implementing the new revenue standard

Implementing the New Revenue

Standard

#7750BCOURSE MATERIAL

Table of Contents • i

TABLE OF CONTENTS

Implementing the New Revenue Standard 1I. Objective 2II. Background 3III. Scope of Revenue Standard 9IV. Definitions used in ASC 606 10V. Core Principle 11

Test Your Knowledge #1 13Solutions and Suggested Responses #1 15

VI. Five Steps to the ASC 606 Revenue Model 17Step 1: Identify the Contract(s) With a Customer 17


Step 2: Identify the Performance Obligations in the Contract 35Step 3: Determine the Transaction Price 40Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract 55


Step 5: Recognize Revenue - Entity Satisfies a Performance Obligation 69A. General Rules in Applying Step 5 69B. Control Transfers Over Time- Step 5 74C. Control Transfers at a Point in Time- Step 5 99D. Special Right-to-Invoice Practical Expedient- Step 5 104E. Onerous Contract Rules 105


VII. Selected Issues in Applying the Five Steps of the Revenue Model 113A. Sale with a Right of Return 113B. Sale with a Refund Liability 116C. Principal versus Agent Considerations 118D. Non-Refundable Upfront Fees Received 128E. Warranties 133F. Bill-and-Hold Arrangements 135G. Consignment Arrangements 138


H. Licensing 149I. Presentation of Sales Taxes and Other Similar Taxes Collected from Customers 158J. Shipping and Handling Activities- Step 2 Identifying Performance Obligations 160


K. Breakage in Prepaid Gift Cards 167

ii • Table of Contents


VIII. Contract Costs 179IX. Presentation- General Rules in ASC 606 186


X. Disclosures 201A. General 201B. Detailed Disclosures Required by ASC 606 201C. Disclosures Required for Nonpublic Entities 218

XI. Transition and Effective Date 227Test Your Knowledge #9 235Solutions and Suggested Responses #9 237

XII. Applicable Financial Statement (AFS) and Impact of Tax Act on ASC 606 239Test Your Knowledge #10 247Solution and Suggested Responses #10 249

Glossary 251

Index 253

NOTICEThis course and test have been adapted from supplemental material and uses the materials entitled Implementing the New Revenue Standard ASC 606 Guidance for Private Companies © 2021 and 2020 Fustolo Publishing LLC. Displayed by permission of the author. All rights reserved.

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© Professional Education Services, LP 2021

Program Publication Date 1/15/2021

Implementing the New Revenue Standard • 1

IMPLEMENTING THE NEW REVENUE STANDARD

Assignment 1 ObjectivesAfter completing this chapter, you should be able to:

• Identify an example of premature recognition of revenue.• Identify one of the five steps to apply the new revenue standard.

General

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606).

ASU 2014-09, along with subsequent amendments, resulted in the issuance of new Accounting Standards Codification (ASC) Topic 606. ASC 606 makes sweeping changes to the entire revenue recognition model previously found in ASC 605.

In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, to extend ASU 2014-09’s effective dates by one year.

The revised effective dates for implementing the new ASC 606 are as follows:

• Public entities apply the new standards to annual reporting periods beginning after December 15, 2017 (calendar year 2018).

• Nonpublic entities apply the new standard to annual reporting periods beginning after December 15, 2018 (calendar year 2019).

Both public and nonpublic entities have been permitted to adopt the new standard early, but not before the original public entity effective date of annual periods beginning after December 15, 2016.

Thus, nonpublic entities implement the new revenue standard for calendar year 2019.

FASB delays effective date of ASU 2014-09 due to COVID-19

In June 2020, the FASB issued ASU 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842), Effective Dates for Certain Entities.

In response to the impact of COVID-19 on the ability of companies to implement certain new standards, ASU 2020-05 offers a limited deferral of the effective dates of the following:

• ASU 2014-09, Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (Revenue), and

• ASU 2016-02, Leases (Topic 842) (Leases).

The new implementation date of ASU 2014-09 with respect to the new revenue standard, is as follows:

2 • Implementing the New Revenue Standard

1. Public entities: No change. The implementation date remains for annual reporting periods beginning after December 15, 2017 (calendar year 2018).

2. All other entities, including nonpublic entities, that have not yet issued financial statements or made financial statements available for issuance as of June 3, 2020: The implementation date is delayed for one year to the following dates:

a) Annual reporting periods beginning after December 15, 2019 (calendar year 2020), and interim reporting periods within annual reporting periods beginning after December 15, 2020.

b) However, all other entities (including nonpublic entities) may elect to implement ASU 2014-09 earlier using the original implementation date (calendar year 2019 or other period) to either:

• An annual reporting period beginning after December 15, 2016, including interim reporting periods within that reporting period, or

• An annual reporting period beginning after December 15, 2016, and interim reporting periods within annual reporting periods beginning one year after the annual reporting period in which an entity first applies the amendments in ASU 2014-09.

Observation

For a nonpublic entity that issued financial statements on or before June 3, 2020, the entity is required to apply the new ASU 2014-09 revenue standard changes in calendar year 2019. However, if an entity did not issue or have financial statements available to be issued by June 3, 2020, the effective date is delayed until calendar year 2020, although the entity may elect to apply the standard to the original 2019 effective date.

I. OBJECTIVE

The purpose of new ASC 606 is to make the following key changes in U.S. GAAP and international standards (IFRS):

a. Remove inconsistencies and weaknesses in revenue requirements

b. Provide a more robust framework for addressing revenue issues

c. Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets


d. Provide more useful information to users of financial statements through improved disclosure requirements, and

e. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.

II. BACKGROUND

Revenue recognition has been an important topic and a primary concern in recent cases of fraud and accounting violations noted by the SEC. Traditional accounting rules for recognizing revenue have become outdated as more complex revenue transactions have become the norm.

Based on several reliable accounts, revenue recognition issues have accounted for approximately 50% of all financial statement frauds. Some of the more important revenue violations involve:

1. Recognition of revenue made prematurely, such as:

• “Channel stuffing” (shipping inventory in excess of orders, or giving customers incentives to purchase more goods than they need in exchange for future discounts or other benefits);

• Reporting revenue after goods are ordered, but before they are shipped;

• Reporting revenue when significant services have not been performed;

• Improper use of the percentage-of-completion method; and

• Improper year-end cutoff procedures.

2. Recognition of revenue that has not been earned, including:

• Recognizing revenue on bill-and-hold arrangements, consignment sales, sales subject to contingencies, and those with the right to return goods, sales coupled with purchase discounts or credits, and other side agreements.

3. Reporting sales to fictitious or nonexistent customers.

4. Sales to related parties in excess of market value.

5. Recognizing transactions at fair value that relate to exchanges of similar assets.

6. Reporting peripheral or incidental transactions, such as nonrecurring gains.1

In addition to traditional revenue manipulation strategies, there are numerous methods that a company can use to recognize revenue, subject to certain limitations, including:

• Traditional sales method

• Percentage completion method

• Completed contract method

1. Financial Statement Fraud, Integrity of Financial Information Continue to Be Burner Issues (AICPA).


• Installment sales method

Thus, it is clear that there have been simply too many variations in both methods and applications related to such a key financial statement item such as revenue.

For close to a decade, revenue recognition has been at the top of the list of the FASB’s key issues based on the annual survey of the Financial Accounting Standards Advisory Council (FASAC).

Revenue is usually the largest single item in the financial statements. According to the FASB, studies confirm that revenue is the single largest category of financial statement restatements.2 As a result, issues related to revenue recognition are important to tackle.

Prior to ASC 606, there has been no general standard for revenue recognition although there were more than 200 separate pieces of authoritative literature scattered throughout U.S. GAAP. Most of the detailed authority on revenue was offered within industry-specific guidance, rather than a broader-based guidance. Further, authority was scattered among previously issued APB Opinions, FASB Statements, AICPA Auditing and Accounting Guides, AICPA Statements of Position (SOP), FASB Interpretations and Emerging Issues Task Force (EITF) Issues, SEC Staff Accounting Bulletins (SABs), and other pronouncements. The result has been a gap (no pun) between broad conceptual guidance in the FASB concept statements, and the more detailed guidance.

Previously, the SEC issued Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements. SAB No. 101 concluded that revenue should not be recognized until it was realized.

SAB 101’s model stated that realization occurred when four criteria were met:

1. Persuasive evidence of an arrangement existed

2. Delivery had occurred

3. The seller’s price to the buyer was fixed and determinable, and

4. Collectibility was reasonably assured.

The four criteria mirrored the criteria for revenue recognition of software revenue noted in ASC 985, Software Revenue Recognition.

The FASB Emerging Issues Task Force (EITF) has also issued guidance on revenue recognition, particularly guidance related to e-commerce and revenue arrangements with multiple deliverables. However, because there is no general standard for revenue recognition, the EITF has been in a position to interpret, rather than establish, overall GAAP for revenue.

There have been revenue recognition issues with international standards, as well. To date, international standards have offered limited guidance on revenue-related issues, particular related to the accounting for multiple-element arrangements.

2. FASB Proposal for a New Agenda Project: Issues Related to The Recognition of Revenues and Liabilities.


Why create the revenue project?

The FASB cites several reasons for its revenue project, including:

a. Much of the existing U.S. GAAP for revenue was developed before the Conceptual Framework.

b. U.S. GAAP contains no comprehensive standard for revenue recognition that is generally applicable.

c. U.S. GAAP for revenue recognition consists of more than 200 pronouncements by various standard setting bodies that is hard to retrieve and sometimes inconsistent.

d. Despite the large number of revenue recognition pronouncements, there is little guidance for service activities, which is the fastest growing part of the U.S. economy.

e. Revenue recognition is a primary source of restatements due to applicable errors and fraud that undermine investor confidence in financial reporting.

f. Users face noncomparability among entities and industries, with little information to assist in identifying and adjusting for the differences.

g. Accounting policy disclosures are too general to be informative.

h. Revenue data are highly aggregated, and users say they would like more detail about specific revenue-generating activities.

In May 2014, the FASB and IASB issued ASU 2014-09, Revenue From Contracts With Customers.

ASU 2014-09 creates new ASC 606, a single, principles-based revenue recognition standard for International Financial Reporting Standards (IFRSs) and U.S. GAAP that applies across various industries and capital markets.

The ASU does the following:

• Creates a new ASC Topic 606, Revenue from Contracts with Customers, and the IASB is issuing IFRS 15, Revenue from Contracts with Customers.

• Supersedes the revenue recognition requirements in ASC Topic 605, Revenue Recognition, and most industry-specific guidance.

• Supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition-Construction-Type and Production-Type Contracts.

• Amends the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer (for example, assets within the scope of Topic 360, Property, Plant, and Equipment, and intangible assets within the scope of Topic 350, Intangibles—Goodwill and Other).


New ASC 606 makes the following changes to existing GAAP for revenue recognition:

• Removes inconsistencies in existing requirements

• Creates a new criterion for revenue recognition which is based on a transfer of control

• Requires that contracts be identified and segmented into performance obligations

• Requires a determination of transaction price, taking into account certain factors such as credit risk and time value, among other factors

• Makes changes to how contract costs are accounted for including requiring certain contract costs to be capitalized as assets

• Provides a new presentation of revenue-related accounts in the statement of financial position, and

• Requires expanded disclosures.

Who is most affected?

ASC 606 affects any entity that either enters into contracts with customers to transfer goods or services, or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts).

Certain types of contracts within the software, telecom, and real estate industries are most affected by the new standard.

FASB-IASB Joint Transition Resource Group (TRG) for Revenue Recognition

In June 2014, the FASB and IASB announced the formation of a Joint Transition Resource Group for Revenue Recognition (TRG).

The purpose of the TRG is to inform the FASB and IASB of potential revenue standard implementation issues that could arise as companies implement ASU 2014-09.

The TRG is comprised of financial statement preparers, auditors and users from various industries and geographic locations, along with those from both public and private companies. Most TRG meetings are co-chaired by the Vice Chairmen of the FASB and IASB.

FASB Revenue Recognition Implementation Q&As

In January 2020, the FASB staff compiled a document entitled Financial Accounting Standards Board Revenue Recognition Implementation Q&As Compiled from Previously Issued Educational Materials. According to the Q&A, the FASB staff’s objective in compiling the Q&A was to improve the ease of navigating the educational resources and not to issue any new implementation guidance. In fact, the Q&A was compiled from publicly available TRG memos and other educational resources that had previously been made available during the implementation of ASU 2014-09 (ASC 606).


Changes to ASC 606 since the issuance of ASU 2014-09

Since ASU 2014-09 was issued, there have been numerous practice issues that have come forth as companies implemented the new standard.

To address these concerns, since 2014, the TRG has issued approximately 56 TRG memos addressing various revenue issues requiring guidance, including:

• Licenses of Intellectual Property

• Identifying Performance Obligations

• Dealing with Contract Modifications and Completed Contracts

• Presenting Sales Tax Gross versus Net

• Gross vs. Net Revenue Presentation

• Shipping and Handling and Whether It Is a Separate Performance Obligation

• Capitalization and Amortization of Incremental Costs of Obtaining a Contract

• Sales-Based or Usage-Based Royalty with Minimum Guarantee

• Payments to Customers

• Over Time Revenue Recognition

• Customer Options for Additional Goods and Services

• Evaluating How Control Transfers over Time

• Credit Cards

• Warranties

• Collectibility Issues

• Variable Consideration

• Noncash Consideration in Revenue Recognition

• Costs to Obtain a Contract

• Contract Modifications

• Performance Obligations

Changes made to date to ASU 2014-09, Revenue from Contracts with Customers (Topic 606) follow:


Changes Made to ASU 2014-09 (ASC 606) Since Issuance

ASU Issued Date Issued What It Does

ASU 2015-14: Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date

Aug 2015 Defers the effective date of ASU 2014-09 by one year.

ASU 2016-04: Liabilities-Extinguishments of Liabilities (Subtopic 405-20): Recognition of Breakage for Certain Prepaid Stored-Value Products **

Mar 2016 Addresses derecognition (removed) of a prepaid stored-value product liability and recognition of breakage revenue.

ASU 2016-08: Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations- Reporting Revenue Gross versus Net

Mar 2016 Addresses criteria used to determine whether an entity is a principal or agent in a specific performance obligation in recording revenue gross versus net.

ASU 2016-10: Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing

Apr 2016 Provides further guidance in identifying performance obligations and licensing.

ASU 2016-11: Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting (SEC Update)

May 2016 Amends SEC staff announcements for the new revenue standard.

ASU 2016-12: Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients

May 2016 Provides further guidance to ASC 606 dealing with: 1) collectibility, 2) presentation of sales and other taxes, 3) noncash consideration, and 4) contract modifications, completed contracts and technical corrections at transition.

ASU 2016-20: Technical Corrections and Improvements to Topic 606: Revenue from Contracts with Customers

Dec 2016 Makes numerous miscellaneous technical corrections and modifications to the originally issued ASU 2014-09.

ASU 2017-13: Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC Update)

Sep 2017 Amends SEC staff announcements for the new revenue standard.


Changes Made to ASU 2014-09 (ASC 606) Since Issuance

ASU Issued Date Issued What It Does

ASU 2017-14: Income Statement—Reporting Comprehensive Income (Topic 220), Revenue Recognition (Topic 605), and Revenue from Contracts with Customers (Topic 606) (SEC Update)

Nov 2017 Amends SEC staff announcements for the new revenue standard.

ASU 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842), Effective Dates for Certain Entities

June 2020 Delays the effective date of ASU 2014-09 by one year for entities other than public entities.

** Not part of the revenue project, but has a direct impact on revenue in ASC 606.

Some, but not all, of the changes in the previous chart are discussed in this chapter.

III. SCOPE OF REVENUE STANDARD

1. An entity shall apply the guidance in ASC 606, except the following, which are exempt from the application of ASC 606:

a) Lease contracts within the scope of ASC 840, Leases.

b) Insurance contracts within the scope of ASC 944, Financial Services-Insurance.

c) Financial instruments and other contractual rights or obligations within the scope of the following ASC Topics:

• ASC 310, Receivables

• ASC 320, Investments—Debt and Equity Securities

• ASC 323, Investments—Equity Method and Joint Ventures

• ASC 325, Investments—Other

• ASC 405, Liabilities

• ASC 470, Debt

• ASC 815, Derivatives and Hedging

• ASC 825, Financial Instruments

• ASC 860, Transfers and Servicing

d) Guarantees (other than product or service warranties) within the scope of ASC 460, Guarantees.

e) Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers.


Example: ASC 606 does not apply to a contract between two oil companies that agree to an exchange of oil to fulfill demand from their customers in different specified locations on a timely basis. ASC 845, Nonmonetary Transactions, may apply to nonmonetary exchanges that are not within the scope of ASC 606.

IV. DEFINITIONS USED IN ASC 606

Contract: An agreement between two or more parties that creates enforceable rights and obligations.

Contract Asset: An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Contract Liability: An entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer.

Customer: A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.

Not-for-Profit Entity: An entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity:

a. Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return

b. Operating purposes other than to provide goods or services at a profit

c. Absence of ownership interests like those of business entities.

Performance Obligation: A promise in a contract with a customer to transfer to the customer either:

a. A good or service (or a bundle of goods or services) that is distinct

b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Probable: The future event or events are likely to occur.

Public Business Entity: A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.

a. It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).

b. It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.


c. It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of, or for purposes of issuing, securities that are not subject to contractual restrictions on transfer.

d. It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.

e. It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to satisfy this criterion.

Refund Liability: The portion of consideration received from a customer that an entity expects to refund.

Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Standalone Selling Price: The price at which an entity would sell a promised good or service separately to a customer.

Transaction Price: The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.

V. CORE PRINCIPLE

1. The core principle of ASC 606 is:

“An entity recognizes revenue to depict the transfer of promised goods or 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.”

a) An entity recognizes revenue in accordance with the core principle by applying the following five steps:

Step 1: Identify the contract(s) with a customer

Step 2: Identify the performance obligations in the contract

Step 3: Determine the transaction price

Step 4: Allocate the transaction price to the performance obligations in the contract

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation


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TEST YOUR KNOWLEDGE #1The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter (assignment). They are included as an additional tool to enhance your learning experience and do not need to be submitted in order to receive CPE credit.

We recommend that you answer each question and then compare your response to the suggested solutions on the following page(s) before answering the final exam questions related to this chapter (assignment).

1. What reason does FASB cite for the revenue project:

A. accounting policy disclosures are too general to be informative

B. there is too much guidance for service activities making it confusing

C. U.S. GAAP contains a comprehensive standard for revenue recognition that is generally applicable

D. U.S. GAAP for revenue recognition consists of only 15 pronouncements by various standard-setting bodies

2. Company X has obtained a price at which X would sell a promised good separately to a customer. That price is referred to as the which of the following:

A. transaction price

B. standalone selling price

C. selling price

D. performance obligation

3. The revenue recognition standard has a core principle based on which one of the following triggering events occurring:

A. a contract must be signed

B. there must be a completion of the critical stage

C. there must be a transfer of promised goods or services

D. there must be a certain percentage of transaction completed


SOLUTIONS AND SUGGESTED RESPONSES #1Below are the solutions and suggested responses for the questions on the previous page(s). If you choose an incorrect answer, you should review the pages as indicated for each question to ensure comprehension of the material.

1. A. CORRECT. FASB cites that accounting policy disclosures are too general to be informative. The revenue project helps alleviate some of the generality related to revenue disclosures.

B. Incorrect. FASB cites that despite the large number of revenue recognition pronouncements, there is little guidance for service activities, which is the fastest growing part of the U.S. economy.

C. Incorrect. FASB cites that U.S. GAAP contains no comprehensive standard for revenue recognition that is generally applicable.

D. Incorrect. FASB cites that U.S. GAAP for revenue recognition consists of more than 200 pronouncements by various standard-setting bodies that is hard to retrieve and sometimes inconsistent.

(See page 5 of the course material.)

2. A. Incorrect. Transaction price is the amount of consideration for transferring goods or services and is not necessarily the price to sell a good separately.

B. CORRECT. ASC 606 defines the standalone selling price as that price at which an entity would sell a good or service separately to a customer. The key to this definition is that it is the price, if sold separately, and not combined with other performance obligations.

C. Incorrect. A selling price does not necessarily identify the price if sold separately.

D. Incorrect. A performance obligation is a promise in a contract to transfer a good or service and does not necessarily relate to the price if sold separately.


3. A. Incorrect. A contract signed is not identified as a triggering event under the revenue recognition standard.

B. Incorrect. The proposal does not address whether a critical stage has to be surpassed in order for there to be revenue recognition.

