In accordance with paragraph 606-10-25-27(c), if an 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, the entity satisfies its performance obligation, and recognizes revenue, over time. An entity must meet both of the criteria in paragraph 606-10-25-27(c) in order to recognize revenue over time.

Paragraphs 606-10-55-8 through 55-10 provide guidance around the assessment of whether an entity’s performance creates an asset with no alternative use. In assessing whether an asset does not have an alternative use to an entity in accordance with paragraph 606-10-25-28, an entity should consider both the effects of contractual restrictions and practical limitations on an entity’s ability to readily direct that asset for another use, such as selling it to a different customer. A contractual restriction is substantive if a customer could enforce its rights to the promised asset if the entity sought to direct the asset for another use. A practical limitation exists if an entity would incur a significant economic loss to direct the asset for another use.

Stakeholders have raised a question about at which stage in production (or manufacturing) should an entity conclude that the asset has no alternate use. For example, if an asset can be sold to a different customer throughout most of the production process, but the asset that exists at the end of the production process has no alternative use, does the asset have no alternate use when evaluating the over-time criteria in paragraph 606-10-25-27(c)? In other words, stakeholders have asked whether the timing of the customization matters when assessing the criteria in paragraph 606-10-25-27(c).

Paragraph 606-10-25-28 provides guidance that an entity should consider the completed asset and BC136 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), provides further clarification of that guidance. TRG members observed that if the entity is contractually restricted or has a practical limitation on its ability to direct the asset for another use, then the asset would not have alternative use, regardless of the characteristics of the ultimate asset.

Paragraph 606-10-25-28 states that the assessment of the no alternative use criterion should be performed at contract inception and that this evaluation should not be reassessed unless the parties to the contract approve a contract modification that substantively changes the performance obligation. In addition, paragraph BC136 of Update 2014-09 states that the no alternative use criterion should be considered in the context of the asset that will ultimately be transferred to the customer.

If the asset does not have an alternative use, the entity would not automatically be required to recognize revenue over time. This is because the entity also must meet the second half of the criteria in paragraph 606-10-25-27(c) related to an enforceable right to payment. Paragraph BC141 of Update 2014-09 states that while the notion of no alternative use is a necessary part of the criterion in paragraph 606-10-25-27(c), it is not enough to conclude that a customer controls an asset. Therefore, an entity also must have an enforceable right to payment for performance completed to date for revenue recognition to occur over time.

As discussed in paragraph BC142 of Update 2014-09, there is a link between the assessment of control and the factors of no alternative use and a right to payment because if an entity is creating an asset that has no alternative use to the entity, the entity is effectively constructing an asset at the direction of the customer. The customized asset would have no use to the entity and, therefore, the entity will require economic protection from the risk of the customer terminating the contract by requiring the customer to pay for the entity’s performance completed to date if the customer terminates the contract. Because the customer is obligated to pay for the entity’s performance and cannot avoid paying for that performance, the customer has obtained the benefits from the entity’s performance and the performing entity should recognize revenue over time as performance occurs.

Consider the following example:

In this example, the entity would evaluate at contract inception whether there is any contractual restriction or practical limitation on its ability to readily direct the asset in its completed state for another use. Because the entity cannot sell the completed equipment to another customer without incurring a significant economic loss, the entity has a practical limitation on its ability to direct the equipment in its completed state and, therefore, the asset does not have an alternative use. However, before concluding that revenue should be recognized over time, an entity must evaluate whether it has an enforceable right to payment.

When assessing whether the overtime criteria in paragraph 606-10-25-27(c) have been met, some TRG members discussed the linkage among right of payment, measure of progress, and the timing of the customization of a good. TRG members observed that the example above does not include any facts regarding right to payment. However, TRG members raised questions about the effect on the over-time assessment in scenarios in which an entity does not have a right to payment before the start of the product customization (for example, before the customization the product may be considered inventory). The staff explained that the right to payment is for performance completed to date on the contract and that performance should coincide with how an entity defines the nature of its performance obligation and its performance when measuring progress towards satisfaction of that performance obligation.