Some stakeholders have raised questions on how to account for pre-production activities. Some long-term supply arrangements require an entity to undertake efforts in upfront engineering and design to create new technology or adapt existing technology to the needs of the customer. The pre-production activity is often a prerequisite to delivering any units under a production contract.

If a pre-production activity is a promised good or service (a performance obligation or a part of a performance obligation) in a contract with a customer, then the activity will have implications for the timing of revenue recognition. An entity would allocate a portion of the transaction price to that good or service if it is a single performance obligation or allocate a portion of the transaction price to a combined performance obligation that includes the pre-production activities along with other goods and services. If the pre-production activities transfer to a customer and are included in a single performance obligation satisfied over time, then those activities are considered when measuring progress towards complete satisfaction of the performance obligation.

The entity first would evaluate the nature of its promise with the customer. Topic 606 specifies that not every activity that is performed to fulfill a contract is necessarily a promise to the customer for purposes of identifying performance obligations. Therefore, an entity should consider whether pre-production activities are a promised good or service or activities that do not transfer a good or service to the customer.

Topic 606 acknowledges (paragraph 606-10-25-17) that an entity is often required to undertake numerous activities to ultimately fulfill its promise to a customer, and that not every activity will result in the transfer of a promised good or service. For example, the profit-directed activities of an entity that includes the process by which revenue is generated, encompassing activities such as purchasing raw materials, manufacturing goods, transporting goods to market, and selling generally would not be additional promises to the customer to undertake those activities. Fulfillment costs that an entity incurs when performing some activities, although required to ultimately transfer the good or service to the customer, are not necessarily a promise to transfer an additional good or service to the customer. In paragraph BC93 of Update 2014-09, the Boards reiterated their intent that an entity should not account for activities that do not transfer a good or a service to a customer, including fulfillment activities “even though those activities are required to successfully transfer the goods or services for which the customer has contracted.”

The determination of whether pre-production activities are a promised good or service in a contract sometimes will require judgment. Entities may find it helpful to consider that the core principle of Topic 606 “is that an entity shall recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” Furthermore, Topic 606 specifies that the good or service is transferred when (or as) the customer obtains control.

Accordingly, if an entity is having difficulty determining whether pre-production activities are a promised good or service, the staff think it would be helpful for the entity to consider as part of this assessment whether control of that good or service is ever transferred to the customer. For example, if the entity is performing engineering and development as part of developing a new product for a customer and the customer will own the intellectual property (for example, patents) that results from those activities, then the entity likely would conclude that it is transferring control of that intellectual property to the customer. Consequently, the entity likely would conclude that the activities are a promised good or service in the contract.

The staff have used the straightforward example above to illustrate a case in which it would be clear that control has transferred. However, sometimes an entity will need to apply judgment to determine whether control of a good or service is ever transferred to the customer. Topic 606 includes criteria in paragraph 606-10-25-27 for determining whether an entity transfers control of a good or service over time and, therefore, satisfies a performance obligation over time. The staff think one of those criteria that may be applicable to pre-production activities is whether the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. Paragraph 606-10-55-6 notes that sometimes an entity may not be able to readily identify whether this criterion is met. In those circumstances, an entity would consider whether another entity would need to reperform the work that the entity has completed to date if that other entity were to fulfill the remaining performance obligation. For example, consider a scenario in which an entity is performing engineering and development as part of developing a new product for a customer. If the entity provides the customer with periodic progress reports (in a level of detail that would not require the customer to contract with another entity to reperform the work) or if the entity is required to provide the customer with the design information completed to date in the case of a termination, then the entity likely would conclude that control of that service has transferred to the customer.

The notion of control and considering when goods or services do not transfer to a customer also can be found in the guidance on measuring complete satisfaction of a performance obligation.

As an example, when a piece of equipment is transferred over time, an entity has determined that the customer has control over the asset because, for example, the entity has a right to payment for an asset with no alternative use. The entity might include labor costs in a cost-to-cost input method measure of progress for constructing the piece of equipment. The labor itself is not a separate promised good or service to the customer in the contract. However, each time the worker turns a wrench, the asset (the equipment) is changed and the customer obtains control of that changed asset. Similarly, an entity might determine the pre-production cost should be included in the measure of progress, depending on the circumstances of the arrangement. However, if the arrangement involves a significant amount of costs for the entity near the start of the arrangement and the activities giving rise to those costs do not transfer a good or a service to the customer, then the entity should consider the guidance on adjustments to measure of progress when using a cost based input method in paragraph 606-10-55-21. Application of that guidance would require an entity to consider whether the costs for certain activities should be excluded from the measure of progress or whether the input method should be adjusted to recognize revenue only to the extent of that cost incurred.