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6.3 Performance obligations satisfied over time
Publication date: 30 Aug 2020
us Revenue guide 6.3
Management needs to determine, at contract inception, whether control of a good or service transfers to a customer over time or at a point in time. Arrangements where the performance obligations are satisfied over time are not limited to services arrangements. Complex assets or certain customized goods constructed for a customer, such as a complex refinery or specialized machinery, could also transfer over time, depending on the terms of the arrangement.
The assessment of whether control transfers over time or at a point in time is critical to the timing of revenue recognition. It will also affect a reporting entity’s determination of whether a contract is a series of distinct goods or services that should be accounted for as a single performance obligation. In order to qualify as a series, each distinct good or service in the series must meet the criteria for over time recognition. Refer to RR 3.3.2 for further discussion of the series guidance and its implications.
Revenue is recognized over time if any of the following three criteria are met.
Excerpt from ASC 606-10-25-27
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met:
a. The customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs…
b. 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…
c. 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
6.3.1 Customer receives and consumes benefits as the entity performs
This criterion primarily applies to contracts for the provision of services, such as transaction processing or security services. A reporting entity transfers the benefit of the services to the customer as it performs and therefore satisfies its performance obligation over time.
This criterion could also apply to arrangements that are not typically viewed as services, such as contracts to deliver electricity or other commodities. For example, a reporting entity that provides a continuous supply of natural gas upon demand might conclude that the natural gas is simultaneously received and consumed by the customer. This assessment could require judgment. Refer to Revenue TRG Memo No. 43 and the related meeting minutes in Revenue TRG Memo No. 44 for further discussion of this topic.
The customer receives and consumes the benefits as the reporting entity performs if another reporting entity would not need to substantially reperform the work completed to date to satisfy the remaining obligations. The fact that another reporting entity would not have to reperform work already performed indicates that the customer receives and consumes the benefits throughout the arrangement.
Contractual or practical limitations that prevent a reporting entity from transferring the remaining obligations to another reporting entity are not considered in this assessment. The objective is to determine whether control transfers over time using a hypothetical assessment of whether another reporting entity would have to reperform work completed to date. Limitations that would prevent a reporting entity from practically transferring a contract to another reporting entity are therefore disregarded.
Example RR 6-1 illustrates a customer simultaneously receiving and consuming the benefits provided by a reporting entity's performance. This concept is also illustrated in Example 13 of the revenue standard (ASC 606-10-55-159 through ASC 606-10-55-160).
EXAMPLE RR 6-1
Recognizing revenue – simultaneously receiving and consuming benefits
RailroadCo is a freight railway reporting entity that enters into a contract with Shipper to transport goods from location A to location B for $1,000. Shipper has an unconditional obligation to pay for the service when the goods reach point B.
When should RailroadCo recognize revenue from this contract?
Analysis
RailroadCo would recognize revenue as it transports the goods because the performance obligation is satisfied over that period. RailroadCo would determine the extent of transportation service delivered at the end of each reporting period and recognize revenue in proportion to the service delivered.
Shipper receives benefit as the goods are moved from location A to location B since another reporting entity will not need to transport the goods to their current location if RailroadCo fails to transport the goods the entire distance. There might be practical limitations to another reporting entity taking over the shipping obligation partway through the contract, but these are ignored in the assessment.
6.3.2 Entity creates or enhances an asset that the customer controls
This criterion applies in situations where the customer controls the work in process as the reporting entity manufactures goods or provides services. The asset being created can be tangible or intangible. Such arrangements could include construction or manufacturing contracts in which the customer controls the work in process, or research and development contracts in which the customer owns the findings. For example, if a reporting entity is constructing a building on a customer’s land, the customer would generally control any work in process arising from the reporting entity’s performance.
Management should apply the principle of control to determine whether the customer obtains control of an asset as it is created, which could require judgment. The control principle should be applied to the asset that the reporting entity’s performance creates or enhances. For example, if the reporting entity is constructing an asset, management should assess whether the customer controls that asset as it is constructed. A customer’s ability to sell or pledge a right to obtain the asset in the future is not evidence of control of the asset itself.
As discussed in BC 129, the FASB included this criterion to address situations in when the customer clearly controls the asset being created or enhanced. Absent evidence that the customer controls the asset (based on the control definition and indicators discussed in RR 6.5), management would need to assess the other criteria to conclude whether control transfers over time.
6.3.3 Asset has no alternative use and the entity has right to payment
This last criterion was developed to assist reporting entities in their assessment of control in situations where applying the first two criteria for recognizing revenue over time discussed in RR 6.3.1 and RR 6.3.2 is challenging. Reporting entities that create assets with no alternative use that have a right to payment for performance to date recognize revenue as the assets are produced, rather than at a point in time (for example, upon delivery).
This criterion might also be useful in evaluating services that are specific to a customer. An example is a contract to provide consulting services where the customer receives a written report when the work is completed and is obligated to pay for the work completed to date if the contract is cancelled. Revenue is recognized over time in this situation since no asset with an alternative use is created, assuming the right to payment compensates the reporting entity for performance to date.
6.3.3.1 No alternative use
An asset has an alternative use if a reporting entity can redirect that asset for another use or to another customer. An asset does not have an alternative use if the reporting entity is unable, because of contractual restrictions or practical limitations, to redirect the asset for another use or to another customer. Contractual restrictions and practical limitations could exist in a broad range of contracts. Judgment is needed in many situations to determine whether an asset has an alternative use.
Management should assess at contract inception whether the asset that will ultimately be transferred to the customer has an alternative use. This assessment is only updated if there is a contract modification that substantively changes the terms of the arrangement.
Contractual restrictions on a reporting entity's ability to redirect an asset are common in some industries. A contractual restriction exists if the customer has the ability to enforce its right to a specific product or products in the event the reporting entity attempts to use that product for another purpose, such as a sale to a different customer.
One type of restriction is a requirement to deliver to a specific customer certain specified units manufactured by the reporting entity (for example, the first ten units manufactured). Such a restriction could indicate that the asset has no alternative use, regardless of whether the product might otherwise be a standard inventory item or not highly customized. This is because the customer has the ability to restrict the reporting entity from using it for other purposes.
Practical limitations can also indicate that an asset has no alternative use. An asset that requires significant rework (at a significant cost) for it to be suitable for another customer or for another purpose will likely have no alternative use. For example, a highly specialized part that can only be used by a specific customer is unlikely to be sold to another customer without requiring significant rework. A practical limitation would also exist if the reporting entity could only sell the asset to another customer at a significant loss. It may require significant judgment in some cases to determine whether practical limitations exist in an arrangement.
6.3.3.2 Right to payment for performance to date
This criterion is met if a reporting entity is entitled to payment for performance completed to date, at all times during the contract term, if the customer terminates the contract for reasons other than the reporting entity's nonperformance. The assessment of whether a right to payment exists may not be straight forward and depends on the contract terms and relevant laws and regulations. Management will generally have to assess the right to payment on a contract-by-contract basis; therefore, variances in contract terms could result in recognizing revenue at a point in time for some contracts and over time for others, even when the products promised in the contracts are similar. Refer to US Revenue TRG Memo No. 56 and the related meeting minutes in Revenue TRG Memo No. 60 for further discussion of this topic.
A reporting entity’s right to payment for performance completed to date does not have to be a present unconditional right; that is, the contract does not have to contain explicit contractual terms that entitle the reporting entity to invoice at any point throughout the contract period. Many arrangements include terms that stipulate that progress or milestone payments are required only at specified intervals, or only upon completion of the contract. Regardless of the stated payment terms or payment schedule, management needs to determine whether the reporting entity would have an enforceable right to demand payment if the customer cancelled the contract for other than a breach or nonperformance. A right to payment would also exist if the contract (or other laws) entitles the reporting entity to continue fulfilling the contract and demand payment from the customer under the terms of the contract in the event the customer attempts to terminate the contract.
Assessing whether a right to payment is enforceable
A reporting entity’s enforceable right to payment for performance completed to date will generally be evidenced by the contractual terms agreed to by the parties. However, the revenue standard provides that legislation or legal precedent in the relevant jurisdiction might supplement or override the contractual terms. A reporting entity asserting that it has an enforceable right to payment despite the lack of a contractual right should have sufficient legal evidence to support this conclusion. The fact that the reporting entity would have a basis for making a claim against the counterparty in a court of law is not sufficient to support that there is an enforceable right to payment.
If the contractual terms do not provide for a right to payment, we do not believe management is required to do an exhaustive search for legal evidence that might support an enforceable right to payment; however, it would be inappropriate for a reporting entity to ignore evidence that clearly provides for such a right. Similarly, if the contractual terms do provide for a right to payment, it would be inappropriate to ignore evidence that clearly indicates such rights have no binding legal effect.
Even if a reporting entity has a customary business practice of not enforcing right to payment clauses in its contracts, this generally does not mean there is no longer an enforceable right to payment. Such a business practice would only impact the assessment if it renders the right unenforceable in a particular legal environment.
