Chapter 8 — Step 5: Determine When to Recognize Revenue

A manufacturer of automobile parts enters into a contract with a customer for the initial production of 1,000 parts for the customer’s new vehicle. The parts are highly customized and only compatible with the customer’s new vehicle (i.e., the parts would not function in other vehicles). The contract provides the manufacturer with an enforceable right to payment for its performance throughout the contract period in accordance with ASC 606-10-25-27(c). There are no contractual restrictions preventing the manufacturer from redirecting the finished parts to a third party. However, since an aftermarket for the parts does not exist at contract inception and there are no other customers to which the part can be readily directed, the manufacturer is limited practically from redirecting the parts for another use.

In this example, the contract for the initial production of parts meets the criterion in ASC 606-10-25-27(c) for recognizing revenue over time. In accordance with ASC 606-10-25-27(c), an entity is required to recognize revenue over time if the asset being produced has no alternative use and the entity has an enforceable right to payment. ASC 606-10-25-28 further requires an entity to determine “at contract inception” whether the asset being produced has an alternative use. Since the manufacturer in this fact pattern is limited practically from redirecting the parts for another use (because no aftermarket exists at contract inception), the parts do not have an alternative use. Since the parts do not have an alternative use and, as noted above, the contract provides an enforceable right to payment for the manufacturer’s performance throughout the contract period, the criterion in ASC 606-10-25-27(c) would be met. However, once an aftermarket for the parts does exist, the manufacturer would be able to redirect the parts to another party, thereby creating an alternative use. At that point, the criterion in ASC 606-10-25-27(c) for recognizing revenue over time would no longer be met for future contracts to manufacture and deliver the parts (including any modifications to the original contract that substantively change the performance obligation).

We acknowledge that in other situations, a manufacturer of parts may believe that it is highly probable that an aftermarket for the parts will exist in the future (e.g., after the development stage). In these situations, entities will need to apply judgment and consider all of the relevant facts and circumstances, including, but not limited to, (1) historical evidence, (2) the quantity of the parts, (3) the nature of the parts, (4) the stage of development, (5) the existence of a contract, and (6) contract negotiations. Entities may want to consult with their accounting advisers in such situations.

Entity X enters into a contract with Customer Y under which X will construct an asset for Y that has no alternative use to X. To build this machine, X acquires standard materials that it regularly uses in other contracts and manufactures some “generic” component parts for inclusion in the customer’s asset. These standard materials remain interchangeable with other items until actually deployed in the construction of the asset for Y.

If Y cancels the contract, X will be entitled to reimbursement for costs incurred for work completed to date plus a margin of 10 percent (which is considered to be a reasonable margin in accordance with ASC 606-10-55-11). However, X will not be reimbursed for any materials (e.g., subcomponent parts) that have been purchased for use in the contract but have not yet been used and are still controlled by X.

Under ASC 606-10-25-27(c), revenue from a contract should be recognized over time if 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” (emphasis added).

The asset that X is constructing for Y has no alternative use to X, and the terms of the contract reimburse X for the costs of work completed to date plus a reasonable margin. However, materials (e.g., subcomponent parts that may be classified as inventory) that have not yet been used are not part of “performance completed to date”; therefore, there is no requirement that the entity have an enforceable right to reimbursement for such items.

Under the contract termination provisions, if the customer terminates the contract early, X is entitled to payment of costs incurred plus a reasonable profit margin. However, the contractual terms do not include payment for standard materials or “generic” component parts that were specifically acquired for the project but not yet incorporated into the customized machine.

That is, if the raw materials or work in process has an alternative use before being integrated into the manufacturing process, the raw materials or work in process would not be considered costs of the contract until integrated into the manufacturing process. Consequently, the materials or work in process does not transfer to the customer until (1) integration of the materials or work in process into the project and (2) the entity has an enforceable right to payment.

Therefore, the absence of a right to payment for raw materials or work in process that has an alternative use does not preclude an entity from being able to conclude that a performance obligation is satisfied over time when the entity has an enforceable right to payment for performance completed to date once the entity has integrated the raw materials or work in process into the project. Accordingly, X’s contract with Y meets the condition in ASC 606-10-25-27(c) for recognition of revenue over time.

Entity A, a real estate developer, entered into sales and purchase agreements with various buyers before the completion of a property project. The properties are located in Country B. The sales and purchase agreements include the following key terms:

• A specific unit is identified in the contract.
• Entity A is required to complete the property in all respects in compliance with the conditions set out in the sales agreement and the related building plans within two years from the time when the sales contracts are entered into.
• The property remains at A’s risk until delivery.
• The buyer is not permitted at any time before delivery to sub-sell the property or transfer the benefit of the agreement. However, the buyer can at any time before the date of assignment mortgage the property to finance the acquisition of the property.
• The agreement specifies that the sales agreement can be canceled only when both the buyer and A agree to do so — in effect, the buyer does not have the right to cancel the sales agreement.
• If both the buyer and A agree to cancel the contract, A has the right to retain 10 percent of the total purchase price, and the buyer is required to pay for all necessary legal and transaction costs incurred by A in relation to the cancellation.
• If A fails to complete the development of the property within the specified two-year period, the buyer has the right to rescind the sales contract and A is required to repay to the buyer all amounts paid by the buyer together with interest. Otherwise, the buyer does not have a right to cancel the contract.
• The purchase consideration is payable as follows:

  • 5 percent of the entire sale consideration upon entering into the sales agreement.
  • 5 percent of the purchase consideration within one month from the date when the sales agreement is entered into.
  • 5 percent of the purchase consideration within three months from the date when the sales agreement is entered into.
  • The remaining 85 percent of the purchase consideration upon delivery of the property.

