Revenue Recognition — Determining Whether a Performance Obligation Is Satisfied at a Point in Time or Over Time
Did you know that entities should not presume that revenue should be recognized at a point in time for the sale of “goods” under the FASB’s new revenue standard (the guidance in ASU 2014-09,1 as amended2)? That is, under the ASU, revenue from the sale of what many would consider goods (e.g., customized products) may be recognized over time because an entity may in effect be providing a manufacturing “service.”
When evaluating the appropriate timing of revenue recognition, an entity should first consider whether it meets one of the following criteria in ASC 606-10-25-27 to recognize revenue 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 third criterion (ASC 606-10-25-27(c)) was developed because the FASB and the International Accounting Standards Board observed that applying the first two criteria could sometimes be challenging. In addition, the boards believed that there are other scenarios economically similar to those described in ASC 606-10-25-27(a) and (b) in which an entity’s performance is more akin to a service than the sale of a good. Paragraph BC132 of ASU 2014-09 states that the boards regarded the third criterion as potentially necessary not only “for services that may be specific to a customer (for example, consulting services that ultimately result in a professional opinion for the customer) but also for the creation of tangible (or intangible) goods.” This is because some arrangements may require the delivery of a good (or an intangible asset), but the asset created and delivered is highly customized for a specific customer and the entity is guaranteed an economic return (i.e., profit on top of costs incurred) as it performs under the contract (i.e., creates the asset). Economically, these arrangements are similar to service contracts, and the new revenue standard requires them to be accounted for as such.
The third criterion includes two subcriteria that identify contractual obligations that are economically similar to service obligations: “[t]he 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 remainder of this publication focuses on key considerations related to these subcriteria.
No Alternative Use
Because the new revenue standard requires that an entity recognize revenue when or as control of a good or service is transferred to a customer, the two subcriteria were developed to identify instances in which control of a customized good is or is not transferred to a customer over time. The notion of alternative use was developed to distinguish circumstances in which the entity’s performance creates an asset that is controlled by the entity rather than by the customer. If the asset has an alternative use, the asset could easily be redirected to another customer, which means the entity, rather than the customer, controls the asset while it is being created. This is commonly the case for standard inventory-type items for which an entity could substitute assets to satisfy its performance obligation (and the customer therefore could not restrict the entity from directing the asset to another customer). The criterion in ASC 606-10-25-27(c) applies to circumstances in which the entity creates a highly customized or specialized asset that the entity is practically precluded from redirecting to another customer without incurring significant costs or a significant economic loss.
In some cases, the assessment of whether an asset has an alternative use will be straightforward, while in other cases, an entity will need to apply significant judgment to determine whether the asset has an alternative use.
The questions below are commonly raised when an entity is evaluating whether an asset has an alternative use to that entity.
Should an entity consider both contractual and practical limitations related to its ability to redirect the asset? — Yes. In making the assessment of whether an asset has an alternative use to an entity, the entity needs to consider both practical limitations and contractual restrictions on redirecting the asset for another use. For example, if the terms of the contract indicate that the entity is prohibited from transferring the asset to another customer and that restriction is substantive, the entity would conclude that the asset does not have an alternative use because the entity is contractually prohibited from redirecting the asset for another use. That is, the asset is being created specifically for, and can be transferred to, only the customer.ASC 606-10-55-10 states that a practical limitation exists “if an entity would incur significant economic losses to direct the asset for another use.” ASC 606-10-55-10 further notes that a significant economic loss could exist if the entity either (1) “would incur significant costs to rework the asset” or (2) “would only be able to sell the asset at a significant loss.”
- Does the new revenue standard define “significant” when an entity is determining whether it is practically limited in its ability to redirect the asset for another use? — No. ASC 606 does not define “significant.” In a manner similar to other areas of U.S. GAAP (and other areas in the new revenue standard), an entity should apply judgment when determining whether the significance threshold is reached.
- Should an entity consider protective rights related to the asset? — No. Contractual restrictions that provide the customer with a protective right are not sufficient to establish that there is no alternative use for the asset. Protective rights typically allow the entity to substitute the asset, or redirect the asset, without the customer’s knowledge. For example, terms of the contract may indicate that the entity cannot transfer a good because the customer has legal title to the goods in the contract; however, these terms act merely as protection in the event of liquidation, and the entity can physically substitute the asset or redirect it to another customer for little cost. This type of contractual restriction is a protective right and would not be viewed as transferring control to the customer. An entity should apply judgment when assessing whether a contractual restriction represents a protective right or a substantive restriction that affects the entity’s ability to redirect the asset.
- Should an entity periodically reevaluate whether an asset has an alternative use in a contract? — No. The assessment of alternative use should be performed at contract inception and should not be revisited. If the asset subsequently has an alternative use (e.g., a substantive aftermarket is established for the asset), the entity would no longer meet the criterion in ASC 606-10-25-27(c) for recognizing revenue over time for future contracts to manufacture and deliver the asset. However, if the original contract is not modified, the entity would not change its accounting for the contract even if market conditions change in such a way that the asset has an alternative use because of changes in the customer base (e.g., because of the expectation of aftermarket sales).
- Does the conclusion depend on the timing of the customization of the asset (e.g., at the beginning, middle, or end of the production process)? — No. Regardless of the timing of the customization in the production process (i.e., when the good has no alternative use), an entity should consider whether the completed asset could be redirected to another customer without incurring significant additional costs or a significant loss. If the completed asset is deemed to have no alternative use, that aspect of the criterion in ASC 606-10-25-27(c) would be met.
The aforementioned questions are not all encompassing but may be helpful to an entity evaluating this over time revenue recognition criterion.
Enforceable Right to Payment
In addition to concluding that there is no alternative use for an asset, an entity must also conclude that it has an enforceable right to payment for performance completed to date. The boards reasoned that if the entity is creating a highly specialized or customized asset at the customer’s direction (i.e., the entity meets the first subcriterion in ASC 606-10-25-27(c)), the entity would want to be economically protected from the risk associated with doing so. This is because if the contract were terminated, without an enforceable right to payment, the entity would be left with an asset with little or no value. Requiring a customer to pay for performance completed to date suggests that the customer (rather than the entity) controls the customized good as it is being created. In other exchange transactions (e.g., for the sale of noncustomized goods), entities typically have an enforceable right to payment once control of the good transfers to the customer. Further, the fact that the customer is obligated to pay for the performance completed to date suggests that it received some economic benefit from the performance.
The questions below are commonly raised when an entity is evaluating whether it has an enforceable right to payment for performance completed to date.
What factors should an entity consider in assessing whether it has an enforceable right to payment? — An entity should consider the terms of the contract, specifically the termination provisions and related penalties associated with termination, when evaluating whether it has an enforceable right to payment. In addition to assessing the terms of the contract, an entity should consider the following factors as noted in ASC 606-10-55-14:
“Legislation, administrative practice, or legal precedent [that] confers upon the entity a right to payment for performance to date even though that right is not specified in the contract with the customer.”
“Relevant legal precedent [that] indicates that similar rights to payment for performance completed to date in similar contracts have no binding legal effect.”
“An entity’s customary business practice of choosing not to enforce a right to payment that has resulted in the right being rendered unenforceable in that legal environment.”See the question below for additional considerations on the evaluation of whether an enforceable right to payment exists when an entity chooses not to enforce its right to payment.
Does an entity have an enforceable right to payment if it has the right to recover only costs or lost profit from the customer in the event of a contract termination? — No. The new revenue standard is clear that the right to payment for performance completed to date must include compensation for costs incurred to date plus a reasonable profit margin. An enforceable right to payment would not exist if an entity has the right to require the customer to reimburse it only for costs incurred (without a margin) or lost profit.However, the entity does not need to have an enforceable right to payment for all costs incurred to date plus a reasonable margin. Specifically, the fact that an entity would not be entitled to a reimbursement for raw materials not yet placed into production (or entitled to only a reimbursement of costs for the raw materials) would not preclude the entity from concluding that an enforceable right to payment exists. This is because 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 costs plus a margin for such items. As long as the entity has an enforceable right to payment once it has integrated the raw materials or work in process into the project, it would meet the second subcriterion in ASC 606-10-25-27(c).
