 The entity uses an input method based on costs incurred to measure its progress toward complete satisfaction of the performance obligation. The entity assesses whether the costs incurred to procure the elevators are proportionate to the entity’s progress in satisfying the performance obligation in accordance with paragraph 606-10-55-21. The customer obtains control of the elevators when they are delivered to the site in December 20X2, although the elevators will not be installed until June 20X3. The costs to procure the elevators ($1.5 million) are significant relative to the total expected costs to completely satisfy the performance obligation ($4 million). The entity is not involved in designing or manufacturing the elevators.

55-190 The entity concludes that including the costs to procure the elevators in the measure of progress would overstate the extent of the entity’s performance. Consequently, in accordance with paragraph 606-10- 55-21, the entity adjusts its measure of progress to exclude the costs to procure the elevators from the measure of costs incurred and from the transaction price. The entity recognizes revenue for the transfer of the elevators in an amount equal to the costs to procure the elevators (that is, at a zero margin).

55-191 As of December 31, 20X2, the entity observes that:

Other costs incurred (excluding elevators) are $500,000.
Performance is 20% complete (that is, $500,000 ÷ $2,500,000).

55-192 Consequently, at December 31, 20X2, the entity recognizes the following:

The example below illustrates the treatment of prepaid costs for work to be performed in the future.

Example 8-8

A contractor undertakes a three-year contract. At the end of year 1, management estimates that the total revenue on the contract will be $1,000 and that total costs will be $900, of which $300 has been incurred to date. Of the $300 incurred to date, $50 is related to materials purchased in year 1 that will be used in year 2. The materials purchased in advance are generic and were not specifically produced for the contract. The contractor has determined that the contract is a single performance obligation that will be satisfied over time. To calculate the progress toward complete satisfaction of its performance obligation, the contractor uses an input method based on costs incurred to date in proportion to the total anticipated contract costs.

ASC 606-10-55-21 states, in part, that “an entity should exclude from an input method the effects of any inputs that . . . do not depict the entity’s performance in transferring control of goods or services to the customer.”

Materials purchased that have yet to be used may not form part of the costs that contribute to the transfer of control of goods or services to the customer. For example, if materials have been purchased that the contractor is merely holding at the job site, and these materials were not specifically produced or fabricated for any projects, transfer of control of such materials will generally not have passed to the customer.

Accordingly, in this example, an adjustment is required for the purchased materials not yet used because the materials are related to the work to be performed in the future, and control of the materials has not transferred to the customer, as illustrated below.

Therefore, in year 1, contract revenue of $280 (28% of $1,000) and contract costs of $250 are recognized in profit or loss. Contract costs of $50 corresponding to the purchased materials not yet used are recognized as inventories. See also Section 8.5.5.

8.5.9.3 Incremental Costs of Obtaining a Contract

When using an input method, an entity should exclude from its measure of progress the costs it incurred to obtain the contract with the customer because such costs do not depict an entity’s performance under the contract. Chapter 13 discusses how to account for the incremental costs of obtaining a contract with a customer.

ASC 606-10-25-31 states that an entity’s objective, when measuring progress, is to depict its performance in transferring control of goods or services promised to a customer. ASC 606-10-55-21 also specifies that inputs that do not depict such performance are excluded from the measurement of progress under an input method.

Costs of obtaining a contract are not a measure of fulfilling it and, accordingly, are excluded from the measurement of progress (both the measure of progress to date and the estimate of total costs incurred to satisfy the performance obligation) irrespective of whether they are recognized as an asset in accordance with ASC 340-40-25-1. Such assets are amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset is related (see Chapter 13 for additional information). Accordingly, rather than being used to determine the pattern of revenue recognition, capitalized costs of obtaining a contract are amortized in accordance with the expected pattern of transfer of goods or services. In contrast, costs of fulfilling the contract that depict an entity’s performance would be included in the measurement of progress.

8.5.10 Measuring Progress — Stand-Ready Obligations

As discussed in Section 5.4.3, step 2 of the revenue model (i.e., identify the performance obligations) addresses how to assess the nature of a stand-ready obligation on the basis of what, in fact, the entity is promising to deliver to the customer (i.e., a discrete set of performance obligations over a fixed period or a performance obligation that is unlimited over a fixed period). This concept is illustrated in Example 18 of ASC 606, which is reproduced below.