C. CORRECT. The core principle of the standard is that an entity shall recognize revenue when the entity satisfies a performance obligation by transferring a promised good or service to a customer.

D. Incorrect. The proposal does not deal with a percentage-of-completion approach to revenue recognition.




• Recall a condition that must be met to identify a separate performance obligation.• Identify methods authorized to estimate variable consideration in a contract.• Recognize information that can be used to allocate the transaction price to performance obligations.

VI. FIVE STEPS TO THE ASC 606 REVENUE MODEL

STEP 1: IDENTIFY THE CONTRACT(S) WITH A CUSTOMER

General

Step 1 of the five-step process under ASC 606’s new revenue model is to identify the contract(s) with a customer and whether it is, in fact a contract.

Here are a few basic rules:

a. Step 1 is done on a contract-by-contract basis.

b. There are rules that allow the combining of two or more contracts that are similar.

c. In order to apply Step 1, there must be:

• A contract, and

• A customer.

Rules in applying Step 1

A contract

1. A contract is an agreement between two or more parties that creates enforceable rights and obligations.

a) A contract can be written, oral, or implied by the entity’s customary business practices.

b) Enforceability of the rights and obligations in a contract is a matter of law.

c) An entity shall consider the practices and processes of the entity in determining whether and when an agreement with a customer creates enforceable rights and obligations.

d) An entity should apply the requirements in Step 1 to each contract that meets the following criteria:

1) There is approval and commitment of the parties,

2) There is identification of the rights of the parties,


3) There is identification of the payment terms,

4) The contract has commercial substance, and

5) It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer (collectibility criterion).

e) A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties).

A contract is wholly unperformed if both of the following criteria are met:

1) The entity has not yet transferred any promised goods or services to the customer.

2) The entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.

f) When a contract with a customer does not meet the criteria in (1)(d) above, and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenue only when either of the following events has occurred:

1) The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable, or

2) The contract has been terminated, and the consideration received from the customer is nonrefundable.

Note

If the two criteria above in (f)(1) or (2) are not met, the consideration received from the customer should be recorded as a liability until one of the two criteria is met.

A customer

2. Step 1 must be applied to a contract only if the counterparty to that contract is a customer.

a) ASC 606 defines a customer as:

“A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”


b) A counterparty to a contract is not considered a customer if the entity and counterparty participate in an activity or process in which the parties share in the risks and benefits that result from the activity or process, rather than to obtain the output of the entity’s ordinary activities.

Examples of activities that do not involve a customer include:

• Parties involved in the development of an asset in a collaboration arrangement

• Partnerships and joint ventures for profit

Note

The revenue standard applies to contracts involving transactions with customers. In most partnerships and joint ventures, the parties share the risks and benefits so that none are customers. Thus, the profit/revenue generated from such an arrangement is outside the scope of the revenue standard.

3. An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met:

a) The contracts are negotiated as a package with a single commercial objective,

b) The amount of consideration to be paid in one contract depends on the price or performance of the other contract, and

c) The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.

4. In applying Step 1 (whether there is a contract), the collectibility of the consideration to which the entity expects to be entitled must be probable for there to be a contract.

a) If collectibility is not probable, an entity should not recognize revenue until it subsequently concludes that collectibility is probable or other criteria are met. Any payments received are credited to a liability account.

b) Probable is defined as “likely to occur.”

Note

In applying Step 1 (whether there is a contract), one criterion that must be met is that it is probable that the entity will collect the consideration. Probable is defined as “likely to occur.” If collectibility is not probable, an entity should not recognize revenue until it subsequently concludes that collectibility is probable or other criteria are met. Any collections are recorded as a liability.


5. ASC 606 specifically excludes the following contracts from the scope of the revenue standard and from Step 1:

a) Lease contracts within the scope of ASC 840, Leases.

b) Insurance contracts within the scope of ASC 944, Financial Services-Insurance.

c) Financial instruments and other contractual rights or obligations within the scope of the following ASC Topics:

• ASC 310, Receivables

• ASC 320, Investments—Debt and Equity Securities

• ASC 323, Investments—Equity Method and Joint Ventures

• ASC 325, Investments—Other

• ASC 405, Liabilities

• ASC 470, Debt

• ASC 815, Derivatives and Hedging

• ASC 825, Financial Instruments

• ASC 860, Transfers and Servicing

d) Guarantees (other than product or service warranties) within the scope of ASC 460, Guarantees.

e) Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers.

f) Contributions and donations received.3

g) Investment income, such as that derived from dividends, interest and capital gains.

Example 1: Company X sells goods to its customers. In most cases, X does not receive a written sales order from the customer. Instead, the customer simply calls in the order and the goods are delivered.

X delivers goods to Company Y, a long-term customer who called in the order.

Like other customers, X and Y have a good understanding (based on past practice) of the terms of the arrangement when X delivers goods to Y:

a. There is approval and commitment of X and Y to the arrangement

b. There is identification of the rights of X and Y

c. Based on past practice, there is identification of the payment terms, which are 30 days net

3. Per Paragraph BC 28 of ASC 606 as affirmed by TRG Memo 26, issued March 2015: A contribution received is a nonreciprocal transfer not given in exchange for goods or services. It is not within the scope of ASC 606.


d. The contract has commercial substance, and

e. It is probable that X will collect from Y based on past practice.

Is there a contract with a customer for purposes of X applying Step 1?

Conclusion: Even though oral, it is likely that X has a contract with Y for applying Step 1 to the revenue model.

Consider the following facts:

a. ASC 606 states that a contract is an agreement between two or more parties that creates enforceable rights and obligations. It further states that a contract can be written, oral, or implied by the entity’s customary business practices.

b. Enforceability of the rights and obligations in a contract is a matter of law and there is no indication from the facts that an oral contract is not enforceable.

c. Moreover, ASC 606 states that an entity shall consider the practices and processes of the entity in determining whether and when an agreement with a customer creates enforceable rights and obligations. Historically, the parties have operated with oral contracts.

d. Finally, it appears the parties have satisfied the requirements of each contract in applying Step 1:

• There is approval and commitment of the parties

• There is identification of the rights of the parties

• There is identification of the payment terms

• The contract has commercial substance

• It is probable that X will collect the consideration from Customer Y.

Based on the previous analysis, it is likely that X has a contract with Customer Y.

Example 2: Two drug companies: D1 and D2, join forces to find a cure for involuntary laughing (a major undertaking).

Under a joint-venture agreement, the two parties invest labor, equipment, resources, etc. into this joint venture with the agreement that any profits will be shared on a 50%-50% basis.

From the perspective of Company D1, does D1 have a contract with a customer for purposes of applying Step 1 of the revenue standard?

Conclusion: It is highly unlikely that the arrangement is within the scope of ASC 606’s revenue standard.

Although D1 does have a contract with D2, D1 does not have a contract with a customer, as D2 is not a customer under ASC 606’s definition.


ASC 606 states that a counterparty to a contract is not considered a customer if the entity and counterparty participate in an activity or process in which the parties share in the risks and benefits that result from the activity or process, rather than to obtain the output of the entity’s ordinary activities.

In this case, the parties share the risks and benefits (profit and loss) on a 50-50% basis. D1 likely has a collaboration with D2, instead of a contract with a customer. Thus, D2 is not a customer of D1 and the contract is outside the scope of ASC 606. Instead, the arrangement might be within the scope of ASC 808, Collaborative Arrangements.

Collectibility Criterion in Step 1

In Step 1 of the five steps under the new revenue standard, an entity must:

Identify the Contract(s) with the Customer

1. An entity satisfies Step 1 and accounts for a contract with a customer only when all of the following criteria are met:

a) The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations;

b) The entity can identify each party’s rights regarding the goods or services to be transferred;

c) The entity can identify the payment terms for the goods or services to be transferred;

d) The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract); and

e) Collectibility criterion: It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

Observation

Notice that ASC 606 inserts the collectibility issue into the front of the revenue model in Step 1, when identifying the contract with the customer. It appears that the reason for including the collectibility criterion in Step 1 is to act as a stop gap, preventing companies from recording revenue, and then recording a large impairment loss (as bad debt expense). Absent including the collectibility criterion in Step 1, companies would record revenue on “bad” contracts and then record a corresponding bad debt expense when the receivable became uncollectible a short time later. In essence, this would result in window dressing by artificially inflating revenue for sales that the company knew might not ultimately convert to cash.


2. If the collectibility criterion is not met (e.g., it is not probable that the consideration will be collected), there is no contract in Step 1 and the requirements of the revenue standard cannot be satisfied.

In such cases, the following occurs:

a. Revenue is not recognized until it subsequently concludes that collectibility is probable.

b. Any collections received are recorded as a liability on the balance sheet.

c. No receivable is permitted to be recorded until there is probability of collectibility.

d. The entity is not permitted to use the cash method to account for the transaction as ASC 606 does not permit use of the cash method.4

Definition of probable

In determining whether there is a contract in Step 1, it must be probable that the entity will collect the consideration to which it is will be entitled for goods or services transferred to the customer.

A few observations about the probable threshold:

1. Probable means “likely to occur,” which is usually measured at a 75% to 80% confidence level.

2. The probable threshold differs from and supersedes the “reasonably assured” one that was previously found in ASC 605.

Performing the assessment of collectibility

ASC 606 provides some basic rules for performing the collectibility criterion assessment.

1. The evaluation of whether collectibility is probable should be done at the inception of the contract and not reassessed unless there are significant changes in facts and circumstances.

2. The evaluation is done only as to whether a customer has the ability and intent to pay the promised consideration, taking into account factors such as past experience, the class of the customer, and the customer’s financial stability, among other factors.

3. An entity shall assess the collectibility of the consideration promised in a contract for the goods or services that will be transferred to the customer, rather than assessing the collectibility of the consideration promised in the contract for all of the promised goods or services.

4. In prior GAAP’s ASC 605, four criteria were required to be satisfied for revenue recognition. One was that collectibility was “reasonably assured.” ASC 606 replaces the “reasonably assured” threshold with “probable.”


4. Assessing collectibility

a) The collectibility assessment in Step 1 (identifying a contract with a customer), is based on whether the customer has the ability and intent to pay the consideration to which the entity will be entitled in exchange for the goods or services that will be transferred to the customer.

b) In determining whether it is probable that the entity will collect substantially all of the consideration to which it will be entitled, the collectibility assessment is partly a forward-looking assessment and requires an entity to use judgment and consider all facts and circumstances including:

• The entity’s customary business practices, and

• Its knowledge of the customer.

c) When assessing whether a contract meets the collectibility criterion, an entity should:

• Determine whether the contractual terms and its customary business practices indicate that the entity’s exposure to credit risk is less than the entire consideration promised in the contract because the entity has the ability to mitigate its credit risk.

d) Examples of contractual terms or customary business practices that might mitigate the entity’s credit risk include the following:

• Payment terms: In some contracts, payment terms limit an entity’s exposure to credit risk.

• The ability to stop transferring promised goods or services: An entity may limit its exposure to credit risk if it has the right to stop transferring additional goods or services to a customer in the event that the customer fails to pay consideration when it is due.

e) An entity’s ability to repossess an asset transferred to a customer should not be considered for the purpose of assessing the entity’s ability to mitigate its exposure to credit risk.

Failing the collectibility criterion

When a contract with a customer (Step 1) does not meet the collectibility criterion and an entity receives consideration from the customer, the entity shall recognize the consideration as a liability until the collectibility criterion is satisfied.

Exceptions-events: An entity recognizes cash received as revenue only when one or more of the following events have occurred:

1. The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received and is nonrefundable.


2. The contract has been terminated, and the consideration received is nonrefundable, or

3. The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.

If none of the above events (1) to (3) are met, any cash received is credited to a liability account.

If any one of the events in (1), (2), or (3) above is met, the cash received is recorded as revenue.

Observation

The new ASC 606 requirements on collectibility can have a dramatic effect on the way in which an entity records revenue in cases where collectibility is in question. Prior guidance in ASC 605 used a “reasonably assured” threshold for collectibility. In cases in which collectibility was not reasonably assured, revenue was not recognized but an entity could resort to use of the cash method. That meant that partial payments of cash received could be recognized as revenue. That changes under ASC 606. First, ASC 606 uses a “probable” threshold (about 75%-80% probability) to determine collectibility at the inception of the contract. Second, ASC 606 does not permit use of the cash method of accounting as a default when the new revenue standard criteria are not satisfied. Therefore, ASC 606 provides that if the collectibility criterion is not met, there is no contract recognized. With no contract recognized, if cash is received from a customer, that cash is accumulated in a liability account and not recognized as revenue. The exception is that if any one of (1) to (3) above is satisfied and cash is received, that cash is recorded as revenue.

If the collectibility criterion is satisfied in Step 1 (identify the contract with the customer), should revenue be recorded net of estimated bad debts?

No. ASC 606 does not alter the way in which an entity accounts for receivables in ASC 310, Receivables. If an entity satisfies Step 1 and there is a contract, it books a receivable in Step 5. If, in the future, the receivable is uncollectible, that receivable is written down using an allowance account under the contingency rules found in ASC 450, Contingencies. There is no provision in ASC 606 that permits the revenue recorded to be reduced by any potential uncollectibles that may occur in the future.

Example: Company X bills a customer $100,000 and expects bad debts to be $2,000.

Conclusion: X should record revenue of $100,000 at the gross amount to which X is entitled.

The contract receivable of $100,000 should be assessed for impairment under the guidance in ASC 310, Receivables. If there is an impairment for $2,000, the receivable is written down with an adjustment of $2,000 for bad debt expense.


Recording the initial revenue at a net amount of $98,000 is not authorized in ASC 606.

Once an entity satisfies the collectibility criterion, should it be reassessed in the future?

No. ASC 606 states that once an entity concludes that the collectibility criterion is met and there is a contract in Step 1, there is no requirement to reassess collectibility unless there is a “significant change in facts and circumstances.”

An example of a significant change in facts and circumstances might include a customer’s ability to pay the consideration deteriorates significantly.

If an entity fails the collectibility criterion in Step 1, is it permitted to use the cash method (installment sales method or cost recovery method)?

No.

A significant change made by ASC 606 is that an entity is no longer permitted to use the cash method, (installment sales method or cost recovery method).

Pre-ASC 606’s GAAP, found in ASC 605-10-25, permitted an entity to use the installment sales or cost recovery method if collectibility was not reasonably assured.

That rule has been eliminated by ASC 606, which now highlights a significant difference between new ASC 606’s model and the previous ASC 605 model, which permitted use of the cash method (installment sales or cost recovery method) in limited cases when collectibility was not reasonably assured.

Under ASC 606’s rule, if it is not “probable that the entity will collect the consideration,” there is no contract in Step 1. With no contract, any nonrefundable amounts received are credited to a liability account until the contract is complete. Contrast that result with ASC 605’s previous rule in which amounts received would be credited to revenue when collectibility was not reasonably assured.

ASC 606 does have one exception under which an entity recognizes cash received as revenue, only when one or more of the following events have occurred:

1. The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received and is nonrefundable;

2. The contract has been terminated, and the consideration received is nonrefundable; or

3. The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.

Absent this exception and one of the three conditions above being met, an entity is no longer permitted to use the cash method (installment sales or cost recovery) under the new ASC 606 revenue model.


Examples- Step 1

Example 1: Collectibility

Company X sells a commercial building for $1,000,000.

The buyer (customer) makes a down payment of $50,000 and the entity extends a loan for $950,000.

The loan calls for annual interest payments at 4% per year for five years, with the $950,000 payable at the end of Year 5.

The buyer intends to open a furniture company and has no prior experience in that business.

The buyer has not pledged any additional collateral for the loan other than guaranteeing the loan.

The buyer’s personal assets are not sufficient to fund the guarantee if needed.

The buyer intends to repay the loan from the profits of the furniture company.

Conclusion:

In this situation, X concludes that there are too many risk factors impacting the probability of the collection of the remaining $950,000 proceeds.

Thus, X determines that collectibility is not probable.

If collectibility is not probable, X does not recognize the contract in Step 1 and does the following:

• X does not derecognize the building sale.

• X records all interest payments received on the loan as a contract liability until such time as X determines that collectibility becomes probable.

• At that time, the contract liability is debited and interest income is recorded.


Company X sells equipment to its customer with three years of maintenance for total consideration of $1 million, due in monthly installments over two years.

At contract inception, X determines that the customer does not have the ability to pay as amounts become due and, therefore, collection of the consideration is not probable.

X delivers the equipment at the inception of the contract.

At the end of the first year of the contract, the customer makes a partial payment of $200,000 to X.

X continues to provide maintenance services, but concludes that collection of the remaining consideration is not probable.


Conclusion:

The general rule is that if the collectibility criterion is not met in Step 1, any cash received is recorded as a liability.

The exception is that if one of the three events is satisfied, that partial cash received is recorded as revenue.

In general, those events include, among them that:

1. There are no remaining obligations to transfer goods or services to the customers, and all, or substantially all of the consideration promised by the customer has been received.

2. The contract has been terminated and the consideration is nonrefundable.

3. The entity has stopped transferring goods or services to the customer.

None of the above events has taken place in this example. In fact, the company continues to provide services and has not terminated the contract. Moreover, the customer still owes a balance of $800,000 ($1,000,000 less $200,000 received), from the contract.

The result is that X cannot recognize revenue for the $200,000 partial payment received because it has concluded that collection is not probable.

Instead, the $200,000 is recorded as a liability until such time as it is probable as to the collectibility of the remaining balance of the contract.

Entry- Year 1: dr crCash 200,000

Deferred revenue (liability) 200,000

X should continue to reassess collectibility during each reporting period.

Why doesn’t the entry include a receivable for the remaining $800,000 due?

ASC 606-10-45 states that a receivable is an entity’s “right to consideration that is unconditional.” A right is unconditional if only the passage of time is required before there is payment. Because there is a lack of probability of payment, the contract is not recognized under ASC 606. Thus, without a contract for GAAP purposes, no receivable exists.


Company Y enters into a contract on January 2, 20X1 to sell 1,000 units of a product to Company X for $100 per unit (total of $100,000).

X is a startup company with limited financial resources.

The selling price is $100,000.

At inception, Y determines that collection from X is not probable.


Y ships 600 units to X.

X pays Y a nonrefundable deposit of $50,000 by the end of March 31, 20X1.

Even though Y received $50,000 of the total of $100,000, on March 31, 20X1, collectibility is still not probable.

There are no events such as:

1. There are no remaining obligations to transfer goods or services to the customers and all, or substantially all of the consideration promised by the customer has been received.

2. The contract has been terminated and the consideration is nonrefundable.

3. The entity has stopped transferring goods or services to the customer.

Conclusion:

On March 31, 20X1, Y should record the $50,000 received as a liability as follows:

Entry- March 31, 20X1: dr crCash 50,000

Deferred revenue (liability) 50,000

The $50,000 represents a partial cash payment received. Because the collectibility criterion is not satisfied in Step 1, that means that Step 1 is not met and there is no contract identified for accounting purposes.

Therefore, the partial cash received is recorded as a liability.

Example 3A: Collectibility

Same facts as Example 3 except that on June 30, 20X1:

• X goes out of business,

• Y does not ship any more goods, and

• Y terminates the contract.

Conclusion:

Even though Y fails the collectibility criterion and there is no contract recognized, one of the events has occurred that allows for recognition of partial cash received.

One of those events is where a contract has been terminated, and the consideration received is nonrefundable, which is the case in this example. Thus, on June 30, 20X1, one of the events that permits partial cash to be recognized as revenue is satisfied.

At June 30,1, 20X1, Y should record the $50,000 received as revenue as follows:


Entry- June 30, 20X1: dr crDeferred revenue (liability) 50,000

Revenue 50,000


Company Y enters into a contract on January 2, 20X1 to sell 1,000 units of a product to Company X for $100 per unit (total of $100,000).

X is a startup company with limited financial resources.

The selling price is $100,000.

At inception, Y determines that collection from X is probable.

Y ships 600 units to X.

X pays Y a nonrefundable deposit of $50,000 by the end of March 31, 20X1.

Conclusion:

Because collectibility is probable and the other criteria for satisfying Step 1 (e.g., identify contract with customer) are met, revenue is recognized on the contract as follows:

Entry- January 2, 20X1: dr crAccounts receivable (600 x $100) 60,000

Revenue 60,000

Entry- March 31, 20X1: dr crCash 50,000

Accounts receivable 50,000




1. Company X is applying the revenue standard to its business. In applying Step 1, it is concerned about the collectibility of the consideration. If collectibility is not probable, how should X account for payments received:

A. as revenue

B. as a liability

C. do not record any payments received

D. disclose only

2. In applying Step 1 of the revenue recognition standard (identify the contract with a customer), which of the following is a criterion that must be met:

A. the entity has not identified each party’s rights, but plans to do so

B. the entity expects to identify the payment terms

C. the contract has commercial substance

D. the parties to the contract are negotiating the final terms of the contract



1. A. Incorrect. ASC 606 states that if collectibility is not probable, an entity should not recognize revenue until it subsequently concludes that collectibility is probable.