What is a reasonable profit margin? — As discussed above, the new revenue standard is clear that the right to payment for performance completed to date must include compensation for costs incurred to date plus a reasonable profit margin. However, the new revenue standard does not prescribe a bright-line threshold for what constitutes “reasonable.” Determining whether a specified margin in the contract is reasonable requires judgment. A reasonable profit margin does not necessarily mean the profit margin that the entity would earn on the entire contract once completed (i.e., if the contract were to be terminated at any point in time, the partially completed asset may not be proportional to the value of the contract if it was completed). Rather, a reasonable profit margin should be (1) based on a reasonable proportion of the entity’s expected profit margin or (2) a reasonable return on the entity’s cost of capital.Note that some contracts may be priced at a loss (i.e., a negative margin). This might be the case in situations in which an entity expects to be awarded optional contracts for additional goods or services that relate to the customized good. A contract that is priced to result in a negative margin may still meet the criterion in ASC 606-10- 25-27(c) if the entity has an enforceable right to payment for performance completed to date.
Does the entity need to have a present unconditional right to payment to conclude that it has an enforceable right to payment? — No. While the right to payment must be an enforceable right to demand or retain payment (or both), it does not need to be a present unconditional right to payment in the event that the customer terminates the contract before the asset is fully completed. ASC 606-10-55-12 notes that “[i]n many cases, an entity will have an unconditional right to payment only at an agreed-upon milestone or upon complete satisfaction of the performance obligation.” In these cases, the entity should evaluate whether it would have the “right to demand or retain payment for performance completed to date if the contract were to be terminated before completion for reasons other than the entity’s failure to perform as promised.”
Should an entity consider its intent or past practice related to the enforcement of contractual or legal rights when evaluating whether it has an enforceable right to payment? — Generally, no. An entity may have an established practice of not enforcing its contractual or legal rights (e.g., not continuing to transfer the goods or services for which it could seek payment, not seeking a reimbursement in excess of cost, not collecting a penalty from the customer), or it may assert that it has no intention of enforcing its contractual or legal rights. That is, it may be uncommon for an entity to pursue legal action against a customer if the customer canceled a contract, especially when there is an ongoing customer-vendor relationship.Notwithstanding this fact, an entity’s intent or past practice of enforcing payment should generally not be considered in the evaluation of whether the entity has an enforceable right to payment. The determination of whether an enforceable right to payment exists is evaluated under the terms of the contractual arrangement as a matter of law. An entity’s intent or past practice related to the enforcement of contractual or legal rights should be considered only if the intent or past practice has created a legal precedent as a matter of law that negates the enforceable right in a contract.
Does a deposit or prepayment represent an enforceable right to payment? — Generally, no. A deposit or payment to compensate the entity for inconvenience or loss of profit in the event of a termination does not represent an enforceable right to payment because it is not compensating the entity for performance completed to date. However, if the customer pays in full up front, this could be viewed as a right to payment if the entity is able to retain all or a portion of the payment for performance completed to date in the event of a contract termination.
What if the contract does not explicitly specify an entity’s right to payment upon contract termination? — We believe that when a contract’s written terms do not specify the entity’s right to payment upon contract termination, the entity can presume that it does not have an enforceable right to payment (i.e., the contract does not meet the criterion in ASC 606-10-25-27(c) for over time revenue recognition).However, if the entity asserts that it has an enforceable right to payment when such a right is not explicitly provided for in the contract, we would expect the entity to support its assertion on the basis of legislation, administrative practice, or legal precedent. This analysis would need to demonstrate that an enforceable right to payment exists in the relevant jurisdiction as a matter of law. The fact that the entity would have a basis for making a claim against the counterparty in a court of law would not be sufficient to support the existence of an enforceable right to payment.