ASC 606-10

Example 18 — Measuring Progress When Making Goods or Services Available

55-184 An entity, an owner and manager of health clubs, enters into a contract with a customer for one year of access to any of its health clubs. The customer has unlimited use of the health clubs and promises to pay $100 per month.

55-185 The entity determines that its promise to the customer is to provide a service of making the health clubs available for the customer to use as and when the customer wishes. This is because the extent to which the customer uses the health clubs does not affect the amount of the remaining goods and services to which the customer is entitled. The entity concludes that the customer simultaneously receives and consumes the benefits of the entity’s performance as it performs by making the health clubs available. Consequently, the entity’s performance obligation is satisfied over time in accordance with paragraph 606-10-25-27(a).

55-186 The entity also determines that the customer benefits from the entity’s service of making the health clubs available evenly throughout the year. (That is, the customer benefits from having the health clubs available, regardless of whether the customer uses it or not.) Consequently, the entity concludes that the best measure of progress toward complete satisfaction of the performance obligation over time is a time-based measure, and it recognizes revenue on a straight-line basis throughout the year at $100 per month.

For a stand-ready obligation that is satisfied over time, an entity may measure progress toward complete satisfaction of the performance obligation by using one of various methods, including input and output methods. Although ASC 606-10-55-16 through 55-21 provide guidance on when an entity would use an output or input method, the guidance does not prescribe the use of either method. However, an entity does not have a “free choice” when selecting a measure of progress. While an entity may use either type of method, the actual method selected should be consistent with the clearly stated objective of depicting the entity’s performance (i.e., the entity’s satisfaction of its performance obligation in transferring control of goods or services to the customer).

Further, although ASC 606 does not permit an entity to default to a straight-line measure of progress on the basis of the passage of time (because a straight-line measure of progress may not faithfully depict the pattern of transfer), ASC 606 does not prohibit the use of a straight-line measure of progress, and such a time-based method may be reasonable in some cases depending on the facts and circumstances. An entity would need to use judgment to select an appropriate measure of progress on the basis of the arrangement’s particular facts and circumstances.

Example 18 in ASC 606-10-55-184 through 55-186 illustrates a health club membership involving an entity’s stand-ready obligation to provide a customer with one year of access to any of the entity’s health clubs. In the example, the entity determines that the customer benefits from the stand-ready obligation evenly throughout the year.

Other examples of stand-ready obligations include the following:

Snow removal services — An entity promises to remove snow on an “as needed” basis (i.e., a single amount is paid irrespective of the number of times the snow removal services are performed). In this type of arrangement, the entity does not know and most likely cannot reasonably estimate whether, how often, and how much it will snow. This suggests that the entity’s promise is to stand ready to provide the snow-removal services on a when-and-if-needed basis. As a result, a time-based measure of progress may be appropriate. However, a pure straight-line recognition pattern over each month of an annual contract may not be reasonable if that would allow recognition of revenue during months (i.e., warmer months) when the entity either is not performing or is performing to a markedly reduced extent. For such a fixed-fee service contract, although the contract term is fixed (i.e., one year), the pattern of benefit of the services to the customer, as well as the entity’s efforts to fulfill the contract, would most likely vary throughout the year because there would be less expectation of snowfall during the warmer months of the year.
Unspecified software upgrades — An entity promises to make unspecified (i.e., when-and-if-available) software upgrades available to a customer. The nature of the entity’s promise is fundamentally one of providing the customer with assurance that any upgrades or updates developed by the entity during the period will be made available because the entity stands ready to transfer updates or upgrades when and if they become available. The customer benefits from the guarantee evenly throughout the contract period because any updates or upgrades developed by the entity during the period will be made available. As a result, a time-based measure of progress over the period during which the customer has rights to any unspecified upgrades developed by the entity would generally be appropriate unless the entity’s historical experience suggests that another method would more faithfully depict the pattern of transfer of the when-and-if-available upgrades to the customer.