B. CORRECT. If collectibility is not probable, the revenue standard requires that payments received be credited to a liability account.

C. Incorrect. The revenue standard does not provide for not recording the payments received. Instead, it concludes that such payments received are not recorded as revenue and are recorded as a liability.

D. Incorrect. The revenue standard does not provide for disclosure only as the payments must be recorded, as well.


2. A. Incorrect. One criterion is that the entity can identify each party’s rights regarding the goods or services being transferred.

B. Incorrect. The rules require that the entity actually can identify the payment terms, and not that the entity expects to.

C. CORRECT. One criterion is that the contract has commercial substance, such that the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract.

D. Incorrect. The requirement is that the parties to the contract must have approved the contract, not merely negotiating the final terms of the contract.



STEP 2: IDENTIFY THE PERFORMANCE OBLIGATIONS IN THE CONTRACT

General

Step 2 of the five-step revenue model provides that at contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation, each promise to transfer to the customer either:

a) A good or service (or a bundle of goods or services) that is distinct, or

b) A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

1. A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer.

a) If an entity promises in a contract to transfer more than one good or service to the customer, the entity should account for each promised good or service as a separate performance obligation only if:

1) It is distinct, or

2) There is a series of distinct goods or services that are substantially the same and have the same pattern of transfer.

b) A good or service that is not distinct should be combined with other promised goods or services until the entity identifies a bundle of goods or services that is distinct.

Note

A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met: a) Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria to be a performance obligation satisfied over time, and b) The same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

2. A good or service is distinct if both of the following criteria are met:

a) Capable of being distinct: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and

b) Distinct within the context of the contract: The entity’s promise to transfer the good or service is separately identifiable from other promises in the contract.


Note

A customer can benefit from a good or service if the good or service could be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits.

3. Separately identifiable:

a) In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable, the objective is to determine whether the nature of the promise, within the context of the contract, is either:

1) To transfer each of those goods or services individually, or,

2) To transfer a combined item or items to which the promised goods or services are inputs.

b) Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following:

• The entity provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted.

• One or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract.

• The goods or services are highly interdependent or highly interrelated.

4. Promised goods or services:

a) Depending on the contract, promised goods or services may include, but are not limited to, the following:

• Sale of goods produced by an entity (for example, inventory of a manufacturer)

• Resale of goods purchased by an entity (for example, merchandise of a retailer)

• Resale of rights to goods or services purchased by an entity (for example, a ticket resold by an entity acting as a principal)

• Performing a contractually agreed-upon task (or tasks) for a customer


• Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use and when the customer decides

• Providing a service of arranging for another party to transfer goods or services to a customer (for example, acting as an agent of another party)

• Granting rights to goods or services to be provided in the future that a customer can resell or provide to its customer (for example, an entity selling a product to a retailer promises to transfer an additional good or service to an individual who purchases the product from the retailer)

• Constructing, manufacturing, or developing an asset on behalf of a customer

• Granting licenses

• Granting options to purchase additional goods or services (when those options provide a customer with a material right).

b) Promised goods or services do not include activities that an entity must undertake to fulfill a contract unless those activities transfer a good or service to a customer.

Example: A services provider may need to perform various administrative tasks to set up a contract. The performance of those tasks does not transfer a service to the customer as the tasks are performed. Therefore, those setup activities are not promised goods or services in the contract with the customer.

c) An entity is not required to assess whether promised goods or services are separate performance obligations if they are immaterial to the contract with the customer.

1) If the revenue related to an immaterial performance obligation is recognized before those immaterial goods or services are transferred to the customer, then the related costs to transfer those goods or services shall be accrued.

2) An entity shall not apply this new immaterial guidance to a customer option to acquire additional goods or services that provides the customer with a material right.

d) Performance obligations identified in a contract may include promises that are implied by an entity’s customary business practices, published policies, or specific statements if, at the time of entering into the contract, those promises create a reasonable expectation of the customer that the entity will transfer a good or service to the customer.


Example: Determining Whether Goods or Services Are Distinct (From Example 11 of ASU 2014-09, as modified by ASU 2016-10 and by the Author)

An entity, a software developer, enters into a contract with a customer to:

• Transfer a software license,

• Perform an installation service, and

• Provide unspecified software updates and technical support (online and telephone) for a two-year period.

The entity sells the license, installation service, and technical support separately.

The installation service includes changing the web screen for each type of user (for example, marketing, inventory management, and information technology).

The installation service is routinely performed by other entities and does not significantly modify the software.

The software remains functional without the updates and the technical support.

The entity assesses the goods and services promised to the customer to determine which goods and services are distinct.

• The entity observes that the software is delivered before the other goods and services and remains functional without the updates and the technical support.

• The customer can benefit from the updates together with the software license transferred at the outset of the contract.

• The entity concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available.

The entity also determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises.

In reaching this determination, the entity considers the following:

• The installation services do not significantly affect the customer’s ability to use and benefit from the software license because the installation services are routine and can be obtained from alternate providers.

• The software updates do not significantly affect the customer’s ability to use and benefit from the software license because the software updates in this contract are not necessary to ensure that the software maintains a high level of utility to the customer during the license period.


• None of the promised goods or services significantly modify or customize one another and the entity is not providing a significant service of integrating the software and the services into a combined output.

• The software and the services do not significantly affect each other and are not highly interdependent or highly interrelated because the entity would be able to fulfill its promise to transfer the initial software license independent from its promise to subsequently provide the installation service, software updates, or technical support.

Conclusion:

On the basis of this assessment, the entity identifies four performance obligations in the contract for the following goods or services:

a. The software license

b. An installation service

c. Software updates

d. Technical support

The reason is because each good or service is distinct in that each satisfies two criteria:

1. Capable of being distinct: The customer can benefit from each good and service either on its own or together with other resources that are readily available to the customer, and

2. Distinct within the context of the contract: The entity’s promise to transfer each good and service is separately identifiable from other promises in the contract.

Thus, the entity completes Steps 3, 4 and 5 to each of the four performance obligations. In doing so, the entity will allocate a portion of the transaction price to each of the four performance obligations (Step 4), and determine whether revenue assigned to each performance obligation is satisfied at a point in time or over time in Step 5.

Example 2:

Company X is a manufacturer who has a contract to provide 100 units of Product B to a customer over a two-year period.

X determines that the product is distinct and qualifies to be recognized in revenue over time in Step 5.

X wants to determine whether the promise to deliver 100 units represents one performance obligation, or 100 separate performance obligations.

Conclusion: X should treat the promise to deliver 100 units of Product B as one single performance obligation.


ASC 606 provides that a promise to transfer more than one good or service to a customer is treated as a performance obligation if there is a series of distinct goods or services that are substantially the same and have the same pattern of transfer.

The ASU further states that a series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met: a) Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria to be a performance obligation satisfied over time, and b) The same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

These facts are present in this example. Thus, there is one performance obligation, which is the promise to deliver 100 units of Product B, over a two-year period.

STEP 3: DETERMINE THE TRANSACTION PRICE

General

Step 3 of the five-step revenue model requires that an entity shall determine the transaction price.

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.

Following are the general rules in applying Step 3 of ASC 606:

1. An entity shall consider the terms of the contract and its customary business practices to determine the transaction price.

2. The transaction price is the amount of consideration (for example, payment) to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.

3. To determine the transaction price, in addition to the fixed consideration in the contract, an entity should consider the effects of:

• Variable consideration

• Noncash consideration

• Consideration payable to a customer, and

• Significant financing component in the contract.

4. Details of each element of the transaction price, in addition to the fixed consideration, follow:

a) Variable consideration: If the amount of consideration in a contract is variable, an entity should determine the amount (to include in the transaction


price) by estimating either the expected value (that is, probability-weighted amount) or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled.

Constrained estimates of variable consideration: An entity should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

b) Noncash consideration: If a customer promises consideration in a form other than cash, an entity should measure the noncash consideration (or promise of noncash consideration) at fair value. If an entity cannot reasonably estimate the fair value of the noncash consideration, it should measure the consideration indirectly by reference to the standalone selling price of the goods or services promised in exchange for the consideration. If the noncash consideration is variable, an entity should consider the guidance on constraining estimates of variable consideration.

c) Consideration payable to the customer: If an entity pays, or expects to pay, consideration to a customer (or to other parties that purchase the entity’s goods or services from the customer) in the form of cash or items (for example, credit, a coupon, or a voucher) that the customer can apply against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer), the entity should account for the payment (or expectation of payment) as a reduction of the transaction price or as a payment for a distinct good or service (or both). If the consideration payable to a customer is a variable amount and accounted for as a reduction in the transaction price, an entity should consider the guidance on constraining estimates of variable consideration.

d) Significant financing component: An entity should adjust the promised amount of consideration for the effects of the time value of money if the timing of the payments agreed upon by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing for the transfer of goods or services to the customer. In assessing whether a financing component exists and is significant to a contract, an entity should consider various factors.

As a practical expedient, an entity need not assess whether a contract has a significant financing component if the entity expects at contract inception that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less.


5. An entity does not consider the effects of customer credit risk (that is, collectibility) when determining the transaction price.

Variable Consideration in Step 3

Perhaps one of the most important elements of the transaction price determined in Step 3 of the revenue model is variable consideration.

ASC 606 makes significant changes to the way in which variable consideration is accounted for in the new revenue standard.

Pre-ASC 606 GAAP found in ASC 605 has provided the following rules for recording variable consideration:

1. An entity recognizes variable consideration, such as incentive bonuses, only in the year the variable consideration becomes fixed and determinable (e.g., any contingency becomes resolved).

2. An entity is not permitted to record estimated variable consideration prior to the fixed and determinable criteria being satisfied.

The new ASC 606 revenue standard changes GAAP significantly by requiring an entity to estimate variable consideration as part of the transaction price.

New ASC 606 rules- variable consideration- Step 3

ASC 606 provides the following rules to apply to variable consideration in fulfilling Step 3 of the revenue standard.

1. Variable consideration is consideration promised in a contract that includes a variable amount.

2. Common examples of variable consideration include the following:

• Discounts

• Rebates

• Refunds

• Credits

• Incentives

• Performance bonuses

• Penalties

• Contingencies

• Price concessions, or

• Other similar items.

3. The consideration can vary for several reasons:


a) Due to discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items.

b) If an entity’s entitlement to consideration is contingent on the occurrence or nonoccurrence of a future event.

Example: An amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

4. The variability relating to the consideration promised by a customer may be explicitly stated in the contract, or it might be implicit and not stated in the contract.

In addition to the terms of the contract, the promised consideration is considered variable if either of the following circumstances exists:

a) The customer has a valid expectation based on an entity’s customary business practices, published policies, or specific statements that the entity will accept an amount of consideration that is less than the price stated in the contract, or

b) Other facts and circumstances indicate that the entity’s intention, when entering into the contract with the customer, is to offer a price concession to the customer.

Example: The customer expects that the entity (seller) will offer a price concession so that the customer pays less than the consideration stated in the contract. Depending on the jurisdiction, industry, or customer, this offer may be referred to as a discount, rebate, refund, or credit.

5. In determining the transaction price in Step 3, if the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of variable consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

a) At the end of each reporting period, an entity must update the estimated transaction price (including updating the variable consideration) to reflect the circumstances present at the reporting date and the changes in circumstances during the reporting period.

6. To estimate the variable consideration in the transaction price, an entity should use either of the following two methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a) Expected value method: The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the transaction price if an entity has a large number of contracts with similar characteristics.


b) Most likely amount method: This amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the transaction price if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

Note

When estimating variable consideration, an entity should apply one method consistently throughout the contract.

7. Constraining Estimates of Variable Consideration

a) ASC 606 places a constraint on the amount of variable consideration that can be estimated and recorded as part of the transaction price in Step 3 of the revenue model.

b) An entity shall include in the transaction price some or all of an amount of variable consideration estimated only to the extent that it is probable that a significant reversal in the amount of cumulative revenue5 recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

1) Probable means “likely to occur.”

c) In assessing whether it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur once the uncertainty related to the variable consideration is subsequently resolved, an entity shall consider both the likelihood and the magnitude of the revenue reversal.

Factors that could increase the likelihood or the magnitude of a revenue reversal6 include, but are not limited to, any of the following:

1) The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

2) The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

5. In evaluating whether a potential reversal of revenue would be “significant,” the term “revenue” means the total revenue assigned to the transaction price for the performance obligation, including both fixed and variable consideration. FASB TRG Memo 14 confirms that approach.6. For purposes of determining the magnitude of a potential revenue reversal, revenue is considered to be the total revenue assigned to the transaction price for the performance obligation, including both fixed and variable consideration.


3) The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

4) The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

5) The contract has a large number and broad range of possible consideration amounts.

Example 1: Expected Value Method- Variable Consideration

Company X is a distributor that enters into a five-year contract with the manufacturer of Product B.

Under the contract, X receives a performance bonus which varies based on X achieving certain milestones of purchasing quantities of Product B from the manufacturer during the five-year period.

The probability of achieving the milestones required to earn the bonus is summarized in the following chart:

Cumulative units purchased Bonus Probability

< 1,000,000 $0 10%1,000,000 $200,000 25%1,500,000 $400,000 45%2,000,000 $800,000 20%

Historically, X has achieved milestones and received performance bonuses from the manufacturer with respect to similar contracts performed previously.

Conclusion: In applying Step 3 (determining the transaction price), X is required to estimate variable consideration to the extent that it is probable that a significant reversal in the amount of variable consideration recognized will not occur once that variable consideration is resolved.

X is required to use either the expected value, or more likely amount method to estimate variable consideration to include in the transaction price.

Because X has a range of possible amounts (more than two), the expected value method is used.

Cumulative units Purchased Bonus Probability Weighted bonus

< 1,000,000 $0 10% $01,000,000 $200,000 25% $50,0001,500,000 $400,000 45% $90,0002,000,000 $800,000 20% $160,000

Total $300,000


The sum of the probability-weighted amounts of possible amounts is $300,000 which is the variable consideration that should be included as part of the transaction price in Step 3.

Prior to including the $300,000 in the transaction price in Step 3, X should do a constraint test of the variable consideration to determine whether it is probable that a significant reversal in cumulative revenue will not occur.

In doing this evaluation, X should consider the likelihood and magnitude of such a reversal in comparison to the total transaction price (fixed and variable consideration) assigned to the performance obligation.

Assuming there is no constraint, X should include the $300,000 in the transaction price for Step 3. Finally, when recognizing revenue in Step 5, it is likely X will recognize the $300,000 over the five-year contract period (over time) either on a straight-line basis ($60,000 per year x 5 years) or using another method to allocate the $300,000 over the five-year period.

Example 2: Most Likely Amount Method- Variable Consideration

Company X is a contractor.

X enters into a contract to construct a mixed-use residential and commercial facility for a customer.

Under the terms of the agreement, the construction price is $100 million and the construction period is three years ending December 31, 2023.

In addition, X receives incentive bonuses as follows:

If X completes the project on time, by December 31, 2023: Zero incentive bonus

If X completes the project early, prior to June 30, 2023:$5 million incentive bonus

Because X has a history of performing these types of construction projects, X believes it is close to 100% likely that it will complete the project early and earn the $5 million incentive fee.

Conclusion: Because there is variable consideration and only two potential outcomes (zero or $5 million), X uses the mostly likely amount method to estimate the variable consideration. In this case, X selects $5 million as the most likely outcome so that $5 million is the variable consideration.

However, before X includes the $5 million in the transaction price in Step 3, X must perform a constraint test of the $5 million to determine whether it is probable that a significant reversal in cumulative revenue will not occur.

Assuming no constraint is evident (no significant reversal is probable), X includes the $5 million in the transaction price in Step 3.

The result is that for determining the transaction price in Step 3, X includes $5 million of variable consideration. In addition, X includes the fixed consideration of $100 million for the total transaction price of $105 million.


Then, in Step 5, X is likely to recognize the $5 million variable consideration over time, allocating it over the three years of the construction project. Similarly, the $100 million of fixed consideration is likely to qualify to be allocated to revenue over time (over the three-year period) using an output or input method such as percentage of costs, etc.

Example 3: Constraining Estimates of Variable Consideration

In 2023, Company X sells a development property to Company Y for $100 million.

As part of the sales agreement, if Y develops the property over the next 10 years through 2033, X receives an additional 3% of any gross proceeds in excess of $250 million.

Because Y has not started any development plans and any future proceeds are speculative, Y uses the most likely amount method to estimate the variable consideration.

In this case, Y estimates the most likely amount to be less than $250 million so that X is estimated to receive variable consideration of zero.

Using the constraint of variable consideration, it is not probable that a significant reversal in any amount of cumulative revenue recognized would not occur.

Thus, no variable consideration should be recorded as part of the transaction price in Step 3, in any case.

However, at the end of each reporting period, X must update the estimated transaction price (including updating the variable consideration) to reflect the circumstances present at the reporting date and the changes in circumstances during the reporting period. In one of the future periods, once Y starts development plans for the property, it may be likely that X’s updated estimate might result in X recording variable consideration as part of the transaction price for that future period.

In Step 3 for 2023, the transaction price for X for this transaction consists of the $10 million fixed revenue and zero variable revenue.

Noncash Consideration in Step 3

Some contracts include promises of consideration in a form other than cash (that is, noncash consideration).

Noncash consideration can come in many forms other than cash, such as:

• Share of common stock

• Other equity instruments

• Equipment, and

• Advertising and promotion, etc.

Step 3 of the revenue model requires an entity to determine the transaction price of the contract.


As it relates to noncash consideration, ASC 606 offers the following basic rules in applying noncash consideration in Step 3:

1. Any noncash consideration received from a customer needs to be included when determining the transaction price.

2. Noncash consideration is measured as part of revenue at the fair value received.

ASU 2016-12, Revenue from Contracts with Customers (Topic 606)- Narrow-Scope Improvements and Practical Expedients, makes further amendments to ASC 606 related to noncash consideration and its measurement.

The amendments in ASU 2016-12 specify that:

1. The measurement date to be used for noncash consideration is the contract inception.

2. The fair value of the noncash consideration may vary after contract inception because of the form of the consideration (for example, a change in the price of a share to which an entity is entitled to receive from a customer).

a) Changes in the fair value of noncash consideration after contract inception that are due to the form of the consideration are not included in the transaction price.

Example: The fair value of an investment in equities increases from the contract inception date.

Conclusion: The change in fair value of the equity investment should not be included in the transaction price for the service revenue. Instead, that change in fair value should be accounted for based on other GAAP for investments in equity securities. In general, ASC 321, Investments- Equity Securities, would record the unrealized gain on the increase in the fair value and include it in the entity’s earnings, but not part of the service revenue.

b) If the fair value of the noncash consideration promised by a customer varies for reasons other than only the form of the consideration, an entity shall apply the guidance on variable consideration found in ASC 606.

Examples:

• An entity receives an additional 100 shares of common stock as a performance bonus for achieving an on-time performance.

• An entity receives a discounted exercise price on common stock as a performance bonus.

c) If the fair value of the noncash consideration varies because of both the form of the consideration and also for reasons other than the form of the consideration, an entity shall apply the guidance on variable consideration


only to the variability resulting from reasons other than the form of the consideration.

Example: Company X receives 1,000 shares of Y’s common stock as compensation for services under a contract. After the contract inception date, fair value of the noncash consideration increases for two reasons. First, the fair value of the shares of common stock increases in the market. Second, X receives an additional 100 shares as a bonus for completion of the project.

Conclusion: The increase in the fair value due to the market is not part of the transaction price. However, the portion of the increase related other than the form of the consideration (equity securities) is the additional 100 shares of stock as a performance bonus. That portion of the change in fair value should be included in the transaction price (Step 3) and accounted for under the variable consideration rules.

Example 1:

Company X enters into a contract to provide consulting services to Distributor.

The term of the services contract is one year beginning January 1, 2020 (contract inception date) and ending December 31, 2020.

In exchange for the services, X receives 100,000 shares of Distributor Inc.’s common stock, which are distributed to X in quarterly intervals.

The value of Distributor’s common stock is as follows:

Date

Fair value of Distributor’s

common stock

January 1 2020 (contract inception) $240,000January 31 2020 $245,000February 28 2020 $247,000March 31 2020 $246,000April 30 2020 $250,000May 31 2020 $255,000June 30 2020 $258,000July 31 2020 $260,000August 31 2020 $263,000September 30 2020 $266,000October 31 2020 $268,000November 30 2020 $270,000December 31 2020 $272,000


Conclusion:

X should measure the noncash consideration (100,000 shares of common stock) at its fair value on the contract inception date (January 1, 2020), which is $240,000.

Once measured at $240,000 at the contract inception date, the $240,000 should be recognized over time over the 12-month period as the service is rendered. Assuming a straight-line method is indicative of the way in which revenue is earned, the $240,000 should be recorded as revenue at $20,000 per month ($240,000/12 months).

Changes in fair value after the January 1, 2020 contract inception date should not be reflected in X’s service revenue. Those changes in fair value should be accounted for using the GAAP rules for investments found in ASC 321, Investments-Equity Securities, which recognizes any unrealized gains or losses in equity securities in the income statement.

Entries:dr cr

January 1, 2020:Contract receivable 240,000

Deferred revenue- contract 240,000To measure noncash consideration at the fair value of the common stock on January 1, 2020

Each month, January to December 2020:Deferred revenue-contract 20,000

Revenue 20,000To record contract revenue over time for each of the twelve months ($240,000/12)

December 31, 2020:Investment- equity securities 32,000

Unrealized gain on securities (income statement) 32,000To record unrealized gain on securities per ASC 321: ($272,000- $240,000)

What if an entity cannot measure the fair value of noncash consideration?

ASC 606-10-32-22 states that if an entity cannot reasonably estimate the fair value of the noncash consideration received, the entity shall measure the consideration indirectly by reference to the standalone selling price of the goods or services promised to the customer (or class of customer) in exchange for the consideration.

Consideration Payable to the Customer- in Step 3

In determining the transaction price in Step 3 of the revenue standard, ASC 606 requires an entity to consider the effects of the following elements in addition to any fixed consideration in a contract:


• Variable consideration

• Noncash consideration

• Consideration payable to a customer

• Significant financing component in the contract

As obviously displayed in the list is consideration payable to a customer.

As part of a contract, an entity might be required to provide a customer with some sort of incentive payment against the consideration to be received from that customer.

The incentive can be in the form of:

• A credit

• A rebate

• Slotting fees for retailers

• Other credits such as vouchers or coupons

• Adverting arrangements

Consideration payable to a customer includes:

• Cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer).

• Credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer).

ASC 606 rules for consideration payable to a customer- Step 3

1. ASC 606 provides the following rules in accounting for consideration payable to a customer in determining the transaction price in Step 3:

a) An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service that the customer transfers to the entity.

b) If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) under the variable consideration rules.

2. If consideration payable to a customer is accounted for as a reduction of the transaction price, an entity shall recognize the reduction of revenue when (or as) the later of either of the following events occurs:


a) The entity recognizes revenue for the transfer of the related goods or services to the customer.

b) The entity pays or promises to pay the consideration (even if the payment is conditional on a future event). That promise might be implied by the entity’s customary business practices.

3. If consideration payable to a customer is a payment for a distinct good or service from the customer, then an entity shall account for the purchase of the good or service in the same way that it accounts for other purchases from suppliers (typically as an operating expense).

a) If the amount of consideration payable to the customer exceeds the fair value of the distinct good or service that the entity receives from the customer, then the entity shall account for such an excess as a reduction of the transaction price.

b) If the entity cannot reasonably estimate the fair value of the good or service received from the customer, it shall account for all of the consideration payable to the customer as a reduction of the transaction price.

4. A good or service is distinct if both of the following criteria are met:


b) Distinct within the context of the contract: The entity’s promise to transfer the good or service is separately identifiable from other promises in the contract.

Note

A customer can benefit from a good or service if the good or service could be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits.

Example: Tito’s Chips (Tito) sells potato chips to FoodCo Super Market (FoodCo).

Tito also gives FoodCo the following as part of the negotiation for the sale of the potato chips.

• $100,000 as a slotting fee to ensure the chips are favorably displayed in the supermarket, and

• $50,000 for cooperative advertising.

The slotting fees are not distinct because the customer (FoodCo) cannot benefit from the slotting fees (shelf space) on its own. Further, the slotting fees are not separately identifiable from the sale of the product (chips).


As for the cooperative advertising, it is distinct because Tito could have chosen to hire a third party to provide similar advertising independent of the sale of the chips.

Conclusion:

ASU 606 provides the general rule that an entity shall account for consideration payable to a customer as a reduction of the transaction price.

The exception is that if consideration payable to a customer is a payment for a distinct good or service from the customer, then an entity shall account for the purchase of the good or service in the same way that it accounts for other purchases from suppliers, which is as an operating expense.

A good or service is distinct if both of the following criteria are met:

• The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer, and

• The entity’s promise to transfer the good or service is separately identifiable from other promises in the contract.

That is, a good or service is distinct if the entity can purchase the good or service from a third party.

In Example 1, Tito needs to address how it is going to account for the $100,000 of slotting fees and $50,000 of cooperative advertising it is paying FoodCo.

As for the $100,000 slotting fees, Tito should account for the slotting fees as a reduction of the transaction price in fulfilling Step 3. The slotting fees are not distinct because FoodCo cannot benefit from the slotting fees on its own and the slotting fees are not separately identifiable from FoodCo’s purchase of chips from Tito. That is, FoodCo cannot benefit from the slotting fees separately from the purchase of the potato chips from Tito.

With respect to the $50,000 of cooperative advertising, Tito should record this cost to advertising expense and not as a reduction in the transaction price. The reason is because the cooperative advertising is distinct. The advertising that FoodCo is giving Tito is distinct because Tito could have engaged a third party to purchase the same advertising separately from the sale of chips.

Significant Financing Component in the Contract in Step 3

In determining the transaction price in Step 3, there may be instances in which there is a financing component embedded in the price of goods and services. ASC 606 requires an entity to make an adjustment to the transaction price to reflect that financing component if it is significant.

ASC 606 states that the objective when adjusting the promised amount of consideration for a significant financing component is for an entity to recognize revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (that is, the cash selling price).

In reflecting the significant financial component in the determination of the transaction price (Step 3), ASC 606 states the following:


1. In determining the transaction price (in Step 3), an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing in the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component.

a) A significant financing component may exist, regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

2. An entity shall consider all relevant facts and circumstances in assessing whether a contract contains a financing component and whether that financing component is significant to the contract, including both of the following:

a) The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services.

b) The combined effect of both of the following:

1) The expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services.

2) The prevailing interest rates in the relevant market.

3. A contract with a customer would not have a significant financing component if any of the following factors exist:

a) The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.

b) A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity (for example, if the consideration is a sales-based royalty).

c) The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract

4. As a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract


inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.

5. When adjusting the promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception.

a) That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract.

b) An entity may be able to determine the discount rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer.

c) After contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk).

6. An entity shall present the effects of financing (interest income or interest expense) separately from revenue from contracts with customers in the statement of comprehensive income (statement of activities).

a) Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer.

b) In accounting for the effects of the time value of money, an entity also shall consider the subsequent measurement guidance in ASC 835-30, Interest- Imputation of Interest, including:

• The presentation of the discount and premium on the financial, and

• Use of the effective interest method.

STEP 4: ALLOCATE THE TRANSACTION PRICE TO THE PERFORMANCE OBLIGATIONS IN THE CONTRACT

After identifying the contract (Step 1), identifying the performance obligations (Step 2), and determining the transaction price (Step 3), ASC 606 requires an entity to perform Step 4, which is to allocate the transaction price to each performance obligation identified in the contract.

Once Step 4 is completed, the final step in the revenue standard model (Step 5) is to recognize revenue when (or as) the entity satisfies a performance obligation.

In completing Step 4, ASC 606 states the following:

1. The objective when allocating the transaction price in Step 4 is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an


amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.

2. For a contract that has more than one performance obligation, an entity should allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.

a) The transaction price includes a discount or variable consideration that relates entirely to one of the performance obligations in a contract.

b) The Step 4 allocation rules do not apply if a contract has only one performance obligation. However, certain portions may apply if an entity promises to transfer a series of distinct goods or services identified as a single performance obligation and the promised consideration includes variable amounts.

3. An entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis.

4. To allocate an appropriate amount of consideration to each performance obligation, an entity must determine the standalone selling price at contract inception of the distinct goods or services underlying each performance obligation and would typically allocate the transaction price on a relative standalone selling price basis.

a) The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer.

b) ASC 606 offers two approaches to determining the standalone selling price:

• Use the observable price (preferable)

• Estimate a standalone price (if not directly observable)

5. Using an observable price as the standalone selling price:

a) The best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.

b) A contractually stated price or a list price for a good or service may be (but shall not be presumed to be) the standalone selling price of that good or service.

6. Estimating the standalone price:

a) If a standalone selling price is not directly observable, an entity shall estimate the standalone selling price at an amount that would result in the allocation of the transaction price meeting the allocation objective.

b) When estimating a standalone selling price, an entity shall consider all information that is reasonably available to the entity, including:


• Market conditions, such as supply and demand for the good or service,

• Entity-specific factors, such as business pricing strategy and practices,

• Information about the customer or class of customer, such as type of customer, geographic region, and distribution channel, and

• Reasonably available data points.7

a) In estimating a standalone selling price, an entity shall maximize the use of observable inputs and apply estimation methods consistently in similar circumstances.

b) Suitable methods for estimating the standalone selling price of a good or service include, but are not limited to, the following:

Adjusted market assessment approach: An entity evaluates the market in which it sells goods or services and:

• Estimates the price that a customer in that market would be willing to pay for the good or service, and

• Refers to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins.

Expected cost plus a margin approach: An entity could forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service.

Residual approach: An entity may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract.

An entity may use a residual approach to estimate the standalone selling price of a good or service only if one of the following criteria is met:

• The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence).

• The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain).

7. BC 269 of ASU 2014-09 provides guidance on this issue. Reasonably available data points include a standalone selling price of the good or service, the costs incurred to manufacture or provide the good or service, related profit margins, published price listings, third-party or industry pricing, and the pricing of other goods or services in the same contract.


Note

An entity might need to use a combination of methods to estimate the standalone selling prices of the goods and services promised if two or more goods or services have highly variable or uncertain standalone prices.

Example: An entity may use a residual approach to estimate the aggregate standalone selling price for those promised goods or services with highly variable or uncertain standalone selling prices and then use another method to estimate the standalone selling prices of the individual goods or services relative to that estimated aggregate standalone selling price determined by the residual approach.

7. An entity shall allocate a discount proportionately to all performance obligations in the contract using relative standalone selling prices of the underlying distinct goods or services.

a) An entity shall allocate a discount entirely to one or more, but not all, performance obligations in the contract if all of the following criteria are met:

• The entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a standalone basis.

• The entity also regularly sells on a standalone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the standalone selling prices of the goods or services in each bundle.

• The discount attributable to each bundle of goods or services described above is substantially the same as the discount in the contract, and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs.

Note

If a discount is allocated entirely to one or more performance obligations in the contract, an entity shall allocate the discount before using the residual approach to estimate the standalone selling price of a good or service.


What if there is a range of standalone selling prices?

ASC 606 does not address the issue of using a range of standalone selling prices. However, there could be instances in which the standalone selling price has a range of observable values. The FASB has not opined on the issue in which there is a range of standalone selling prices. One approach that could be considered is to use the contractual or stated selling price as the standalone selling price if it is within the range of standalone selling prices.

8. Allocating variable consideration to performance obligations in Step 4:

a) Variable consideration that is promised in a contract may be attributable to the entire contract or to a specific part of the contract, such as either of the following:

1) One or more, but not all, performance obligations in the contract (for example, a bonus may be contingent on an entity transferring a promised good or service within a specified period of time).

2) One or more, but not all, distinct goods or services promised in a series of distinct goods or services that forms part of a single performance obligation.

b) An entity shall allocate a variable amount (and subsequent changes to that amount) entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation if both of the following criteria are met:

1) The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).

2) Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective when considering all of the performance obligations and payment terms in the contract.

c) Any remaining amount of the transaction price that does not meet the criteria in (b) above shall be allocated to performance obligations under the general rules in Step 4.

9. Changes in the Transaction Price- Step 4:

a) An entity shall allocate to the performance obligations in the contract any subsequent changes in the transaction price on the same basis as at contract inception.


1) An entity shall not reallocate the transaction price to reflect changes in standalone selling prices after contract inception. Amounts allocated to a satisfied performance obligation shall be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes.

b) An entity shall allocate a change in the transaction price entirely to one or more, but not all, performance obligations or distinct goods or services promised in a series that forms part of a single performance obligation only if allocating variable consideration to one or more, but not all, performance obligations.

Note

A transaction price can change for various reasons, including the resolution of uncertain events or other changes in circumstances that change the amount of consideration to which an entity expects to be entitled in exchange for the promised goods or services.

c) An entity shall account for a change in the transaction price that arises as a result of a contract modification. However, for a change in the transaction price that occurs after a contract modification, an entity shall allocate the change in the transaction price in whichever of the following ways is applicable:

1) An entity shall allocate the change in the transaction price to the performance obligations identified in the contract before the modification if, and to the extent that, the change in the transaction price is attributable to an amount of variable consideration promised before the modification.

2) In all other cases in which the modification was not accounted for as a separate contract, an entity shall allocate the change in the transaction price to the performance obligations in the modified contract (that is, the performance obligations that were unsatisfied or partially unsatisfied immediately after the modification).

Example 1: Allocation of Transaction Price- Observable Prices- Step 4

Company X sells equipment.

X sells a bundle of three machines: Machine A, B and C to Company Y for $200,000.

Each machine is distinct and is accounted for as a separate performance obligation in Step 2.

The standalone selling prices of each of the machines is as follows:


Machine Standalone selling price A $50,000B $75,000C $125,000

X is performing Step 4 of the revenue standard and must allocate the transaction price of $200,000 to each of the three separate performance obligations: Machine A, B, and C.

Conclusion: X should allocate the $200,000 transaction price to each of the three machines based on the relative standalone selling prices as follows:

Performance Obligation

Approach

Standalone selling price

Relative %

Allocation- transaction price

A Observable price $50,000 20% $40,000B Observable price $75,000 30% $60,000C Observable price $125,000 50% $100,000

$250,000 100% $200,000

The allocation of the $200,000 transaction price is as follows: Machine A: $40,000, Machine B: $60,000, and Machine C: $100,000.

Once Step 4 is complete and the transaction price is allocated to each of the three performance obligations, the transaction price allocated is recognized as revenue in accordance with Step 5. Although information is not provided, it is likely that each amount allocated to each machine will be recognized as revenue in Step 5 using the “at a point in time” method when control of each machine is transferred to the customer.

Example 2: Allocation of Transaction Price- Mixture of Methods Used- Step 4 [from Example 33 of ASU 2014-09, as modified by the Author]

An entity enters into a contract with a customer to sell Products A, B, and C in exchange for $100,000.

The entity will satisfy the performance obligations for each of the products at different points in time.

The entity regularly sells Product A separately, and therefore the standalone selling price is directly observable.

In Step 2, X considers each product to be a separate performance obligation.

The standalone selling price of Product A is observable, but is not directly observable for B and C.

X uses non-observable approaches to estimate the standalone price for Products B and C as follows:

Product B: Adjusted market assessment approach

Product C: Expected cost plus a margin approach


Standalone prices for the three products follow:

Product

Standalone selling price per unit

Approach

A $50 Observable priceB $25 Adjusted market assessment approachC $75 Expected cost plus a margin approach

Conclusion:

If a contract has more than one performance obligation, an entity should allocate the transaction price to each performance obligation based on standalone prices.

The best evidence of standalone price is the observable price of a good or service. When an observable price is not available, the entity should estimate it using certain suitable methods.

Examples of suitable methods include:

a) Adjusted market assessment approach

b) Expected cost plus a margin approach

c) Residual approach (subject to certain limitations)

Following is an analysis of the standalone prices obtained for the three products and the allocation of the $100,000 transaction price per Step 4.

Product

Standalone Price (given)

%

Allocation of Revenue

Method to Determine Standalone Price

A $50 33% $33,000 Directly observableB $25 17% $17,000 Adjusted market assessment approachC $75 50% $50,000 Expected cost plus a margin approach

$150 100% $100,000

In Step 4, X allocates the $100,000 transaction price to each of the three performance obligations (A, B, and C) using different approaches.

Once the $100,000 of revenue is allocated to each performance obligation, revenue is recognized for each performance obligation per Step 5.




1. Company M is evaluating whether a good in a contract is distinct for purposes of applying Step 2, and identifying its performance obligations. Which of the following is a criterion that suggests the good is distinct:

A. the entity’s promise to transfer the good is combined with another good or service

B. the customer can benefit from the good on its own

C. the customer’s benefit comes solely from the good being used in concert with another good or service

D. the good is unique and cannot be replaced with a reasonable alternative

2. Jill’s Delicious Breads is implementing the revenue standard. The Company has several types of goods its provides to its customers. In Step 2, it is identifying performance obligations. Which of the following is a factor the Company should consider that indicates two or more of its promises to transfer goods to its customers are not separately identifiable:

A. the company does not provide significant service to integrate various goods with other goods

B. one or more of its goods does not significantly modify one or more other goods

C. the goods are highly interdependent

D. the goods are not highly interrelated

3. Which of the following is not one of the four elements used to determine the transaction price in Step 3 of ASC 606:

A. variable consideration

B. significant financing component

C. consideration in the form of cash or a cash equivalent

D. consideration payable to the customer


4. In ASC 606, promised consideration is variable if the customer has a valid expectation of which of the following:

A. that the entity charges a price that is higher than the stated price

B. that the entity will not offer a price concession based on historical practice

C. that the entity will accept an amount that is less than the stated price

D. that the customer will not accept the goods or services within a significant discount

5. Company X is determining the transaction price in Step 3 of the revenue standard. X has some variable consideration it wants to include in the transaction price. X is permitted to include variable consideration in the transaction price to what extent:

A. to the extent of all of the variable consideration contracted

B. to the extent it will reverse within one year of the year end

C. to the extent it is probable that a significant reversal will not occur

D. none; variable consideration is not includable as part of the transaction price because its realization is speculative

6. Company Z offers its customers rebates not related to distinct goods or services. In determining the transaction price in Step 3 of the revenue model, how should Z account for the rebates:

A. as a reduction of the transaction price

B. as a promotion expense

C. as a deferred asset to be amortized against the revenue

D. no action should be taken as it does not relate to revenue

7. Company F cannot obtain a standalone selling price for its performance obligations. F is looking for suitable alternative methods. Which of the following is not identified by ASC 606 as a suitable method to use:

A. adjusted market assessment approach

B. expected cost plus a margin

C. residual approach

D. historical cost



1. A. Incorrect. One criterion is that the entity’s promise to transfer the good is separately identifiable from other promises in the contract.

B. CORRECT. ASC 606 states that a good is distinct if it is capable of being distinct, which can occur if a customer can benefit from the good on its own.

C. Incorrect. The customer’s benefit comes from the good being used on its own, not in concert with another good or service.

D. Incorrect. Distinct does not mean unique. ASC 606 does not include any provision that addresses the uniqueness of the good.


2. A. Incorrect. One factor identified in ASC 606 is that the company does provide a significant service to integrate various goods with other goods. Because they are integrated, they may not be separately identifiable.

B. Incorrect. Several goods are not likely separately identifiable if one or more of its goods does significantly modify one or more other goods. If one good modifies another good, they are not likely to be separately identifiable.

C. CORRECT. ASC 606 states that one factor is that the goods are highly interdependent, suggesting they do not exist separately.

D. Incorrect. One factor is that the goods are highly interrelated.


3. A. Incorrect. Variable consideration is identified as one of the four elements, and is included based on either the expected value or the most likely amount.

B. Incorrect. The standard includes a significant financing component as one of the four elements used to determine the transaction price, and adjusts the promised amount to reflect the time value of money.

C. CORRECT. One of the elements is noncash consideration (not cash consideration) promised in the form other than cash.

D. Incorrect. The standard includes in the transaction price the consideration payable to the customer in the form of cash, credit, or other items that the customer can apply against amounts owed.



4. A. Incorrect. ASC 606 considers consideration to be variable if the customer, not the entity, has an expectation that the entity will accept less than the stated price, not that the price will be higher.

B. Incorrect. The expectation is that the entity will accept less than the stated price.

C. CORRECT. Consideration is variable if the customer has a valid expectation that the entity will accept an amount that is less than the stated price in the contract. That expectation is based on the entity’s customary business practices.

D. Incorrect. The variability is based on whether the entity, not the customer, will accept an amount that is less than the stated price.


5. A. Incorrect. ASC 606 constrains the estimated amount of variable consideration included as part of the transaction price.

B. Incorrect. If it were to reverse within one year of the year end, an entity would certainly not want to estimate variable consideration as part of the transaction price.

C. CORRECT. ASC 606 provides a constraint that limits the amount of estimated variable consideration to include in the transaction price. That amount of variable consideration is included to the extent it is probable that a significant reversal will not occur in the future.

D. Incorrect. Variable consideration is includable as part of the transaction price as long as the entity believes it is probable not to reverse in the future. In that situation, its realization is not speculative.


6. A. CORRECT. ASC 606 requires that consideration payable to a customer be accounted for as a reduction of the transaction price.

B. Incorrect. Because the consideration is not payment for a distinct good or service, it should not be accounted for the way other purchases would be accounted for, such as an operating expense.

C. Incorrect. ASC 606 does not provide for recording consideration payable to a customer as a deferred asset to be amortized against the revenue.

D. Incorrect. ASC 606 requires that the consideration be recorded as a reduction in the transaction price in Step 3.

(See pages 51 to 52 of the course material.)


7. A. Incorrect. ASC 606 does state that the adjusted market assessment approach is a suitable method. Under the adjusted market assessment approach, an entity estimates the price that a customer in that market would be willing to pay for those goods or services.

B. Incorrect. ASC 606 states that the expected cost plus a margin approach is a suitable method. Using this method, an entity forecasts its expected costs of satisfying a performance obligation and then adds an appropriate margin for that good or service.

C. Incorrect. ASC 606 approves the residual approach as a suitable method if certain conditions are met. Using this method, an entity estimates the standalone selling price by computing the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract.

D. CORRECT. Historical cost is not a suitable method identified by ASC 606. The reason is because historical cost could be old and most likely does not represent the current value of the performance obligation.



Assignment 3 ObjectiveAfter completing this chapter, you should be able to:

• Identify two methods that are used to record revenue in Step 5 of the revenue standard.

STEP 5: RECOGNIZE REVENUE - ENTITY SATISFIES A PERFORMANCE OBLIGATION

A. GENERAL RULES IN APPLYING STEP 5

Step 5 is the last step in the five-step process required to recognize revenue under ASC 606’s new revenue model.

Once an entity has allocated the transaction price to each performance obligation in Step 4, the final step is to recognize revenue as each performance obligation is completed.

The general rule in ASC 606 is that:

“An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer.”

Control transfers to a customer either over time or at a point in time.

ASC 606 provides the following guidance in implementing Step 5:

1. An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service.

2. Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.

a) Control also includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset.

b) The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by:

• Using the asset to produce goods or provide services (including public services)

• Using the asset to enhance the value of other assets

• Using the asset to settle liabilities or reduce expenses

• Selling or exchanging the asset

• Pledging the asset to secure a loan

• Holding the asset


Note

When evaluating whether a customer obtains control of an asset, an entity shall consider any agreement to repurchase the asset.

3. The customer satisfies a performance obligation (customer obtains control) under one of two scenarios:

• Over time, or

• At a point in time.

4. For each performance obligation identified in Step 2, an entity shall determine at contract inception whether it satisfies the performance obligation (and the customer obtains control) over time or at a point in time.

a) If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.

5. Measuring revenue over time:

a) 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:

1) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.

2) 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.

3) 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.

b) An entity shall recognize revenue for a performance obligation satisfied over time only if the entity can reasonably measure its progress toward complete satisfaction of the performance obligation.


Note

An entity would not be able to reasonably measure its progress toward complete satisfaction of a performance obligation if it lacks reliable information that would be required to apply an appropriate method of measuring progress.

In some circumstances (for example, in the early stages of a contract), an entity may not be able to reasonably measure the outcome of a performance obligation, but the entity expects to recover the costs incurred in satisfying the performance obligation. In those circumstances, the entity shall recognize revenue only to the extent of the costs incurred until such time that it can reasonably measure the outcome of the performance obligation.

c) Methods that can be used to measure an entity’s progress toward complete satisfaction of a performance obligation satisfied over time include the following:

• Output methods

• Input methods

d) Output methods: An entity recognizes revenue based on direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract, and include:

• Surveys of performance completed to date

• Appraisals of results achieved

• Milestones reached, time elapsed, and

• Units produced or units delivered.

e) Input methods: An entity recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation, including:

• Costs incurred

• Resources consumed

• Labor hours expended

• Costs incurred (similar to percentage of completion method)

• Time elapsed, or

• Machine hours used relative to the total expected inputs to the satisfaction of that performance obligation.


Note

If the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on a straight-line basis.

A shortcoming of input methods is that there may not be a direct relationship between an entity’s inputs and the transfer of control of goods or services to a customer. Therefore, an entity should exclude from an input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer. For instance, when using a cost-based input method, an adjustment to the measure of progress may be required in the following circumstances:

• When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation.

• When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation.

6. Measuring revenue at a point in time:

a) If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time (when a customer obtains control).

b) To determine the point in time at which a customer obtains control of a promised asset and an entity satisfies a performance obligation, the entity should consider indicators of the transfer of control, which include, but are not limited to, the following:

• The entity has a present right to payment for the asset.

• The customer has legal title to the asset.

• The entity has transferred physical possession of the asset.

• The customer has the significant risks and rewards of ownership of the asset.

• The customer has accepted the asset.

The following chart compares performance obligations satisfied over time and at a point in time.


7. Special practical expedient- right-to-invoice:

a) As a practical expedient, if an entity has a right to consideration from a customer in an amount that corresponds directly with the value to the customer of the entity’s performance completed to date, the entity may recognize revenue in the amount to which the entity has a right to invoice.

Example: A entity with a service contract bills a fixed amount for each hour of service provided. The value of the invoice corresponds directly with the value to the customer. In such a case, the entity is permitted to recognize the invoice amount as its revenue and bypass the revenue computation in Step 5.

Can an entity that recognizes revenue at a point in time under the pre-ASC 606 revenue recognition guidance be required to recognize revenue over time under the new ASC 606 revenue standard?

Yes.

In TRG Memo 56, the FASB staff concluded:

“In the staff’s view, an entity that currently recognizes revenue at a point in time should not presume it will recognize revenue at a point in time under Topic 606.

An entity should perform an assessment of its specific facts and circumstances on the basis of the guidance in the new revenue standard. An entity only recognizes revenue at a point in time if it does not meet the over time criteria in the new revenue standard.”

Thus, an entity that recognizes revenue at a point in time under pre-ASC 606 GAAP must perform a new assessment under new ASC 606 to determine whether it should recognize revenue over time or at a point in time.


B. CONTROL TRANSFERS OVER TIME- STEP 5

For some entities, it is critical that they qualify for transferring control of a good or service over time in applying Step 5. If they do not qualify for over-time treatment, revenue is recognized at a point in time.

Certain industries with long-term contracts, such as construction, must ensure they record their revenue over time in Step 5 so that they can recognize revenue over the construction or manufacturing time frame. Otherwise, they default to using a point in time approach which is similar to a completed contract method under existing GAAP.

In order to recognize revenue over time in Step 5, one of three criteria has to be satisfied:

Specifically, an entity transfers control of a good or service over time and should recognize revenue over time if one of the following three criteria is met:

Criterion 1: The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.

Criterion 2: 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.

Criterion 3: 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.

Each of these three criteria are discussed in more detail below.

CRITERION 1: The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.

ASC 606 offers some guidance as to when a customer is deemed to simultaneously receive and consume the benefits provided by an entity’s performance as the entity performs.

The ASC 606 essentially offers two categories of transactions that might satisfy Criterion 1 by demonstrating that a customer simultaneously receives and consumes the benefits provided by the entity’s performance as that entity performs.

1. Contracts in which the entity’s performance is immediately consumed by the customer.

Examples include routine or recurring services (such as a cleaning service or a payroll-processing service) in which the receipt and simultaneous consumption by the customer of the benefits of the entity’s performance can be readily identified.


Note

In Paragraph BC125 of ASU 2014-09, the FASB notes that in many typical “service” contracts, an entity’s performance creates an asset only momentarily because the asset is simultaneously received and consumed by the customer. In such cases, the simultaneous receipt and consumption of the asset means the customer obtains control of the entity’s output as the entity performs. Thus, the entity’s performance obligation is satisfied over time.

2. Contracts in which an entity determines that another entity would not need to substantially reperform the work that the entity has completed to date (e.g., could step in) if that other entity were to fulfill the remaining performance obligation to the customer.

a) In determining whether another entity would not need to substantially reperform the work the entity has completed to date, an entity should make both of the following assumptions:

• Disregard potential contractual restrictions or practical limitations that otherwise would prevent the entity from transferring the remaining performance obligation to another entity.

• Presume that another entity fulfilling the remainder of the performance obligation would not have the benefit of any asset that is presently controlled by the entity and that would remain controlled by the entity if the performance obligation were to transfer to another entity.

Note

In Paragraph BC126 of ASU 2014-09, the FASB observed that there may be service-type contracts in which it is unclear whether the customer receives and consumes the benefit of the entity’s performance over time. This is because the notion of “benefit” can be subjective. The example given is a freight logistics contract in which the entity has agreed to transport goods from Vancouver to New York City. The FASB concluded that the customer does benefit from the entity’s performance as it occurs because if the goods were delivered only part way (for example, to Chicago), another entity would not need to substantially reperform the entity’s performance to date—that is, another entity would not need to take the goods back to Vancouver to deliver them to New York City. The FASB observed that in those cases the assessment of whether another entity would need to substantially reperform the performance completed to date can be used as an objective basis for determining whether the customer receives benefit from the entity’s performance as it is provided.


Example: Customer Simultaneously Receives and Consumes the Benefits – Criterion 1: [From Example 13 of ASU 2014-09]

An entity enters into a contract to provide monthly payroll processing services to a customer for one year.

The promised payroll processing services are accounted for as a single performance obligation.

Conclusion: The entity recognizes revenue over time by measuring its progress toward complete satisfaction of that performance obligation.

The basic rules is that 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 three criteria is met:




In this example, the entity satisfies the performance obligation over time because the customer simultaneously receives and consumes the benefits of the entity’s performance in processing each payroll transaction as and when each transaction is processed (Criterion 1, above).

The fact that another entity would not need to re-perform payroll processing services for the service that the entity has provided to date also demonstrates that the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs.

CRITERION 2: 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.

Criterion 2 applies to situations in which a customer controls work as it is being performed by the entity, such as in the case in which goods are manufactured or constructed, such as work in progress.

1. 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.

a) Criterion 2 applies if an entity’s performance creates or enhances an asset that the customer controls as the asset is being created.

b) In such a case, the customer controls the work in process, and obtains control as the entity performs, and therefore, the entity recognizes revenue over time.

2. The asset that is being created or enhanced (for example, a work in process asset) could be either tangible or intangible.


3. Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.

a) Control also includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset.

b) The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by:

• Using the asset to produce goods or provide services (including public services)

• Using the asset to enhance the value of other assets

• Using the asset to settle liabilities or reduce expenses

• Selling or exchanging the asset

• Pledging the asset to secure a loan

• Holding the asset

Note

When evaluating whether a customer obtains control of an asset, an entity shall consider any agreement to repurchase the asset.

4. Examples of contracts to which this criterion may apply include, but are not limited to, the following:

• Construction contracts and other contracts where an entity builds on the customer’s land.

• Contracts with a government whereby the government is entitled to any work in process.

CRITERION 3: 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.

Criterion 3 is likely to be the criterion most actively used by entities to qualify a performance obligation for over-time revenue recognition in Step 5.

1. In order to qualify for recognizing revenue over time (instead of at a point in time), Criterion 3 requires two elements be satisfied:

Requirement 1: The entity’s performance does not create an asset with an alternative use to the entity, and

Requirement 2: The entity has an enforceable right to payment for performance completed to date.


Observation

Criterion 3 is based on the theory that if an asset created does not have an alternative use, the entity will ensure that it is protected from the customer terminating the contract. In essence, the asset is a custom asset. Moreover, if the entity has the right to collect payment for services rendered to date, that means those services have been created over time. Otherwise, a customer would not agree to granting an entity an enforceable right to progress payments to date.

The fact that there is a customized asset being created (no alternative use) coupled with the enforcement of the right to payment over time, suggests that revenue is being created over time and that control has been transferred to the customer over time.

Requirement 1: The entity’s performance does not create an asset with an alternative use to the entity

The first of two requirements that must be met to satisfy Criterion 3 (and recognize revenue over time in Step 5) is that the entity’s performance does not create an asset with an alternative use to the entity.

Typically, a performance obligation that qualifies for Requirement 1 (in that it does not create an asset with an alternative use) is a contract for the manufacturing or construction of an asset that:

• Has contract restrictions that prevent the selling of the asset to another customer, and/or

• Has an asset that is highly unique or customized so that significant rework would be required for another customer to take over that asset.

1. An asset created by an entity’s performance does not have an alternative use to an entity if the entity is either:

a) Restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset, or

b) Limited practically from readily directing the asset in its completed state for another use.

2. The assessment of whether an asset has an alternative use to the entity is made at contract inception.

a) After contract inception, an entity shall not update the assessment of the alternative use of an asset unless the parties to the contract approve a contract modification that substantively changes the performance obligation.

3. In assessing whether an asset has an alternative use to an entity, an entity should consider the effects of contractual restrictions and practical limitations on the entity’s ability to readily direct that asset for another use, such as selling it to a different customer.


a) A contractual restriction on an entity’s ability to direct an asset for another use must be substantive for the asset not to have an alternative use to the entity.

1) 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.

2) A contractual restriction is not substantive if an asset is largely interchangeable with other assets that the entity could transfer to another customer without breaching the contract and without incurring significant costs that otherwise would not have been incurred in relation to that contract.

b) A practical limitation on an entity’s ability to direct an asset for another use exists if an entity would incur significant economic losses to direct the asset for another use.

1) A significant economic loss could arise because the entity either would incur significant costs to rework the asset or would only be able to sell the asset at a significant loss.

Example: An entity may be practically limited from redirecting assets that either have design specifications that are unique to a customer or are located in remote areas.

c) The possibility of the contract with the customer being terminated is not a relevant consideration in assessing whether the entity would be able to readily direct the asset for another use.

Requirement 2: The entity has an enforceable right to payment for performance completed to date

The second requirement (Requirement 2) that must be met in order for an entity to qualify for Criterion 3 and to recognize revenue over time in Step 5, is that the entity’s performance contract has an enforceable right to payment for performance completed to date.

1. In order for an entity to qualify a performance obligation for Requirement 2 of Criterion 3, the contract must have an enforceable right to payment for performance completed to date.

2. At all times throughout the duration of the contract:

a) The entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised.


3. Right to payment

a) An entity has a right to payment for performance completed to date if the entity would be entitled to an amount that at least compensates the entity for its performance completed to date in the event that the customer or another party terminates the contract for reasons other than the entity’s failure to perform as promised.

1) The right to payment for performance completed to date does not need to be for a fixed amount.

b) An amount that would compensate an entity for performance completed to date would be an amount that approximates the selling price of the goods or services transferred to date rather than compensation for only the entity’s potential loss of profit if the contract were to be terminated.

Selling price of the goods or services transferred to date is based on the following formula:

Costs incurred to date $XX+ Reasonable profit margin XX= Selling price of goods/services transferred to date $XX

c) 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:

1) 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).

2) 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.

d) A contract provision in which the entity is entitled only to recover costs incurred does not have a right to payment for the work to date.

e) The fact that an entity can retain nonrefundable deposits as its sole remedy against a defaulting customer does not mean the entity has an enforceable right, if those deposits are less than the amount that compensates the entity for performance completed to date.

f) An entity’s right to payment for performance completed to date need not be a present unconditional right to payment.


Note

In many cases, an entity will have an unconditional right to payment only at an agreed-upon milestone or upon complete satisfaction of the performance obligation. In assessing whether it has a right to payment for performance completed to date, an entity should consider whether it would have an enforceable right to demand or retain payment for performance completed to date if the contract were to be terminated before completion for reasons other than the entity’s failure to perform as promised.

4. An entity shall consider the terms of the contract, as well as any laws that apply to the contract, when evaluating whether it has an enforceable right to payment for performance completed to date.

5. In assessing the existence and enforceability of a right to payment for performance completed to date, an entity should consider the contractual terms as well as any legislation or legal precedent that could supplement or override those contractual terms, including an assessment of whether:

a) Legislation, administrative practice, or legal precedent confers upon the entity a right to payment for performance to date even though that right is not specified in the contract with the customer.

b) Relevant legal precedent indicates that similar rights to payment for performance completed to date in similar contracts have no binding legal effect.

c) An entity’s customary business practices of choosing not to enforce a right to payment has resulted in the right being rendered unenforceable in that legal environment.

6. The payment schedule specified in a contract does not necessarily indicate whether an entity has an enforceable right to payment for performance completed to date.

Note

Although the payment schedule in a contract specifies the timing and amount of consideration that is payable by a customer, the payment schedule might not necessarily provide evidence of the entity’s right to payment for performance completed to date. This is because, for example, the contract could specify that the consideration received from the customer is refundable for reasons other than the entity failing to perform as promised in the contract.


Example 1: Criterion 3 Test [From Example 16 of the ASU, as modified by the Author]

An entity enters into a contract with a customer to build an item of equipment. The customer does not receive any benefit from the equipment until it is completed.

The equipment is custom made specifically for the customer’s operations.

The payment schedule in the contract specifies that the customer must make the following payments:

• Advance payment at contract inception of 10% of the contract price,

• Regular payments throughout the construction period (amounting to 50% of the contract price), and

• Final payment of 40% of the contract price after construction is completed and the equipment has passed the prescribed performance tests.

The payments are nonrefundable unless the entity fails to perform as promised.

If the customer terminates the contract, the entity is entitled only to retain any progress payments received from the customer. The entity has no further rights to compensation from the customer.

At contract inception, the entity assesses whether its performance obligation to build the equipment is a performance obligation satisfied over time.

As part of that assessment, the entity considers whether it has an enforceable right to payment for performance completed to date, if the customer were to terminate the contract for reasons other than the entity’s failure to perform as promised.

Even though the payments made by the customer are nonrefundable, the cumulative amount of those payments is not expected, at all times throughout the contract, to at least correspond to the amount that would be necessary to compensate the entity for performance completed to date.

Consequently, the entity does not have a right to payment for performance completed to date.

Conclusion:

To review, an entity may recognize revenue over time if one of the following criteria is met:




Thus, the entity seeks to determine whether Criterion 3 is met so that it can recognize revenue over time.


The enforceable right to payment requires that the entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised.

In this example, the entity does not satisfy Criterion 1 above in that the customer does not receive or consume the benefits of the equipment until it is completed.

There is also no evidence that the entity’s performance creates any asset such as work in progress that the customer controls. In fact, the customer does not receive control over the asset until it is completed. Thus, Criterion 2 is not satisfied.

Thus, the question is whether Criterion 3 is satisfied. Criterion 3 requires that:



Criterion 3 has two requirements that must be satisfied:

• First, the equipment does not have an alternative use to the entity. In this example, there is no alternative use because the equipment is custom made.

• Second, the entity has to have an enforceable right to payment. ASU 606 requires that the right be payment for an amount that at least compensates the entity for performance completed to date. In this example, the deposits are nonrefundable but are not at amounts that at least compensate the entity for performance completed to date.

Thus, because the entity does not have an enforceable right to payment for performance completed to date, Criterion 3 is not satisfied. Consequently, the entity’s performance obligation is not satisfied over time.

Because the entity does not meet the criteria to recognize revenue over time, the entity must account for the construction of the equipment as a performance obligation satisfied at a point in time, when control transfers to the customer (at the end of the contract).

Example 2: Assessing Whether a Performance Obligation Is Satisfied at a Point in Time or Over Time [From Example 17 of ASU 2014-09]

SCENARIO A: Entity Does Not Have an Enforceable Right to Payment for Performance Completed to Date

An entity is developing a multi-unit residential complex. A customer enters into a binding sales contract with the entity for a specified unit that is under construction.

Each unit has a similar floor plan and is of a similar size, but other attributes of the units are different (for example, the location of the unit within the complex).


The customer pays a deposit upon entering into the contract, and the deposit is refundable only if the entity fails to complete construction of the unit in accordance with the contract.

The contract has specific language that preclude the entity from being able to direct the unit to another customer. Specifically, the language requires specific performance so that the entity must sell this particular unit to the customer and cannot substitute it with another unit.