Because (1) the evaluation of whether an enforceable right to payment exists depends, in part, on the termination provisions in the entity’s contract with the customer and the respective legal jurisdictions and (2) the entity’s contracts may differ among its customers, the entity may not be able to establish a one-size-fits-all policy for determining whether its customer contracts contain an enforceable right to payment. Rather, the entity may consider grouping contracts with similar termination provisions into portfolios or evaluating each contract individually to determine whether it has an enforceable right to payment.
It is critical that an entity appropriately evaluate whether its contracts to deliver a “good” are economically service contracts that result in over time revenue recognition rather than point in time revenue recognition. In addition to the timing of revenue recognition, this conclusion may affect the following areas in the new revenue standard:
Existence of a significant financing component — Depending on the length of the manufacturing process (i.e., the period over which revenue is recognized) and the timing of payment (e.g., upon delivery of the good), an entity may conclude that the contract contains a significant financing component for which the transaction price should be adjusted.
Capitalization of fulfillment costs — One of the criteria that must be met for an entity to capitalize certain contract fulfillment costs is that the costs generate or enhance a resource of the entity that it will use to satisfy its performance obligation(s) in the future. If the costs relate to satisfied or partially satisfied performance obligations (or it is not clear what the costs relate to), the costs would need to be expensed as incurred. This usually means that an entity that concludes that it is satisfying its performance obligations over time would not have an asset for work in process or finished goods inventory because the fulfillment costs would generally relate to satisfied or partially satisfied performance obligations. If, on the other hand, the entity concluded that it should recognize revenue at a point in time (e.g., upon shipping or delivery of the good), it may be clear that fulfillment costs enhance a resource of the entity that it will use to satisfy a performance obligation in the future (e.g., inventory), and such costs would therefore be capitalized.
Entities must determine the appropriate measure of progress for performance obligations that the entities have concluded are satisfied over time. The new revenue standard outlines two types of methods for measuring progress: output methods and input 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.” While an output method might be the most appropriate method of measuring progress in some instances (e.g., because the outputs used are directly observable and objectively determined), a drawback of using an output method is that there may not always be a directly observable output to reliably measure an entity’s progress. This is often the case for performance obligations that meet the over time recognition criterion in ASC 606-10-25-27(c) (i.e., the asset that the entity’s performance creates has no alternative use and the entity has an enforceable right to payment), because the main output provided to the customer is the completed customized good. Because delivery of the customized good does not occur until the end of the production process, an entity that uses an output method like units delivered to recognize revenue might not faithfully depict its progress toward the manufacturing of a customized good because such a method does not factor in work in progress related to undelivered goods (i.e., it does factor in the services provided over the manufacturing period). Therefore, we generally believe that it is more appropriate for an entity to use an input method to recognize revenue for performance obligations that meet the over time recognition criterion in ASC 606-10-25-27(c). Examples of appropriate input methods include, but are not limited to: (1) costs incurred, (2) labor hours expended, and (3) machine hours used.
Where to Find Additional Information
For more in-depth discussion and analysis of the appropriate timing of revenue recognition, as well as discussions of other topics related to the new revenue standard, see Deloitte’s A Roadmap to Applying the New Revenue Recognition Standard. If you have questions about the new revenue standard or need assistance with interpreting its requirements, please contact any of the following Deloitte professionals:
Deloitte & Touche LLP
+1 313 394 5362
Deloitte & Touche LLP
+1 415 783 6392
Deloitte & Touche LLP
+1 203 761 3039
Deloitte & Touche LLP
+1 312 486 5536
FASB Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers (Topic 606).
For a full list of final ASUs issued by the FASB to amend and clarify the guidance in ASU 2014-09, see Section 19.2.2 of Deloitte’s A Roadmap to Applying the New Revenue Recognition Standard. The guidance in ASU 2014-09, as amended, is codified primarily in FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers, and FASB Accounting Standards Codification Subtopic 340-40, Other Assets and Deferred Costs: Contracts With Customers.