Question RR 6-1 addresses how an acceptance provision affects the assessment of whether a right to payment is enforceable.
Question RR 6-1
Can a reporting entity conclude it has an enforceable right to payment for performance if the contract includes an acceptance provision?
Can a reporting entity conclude it has an enforceable right to payment for performance if the contract includes an acceptance provision?
PwC response
It depends. If the nature of the acceptance provision is to confirm that the reporting entity has performed in accordance with the contract, we believe the provision would not impact the assessment of whether the reporting entity has an enforceable right to payment. However, if the acceptance provision relates primarily to subjective specifications and allows a customer to avoid paying for performance to date for reasons other than a breach or nonperformance, an enforceable right to payment would likely not exist. Refer to RR 6.5.5 for further discussion of acceptance provisions.
Assessing whether the payment compensates for performance to date
The amount of the payment that the reporting entity can enforce must at least compensate the reporting entity for performance to date at any point during the contract. The amount should reflect the selling price of the goods or services provided to date. For example, a reporting entity would have an enforceable right to payment if it is entitled to receive an amount that covers its cost plus a reasonable profit margin for work completed. A reporting entity that is entitled only to recover costs incurred does not have a right to payment for the work to date if the selling price of the finished goods or completed services includes a profit margin.
The revenue standard describes a reasonable profit margin as follows.
Excerpt from ASC 606-10-55-11
Compensation for a reasonable profit margin need not equal the profit margin expected if the contract was fulfilled as promised, but an entity should be entitled to compensation for either of the following amounts:
a. A proportion of the expected profit margin in the contract that reasonably reflects the extent of the entity's performance under the contract before termination by the customer (or another party)
b. A reasonable return on the entity's cost of capital for similar contracts (or the entity's typical operating margin for similar contracts) if the contract-specific margin is higher than the return the entity usually generates from similar contracts.
A specified payment schedule does not necessarily indicate that the reporting entity has a right to payment for performance. This could be the case in situations where milestone payments are not based on performance. Management should assess whether the payments at least compensate the reporting entity for performance to date. The payments should also be nonrefundable in the event of a contract cancellation (for reasons other than nonperformance).
Customer deposits and other upfront payments should also be assessed to determine if they compensate the reporting entity for performance completed to date. A significant nonrefundable upfront payment could meet the requirement if the reporting entity has the right to retain that payment in the event the customer terminates the contract, and the payment would at least compensate the reporting entity for work performed to date throughout the contract. The requirement would also be met even if a portion of the customer deposit is refundable as long as the amount retained by the reporting entity provides compensation for work performed to date throughout the contract.
In assessing whether the reporting entity has a right to payment for performance completed to date, management should only consider payments it has a right to receive from the customer. That is, management should not include payments it might receive from other parties (for example, payments it might receive upon resale of the good).
Question RR 6-2 addresses the assessment of whether a reporting entity has a right to payment when the contract is priced at cost or at a loss.
Question RR 6-2
Can a right to payment for performance completed to date exist when the contract is priced at cost or at a loss, and thus the right to payment does not include a profit margin?
Can a right to payment for performance completed to date exist when the contract is priced at cost or at a loss, and thus the right to payment does not include a profit margin?
PwC response
Yes. The principle for assessing whether a reporting entity has a right to payment for performance is based on whether the reporting entity has a right to be compensated at an amount that approximates the selling price of the goods or services transferred to date. While the selling price for a contract will often be based on estimated costs plus a profit margin, selling price will not include a margin if the contract is priced at cost or at a loss. For example, a reporting entity might be willing to incur a loss on a sale if it has a strong expectation of obtaining a profit on future orders from the customer, even though such orders are not contractually guaranteed. We believe the analysis of right to payment should be focused on whether the reporting entity has a right to a proportionate amount of the selling price (reflecting performance to date) rather than solely based on whether such amount is equal to costs incurred plus a profit margin.
6.3.3.3 Examples of no alternative use and right to payment
Example RR 6-2, Example RR 6-3, Example RR 6-4, and Example RR 6-5 illustrate the assessment of alternative use and right to payment. These concepts are also illustrated in Examples 14-17 of the revenue standard (ASC 606-10-55-161 through ASC 606-10-55-182).
EXAMPLE RR 6-2
Recognizing revenue – asset with an alternative use
Manufacturer enters into a contract to manufacture an automobile for Car Driver. Car Driver specifies certain options such as color, trim, electronics, etc. Car Driver makes a nonrefundable deposit to secure the automobile, but does not control the work in process. Manufacturer could choose at any time to redirect the automobile to another customer and begin production on another automobile for Car Driver with the same specifications.