The remainder of the contract price is payable on completion of the contract when the customer obtains physical possession of the unit.

If the customer defaults on the contract before completion of the unit, the entity’s sole right is to retain the deposit.

At contract inception, the entity determines whether its promise to construct and transfer the unit to the customer is a performance obligation satisfied over time.

The entity determines that it does not have an enforceable right to payment for performance completed to date because until construction of the unit is complete, the entity only has a right to the deposit paid by the customer.

Conclusion:

The entity should account for the sale of the unit as a performance obligation at a point in time.

Here is the analysis of each of the three criteria, one of which must be satisfied in order to record revenue over time.


Response: No. The customer does not receive any benefits until the unit is completed.


Response: No. The customer has no control until the unit is completed.

Criterion 3: Has two requirements that must be met:



Response:

For the first requirement, the asset (unit) being created does not have an alternative use. The entity is restricted contractually from directing the asset for another use during the


creation of asset (e.g., the entity cannot sell the unit to another party) as there is specific performance language in the contract.

The possibility of the contract with the customer being terminated is not a relevant consideration in assessing whether the entity would be able to readily direct the asset for another use.

The second requirement to satisfy Criterion 3 is whether the entity has an enforceable right to payment. Although the entity has the right to retain deposits upon customer default, it does not have the right to recover additional amounts for work completed to date. Thus, the entity does not have an “enforceable right to payment for performance completed to date.”

Consequently, the entity fails Criterion 3. The first requirement that the asset does not have an alternative use is met. However, the second requirement of having an enforceable right to payment is not met. Because both requirements are not satisfied, the entity fails Criterion 3.

The entity fails to satisfy any one of the three criteria necessary to record revenue over time. Thus, the performance obligation is satisfied and revenue recognized in Step 5 at a point in time, which is likely when the asset is delivered to the customer at the end of construction.

SCENARIO B: Entity Has an Enforceable Right to Payment for Performance Completed to Date

An entity is developing a multi-unit residential complex. A customer enters into a binding sales contract with the entity for a specified unit that is under construction.

Each unit has a similar floor plan and is of a similar size, but other attributes of the units are different (for example, the location of the unit within the complex).

The customer pays a nonrefundable deposit upon entering into the contract and will make progress payments during construction of the unit.

The contract has substantive terms that preclude the entity from being able to direct the unit to another customer.

In addition, the customer does not have the right to terminate the contract unless the entity fails to perform as promised.

If the customer defaults on its obligations by failing to make the promised progress payments as and when they are due, the entity would have a right to all of the consideration promised in the contract, if it completes the construction of the unit.

At contract inception, the entity tests to determine whether its promise to construct and transfer the unit to the customer is a performance obligation satisfied over time.


Conclusion:

The entity should account for the sale of the unit as a performance obligation over time.

Here is the analysis of the three criteria for over-time treatment:


Response: No. The customer does not receive any benefits until the unit is completed.


Response: No. The customer has no control until the unit is completed.

Criterion 3: Two requirements must be met:



Response: Yes. Criterion 3 is satisfied.

First, the entity determines that the asset (unit) created by the entity’s performance does not have an alternative use to the entity because the contract precludes the entity from transferring the specified unit to another customer.

Second, if the customer were to default on its obligations, the entity would have an enforceable right to all of the consideration promised under the contract if it continues to perform as promised.

Consequently, 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. Criterion 3 is met.

The entity has a performance obligation that it satisfies over time.

Example 3: Revenue Over Time [From Example 18 of ASU 2014-09, as modified by the Author]

An entity, an owner and manager of health clubs, enters into a contract with a customer for one year of access to any of its health clubs.

The customer has unlimited use of the health clubs and promises to pay $100 per month.

The entity determines that its promise to the customer is to provide a service of making the health clubs available for the customer to use as and when the customer wishes. This is because the extent to which the customer uses the health clubs does not affect the amount of the remaining goods and services to which the customer is entitled.


The entity concludes that the customer simultaneously receives and consumes the benefits of the entity’s performance as it performs by making the health clubs available.

Conclusion:

Because the customer simultaneously receives and consumes the benefits of the entity’s performance, the revenue can be recognized over time (Criterion 1). Given the fact that Criteria 1 is satisfied, there is no need to test Criterion 2 or 3.

The entity also determines that the customer benefits from the entity’s service of making the health clubs available evenly throughout the year. (That is, the customer benefits from having the health clubs available, regardless of whether the customer uses it or not.)

Consequently, the entity concludes that the best measure of progress toward complete satisfaction of the performance obligation over time is a time-based measure, and it recognizes revenue on a straight-line basis throughout the year at $100 per month.

Example 4:

Company X is a manufacturer of equipment who enters into a contract with a customer to manufacture items using a customer’s design specifications.

The initial order is for 1,000 units.

Under the contract, X is precluded from selling any items that use the customer’s design specifications to any other parties.

The contract permits the customer to terminate the contract for convenience with 30 days’ notice. If the termination option is exercised by the customer:

• The customer receives possession of any existing finished goods and work in progress inventory.

• The customer is required to make a payment to X at the contract rate for any finished goods plus pay the entity’s cost plus a 10% contract margin for any work in progress.

Conclusion:

At contract inception, X assesses whether its performance obligation to build the equipment is a performance obligation satisfied over time or at a point in time.

Only one of the three criteria must be satisfied to account for the revenue over time.

In this example, X focuses on Criterion 3 and whether X satisfies Criterion 3. If so, there is no need to assess the other two criteria because only one of the three criteria must be met for over time recognition.

The rule is that Criterion 3 is satisfied and over time measurement of revenue is required if:

a. Requirement 1: X’s performance does not create an asset with an alternative use to the entity, and


b. Requirement 2: The entity has an enforceable right to payment for performance completed to date.

• For an entity to have an enforceable right to payment, the entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised.

First, the equipment does not have an alternative use because X is precluded from selling items to another party using the customer’s design.

Second, X has an enforceable right to payment.

a. X is entitled to payment that compensates X for performance completed to date if the customer terminates the contract.

b. The contract provides that if the customer terminates for convenience, X receives payment based on the 10% contract margin.

Therefore, X is required to measure revenue over time in Step 5, and will be required to measure it using an input or output method (such as costs, labor, etc).

Measuring Revenue Over Time- Analysis of its Application in Step 5

An entity shall recognize revenue for a performance obligation satisfied over time only if the entity can reasonably measure its progress toward complete satisfaction of the performance obligation. That benchmark is satisfied if it meets one of three criteria previously discussed as follows:




If an entity qualifies to recognize revenue for a performance obligation over time in Step 5, it must use a method to measure that revenue over time.

ASC 606 offers the following guidance in measuring revenue over time:

1. ASC 606 offers appropriate methods that can be used to measure an entity’s progress toward complete satisfaction of a performance obligation satisfied over time, and includes the following:

• Output methods

• Input methods


2. In determining the appropriate method for measuring progress, an entity shall consider the nature of the good or service that the entity promised to transfer to the customer.

3. When applying a method for measuring progress:

a) An entity shall exclude from the measure of progress any goods or services for which the entity does not transfer control to a customer.

b) An entity shall include in the measure of progress any goods or services for which the entity does transfer control to a customer when satisfying that performance obligation.

4. As circumstances change over time, an entity shall update its measure of progress to reflect any changes in the outcome of the performance obligation.

a) Any changes to an entity’s measure of progress shall be accounted for as a change in accounting estimate in accordance with ASC 250-10, Accounting Changes and Error Corrections.

5. An entity shall recognize revenue for a performance obligation satisfied over time only if the entity can reasonably measure its progress toward complete satisfaction of the performance obligation.

a) An entity would not be able to reasonably measure its progress toward complete satisfaction of a performance obligation if it lacks reliable information that would be required to apply an appropriate method of measuring progress.

Note

In some circumstances (for example, in the early stages of a contract), an entity may not be able to reasonably measure the outcome of a performance obligation, but the entity expects to recover the costs incurred in satisfying the performance obligation. In those circumstances, the entity shall recognize revenue only to the extent of the costs incurred until such time that it can reasonably measure the outcome of the performance obligation.

6. Output methods:

a) Using output methods, an entity recognizes revenue based on direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract, and include:

• Surveys of performance completed to date

• Appraisals of results achieved

• Milestones reached, time elapsed, and


• Units produced or units delivered.

b) ASC 606 offers a practical expedient, if an entity has a right to consideration from a customer in an amount that corresponds directly with the value to the customer of the entity’s performance completed to date, the entity may recognize revenue in the amount to which the entity has a right to invoice.

Examples:

• A service contract bills a fixed amount for each hour of service provided.

• A health club bills customers monthly for services provided on a monthly basis.

Note

The disadvantages of output methods are that the outputs used to measure progress may not be directly observable and the information required to apply them may not be available to an entity without undue cost. Therefore, an input method may be necessary.

7. Input methods:

a) With input methods, an entity recognizes revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation, including:

• Costs incurred

• Resources consumed

• Labor hours expended

• Costs incurred (similar to percentage of completion method)

• Time lapsed, or

• Machine hours used, relative to the total expected inputs to the satisfaction of that performance obligation.

b) If the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on a straight-line basis.

c) An entity should exclude from an input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer.

Are there drawbacks to using output and input methods?

ASC 606 identifies disadvantages of using both output and input methods to recognize revenue over time.


With respect to output methods, ASC 606 states that when an entity evaluates whether to apply an output method to measure its progress, the entity should consider whether the output selected would faithfully depict the entity’s performance toward complete satisfaction of the performance obligation.

An output method would not provide a faithful depiction of the entity’s performance if the output selected would fail to measure some of the goods or services for which control has transferred to the customer.

Example: Output methods based on units produced or units delivered would not faithfully depict an entity’s performance in satisfying a performance obligation if, at the end of the reporting period, the entity’s performance has produced work in process or finished goods controlled by the customer that are not included in the measurement of the output.

With input methods, ASC 606 suggests that a shortcoming of input methods is that there may not be a direct relationship between an entity’s inputs and the transfer of control of goods or services to a customer.

Therefore, an entity should exclude from an input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer. For instance, when using a cost-based input method, an adjustment to the measure of progress may be required in the following circumstances:

a. When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation. For example, an entity would not recognize revenue on the basis of costs incurred that are attributable to significant inefficiencies in the entity’s performance that were not reflected in the price of the contract (for example, the costs of unexpected amounts of wasted materials, labor, or other resources that were incurred to satisfy the performance obligation).

b. When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation. In those circumstances, the best depiction of the entity’s performance may be to adjust the input method to recognize revenue only to the extent of that cost incurred. For example, a faithful depiction of an entity’s performance might be to recognize revenue at an amount equal to the cost of a good used to satisfy a performance obligation if the entity expects at contract inception that all of the following conditions would be met:

• The good is not distinct.

• The customer is expected to obtain control of the good significantly before receiving services related to the good.

• The cost of the transferred good is significant relative to the total expected costs to completely satisfy the performance obligation.

• The entity procures the good from a third party and is not significantly involved in designing and manufacturing the good (but the entity is acting as a principal).


Sample Output and Input Methods

Output methods:

UNITS PRODUCED Units produced to date X Transaction price = Revenue recognized to dateEstimated total units

APPRAISAL OF RESULTS ACHIEVED% of project achieved to date X Transaction price = Revenue recognized to datebased on appraisal

Input methods:

BASED ON COSTSCosts incurred to date X Transaction price = Revenue recognized to dateEstimated total costs

BASED ON LABORLabor incurred to date X Transaction price = Revenue recognized to dateEstimated total labor costs

BASED ON MACHINE HOURSMachine hours incurred to date X Transaction price = Revenue recognized to dateEstimated total machine costs

TIME LAPSED# months to date X Transaction price = Revenue recognized to dateEstimated total months for project

Using Input Method Based on Costs Incurred

Most entities who have used the traditional percentage-of-completion method will likely measure revenue over time (Step 5) using a cost-based input method. In doing so, the new formula under ASC 606 will approximate the method previously used in ASC 605.

Although not specifically codified within ASC 606, a typical cost-based input method looks like this:

Costs incurred to date (1) X Transaction price = Revenue recognized to dateEstimated total costs (1)

(1): Includes direct materials, labor, subcontract costs, and other costs incurred related to the entity’s performance

There are a few issues an entity should consider when using the cost-based input method.

1. An adjustment to costs incurred to date might be required prior to applying the cost formula.


2. An entity should exclude from the cost-based input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer, which occurs in the following situations:

a) When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation.

b) When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation.

In those circumstances, the best depiction of the entity’s performance may be to remove the cost from both the contract revenue and costs, and then apply the cost-based formula to the remainder of costs.

Which costs should be included in the cost-based input formula?

ASC 606 does not explicitly define what costs are included in a cost-based formula using an input method.

ASC 606-1-55-21 does give some guidance as to what should be excluded.

An entity should exclude from an input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer. Such excludable costs are those that:

• Do not contribute to an entity’s progress in satisfying the performance obligation and transferring the goods and services.

• Are not proportionate to the entity’s progress in satisfying the performance obligation and transferring the goods and services.

Absent specific guidance, an entity should follow the cost-to-cost approach that was used in the pre-ASC 606 percentage-of-completion method.

Using the existing cost-to-cost approach as a guide, an entity using the cost-based input method should include the following costs in both the numerator and denominator of the formula. These costs typically contribute directly to and entity’s progress in satisfying the performance obligation:

• Direct materials

• Direct labor

• Subcontract costs

• Other costs incurred that are related to the entity’s performance under a contract and the transfer of the goods and services to the customer.

Costs that should not be included in the cost-based formula consist of any costs that do not contribute directly to the transfer of the goods and services to the customer, such as:

• General and administrative costs


• Marketing costs

• Cost of unexpected wasted materials, labor or other resources8

• Uninstalled equipment and materials

• Depreciation and amortization on idle equipment and intangibles

• Research and development costs

Examples- Revenue Recognized Over Time- Step 5

The author presents the following examples to illustrate the application of ASC 606 when an entity qualifies to recognize revenue in Step 5 over time. Some of the examples have been extracted from ASC 606, as modified by the Author.

Example 1: Measuring Progress When Making Goods or Services Available

Source: Example 18 of ASU 2014-09, as modified by the Author

An entity, an owner and manager of health clubs, enters into a contract with a customer for one year of access to any of its health clubs for the calendar year 2023.

The customer has unlimited use of the health clubs and promises to pay $100 per month (total of $1,200 for the year).

The entity determines that its promise to the customer is to provide a service of making the health clubs available for the customer to use as and when the customer wishes.

This is because the extent to which the customer uses the health clubs does not affect the amount of the remaining goods and services to which the customer is entitled.

The entity considers the three criteria to qualify revenue to be recognized over time in step 5.

The entity concludes that it satisfies Criterion 1 as follows:

The customer simultaneously receives and consumes the benefits of the entity’s performance as it performs by making the health clubs available. That is, as the customer pays its monthly fee of $100, the customer also receives the benefit of access to the health club services.

Conclusion:

Because Criterion 1 is satisfied in Step 5, the entity’s performance obligation is satisfied over time.

The next question is what method should the entity use to measure the revenue over time: an output or input method?

8. See ASC 606-10-55-21.


• The entity determines that the customer benefits from the entity’s service of making the health clubs available evenly throughout the year. That is, the customer benefits from having the health clubs available, regardless of whether the customer uses it or not.

• Consequently, the entity concludes that the best measure of progress toward complete satisfaction of the performance obligation over time is a time-based (lapsed) measure, and it recognizes revenue on a straight-line basis throughout the year at $100 per month.

For example, in January 2023 revenue would be recognized $100 of revenue based on annual revenue of $1,200 as follows:

TIME LAPSED (time based)# months to date (1 month) X Transaction price = Revenue recognized to dateEstimated total months (12 months) $1,200 $100

Example 2: Installation – Over Time Revenue Recognition

Construction Inc. enters into a contract with Real Estate Co. (customer) to replace 1,000 windows throughout residential apartment buildings.

The fee to replace the windows is $400,000 to be performed evenly over approximately 24 months at about 40-50 windows installed per month, depending on weather and occupancy.

The installation period is January 1, 2023 to December 31, 2024 (24 months).

Real Estate Co. owns the apartment buildings on which the windows will be installed.

The contract provides that Real Estate Co. (customer) controls the installation of the windows.

At the end of the first year (December 31, 2023), Construction Inc. has replaced 550 of the 1,000 windows.

Construction Inc. performances the analysis in Step 5 to determine whether it should recognize revenue over time or at a point in time.

In evaluating the three criteria in Step 5, Construction Inc. concludes that it qualifies to recognize revenue on this contract over time.

The reason is because the company meets Criterion 2 in that:

The entity’s performance (Construction Inc.) creates or enhances an asset (work in progress installation of the windows) that the customer controls as the asset (window installation) is created or enhanced.

Criterion 2 applies to situations in which a customer controls work as it is being performed by the entity, such as in the case in which goods are manufactured or constructed such as work in progress.

One fact supporting Criterion 2 satisfaction is that the contract provides that Real Estate Co. (customer) controls the installation of the windows. Thus, Real Estate Co. controls the installation in that it has the ability to direct the installation and, of course, obtains the benefits from the installation as it occurs.


Once Construction Inc. qualifies for over-time recognition of the $400,000 of revenue, the next step is to select a method to use to measure the recognition of the revenue over time.

Assume in this case, Construction Inc. decides the best method is an output method based on units produced because the services performed appear to be consistent across the 1,000 units to be installed.

Conclusion:

Revenue to be recognized after 12 months is as follows:

UNITS PRODUCED- December 31, 2023Units produced to date (550) X Transaction price = Revenue recognized to dateEstimated total units (1,000) $400,000 $220,000

For the year ended December 31, 2023, Construction Inc. should record revenue of $220,000 out of the total contract amount of $400,000.

Example 3: Traditional Input Method- Costs Incurred

In November 2022, Refurbco contracts with a customer to refurbish a 3-story building for a total contract price of $5 million.

Refurbco considers the contract to be one single performance obligation.

Moreover, Refurbco believes it qualifies to recognize revenue on the contract over time because it satisfies Criterion 2 in Step 5 as follows:

Refurbco’s performance creates or enhances an asset (work in process) that the customer controls as the asset is created or enhanced. The customer controls the refurbishment because the customer owns the building and can control the work in progress.

Total expected costs are $4 million.

A summary of the transaction price and expected costs is as follows:

Transaction price- renovation $5,000,000

Estimated costs: Total estimated total costs (4,000,000)

Estimated profit $1,000,000

Refurbco uses a cost-based input method to measure its progress toward complete satisfaction of the performance obligation. The company believes that using the cost method, there is a direct relationship between an entity’s inputs (costs) and the transfer of control of goods or services to a customer.

At December 31, 2022, Refurbco has incurred $2,000,000 of the total of $4,000,000 of renovation costs (50%).


Conclusion:

Refurbco qualifies for recognizing revenue on the contract over time and elects to use an input method based on costs.

But, in this case, it appears that the inputs (costs) do depict the transfer of control to the customer so that including all costs in the costs method formula is appropriate.

Following is the calculation of revenue recognized in 2022 based on the input method using costs incurred.

BASED ON COSTS- December 31, 2022Costs incurred to date ($2,000,000) X Transaction price = Revenue recognized to dateEstimated total costs ($4,000,000) $5,000,000 $2,500,000

As a result, for year ended December 31, 2022, Refurbco should record revenue of $2,500,000, costs incurred to date of $2,000,000, and a net profit to date of $500,000.

December 31, 2022Revenue $2,500,000Cost of goods sold (2,000,000)Profit $500,000

Example 3A: Cost Does Not Depict Transfer of Control

Same facts as Example 3 except that total expected costs are $4 million, including a cost of $1.5 million for the elevators.

A summary of the transaction price and expected costs is as follows:

Transaction price- renovation $5,000,000

Estimated costs: Elevator equipment (1,500,000)Renovation costs (2,500,000)

Total estimated total costs (4,000,000)

Estimated profit $1,000,000

The elevators are delivered to the site in December 2022 and will not be installed until June 30, 2023.

Refurbco controls the elevators on the delivery date.

At December 31, 2022, Refurbco has incurred $500,000 of the total of $2,500,000 of renovation costs (20%), exclusive of the elevator cost.


Conclusion:

Refurbco qualifies for recognizing revenue on the contract over time and elects to use a cost-based input method.

But, in this case, one of the inputs (costs) for the elevator does not depict the transfer of control to the customer. The reason is because the elevator is complete when delivered even though the rest of the project is not complete.