Note that for simplicity, this example does not address whether there is a significant financing component.

Under ASC 606, an entity satisfies a performance obligation over time when it transfers control of the promised good or service over time. ASC 606-10-25-27 states that an entity transfers control of a good or service over time and, consequently, satisfies a performance obligation and recognizes revenue over time if one of the following criteria is met:

Criterion (a) above is not relevant in the determination of whether revenue from real estate sales (before completion) should be recognized over time or at a point in time. This is because buyers generally do not consume all of the benefits of the property as the real estate developers construct the property; rather, those benefits are consumed in the future.

Criterion (b) above is not directly relevant either because, without further consideration of criterion (c), a conclusion cannot be reached about whether the buyers have control of the property as A develops the property. For example, property buyers may not obtain physical possession of or title to the property until construction is completed.

Entity A should focus on criterion (c), and particularly on (1) whether an asset has been created with an alternative use to the real estate developer and (2) whether the real estate developer has an enforceable right to payment for performance completed to date.

In accordance with ASC 606-10-25-28, an asset does not have an alternative use to an entity if the entity is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use.

With regard to contract restriction, ASC 606-10-55-8 states that the entity does not consider the possibility of a contract termination in assessing whether the entity is able to direct the asset to another customer.

Since each sales contract specifies the unit to be delivered, the property unit does not have an alternative use to A. The contract precludes A from transferring the specified unit to another customer.

The payment schedule per the sales and purchase agreement does not correspond to the performance completed to date. However, in assessing whether it has the right to payment for performance completed to date, A should not only consider the payment schedule but should also consider ASC 606-10-55-13, which states:

In the circumstances under consideration, the contract specifies that the customer cannot terminate the contract unless both the property developer and the buyer agree to do so. In effect, the buyer does not have the discretion to terminate the contract as it wishes.

ASC 606-10-25-28 requires an entity to consider the terms of the contract, as well as any laws that apply to the contract, when evaluating whether it has an enforceable right to payment for performance completed to date. If, taking into account practice and legal precedent in Country B, A has the right to continue to perform the contract and be entitled to all of the consideration as promised, even if the buyer acts to terminate the contract (as articulated in ASC 606-10-55-13 and ASC 606-10-55-88), A has the enforceable right to payment for performance completed to date.

The same response (i.e., the recognition of revenue over time) applies irrespective of whether A allows buyers to choose to pay the consideration on the basis of the agreed-upon payment schedule or to pay all of the consideration up front.

Since the asset does not have an alternative use to A, and provided that A has an enforceable right to payment for performance completed to date, it should recognize revenue over time. However, if A does not have an enforceable right to payment for the performance completed to date, it should recognize revenue at a point in time (i.e., at the point when the control of the property unit is transferred to the buyer, which would normally be at the time of delivery).

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.

Company A is a global mining company whose products — primarily iron ore pellets — are used in the integrated steel industry. Company A’s contracts with its customers include a provision under which title to, and the risk of loss, damage, or destruction of, iron ore pellets are not transferred to the customer until receipt of payment. This clause is intended to be protective, and its main objective is to provide additional protection to A in the event of nonpayment. (For purposes of this example, assume that collectibility is not in question.) Under these arrangements, which are governed by the UCC, A will ship the iron ore pellets to the customer’s facility before receiving payment. Upon delivery of the iron ore pellets to the customer’s facility, A has a present right to payment (i.e., the customer cannot refuse or withhold payment for iron ore pellets that have been delivered). Because of the nature of the products (tons of iron ore), once the iron ore pellets have been delivered to the customer’s facility, it is not practical to physically redirect them to another location, and physical risk of loss is not substantive since the pellets are virtually indestructible. Once delivered, the pellets are indistinguishable from pellets at the customer’s location for which title has been transferred (i.e., payment has been made). In addition, the contract does not prohibit the customer from consuming the pellets before payment. That is, the customer can direct the use of, and obtain the benefits from, the pellets once the pellets are delivered to the customer’s location.

The table below provides an assessment of indicators that control has been transferred to the customer.

Notwithstanding that A retains legal title, it is appropriate for A to recognize revenue upon delivery of the iron ore pellets. In light of the assessment of the control indicators in the table above and an assessment of the control principle, control of the iron ore pellets is transferred from the seller to the customer upon delivery even though title is not transferred until payment is received. Given the nature of the product, greater emphasis should be placed on the physical possession and right to payment indicators because while A may retain the right to redirect or repossess the goods in the event that the customer does not pay, A does not have the practical ability to do so. In addition, the risk of loss is not meaningful in this scenario since the product is virtually indestructible. Further, the contract does not prohibit the customer from consuming the goods before payment, and because of the pellets’ physical location (i.e., at the customer’s location), the customer has the ability to use the pellets in its own production facilities. Therefore, from the customer’s perspective, the customer controls the iron ore pellets once the pellets are delivered to the customer’s location.

Company A, which sells goods FOB destination (i.e., title does not pass to the buyer until the goods reach the agreed destination), is responsible for any loss in transit. To protect itself from loss, A contracts with the shipping company for the shipping company to assume total risk of loss while the goods are in transit.

Company A has not satisfied the performance obligation when the goods are shipped; the performance obligation is to provide the customer with the goods, whose title, risks and rewards of ownership, and physical possession will only be passed to the customer when the goods reach the agreed destination. Further, the fact that A has managed its risk while the goods are in transit by having a contract with the shipping company does not mean that it has transferred control of the goods to the customer at the time when the goods are shipped.

After performing the above analysis, A determines that control does not pass to the customer until the goods reach the agreed destination. Therefore, it is not appropriate for A to recognize revenue when the goods are shipped.