Dissecting the New Revenue Recognition Guidance: Step 5 of the Five-Step Framework
Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as amended, creates a five-step framework for entities to determine when and how much revenue should be recognized. The first article in the ‘Dissecting the New Revenue Recognition Guidance’ series discussed step 1: identifying the contract(s) with a customer. The second article in the series explained step 2: identifying performance obligations in the contract. The third article discussed step 3: determining the transaction price. The fourth article discussed step 4: allocating the transaction price to the performance obligations in the contract. This article focuses on step 5: recognizing revenue when (or as) the entity satisfies performance obligations.
Step 5: Recognize Revenue When (or as) the Entity Satisfies Performance Obligations
After completing the first four steps in the five-step framework, entities are finally ready to recognize revenue.
The fifth and final step of the new revenue recognition standard is to recognize revenue when or as the performance obligations in the contract are satisfied.
Satisfaction of the Performance Obligations
Satisfaction of the performance obligations occurs by the transfer of control of the promised good or service to the customer. When determining transfer of control, each performance obligation needs to be assessed whether the transfer of control occurred over time or at a specific point in time.
Over Time Revenue Recognition
If one of the following criteria is met, the transfer of control occurs over time, and therefore recognizes 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, or
- 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.
Example 1 – Simultaneously Receives and Consumes the Benefits
Trucking Company enters into an agreement with a customer to ship goods from point A to point B for $2,000. The customer has an unconditional obligation to pay for the service when the goods reach point B. When should Trucking Company recognize revenue?
Since another entity would not have to re-perform Trucking Company’s work, Trucking Company would recognize revenue as it transports the goods because the performance obligation has been satisfied over time. Trucking Company would determine the extent of the services provided at the end of each reporting period and recognize revenue in the proportion to the service provided.
Example 2 – Customer Controls Work in Process
Contracting Company enters into an agreement to build a building for a customer with the following terms:
- The building is built to the customer’s specifications and the customer can make modifications throughout the construction period,
- Progress payments are made throughout the construction process by the customer, and
- The customer can cancel the agreement at any time and any progress on the building is property of the customer.
In this example, the customer controls the building process at all times, the building is customized to the specifications of the customer, and the customer owns the property as it is constructed. As a result, the performance obligation is being satisfied over time and Contracting Company should recognize revenue in proportion to the services being provided.
Example 3 – Asset Without an Alternative Use
Manufacturing Company enters into an agreement with a customer to manufacture a highly specialized piece of equipment solely for the customer with the following terms:
- The customer does not take physical possession of the equipment as it is being built,
- The agreement contains one performance obligation as the goods and services provided are not distinct, and
- The customer is obligated to pay Manufacturing Company an amount equal to the costs incurred plus an agreed upon profit margin if the agreement is cancelled.
In this example, the specialized piece of equipment is manufactured to the customer’s specifications and Manufacturing Company cannot sell the piece of equipment to a different customer without substantial modifications to the good. Therefore, the piece of equipment does not have an alternative use. As a result, the performance obligation is satisfied over time and Manufacturing Company should recognize revenue in proportion to the services being provided.
There are two main methods used to measure the satisfactory of performance obligations over time:
- Output methods: recognize revenue based on direct measurements of the value transferred to the customer.
- Input methods: recognize revenue based on the entity’s efforts to satisfy the performance obligation.
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. Some examples include units produced or delivered, specific contract milestones met, etc. This method directly measures performance and is typically the most accurate representation of progress.
Input methods recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation relative to the total expected inputs to the satisfaction of that performance obligation. Some examples include resources consumed, labor hours expended, costs incurred, etc. This method requires more judgment to determine the progress being made and can include or exclude certain performance measurements that are associated with the performance obligation.
Point in Time Revenue Recognition
If a performance obligation is not satisfied over time based on meeting one of the three criteria above, the entity then satisfies the performance obligation at a point in time. In order to determine the point in time, the standard includes, but is not limited to, the following indicators:
- The entity has a present right to payment for the asset,
- The customer has legal title to the asset,
- The entity has transferred physical possession of the asset,
- The customer has the significant risks and rewards of ownership of the asset, or
- The customer has accepted the asset.
All of the indicators above indicate that the performance obligation has been met and that the transfer of control of the good or service has been satisfied. At this point in time, the customer typically has control of the asset, and the entity has been relieved of all obligations and is able to recognize revenue accordingly.
As discussed throughout the five-part series, the new revenue recognition standard is a complete overhaul of existing guidelines. Management should take the time to analyze all of the entity’s different revenue streams and determine the proper revenue recognition treatment. For public companies and private companies, the new standard became effective for annual reporting periods beginning after Dec. 15, 2017 and Dec. 15, 2018, respectively. Now is the time to begin analyzing your revenue streams to ensure that the proper accounting treatment is being applied.
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