Paragraph ASC 606-10-55-21states that:

“an entity should exclude from an input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer. For instance, when using a cost-based input method, an adjustment to the measure of progress may be required…”

When using a cost-based input method, an adjustment to costs incurred to date might be required prior to applying the cost formula. Such a requirement may be necessary:

1. When a cost incurred does not contribute to an entity’s progress in satisfying the performance obligation.

2. When a cost incurred is not proportionate to the entity’s progress in satisfying the performance obligation.

Thus, in applying the cost method, Refurbco first should remove the $1.5 million of elevator cost from the computation.

The elevators have been delivered and 100% of that cost ($1.5 million) is not proportionate of the remainder of the renovation job.

Following is the calculation of revenue recognized in 2022 based on the input method using costs incurred.

Costs incurred to date- December 31, 2022Elevator $1,500,000Other costs $2,500,000 20% 500,000

Costs incurred to date $2,000,000


Revenue recognized to date: December 31, 2022Transaction price $5,000,000Elevator (1,500,000)Remainder revenue $3,500,000

Revenue recorded$3,500,000 x 20% $700,000Elevator 1,500,000

Revenue to date $2,200,000

As a result, for year ended December 31, 2022, Refurbco should record revenue of $2,200,000, costs incurred to date of $2,000,000 and a net profit to date of $200,000, as shown below:

December 31, 2022Revenue $2,200,000Cost of goods sold (2,000,000)Profit $200,000

C. CONTROL TRANSFERS AT A POINT IN TIME- STEP 5

To review, ASC 606 provides the following guidance in implementing Step 5:

1. An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer.

a) A good or service is transferred when (or as) the customer obtains control of that good or service.

2. Control of an asset refers to the:

• Ability to direct the use of the asset, and

• Obtain substantially all of the remaining benefits from the asset.

3. The customer satisfies a performance obligation (customer obtains control) under one of two scenarios:

• Over time, or

• At a point in time.

4. In Step 5, for each performance obligation identified, an entity shall determine at contract inception whether it satisfies the performance obligation (and the customer obtains control) over time or at a point in time.

5. If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time (when a customer obtains control).


6. Point in time

a) To determine the point in time at which a customer obtains control of a promised asset and an entity satisfies a performance obligation, the entity should consider indicators of the transfer of control, which include, but are not limited to, the following:

1) The entity has a present right to payment for the asset.

2) The customer has legal title to the asset.

3) The entity has transferred physical possession of the asset.

4) The customer has the significant risks and rewards of ownership of the asset.

5) The customer has accepted the asset.

Observation

ASC 606 offers the previous list of indicators that there is a transfer of control. The list is not all inclusive, and because they are “indicators,” there is no requirement that an entity satisfy all of the ones on the list.

7. Indicators of a transfer of control at a point in time

Following is a brief discussion of each of the indicators of the transfer of control to a customer:

Indicator 1: The entity has a present right to payment for the asset

ASC 606 states that if a customer presently is obliged to pay for an asset, that may indicate that the customer has control over the asset and has a) obtained the ability to direct the use of, and b) obtained substantially all of the remaining benefits from, the asset in exchange.

Indicator 2: The customer has legal title to the asset

ASC 606 provides that legal title may indicate which party to a contract has the ability to direct the use of, and obtain substantially all of the remaining benefits from, an asset or to restrict the access of other entities to those benefits.

a. The transfer of legal title of an asset may indicate that the customer has obtained control of the asset.

b. If an entity transfers the asset to the customer, but retains legal title to the asset, solely as protection against the customer’s failure to pay, those rights of the entity would not preclude the customer from obtaining control of an asset.


Example 1: Company X sells goods to a customer who is in financial trouble.

The physical goods are shipped to the customer.

In order to secure payment from the customer, X retains title to the goods even though physical possession of the goods is transferred to the customer.

X’s retention of title does not affect the customer’s control over the goods in that it does have the ability to a) direct the use of, or b) obtain substantially all of the remaining benefits from, the goods.

Conclusion: The fact that the seller (X) retains title to the asset, in and of itself, does not mean that control has not transferred to the customer.

The key question is whether the customer has control over the asset and has a) obtained the ability to direct the use of, and b) obtained substantially all of the remaining benefits from, the asset in exchange.

X must consider all indicators together as a whole to determine whether the customer has control. Title retained by X to protect against the customer’s failure to pay is not a disqualifying factor.

Example 1A: Same facts as Example 1 except that X does not retain title to the goods transferred to the customer. Instead, X obtains a security interest in the goods in the form of a UCC-1 filing until the customer pays for the goods in full.

Conclusion: Like its analysis in Example 1, X must look at all indicators and do an assessment as to whether control has been transferred to the customer so that revenue can be recognized at the point in time at which the transfer of control occurs.

The key question is whether the customer has control over the asset and has a) obtained the ability to direct the use of, and b) obtained substantially all of the remaining benefits from, the asset in exchange.

Does the fact that X holds a UCC-1 security interest in the goods affect the customer’s ability to direct the use of, or obtain substantially all of the remaining benefits from, the goods?

The author believes that the security interest might restrict the customer’s control over the asset in terms of its ability to use the asset and obtain substantially all of the remaining benefits from it.

Thus, in making the assessment as to whether control has transferred, it would appear the security interest disqualifies the transfer of title as an indicator supporting transfer of control.

However, X might have other indicators that, as a whole, support control transferring to the customer such as right to payment, risks and rewards transferring to the customer, etc.

Indicator 3: The entity has transferred physical possession of the asset

ASC 606 suggests that a customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits.

However, physical possession may not coincide with control of an asset in all cases.


Examples:

• In some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset even though the entity continues to control that asset.

• Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls.

• In consignment arrangements, an entity transfers control but not necessarily title.

Indicator 4: The customer has the significant risks and rewards of ownership of the asset

The transfer of the significant risks and rewards of ownership of an asset to the customer may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.

When evaluating the risks and rewards of ownership of a promised asset, an entity shall exclude any risks that give rise to a separate performance obligation in addition to the performance obligation to transfer the asset.

Example: An entity may have transferred control of an asset to a customer but not yet satisfied an additional performance obligation to provide maintenance services related to the transferred asset.

Indicator 5: The customer has accepted the asset

A customer’s acceptance of an asset may indicate that the customer has obtained control of the asset.

a) Customer acceptance clauses allow a customer to cancel a contract or require an entity to take remedial action if a good or service does not meet agreed-upon specifications.

1) An entity should consider such clauses when evaluating when a customer obtains control of a good or service.

2) If an entity can objectively determine that control of a good or service has been transferred to the customer in accordance with the agreed-upon specifications in the contract, then customer acceptance is a formality that would not affect the entity’s determination of when the customer has obtained control of the good or service.

b) If an entity cannot objectively determine that the good or service provided to the customer is in accordance with the agreed-upon specifications in the contract, then the entity would not be able to conclude that the customer has obtained control until the entity receives the customer’s acceptance.


c) If an entity delivers products to a customer for trial or evaluation purposes and the customer is not committed to pay any consideration until the trial period lapses, control of the product is not transferred to the customer until either the customer accepts the product or the trial period lapses.

Example 1: At Point in Time

Company Y is a manufacturer of medical supplies.

Y enters into a contract with a distributor under which the distributor takes title to the supplies upon receipt in the distributor’s warehouse.

Payment is due in full once received in the distributor’s warehouse.

The distributor has the right of return of damaged goods only.

Y is certain that its performance obligation is recognized at a point in time because the three criteria for over time treatment are not satisfied.

Conclusion:

The entity assesses at what point in time the distributor obtains control of the equipment. That is the time at which the performance obligation is considered complete and revenue is recognized under the point-in-time approach.

Factors to consider whether a transfer of control to the customer has occurred, include:

• The entity has a present right to payment for the asset.

• The customer has legal title to the asset.

• The entity has transferred physical possession of the asset.

• The customer has the significant risks and rewards of ownership of the asset.

• The customer has accepted the asset.

Y concludes that control transfers to the distributor when the equipment is delivered (transferred) to the distributor’s warehouse.

On that date of delivery to the distributor’s warehouse:

• Y has a present right to payment for the asset.

• The customer (distributor) has legal title to the asset.

• Y has transferred physical possession of the asset.

• The customer (distributor) has the significant risks and rewards of ownership of the asset based on the fact that there is no right of return.

• The customer (distributor) has accepted the asset.


The result is that on the date of delivery, there is a transfer of control of the asset to the customer. Thus, on that date, Y recognizes the revenue at that point in time.

D. SPECIAL RIGHT-TO-INVOICE PRACTICAL EXPEDIENT- STEP 5

ASC 606 offers a practical expedient that permits an entity to bypass the entire decision-making process in Step 5.

ASC 606-10-55-18 states:

“As a practical expedient, if an entity has a right to consideration from a customer in an amount that corresponds directly with the value to the customer of the entity’s performance completed to date, the entity may recognize revenue in the amount to which the entity has a right to invoice.”

The practical expedient permits an entity to recognize revenue in the amount of an invoice if the entity:

a) Has a right to the amount in the invoice, and

b) The amount corresponds directly with the value to the customer of the entity’s performance completed to date.

Example 1:

A entity with a service contract bills a fixed amount for each hour of service provided. The value of the invoice corresponds directly with the value to the customer.

Conclusion:

In such a case, the entity is permitted to recognize the invoice amount as its revenue and bypass the (point in time or over time ) revenue computation in Step 5.

Example 2:

Source: TRG Memo 40, as modified by the Author

Power Seller and Power Buyer execute a contract for the purchase and sale of electricity over a six-year term.

Power Buyer is obligated to purchase 10 megawatts (MW) of electricity per hour for each hour during the contract term (87,600 MWh per annual period) at prices that contemplate the forward market price of electricity at contract inception.

The contract prices are as follows:

• Years 1-2: $50/MWh




The transaction price, which represents the amount of consideration to which Power Seller expects to be entitled in exchange for transferring electricity to Power Buyer.

Power Seller concludes that the promise to sell electricity represents one performance obligation that will be satisfied over time.

Conclusion: Power Seller qualifies for the use of the right-to-invoice practical expedient and should recognize revenue in Step 5 based on the invoice that is billed to the customer.

The reasons for the qualification are:

a. Power Seller has a right to the amount invoiced to the customer, and

b. The amount billed to the customer corresponds directly with the value to the customer of the entity’s performance completed to date.

Thus, in Step 5, revenue is recorded under the contract based on the amount invoiced to the customer.

Observation

The right-to-invoice approach is addressed in both TRG Memo. No. 40 and 44. In TRG Memo No. 44, TRG members and FASB staff concluded that even though ASC 606 references situations in which there is a “fixed amount” in the contract, an entity is not precluded from applying the practical expedient in situations in which the price-per-unit changes during the duration of the contract.

The staff and TRG members noted that application of the practical expedient in those situations involves an analysis of the facts and circumstances of the arrangement.

Observation

The right-to-invoice practical expedient is an effective approach to record revenue in Step 5. ASC 606 also offers entities that elect the “right-to-invoice” practical expedient to exclude certain disclosures. This issue is discussed further in the disclosure section of this course.

E. ONEROUS CONTRACT RULES

For years, GAAP has had a provision to deal with indicated losses in construction-type contracts regardless of whether the percentage-of-completion or completed contract method was used. Those rules were found in ASC 605-35-25-45, Revenue Recognition-Construction-Type and Production-Type Contracts-Recognition-Provision for Losses on Contracts and have become known as the onerous contract or indicated loss rules.


In drafting final ASC 606, the FASB decided to retain the guidance in ASC 605-35 with respect to onerous losses, subject to amendments made by ASU 2016-20.

Specifically, ASC 606-10-60-9 states:

“For guidance on determining the need for a provision for losses for construction-type and production-type contracts, see Subtopic 605-35.”

The rules, as amended, in ASC 605-35 that are carried over in ASC 606, state the following:

1. For a contract on which a loss is anticipated, an entity shall recognize the entire anticipated loss as soon as the loss becomes evident.

2. When the current estimates of the amount of consideration that an entity expects to receive in exchange for transferring promised goods or services to the customer, determined in accordance with ASC 606, and contract cost indicate a loss, a provision for the entire loss on the contract shall be made.

3. A provision for a loss shall be made in the period in which the loss becomes evident.

4. In determining the amount that an entity expects to receive, the entity shall use the principles for determining the transaction price in ASC 606 with some exceptions:

a) If there is variable consideration, any variable consideration not recorded due to the constraining estimates rule shall not be eliminated from the transaction price.

b) In addition, the entity shall adjust that amount to reflect the effects of the customer’s credit risk.

5. If a group of contracts are combined in ASC 606, they shall be treated as one unit in determining the necessity for a provision for a loss.

a) If contracts are not combined, the loss is determined at the contract level.

6. As an accounting policy election, performance obligations may be considered separately in determining the need for a provision for a loss.

7. Under the accounting policy election, an entity can elect to determine provisions for losses at either the contract level or the performance obligation level.

a) An entity shall apply this accounting policy election in the same manner for similar types of contracts.

Example:

Company X, a contractor, has a long-term construction contract with a customer.

After allocating the transaction price to the performance obligation in Step 4, it is apparent that X will incur a loss on the contract as follows:


Transaction price allocated to the performance obligation in Step 4 $1,000,000Estimated total contract costs for the performance obligation (1,200,000)Indicated loss $(200,000)

Conclusion:

X should accrue a loss on the contract as follows:

Entry- after completing Step 4 dr crLoss on contract 200,000

Accrued loss on contract 200,000

Observation

The indicated loss rule has been around ever since long-term construction contract accounting has existed. Under ASC 606, it is important that an entity be cognizant of the indicated loss rule.

The timing of the test of indicated loss is fluid. That is, the loss is accrued at any time at which an anticipated loss becomes “evident.” That can come at any time at which the contract costs exceed the amount of consideration expected to be received.

That test can be done either at the contract level or performance obligation level, although the two are likely to be the same in most instances.

If the test is to be done at the performance obligation level, it is likely to be done no earlier than the completion of Step 4, at which time the entity knows the amount of transaction price allocated to the performance obligation.

If the test is done at the contract level, there could be an indicated loss any time after the contract is executed and an anticipated loss is evident.

Note further that the indicated loss rule applies to all entities regardless of the method used to recognize revenue. Thus, entities that use the over time, at a point in time, or even the right-to-invoice method to measure revenue, are susceptible to having an indicated loss. The key issue is whether estimated costs are expected to exceed anticipated revenue. If so, there is an indicated loss that should be recorded.




1. Under ASC 606, an entity recognizes revenue when it satisfies a performance obligation by which of the following:

A. transferring payment for a good or service

B. transferring a promised good or service

C. executing a contract for a good or service

D. delivering the good to the customer

2. Company M is applying Step 5 of the revenue standard to each of its performance obligations. Which of the following is correct. If a performance obligation is ________, it is ________________:

A. not satisfied at a point in time; satisfied over time

B. not satisfied over time; satisfied at a point in time

C. satisfied at a point in time; also satisfied over time

D. not satisfied over time; not satisfied at a point in time

3. Company X is evaluating whether it should recognize revenue related to a performance obligation over time or at a point in time. Which one of the following is a criterion that helps lead to the conclusion that X transfers control of the good or service over time:

A. X creates an asset that the customer controls as the asset is created

B. X’s performance creates an asset with an alternative use

C. X does not have an enforceable right to payment for performance completed to date

D. X’s customer does not receive or consume benefits until the completion of the transfer of the good or service


4. Company N is using a cost-based input method to recognize revenue over time with respect to a customer contract. Using the cost-to-cost approach, which of the following costs should not be included in the formula:

A. direct labor

B. subcontract costs

C. G&A costs

D. other costs that relate to N’s performance under a contract

5. Company M is recognizing revenue in Step 5 at a point in time under the revenue standard. M wants to determine when it transfers control of the asset to the customer and satisfies its performance obligation. Which of the following is a factor in determining transfer of control:

A. customer has no legal title to the asset

B. customer has accepted the asset

C. customer has no real significant risks and rewards of ownership of the asset

D. customer has not yet picked up the asset and obtained possession of the asset

6. Company J has a contract with a customer. On December 31, 20X2, J estimates that it is going to incur a loss on the customer contract. What should J do:

A. disclose the possible loss only

B. recognize the entire anticipated loss as soon as the loss becomes evident

C. do nothing because the loss is nothing more than an estimate

D. estimate a partial loss only for the portion of loss estimated to be incurred to date



1. A. Incorrect. Transferring payment has nothing to do with recognizing revenue.

B. CORRECT. ASC 606 provides that an entity should recognize revenue when it satisfies a performance obligation by transferring a promised good or service.

C. Incorrect. Executing a contract for a good or service has no impact on the timing of revenue recognition.

D. Incorrect. Revenue is recognized when there is a transfer of the promised good or service. Delivering a good is not necessarily indicative of transfer of the promised good to the customer.


2. A. Incorrect. An entity first determines whether the performance obligation is satisfied over time. If not, it is satisfied at a point in time. Thus, the answer is incorrect in that it is backwards.

B. CORRECT. ASC 606 states that in applying Step 5, if a performance obligation is not satisfied over time, it is considered satisfied at a point in time.

C. Incorrect. ASC 606 provides that revenue is recognized either over time or at a point in time, but not both.

D. Incorrect. Under ASC 606, revenue must be recognized either over time or at a point in time.


3. A. CORRECT. One criterion that suggests a transfer of control over time is if the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.

B. Incorrect. One criterion supporting over time treatment is if X’s performance does not create an asset with an alternative use to the entity.

C. Incorrect. If X does have an enforceable right to payment for performance completed to date, that fact is a criterion that supports over time treatment.

D. Incorrect. X’s customer simultaneously receiving and consuming benefits as the entity performs is a criterion for not recognizing revenue until the completion of the transfer of the good or service.



4. A. Incorrect. Direct labor is included in the formula as it contributes directly to N’s progress in satisfying the performance obligation.

B. Incorrect. Subcontract labor is included in the formula as it contributes directly to N’s progress in satisfying the performance obligation.

C. CORRECT. G&A costs are typically excluded from the cost formula as they do not contribute to N’s progress in satisfying the performance obligation and transferring the goods and services.

D. Incorrect. Any other costs that relate to N’s performance under a contract are included in the formulas as they contribute directly to N’s progress in satisfying the performance obligation.


5. A. Incorrect. Having legal title of the asset is an indicator, rather than not having legal title.

B. CORRECT. A factor that demonstrates control is when the customer has accepted the asset.

C. Incorrect. In order to transfer control to a customer, one factor is that the significant risks and rewards of ownership of the asset have passed to the customer.

D. Incorrect. One factor confirming control is if the customer has obtained possession of the asset. In this case, the customer has not yet picked up the asset so that M probably does not have control over the asset.


6. A. Incorrect. Although an entity may choose to disclose the possible loss, the indicated loss rule requires an entity to record a provision for the loss.

B. CORRECT. ASC 606 carries over ASC 605-35’s onerous contract rule. Under the rule, an entity is required to recognize a provision for the entire anticipated loss as soon as the loss becomes evident.

C. Incorrect. The onerous contract rule requires an entity to record a provision for an indicated loss.

D. Incorrect. The rule requires the entire anticipated loss to be recorded, not a partial loss.




• Recognize how to account for the transfer of a product with a right to return.• Recognize the requirement that must be met for a company to be considered a principal in a

revenue transaction.• Recall the general rule that determines whether an entity should record revenue gross or net.• Identify different types of warranties accounted for under the revenue standard.• Identify different types of intellectual property subject to the licensing rules in the revenue standard.• Recognize an example of a prepaid stored-value product.• Recall how an entity should account for breakage related to prepaid stored-value products.

VII. SELECTED ISSUES IN APPLYING THE FIVE STEPS OF THE REVENUE MODEL

The author addresses some of the key issues related to the new revenue standard as follows:

A. Sale with a Right of Return

B. Sales with a Refund Liability

C. Principal versus Agent Considerations

D. Non-Refundable Upfront Fees Received

E. Warranties

F. Bill-and-Hold Arrangements

G. Consignment Arrangements

H. Licensing

I. Presenting Sales Taxes and Other Similar Taxes Collected from Customers

J. Shipping and Handling- Step 2 Identifying Performance Obligations

K. Breakage in Prepaid Gift Cards

A. SALE WITH A RIGHT OF RETURN

It is common for retailers, manufacturers and other companies to provide customers with the right to return a product for a full or partial refund, a credit, or an exchange for another product.

In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receives any combination of the following:


• A full or partial refund of any consideration paid,

• A credit that can be applied against amounts owed, or that will be owed, to the entity, or

• Another product in exchange.

ASC 606 offers a few comments about such returns:

1. A company’s right of return policy might be explicitly stated within the customer contract, or it might be implicitly applied on a case-by-case basis.

