FASB Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, provides a 5-step framework for determining revenue recognition. Our last installment in this series addresses Step 5 – recognizing revenue when the entity satisfies a performance obligation.
The first decision point in Step 5 is the determination of whether the entity satisfies the performance obligation at a point in time or over a period of time. To satisfy an obligation over time and accordingly recognize the revenue over that period of time, at least one of the following criteria must be met:
- The customer must simultaneously receive and consume the benefits provided by the entity. Many service contracts could fall into this category.
- The entity’s performance creates an asset that the customer controls as the asset is created. A road construction contract falls in this category as the customer controls the asset as it is being created.
- The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right of payment for performance completed to date. Examples of this criteria are as follows:
- Consulting contract - the consultant’s work occurs over a period of time and does not have an alternative use as it is specific to the facts and circumstance of the customer.
- Custom manufacturing contract - agreement to manufacture equipment that is unique such that it has no alternative use or ability to sell/salvage outside of the contract.
- In contrast, many construction contracts have payment structures that are not commensurate with performance. For example, a construction contract might have payment requirements at various stages, such as 20% due upon completion of architecture plans, 30% due when ground is broken, and the remaining 50% due when occupancy is granted. In this example, despite an arrangement for payments at various points during the completion of the contract, the timing of the payments is not commensurate with the completion of the project, and consequently is not considered a right of payment for performance completed to date. Accordingly, revenue would not be recognized until an appropriate point in time.
If a performance obligation is not satisfied over time, then revenue will be recognized at a point in time. The question is, when is that point in time? While there is not an all-inclusive list of criteria, considerations include whether the entity has right of payment and the customer has legal title to the goods, whether the customer has received physical custody, whether the customer has risks and rewards of ownership, etc. In addition, the entity needs to consider any ongoing warranties, right of return, or service obligations that would prevent an entity from recognizing revenue or a portion of revenue until after the transfer of custody.
Whether revenue is going to be recognized at a point in time or over a period of time, the entity needs to periodically update its evaluation of revenue recognition over the performance period for any change in circumstances.
Have questions? Please contact your Eide Bailly LLP representative today; we can help you through this process.
Catch up on this series!
Revenue Recognition – Step 1: Identify the Contracts with a Customer
Revenue Recognition – Step 2: Identify the Performance Obligation in the Contract
Revenue Recognition – Step 3: Determine the Transaction Price
Revenue Recognition – Step 4: Allocate the Transaction Price to the Performance Obligation in the Contract
Revenue Recognition – Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation