By Josh Cross, Senior Audit Manager
After all the research and analysis put in working through the prior four steps, you are now able to begin the process for recognizing revenue for the transaction price (Step 3) which has been allocated to each performance obligation (Step 4).
Each performance obligation identified in Step 2 can be satisfied by either the transfer of a promised good or by performing a service to the customer. This distinction will be the main driver for the next decision that needs to be made, and that is, whether the revenue needs to be recorded over time or at a point in time. For a good majority of the identified performance obligations, a good or service will be transferred/consumed over a period of time and therefore revenue would be recognized over that same time period. ASC 606 has helped in this analysis by providing guidance, so to recognize revenue over time, one of the following criteria needs to be met:
- 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.
If none of the above criteria are met, then the revenue should be deferred until a point in time. Some indicators that might help in identifying when exactly that “point in time” is that revenue can be recognized are:
- The customer has obtained physical control of the promised asset.
- The entity has the right to payment per the terms of the agreement.
- The legal title of the asset has been transferred to the customer.
- The customer has accepted the significant risks and rewards of owning the asset.
If you determine that revenue should be recognized over time, ASC 606 outlines two methods to measure the entity’s progress towards completion:
- Output method (milestones, units produced/delivered)
- Input method (costs incurred, labor hours, machine hours)
ASC 606 does not explicitly prefer one method over the other, but the standard does state that the entity needs to determine the appropriate method based on the nature of the good or service that has been promised to the customer. As a result, this cannot be elected at a company-wide level and needs to be analyzed for each individual contract and then again for each individual performance obligation, if there are multiple performance obligations in the contract.
A key consideration when using the input method, is that if a cost-based method is used, there are certain costs that need to be excluded when calculating the amount of revenue to record. ASC 606 refers to these costs as costs attributed to significant inefficiencies because they were never part of the original price determination of the contract. The standard identifies the following as examples of significant inefficiencies: costs of unexpected amounts of wasted materials, labor, or other resources that were incurred to satisfy the performance obligation. However, nowhere in the standard does the term “unexpected amount” get defined, so this is one area that will need to be assessed by each entity because as we know, “normal” amounts of waste can occur, especially in the construction industry, and the standard is not saying you have to eliminate all expenses that are above and beyond an original cost estimate/budget. Each entity will need to look at their own past history to help identify what would be considered to be unexpected vs. normal amounts of waste.
As with any new standard of this magnitude, there are several other nuances that may affect the revenue recognition formula, such as if the contract has a significant financing component, or the contract has a right of return clause, and warranties. Being proactive is the best way to be ready for this new standard. Start by getting a good understanding of your contracts and how the basic principles of ASC 606 will impact your entity. It might also give you a chance to refresh some of your contracts by removing ambiguous language that could make applying ASC 606 more difficult. Beginning this process can be extremely overwhelming but getting an early start is very important to a smooth transition and all of us at ASL are ready to help you navigate through this together.