In last week’s blog, I analogized ASC 606 to a novel with an exciting plot focused on revenue recognition. Probably a stretch, but the point I was making was that there are a few plot twists in the new standard that are not addressed, leaving some questions unanswered. While it is an extensive standard, it can’t possibly cover all of the issues related to revenue recognition that might arise in practice. In that post, I mentioned one of those issues related to shipping and handling activities. This week, I thought I’d explore another unanswered question on the topic of pre-production arrangements.
This question is best addressed using an example. Assume that Bastille Corporation operates a foundry that casts various types of metal based on exact customer specifications. They have clients in the aerospace and automotive industries, and even a few artists for whom they cast metal sculptures! Part of the service that Bastille provides is the creation of the molds that will be used to cast the products. Bastille produces the molds based on customer supplied designs, usually CAD drawings. Bastille enters into a new contract with one of its aerospace clients to produce a new part. The contract specifies a run of 10,000 parts at a set price per part. In addition, Bastille will produce a mold for the cast part from customer supplied CAD drawings. There is a separately specified charge for this service in the contract.
How should this “pre-production” arrangement to produce the mold be accounted for under ASC 606? Is it a separate performance obligation?
The answer is, it depends, but generally it would not be a separate performance obligation (i.e. a “revenue” arrangement). The SEC Staff has discussed this issue because ASC 606 does not provide clear guidance on pre-production activities and these activities are quite common in certain industries. When referring to “pre-production” activities, the SEC means arrangements in which an entity is compensated for activities performed prior to production (but that are necessary for production), such as product design or manufacturing of tools, dies, and/or molds to be used in production. Prior to ASC 606, some entities considered pre-production activities to be a service and therefore reported payments received as revenues and some reported the cost as R&D and the payment as cost reimbursement or advanced payment on the future goods that will be produced.
The SEC Staff has indicated that when assessing these arrangements, a registrant should consider the policies it had under prior guidance. For example, if previously these activities were considered to be a service, meaning revenue, then the analysis under ASC 606 should start with evaluating whether the activities meet the definition of a performance obligation. For more information on determining whether something is a separate performance obligation, check out our blog on Step 2 of the revenue recognition process. The Staff cautioned that it would question a company that historically determined that these activities were “non-revenue” and now believes they are a separate performance obligation (i.e. they are now “revenue”). The Staff has recommended that a company considering such a change should consult with the SEC Staff. The Staff indicated that they would not object to a conclusion that these activities are not separate performance obligations.
Thanks to comments made by the SEC, we now have an answer to a question left unanswered by ASC 606. If you would like more information about the new revenue recognition standard, be sure to check out our step-by-step guide for revenue from contracts with customers.
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