How should Manufacturer recognize revenue from this contract?
Analysis
Manufacturer should recognize revenue at a point in time, when control of the automobile passes to Car Driver. The arrangement does not meet the criteria for a performance obligation satisfied over time. Car Driver does not control the asset during the manufacturing process. Car Driver did specify certain elements of the automobile, but these do not create a practical or contractual restriction on Manufacturer's ability to transfer the car to another customer. Manufacturer is able to redirect the automobile to another customer at little or no additional cost and therefore it has an alternative use to Manufacturer.
Now assume the same facts, except Car Driver has an enforceable right to the first automobile produced by Manufacturer. Manufacturer could practically redirect the automobile to another customer, but would be contractually prohibited from doing so. The asset would not have an alternative use to Manufacturer in this situation. The arrangement would meet the criteria for a performance obligation satisfied over time assuming Manufacturer is entitled to payment for the work it performs as the automobile is built.
EXAMPLE RR 6-3
Recognizing revenue – highly specialized asset without an alternative use
Cruise Builders enters into a contract to manufacture a cruise ship for Cruise Line. The ship is designed and manufactured to Cruise Line's specifications. Cruise Builders could redirect the ship to another customer, but only if Cruise Builders incurs significant cost to reconfigure the ship. Assume the following additional facts:
- Cruise Line does not take physical possession of the ship as it is being built.
- The contract contains one performance obligation as the goods and services to be provided are not distinct.
- Cruise Line is obligated to pay Cruise Builder an amount equal to the costs incurred plus an agreed profit margin if Cruise Line cancels the contract.
How should Cruise Builder recognize revenue from this contract?
Analysis
Cruise Builder should recognize revenue over time as it builds the ship. The asset is constructed to Cruise Line's specifications and would require substantive rework to be useful to another customer. Cruise Builder cannot sell the ship to another customer without significant cost and therefore, the ship does not have an alternative use. Cruise Builder also has a right to payment for performance completed to date. The criteria are met for a performance obligation satisfied over time.
EXAMPLE RR 6-4
Recognizing revenue – right to payment
Design Inc enters into a contract with EquipCo to deliver the next piece of specialized equipment produced. The contract price is $1 million, which includes a profit margin of 30%. EquipCo can terminate the contract at any time. EquipCo makes a nonrefundable deposit at contract inception to cover the cost of materials that Design Inc will procure to produce the specialized equipment. The contract precludes Design Inc from redirecting the equipment to another customer. EquipCo does not control the equipment as it is produced.
How should Design Inc recognize revenue for this contract?
Analysis
Design Inc should recognize revenue at a point in time, when control of the equipment transfers to EquipCo. The specialized equipment does not have an alternative use to Design Inc because the contract has substantive terms that preclude it from redirecting the equipment to another customer. Design Inc, however, is only entitled to payment for costs incurred, not for costs plus a reasonable profit margin. The criterion for a performance obligation satisfied over time is not met because Design Inc does not have a right to payment for performance completed to date. This is because the contract price includes a profit, yet Design Inc can only recover costs incurred if EquipCo terminates the contract.
EXAMPLE RR 6-5
Recognizing revenue – no right to payment for standard components
MachineCo enters into a contract to build a large, customized piece of equipment for Manufacturer. Because of the unique customer specifications, MachineCo cannot redeploy the equipment to other customers or otherwise modify the design and functionality of the equipment without incurring a substantial amount of rework.
MachineCo purchases or manufactures various standard components used to construct the equipment. MachineCo is entitled to payment for costs incurred plus a reasonable margin if Manufacturer terminates the contract early. MachineCo is not entitled to payment for standard components until they have been integrated into the customized equipment that will delivered to the customer. This is because MachineCo can use those components in other projects before they are integrated into the customized equipment.
Does MachineCo have an enforceable right to payment for performance completed to date?
Analysis
MachineCo has an enforceable right to payment for performance completed to date because it will be compensated for costs incurred plus a reasonable margin once the standard components have been integrated into the customized equipment. The revenue standard requires a reporting entity to have a right to payment for performance completed at all times during the contract term. MachineCo’s performance related to the contract occurs once it begins to incorporate the standard components into the customized equipment.
MachineCo has an enforceable right to payment and the equipment does not have an alternative use; therefore, MachineCo should recognize revenue over time as it constructs the equipment. MachineCo would record standard components as inventory prior to integration into the customized equipment.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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