The determination of an appropriate measure of progress for a stand-ready obligation is addressed in Implementation Q&A 49 (compiled from previously issued TRG Agenda Papers 16 and 25). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

Once an entity has determined the nature of the promise to the customer, the entity must determine how to appropriately recognize revenue. As discussed in Section 8.1.1, an entity must first go through steps 1 through 4 before applying step 5 to determine when to recognize revenue. Specifically, an entity must identify the nature of the promised goods and services and determine whether those goods and services are distinct (as described in Chapter 5) before determining the appropriate pattern of revenue recognition. For example, an entity may sell products through a third-party distributor and implicitly or explicitly promise to provide a stand-ready service to the end customer. In these situations, the entity should begin to recognize revenue for a stand-ready service promised to a customer’s customer when the end customer has the ability to access, and begin to consume and benefit from, the service. In addition, as illustrated in Examples 8-9 and 8-10, the pattern of revenue recognition may differ depending on the nature of the promised goods and services in the contract. Therefore, it is critical that an entity carefully assess the promised goods and services in the contract before jumping to revenue recognition in step 5. In some instances, an entity may be providing a service of standing ready to provide as many goods or services as needed by a customer when called upon (i.e., a stand-ready obligation). However, in other instances, an entity may be available to provide goods or services when called upon by a customer, but the customer only has a right to a specified amount of goods or services.

In the two examples below, Entity X enters into two different contracts, one with Customer A and the other with Customer B, to provide cloud computing capacity. Because of the nature of X’s business, very little incremental effort is required as X’s customers use the cloud computing capacity.

Example 8-9

Contract With Customer A for a Specified Quantity

Entity X enters into a three-year contract with A, under which A receives the right to a specified quantity of cloud computing capacity on an “as needed” basis. Unused capacity is forfeited at the end of the contract term. On the basis of historical usage, X does not expect A to use the cloud computing capacity evenly through the contract term but expects A to use all of the agreed capacity before the end of the contract. Once A has used the specified quantity of capacity, A no longer has the ability to use the service, and additional capacity must be separately negotiated.

As discussed in Section 5.4.3.2, for an entity to distinguish between a stand-ready obligation and an obligation to provide a defined amount of goods or services, it will often be helpful to focus on the extent to which the customer’s use of a resource affects the remaining resources to which the customer is entitled.

In the circumstances described, the nature of X’s promise is to provide a fixed capacity, and its performance under the contract is demonstrated by the actual discrete delivery of capacity. In contrast to the example in paragraph BC160 of ASU 2014-09 (see Section 5.4.3.2), when A uses cloud computing capacity, A’s usage does affect the amount of the remaining services to which A is entitled, indicating that X’s promise is to deliver specified services rather than to stand ready.

As a result, X should recognize revenue in a manner that is consistent with A’s usage of the capacity during the reporting period (i.e., by applying a usage-based measure of progress). It would not be appropriate for X to recognize revenue by using a ratable or straight-line method.

Example 8-10

Contract With Customer B for an Unlimited Quantity

In contrast to X’s contract with A, X’s contract with B is to provide unlimited cloud computing capacity as required over a three-year term. Because X has agreed to provide an unlimited quantity of cloud computing capacity, the nature of X’s promise to B is to continuously stand ready to make unlimited cloud computing capacity available, and B’s entitlement to future capacity is not affected by the extent to which B already used capacity. In such circumstances, straight-line revenue recognition might be an appropriate representation of X’s transfer of control for this stand-ready obligation. However, X should consider information from similar contracts regarding historical patterns of performance in using judgment to select an appropriate measure of progress based on its service of making the cloud computing capacity available (which is not necessarily the same as when the customers use the capacity made available to them).

Connecting the Dots

In some arrangements — specifically, arrangements involving software as a service (SaaS) — it may not always be clear whether the nature of the promise is (1) an obligation to provide a specified amount of services (e.g., 5,000 transactions processed through software provided as a service) or (2) a stand-ready obligation to provide services when and if called upon (e.g., to process all of the transactions required through SaaS). Sometimes in practice, an entity may price a SaaS arrangement on the basis of volume expectations but may still be required to stand ready to provide the service for the entire contractual period regardless of whether the customer exceeds the volumes expected at contract inception. In other cases, a customer’s right to use the service may terminate once the initial volumes are exceeded, or the contract would be modified once the volumes are exceeded. In all of these circumstances, an entity will need to carefully consider the contractual rights and obligations to appropriately identify the nature of the promise and to determine an appropriate measure of progress toward complete satisfaction of the performance obligation.

Footnotes

Footnote 1 in TRG Agenda Paper 53 notes that as used in the discussion, “milestones” refer to measures of progress (i.e., they correlate to an entity’s performance toward complete satisfaction of a performance obligation) rather than the “milestone method” under legacy U.S. GAAP.

Quoted from paragraph 19 of TRG Agenda Paper 53.

Quoted from Implementation Q&A 51.

Quoted from Implementation Q&A 47.

Quoted from ASC 606-10-55-18.

Quoted from paragraph BC167 of ASU 2014-09.

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