Are you ready for the new revenue recognition standard? Do you know how transitioning from ASC 605 / SAB 104 to ASC 606, Revenue from Contracts with Customers, will affect your organization? If not, you’re in luck! In our new series of blog posts, we walk through the new five-step model, step-by-step, to get you prepared!
ASC Topic 606 prescribes a new five-step model for entities to follow when recognizing revenue. These five steps are:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfied the performance obligations.
In this post, we will focus on step 5: Recognize revenue when an entity satisfies a performance obligation, including potential changes to existing guidance.
We have now reached the culmination of the new 5-step model. At this point, entities will need to determine the timing of their revenue recognition. This is driven by an entity transferring control of the asset underlying the related good or service to its customer. Control in this context refers to the ability to:
- Direct the use of, and obtain substantially all the benefits from, an asset (i.e., the asset’s potential indirect or direct cash flows), OR
- Prevent other entities from directing the use of, and obtaining the benefits from, an asset.
Based on the nature of a revenue contract, customers may obtain control of the related asset over time or at a point in time. This decision begins with consideration of the following criteria, which indicate control transferring over time:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (e.g., most service contracts).
- The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced (e.g., an asset that is being constructed at the customer’s location).
- 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 (e.g., a highly customized asset where the contract provides a substantive right to payment for work completed to date).
If control transfers over time, an entity will recognize revenue over the period it satisfies the related performance obligation utilizing a method (i.e., input or output method) that best depicts the progression toward satisfying the performance obligation. Regardless of what method they choose, entities need to apply the method consistently to similar performance obligations and in similar transactions or arrangements.
When control does not transfer over time, entities will need to determine the point in time in which control of the underlying asset transfers to a customer. Some indicators to make this determination are as follows:
- Entity has present right to payment for the asset.
- Customer has legal title to the asset.
- Entity has transferred physical possession of the asset.
- Customer has significant risks and rewards of ownership of the asset.
- Customer has accepted the asset.
These examples are not all inclusive and each indicator is not necessarily meant to indicate control transfer by itself.
So how do entities apply these concepts in practice? Let’s take a look:
Bluth Company is currently developing a multi-unit residential complex in Phoenix, Ariz. The property is currently under construction, and it will have both residential rental units and condominium units. The units have similar floor plans and are similar sizes, but other attributes are different (for example, certain units are closer to the complex clubhouse and other amenities).
George Michael enters into a purchase and sale agreement to purchase the first condo unit offered for sale. The transaction has the following characteristics:
- George pays a nonrefundable deposit upon entering into the contract and will make progress payments during the unit’s construction.
- The contract has substantive terms that prevent Bluth from being able to sell or offer the unit to another customer.
- George does not have the right to terminate the contract unless Bluth fails to complete construction of the condo unit.
In addition, if George fails to make the promised progress payments, Bluth has a right to all of the consideration promised in the contract if they complete construction of the condo unit. Courts have previously upheld such rights in lawsuits associated with similar arrangements.
Question 1: How should Bluth recognize revenue under current guidance?
Question 2: How should Bluth recognize revenue under the new guidance (ASC 606)?
Answer to the first question: Existing Guidance
Based on these limited facts, Bluth would apply the deposit method of revenue recognition (i.e., recognize a deposit liability and not recognize any profit) until they meet all of the criteria in ASC 360-20-40-50. One specific criterion that is not met in our example is the requirement that sufficient units have been sold to ensure that the entire property will not revert to rental property.
The criteria in ASC 360-20-40-50 relate specifically to recognizing revenue for the sale of individual units in a condominium project. Once all of the respective criteria are met, profit is recognized by the percentage-of-completion method on the sale of individual units or interests. If a transaction does not meet all of the criteria (as well as the assessment of collectibility using the initial and continuing investment tests described in ASC 360), entities must apply the deposit method of accounting until the criteria are met.
Answer to the second question: New Guidance (ASC 606)
Bluth would recognize revenue over the period of constructing the condo unit.
To arrive at this conclusion, Bluth would determine that the asset created by their performance (i.e., the condo unit) does not have an alternative use to them because the contract prevents Bluth from transferring the specified unit to another customer. Bluth would not consider the possibility of a contract termination in assessing whether the entity is able to direct the asset to another customer.
Bluth also would have a right to payment for performance completed to date. Specifically, if George were to default on his obligations, Bluth would have an enforceable right to all of the consideration promised under the contract if it continues to perform as promised. Not only is this language included in the contract, but it is also proven by similar case law.
Consequently, Bluth would identify a performance obligation that it satisfies over time. To recognize revenue, Bluth would measure its progress toward complete satisfaction of the performance obligation using the method (i.e., input or output) that best depicts this progression.
Revenue recognition under the new standard is driven by the concept of control transfer, which can occur over time or at a point time. This is different than the concept of “risk and reward” transfer, which generally drives revenue recognition in current guidance. To determine proper revenue recognition (i.e. over time or at a point in time), entities will need to evaluate a variety of criteria and factors that differ from current practice. The new standard also replaces all of the specific industry guidance for revenue recognition and certain entities (for example, real estate companies) will need to carefully consider the guidance in ASC 606 as it may differ significantly from current practice.
Other revenue recognition posts by GAAP Dynamics: