By: Jonathan Kraftchick, CPA
Blog Series: Revenue from Contracts with Customers
Post 5 of 6
Recognize Revenue as the Performance Obligations are Satisfied
We’ve already covered the first four steps in our previous articles. The fifth and final step is the fun one. This one allows you to finally put that revenue on the top line, right where it belongs.
Revenue allocated to a performance obligation (Step 4) should be recognized when the goods or services are transferred to the customer, which occurs when the customer has control of the asset or use of the service. At first glance, this isn’t terribly different than current guidance. Let’s take a closer look.
Control is the ability to direct the use and obtain substantially all of the benefits (we’ll define this later) from the asset or service. The following are some factors that could, (though not always) be indicators of control:
- The entity has a present right to payment for the asset.
- The customer has legal title to the asset—If an entity retains legal title solely as protection against the customer’s failure to pay, those rights of the entity would not preclude the customer from obtaining control of an asset.
- The entity has transferred physical possession of the asset.
- The entity has the ability to prevent others from directing the use of and obtaining the benefits from the asset or service.
- The customer has the significant risks and rewards of ownership of the asset—an entity should exclude any risks that give rise to a separate performance obligation. For example, if another performance obligation under the contract was to provide maintenance on a building, the transfer of control for that building would exclude the consideration of risk of maintenance costs.
- The customer has accepted the asset.
Benefit is the potential cash inflows or savings in cash outflows. Common examples of benefits include:
- Using the asset to produce goods or provide services
- Using the asset to enhance the value of other assets
- Using the asset to settle liabilities or reduce expenses
- Selling or exchanging the asset
- Pledging the asset to secure a loan
- Holding the asset
Control can be transferred over time or at a point in time. We’ve already discussed the criteria required to satisfy a performance obligation over time and thus recognize revenue over a period of time in our Step 2 blog post. We’ve also stated that if a performance obligation doesn’t meet the criteria to be recognized over time then it must be recognized at a point in time when control of the good or service is transferred. Most entities will desire to have their performance obligations satisfied over a period of time as it will result in earlier revenue recognition. However, what we haven’t discussed is how to measure progress towards the completion of a performance obligation that is satisfied over time.
Measuring progress towards completion:
There are two acceptable methods for measuring progress towards completion: output and input methods. The method chosen to measure progress should be consistently applied to similar performance obligations under similar circumstances.
Output methods—recognize revenue based on the value transferred to the customer relative to the remaining value to be transferred. Examples include surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered.
Input methods—recognize revenue based on the entity’s effort to satisfy the performance obligation relative to the total expected effort to satisfy the performance obligation. Examples include resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used.
Measuring progress towards completion will require judgment and is not supposed to be an accounting policy choice, but rather the method chosen should be the method which most faithfully depicts the pattern of control transferred. Remember, the principle objective is to recognize revenue in a pattern commensurate with the transfer of control to the customer.
Measuring progress towards completion can be quite complex and judgmental, so let’s walk through a couple examples:
Assume that a construction contractor enters into an arrangement to build 100 miles of road for a local government for $100,000. If at period end, the contractor has built 50 miles of road and the effort required by the contractor and value delivered to the customer is consistent across each of the 100 miles, then an output method such as the number of miles-built might be appropriate and thus, 50% or $50,000 should be recognized. Depending upon whether work in process is material and whether it is controlled by the customer might influence output method selection.
Let’s assume another construction contractor enters into an arrangement to construct a building for $100,000 with an estimated cost to construct of $80,000. At period end, there are incurred costs of $40,000. Of the $40,000, $10,000 is wasted costs and another $10,000 is for uninstalled materials purchased and delivered to the construction site, but not yet used in the construction. Should 37.5% or only 25% ($20K over the $80K total expected costs) of revenue be recognized? Again, judgment is required. If the $10,000 in uninstalled materials meets all of the below criteria then the related costs should be included in estimating progress towards completion:
- Good(s) are not distinct.
- The customer expected to obtain control of the good significantly before receiving the related service (e.g. integration of the good).
- The cost of the good is significant to the relative total cost of satisfying the performance obligation.
- The entity procures the good(s) from a third party and is not significantly involved in designing or manufacturing the good(s) but is still acting as principle (i.e. not an agent transaction).
As you can see, measuring progress towards completion can be quite complex and judgmental.
Jonathan Kraftchick, CPA, is the Senior Manager of Training and Development at Cherry Bekaert, LLP, in their Raleigh office, where he is responsible for overseeing much of the firm’s audit training, course development, and delivery. He attended the University of North Carolina at Chapel Hill and received a BA in economics before continuing on to their master’s of accounting program, graduating in 2001. Since then, he has spent most of his time conducting audit and consulting engagements for a wide variety of companies and industries throughout the Southeast as well as writing and delivering courses both inside and outside the firm. He has also served as a adjunct professor at Elon University in their accounting department. In 2011, he received NCACPA’s Outstanding Seminar Discussion Leader award.
Jonathan is also a member of NCACPA’s Accounting & Attestation Committee. To find out more about this committee, please visit this page.