Over the past several months, Clayton & McKervey has provided information about the new revenue recognition standard released by the Financial Accounting Standards Board (FASB); (Revenue from Contracts with Customers: Topic 606). The standard replaces the current revenue guidance found in multiple places in the FASB codification, and provides a single comprehensive standard that will apply to nearly all industries and will significantly change how revenue is recognized.
Five-Step Process
- Identify the contract with the customer
- Identify the performance obligations in the contract
- Determine the transaction price for the contract
- Allocate the transaction price to each specific performance obligation
- Recognize the revenue when the entity satisfies each performance obligation
Step Five
In step five, after successfully navigating steps one through four, it is time to recognize revenue. This happens as each performance obligation is met by transferring a promised good or service to a customer. The transfer is complete when a customer obtains control of an asset or a service.
Like many of the other steps, there are judgments to be made. One critical judgment is whether the performance obligation is satisfied at a point in time (i.e. the promised good or service is transferred to the customer all at once) or if it is satisfied over time (i.e. the good or service is transferred to the customer as performance occurs). It’s important to note that the determination about when a performance obligation is satisfied happens separately for each performance obligation in a contract.
Another important judgment is determining when a customer obtains control of the good or service. This determines the point at which the performance obligation is satisfied. The standard defines control as the ability to direct the use of, and obtain substantially all of the remaining benefits from the good or service in a reasonable way. Some examples include:
- Using the asset to produce goods or provide services
- Consuming it to improve an asset or decrease costs
- Selling or exchanging the asset for other valuable goods, services, or rights
- Transferring the asset to settle a liability
- Licensing or leasing the asset to others
- Pledging the asset as a security interest
- Holding the asset so that others cannot use it
Note that determining control as it applies in the revenue recognition standard is not always the same as the concept of control in other accounting standards, such as ASC Topic 810 – Consolidation or ASC Topic 860 – Transfers of Financial Assets. It is important to understand control in the context of ASC Topic 606 – Revenue from Contracts with Customers.
Again, performance obligations can be satisfied, and revenue recognized, over time or at a point in time. As covered in step two, one of the following criteria has to be met to recognize revenue over time:
- The customer receives and consumes the benefits of the goods or services as they are provided by the entity (services like cleaning, lawn care, certain accounting and legal services)
- The goods or services create or enhance an asset that the customer controls as the asset is created or enhanced (this would be common for contractors who may renovate a home owned by the customer, or build a structure on land owned by the customer)
- The asset created does not have an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date (some examples are custom design services, or construction of a custom product to customer specifications). An enforceable right to payment for performance completed to date should include the right to costs incurred to date and a reasonable profit margin.
When recognizing revenue over time, the objective is to do so in a pattern commensurate with the transfer of control to the customer. The standard allows the use of output or input models to measure progress towards completion.
Output Methods
Output methods recognize revenue based on the value transferred to the customer. Some examples of output methods are surveys of performance to date, appraisals of results achieved, milestones completed, time elapsed, and units produced. Many different output methods are acceptable provided they represent performance.
Input Methods
Input methods recognize revenue based on the effort to satisfy the performance obligations. Examples of input methods are resources consumed, labor hours expended, and machine hours used. Any wasted costs or costs requisitioned to a job but not used should not be included in estimating progress towards completion.
Under the new standard recognizing revenue over time is not a policy choice as the percentage of completion was prior to ASC 606. It is required for situations that meet the criteria noted above. If the criteria are not met then revenue is recognized at the point in time that control passes to the customer.
For more information about revenue recognition, contact Clayton & McKervey.