2. Exchanges by customers of one product for another of the same type, quality, condition, and price (for example, one color or size for another) are not considered returns.

3. ASC 606 provides the following rules to account for the right to return a product:

a) To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following at the time revenue is recognized in Step 5:

1) Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)

2) A refund liability (portion of the revenue not expected to be entitled to)

3) An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.

Note

An asset (and corresponding adjustment to cost of sales) represents the entity’s right to recover products from customers on settling the refund liability. The asset should initially be measured by reference to the former carrying amount of the inventory less any expected costs to recover those products. Subsequently, an entity should update the measurement of the asset to correspond with changes in the measurement of the refund liability.

b) An entity’s promise to stand ready to accept a returned product during the return period would not be accounted for as a separate performance obligation in addition to the obligation to provide a refund.


Note

The cumulative amount of revenue the entity recognizes to date shall not exceed the amount to which the entity is reasonably assured to be entitled.

c) For any amounts to which an entity does not expect to be entitled, the entity should not recognize revenue when it transfers products to customers but should recognize any consideration received as a refund liability.

Note

Because the contract allows a customer to return the goods, the consideration received from the customer is considered variable consideration. Variable consideration should be measured using either the expected value method or the most likely amount method. The expected value method is based on the sum of probability-weighted amounts in a range. Other companies might use the most likely amount method in which a single most likely amount in a range is selected. For example, a retailer estimates the percentage of returns is between 2% and 3%. The entity could choose 3% for its returns calculation.

1) Subsequently, the entity should update its assessment of amounts to which the entity is reasonably assured to be entitled in exchange for the transferred products and should recognize corresponding adjustments to the amount of revenue recognized.

2) An entity should update the measurement of the refund liability at the end of each reporting period for changes in expectations about the amount of refunds. An entity should recognize corresponding adjustments as revenue (or reductions of revenue).

Example: Right of Return [from ASU 2014-09, as modified by the Author]

Facts:

An entity sells 100 products for $100 each.

The cost of each product is $60.

The entity’s customary business practice is to allow a customer to return any unused product within 30 days and receive a full refund.

The entity estimates (using the most likely amount method) that three products (3%) will be returned. The entity’s experience is predictive of the amount of consideration to which the entity will be entitled.


The entity estimates that the costs of recovering the products will be immaterial and expects that the returned products can be resold at a profit.

Conclusion:

Upon transfer of control of the products, the entity should not recognize revenue for the three products that it expects to be returned. Consequently, the entity should recognize:

Total sales 100 units x $100 = $10,000Estimated returns 3 units x $100 = (300)Sales not expected to be returned 97 units x $100 = $9,700

Entry at date of transfer of control (sale date): dr crAccounts receivable 10,000

Revenue 9,700Refund liability 300

Cost of sales (97 x $60) 5,820Recovery asset (3 x $60) 180

Inventory (100 x $60) 6,000

Observation

Historically, most companies have recognized returns and allowances on a cash basis when the return was actually made.

ASC 606 requires the return and allowance to be recognized at the time the revenue is recorded as a direct reduction of the revenue recognized. Most significant is that there are now a recovery asset and return liability that must be recognized at the time revenue is recorded to reflect the estimates of the returns. The asset is recorded at its inventory carrying amount on the books at the time of sale (e.g., amount at which it is recorded) less any costs, if any, to recover the asset. Once the asset is recorded, it must be evaluated for impairment under ASC 606, and not treated for impairment or lower of cost or market (or lower of cost and net realizable value) under the inventory rules found in ASC 330, Inventory.

B. SALE WITH A REFUND LIABILITY

Similar to a sale with a right to return the goods, it is common that an entity sells goods and offers a form of refund or discount if a customer achieves a defined milestone, such as selling a certain volume of goods on a cumulative basis.

ASC 606 treats such a transaction similar to the way in which a sale with a right of return is accounted for. That is, at the time of recognizing revenue (Step 5), an entity might be required to record the discount as a refund liability.

Following are the rules found in ASC 606-10-32-10:


1. An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer.

2. A refund liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price).

3. The refund liability (and corresponding change in the transaction price and, therefore, the contract liability) shall be updated at the end of each reporting period for changes in circumstances.

Note

If the transaction relates to a sale with a right of return of the goods, the transaction should be accounted for under the sale with a right-of-return rules previously discussed in this chapter, which also require that a refund liability (and related asset) be recorded at the time revenue is recognized in Step 5 to reflect the amount of anticipated return of goods.

Example 1: Sale with Refund Liability

Sarah’s Hot Muffins (Sarah) sells muffins to a distributor and enters into a contract to sell muffins. Under the contract, Sarah sells her muffins to the distributor at $1.00 per muffin on the first 2 million units. Once the customer achieves 2 million units, the customer receives a retroactive price to the first unit of $.80 per unit.

Goods are sold and shipped to the customer in increments of 100,000 units, at which time the customer receives control.

On the date of transfer (shipping) of goods to the customer, the company has an unconditional right to consideration for the goods.

The Company determines that revenue in Step 5 should be recognized at a point in time as each goods are transferred to the customer.

Moreover, the company, based on historical sales, expects that the customer will easily achieve the 2 million unit sales so that the sales price on all units retroactively is $.80.

On March 15, 20X9, the Company ships to the customer 100,000 units and should make the following entry at the date control is transferred to the customer, which is March 15, 20X9.

Conclusion:

On March 15, 20X9, control of 100,000 units is transferred (shipped) to the customer at which time X should record revenue using the point in time approach in Step 5. However, because the company expects to refund $.20 of the $1.00, it should record a refund liability for the $.20, which is the amount for which the entity does not expect to be entitled.


Entry:- Point in Time – Step 5

March 15, 20X9: dr crReceivable (1) 100,000

Revenue 80,000Refund liability 20,000

To record transfer of 100,000 units to customer and recognition of refund liability for discount as follows:

$1.00 x 100,000 units = $100,000 receivable$.80 x 100,000 units = $80,000

The refund liability of $20,000 represents a refund of $.20 per unit, which is expected to be provided to the customer for the volume-based rebate (that is, the difference between the $1.00 price stated in the contract that the entity has an unconditional right to receive and the $.80 estimated transaction price).

(1): The entry is made to a receivable and not to a contract asset because the entity has an unconditional right to the consideration at the date the goods are transferred and control is transferred to the customer.

C. PRINCIPAL VERSUS AGENT CONSIDERATIONS

The issue as to whether an entity should record revenue on a gross or net basis has been around for several decades and came to prominence on or around Year 2000 during the advent of the Internet boom.

Historically, Internet-based startups have created value driven by revenue growth regardless of profitability. In their infancy, companies such as Amazon raised significant capital simply by demonstrating their ability to drive revenue, even though these companies operated for years without generating a profit. Even Enron took advantage of the gross revenue situation when it grossed up some of its energy contracts on natural gas. Most recently, Snapchat made an initial public offering with significant revenue, but lacking profitability.

This revenue-driven model was highlighted during the period 1998 to 2002 as numerous startup companies occupied the Internet market and competed for startup capital prior to going public.

The goal for a typical Internet startup company has been to:

Step 1: Raise start-up capital,

Step 2: Drive revenue (not profits) to justify value, and

Step 3: Cash out with an Internet IPO.

Revenue growth, not profitability, has been the driver attracting investors to Internet-based and Social-Media companies with a captured market share. Again, Amazon is the perfect example of a company that has driven revenue growth, captured market share, and ignored profitability. Despite only marginal profitability, Facebook also attracted investors to its IPO due, in part, to it having 500 million customers.


Presenting revenue gross, when it should be net, is nothing more than another form of window dressing in which a company presents itself as a larger scale entity than reality dictates.

Consider the following example.

Assume Company X receives a 15% commission on $10 million of sales. Scenarios A and B illustrate two ways to present revenue:

Company A Gross

Company B Net

Revenue $10,000,000 $1,500,000Cost of goods sold 8,500,000 0Gross profit on sales $1,500,000 $1,500,000

In looking at the two presentations in the previous table, which Company is larger, A or B?

Clearly Company A, with its $10 million of revenue, appears to be a larger business as compared with Company B with only $1,500,000 of sales. Which company would you invest in? The reality is that both companies are the same company, with the only difference being a gross versus net revenue presentation.

Paragraph 606-10-55-37 states:

“An entity is a principal if the entity controls a promised good or service before the entity transfers the good or service to a customer.”

ASU 2016-08, Revenue from Contracts with Customers (Topic 606)-Principal versus Agent Considerations (Reporting Revenue Gross versus Net), specifically addresses the issues of principal versus agency relationships, as follows:

1. Principal or agent:

Principal: When an entity that is a principal satisfies a performance obligation, the entity recognizes revenue in the gross amount of consideration to which it expects to be entitled in exchange for the specified good or service transferred to the customer.

Agent: When an entity that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or commission (net) to which it expects to be entitled in exchange for arranging for the specified good or service to be provided by the other party.

2. An entity is required to determine whether it is a principal or an agent for each specified good or service promised to the customer.

3. To determine the nature of its promise, the entity should:


a) Identify the specified goods or services to be provided to the customer (which, for example, could be a right to a good or service to be provided by another party), and

b) Assess whether it controls each specified good or service before that good or service is transferred to the customer.

1) A specified good or service is considered a distinct good or service (or a distinct bundle of goods or services) to be provided to the customer.

4. If a contract with a customer includes more than one specified good or service, an entity could be a principal for some specified goods or services, and an agent for others.

5. When another party is involved in providing goods or services to a customer, the entity should determine whether the nature of its promise is a performance obligation:

a) To provide the specified goods or services itself (that is, the entity is a principal), or

b) To arrange for those goods or services to be provided by the other party (that is, the entity is an agent).

Note

If another entity (such as a subcontractor) assumes the entity’s performance obligations and contractual rights in the contract so that the entity is no longer obliged to satisfy the performance obligation to transfer the promised good or service to the customer (that is, the entity is no longer acting as the principal), the entity should not recognize revenue for that performance obligation. Instead, the entity should evaluate whether to recognize revenue for satisfying a performance obligation to obtain a contract for the other party (that is, whether the entity is acting as an agent).

Principal:

1. An entity is a principal if it controls the specified good or service before that good or service is transferred to a customer.

a) An entity does not necessarily control a specified good if the entity obtains legal title to that good only momentarily before legal title is transferred to a customer.

b) An entity that is a principal may satisfy its performance obligation to provide the specified good or service itself or it may engage another party (for example, a subcontractor) to satisfy some or all of the performance obligation on its behalf.


2. When another party is involved in providing goods or services to a customer, an entity that is a principal obtains control of any one of the following:

a) A good or another asset from the other party that it then transfers to the customer.

b) A right to a service to be performed by the other party, which gives the entity the ability to direct that party to provide the service to the customer on the entity’s behalf.

c) A good or service from the other party that it then combines with other goods or services in providing the specified good or service to the customer.

3. When (or as) an entity that is a principal satisfies a performance obligation, the entity recognizes revenue in the gross amount of consideration to which it expects to be entitled in exchange for the specified good or service transferred.

4. Indicators of control- principal

a) ASU 2016-08 offers three indicators that supports that an entity controls the specified good or service before it is transferred to the customer (and is, therefore, a principal) include, but are not limited to, the following:9

1) The entity is primarily responsible for fulfilling the contract promise to provide the specified good or service.

• This indicator typically includes responsibility for the acceptability of the specified good or service (for example, primary responsibility for the good or service meeting customer specifications).

• If the entity is primarily responsible for fulfilling the promise to provide the specified good or service, this may indicate that the other party involved in providing the specified good or service is acting on the entity’s behalf.

2) The entity has inventory risk before the specified good or service has been transferred to a customer, or after transfer of control to the customer (for example, if the customer has a right of return).

• If the entity obtains, or commits to obtain, the specified good or service before obtaining a contract with a customer, that may indicate that the entity has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the good or service before it is transferred to the customer.

3) The entity has discretion in establishing the price for the specified good or service.

9. ASU 2016-08 reduces the number of indicators from five found in ASU 2014-09, to three in ASU 2016-08.


• Establishing the price that the customer pays for the specified good or service may indicate that the entity has the ability to direct the use of that good or service and obtain substantially all of the remaining benefits.

Note

ASU 2016-08 states that in some cases, an agent can have discretion in establishing prices. For example, an agent may have some flexibility in setting prices to generate additional revenue from its service of arranging for goods or services to be provided by other parties to customers.

5. Indicators removed by ASU 2016-08:

a) ASU 2016-08 removes two of the five indicators previously found in ASU 2014-09 as follows:

• The entity’s consideration is not in the form of a commission, and

• The entity is exposed to credit risk for the amount receivable from the customer.

Agent:

1. If an entity is not a principal, it is an agent.

2. If an entity is an agent, revenue is recorded net.

3. An entity is an agent if the entity’s performance obligation is to arrange for the provision of a specified good or service by another party.

4. An entity that is an agent does not control the specified good or service provided by another party before that good or service is transferred to the customer.

a) An agent generally fails some or all three indicators of control found in ASU 2016-08.

b) An agent:

1) Is not the entity primarily responsible for fulfilling the contract promise to provide the specified good or service.

2) Does not have inventory risk.

3) Does not have discretion in establishing the price of the good or service.

c) When (or as) an entity that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or commission (net) to which it expects to be entitled in exchange for arranging for the specified goods or services to be provided by the other party.


Note

An entity’s fee or commission might be the net amount of consideration that the entity retains after paying the other party the consideration received in exchange for the goods or services to be provided by that party.

Must an entity have title to a product to be considered a principal and qualify for gross revenue treatment?

No. ASU 2016-08 does not require that an entity have title to a product for it to be a principal.

The ASU does state that an entity does not necessarily control a specified good if it obtains legal title only momentarily before legal title is transferred to a customer. That is, an entity cannot rely on the fact that for a split second it had title to justify principal (gross) treatment.

ASU 2016-08’s model relies on the concept of “control,” not “title,” to determine whether an entity is a principal.

Ask one question:

Does the entity control the specified good or service before that good or service is transferred to a customer?

If the entity has control before the good or service is transferred to a customer, it is considered a principal, and records revenue from the specified good or service on a gross basis.

Ownership and title has nothing to do with control. For example, in many instances, an entity might be a distributor (middleman) in a drop-ship arrangement under which the goods are shipped directly from the manufacturer to the customer with no legal title transferred to the middleman/distributor.

Yet, the distributor still might have control before the goods are transfers to the customer based on satisfying some or all of the indicators to support principal treatment, such as:

a. The entity is primarily responsible for fulfilling the contract promise to provide the specified good to the customer even though it does not have title to the good.

b. The entity has inventory risk before the specified good is transferred to the customer, or after transfer of control to the customer (for example, if the customer has a right of return).

c. The entity has discretion in establishing the price that the customer pays for the specified good.

All of these indicators can be satisfied without the entity (distributor) taking title to the property.


Examples- Application of ASU 2016-08

Following are examples from ASU 2016-08, as modified by the Author.

Example 1: Arranging for the Provision of Goods or Services (Entity Is an Agent)

[From Examples of ASU 2016-08, as modified by the Author]

• An entity, Webco, operates a website that enables customers to purchase goods from a range of suppliers who deliver the goods directly to the customers.

• Under the terms of Webco’s contracts with suppliers, when a good is purchased via the website, Webco is entitled to a commission that is equal to 10% of the sales price.

• Webco’s website facilitates payment between the supplier and the customer at prices that are set by the supplier.

• Webco requires payment from customers before orders are processed, and all orders are nonrefundable.

• Webco has no further obligations to the customer after arranging for the products to be provided to the customer. Webco is not responsible for products being returned, which is the responsibility of the various suppliers.

Conclusion:

Webco is an agent and revenue should be recorded net.

To determine whether Webco’s performance obligation is to provide the specified goods itself (that is, Webco is a principal) or to arrange for those goods to be provided by the supplier (that is, Webco is an agent), Webco identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.

a. The website operated by Webco is a marketplace in which suppliers offer their goods and customers purchase the goods that are offered by the suppliers.

b. Webco observes that the specified goods to be provided to customers that use the website are the goods provided by the suppliers, and no other goods or services are promised to customers by Webco.

c. Webco concludes that it does not control the specified goods before they are transferred to customers that order goods using the website.

d. Webco does not at any time have the ability to direct the use of the goods transferred to customers. For example, it cannot direct the goods to parties other than the customer or prevent the supplier from transferring those goods to the customer. Webco does not control the suppliers’ inventory of goods used to fulfill the orders placed by customers using the website.


As part of reaching the conclusion that it is an agent, Webco considers the following three indicators.

Webco concludes that these indicators provide further evidence that it does not control the specified goods before they are transferred to the customers.

a. The supplier is primarily responsible for fulfilling the promise to provide the goods to the customer. Webco is neither obliged to provide the goods if the supplier fails to transfer the goods to the customer nor responsible for the acceptability of the goods.

b. Webco does not take inventory risk at any time before or after the goods are transferred to the customer. Webco does not commit to obtain the goods from the supplier before the goods are purchased by the customer and does not accept responsibility for any damaged or returned goods. Webco also has no responsibility for returned goods.

c. Webco does not have discretion in establishing prices for the supplier’s goods. The sales price is set by the supplier.

Consequently, Webco concludes that:

• It is an agent and its performance obligation is to arrange for the provision of goods by the supplier.

• When Webco satisfies its promise to arrange for the goods to be provided by the supplier to the customer (which, in this example, is when goods are purchased by the customer), Webco recognizes revenue in the amount of the 10% commission to which it is entitled.

Example 2: Promise to Provide Goods or Services (Entity Is a Principal)

• Cleanpro enters into a contract with a customer to provide office maintenance services.

• Cleanpro and the customer define and agree on the scope of the services and negotiate the price.

• Cleanpro is responsible for ensuring that the services are performed in accordance with the terms and conditions in the contract.

• Cleanpro invoices the customer for the agreed-upon price monthly with 10-day payment terms.

• Cleanpro regularly engages third-party service providers to provide office maintenance services to its customers. When Cleanpro obtains a contract from a customer, Cleanpro enters into a contract with one of those service providers, directing the service provider to perform office maintenance services for the customer.

• The payment terms in the contracts with the service providers generally are aligned with the payment terms in Cleanpro‘s contracts with customers. However, Cleanpro is obliged to pay the service provider even if the customer fails to pay.


Conclusion:

Cleanpro is a principal and should record revenue it receives from its customers at the gross amount.

To determine whether Cleanpro is a principal or an agent, Cleanpro identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.

Cleanpro observes that the specified services to be provided to the customer are the office maintenance services for which the customer contracted and that no other goods or services are promised to the customer.

While Cleanpro obtains a right to office maintenance services from the service provider after entering into the contract with the customer, that right is not transferred to the customer. That is, Cleanpro retains the ability to direct the use of, and obtain substantially all the remaining benefits from, that right. For example, Cleanpro can decide whether to direct the service provider to provide the office maintenance services for that customer, or for another customer, or at its own facilities. The customer does not have a right to direct the service provider to perform services that Cleanpro has not agreed to provide. Therefore, the right to office maintenance services obtained by Cleanpro from the service provider is not the specified good or service in its contract with the customer.

Cleanpro concludes that it controls the specified services before they are provided to the customer. Cleanpro obtains control of a right to office maintenance services after entering into the contract with the customer but before those services are provided to the customer.

The terms of Cleanpro’s contract with the service provider give Cleanpro the ability to direct the service provider to provide the specified services on Cleanpro’s behalf.

In addition, Cleanpro concludes that the following three indicators provide further evidence that Cleanpro controls the office maintenance services before they are provided to the customer:

a. Cleanpro is primarily responsible for fulfilling the promise to provide office maintenance services. Although Cleanpro has hired a service provider to perform the services promised to the customer, it is Cleanpro itself that is responsible for ensuring that the services are performed and are acceptable to the customer (that is, Cleanpro is responsible for fulfilment of the promise in the contract, regardless of whether Cleanpro performs the services itself or engages a third-party service provider to perform the services).

b. Inventory risk: Although Cleanpro has the inventory risk, Cleanpro has mitigated its inventory risk with respect to the office maintenance services.

• Cleanpro observes that it does not commit itself to obtain the services from the service provider before obtaining the contract with the customer. Nonetheless, Cleanpro concludes that it controls the office maintenance services before they are provided to the customer based on the evidence.

c. Cleanpro has discretion in setting the price for the services to the customer.


Thus, Cleanpro is a principal in the transaction and recognizes revenue in the gross amount of consideration to which it is entitled from the customer in exchange for the office maintenance services.

Example 3: Promise to Provide Goods or Services (Entity Is a Principal)

• Travelpro negotiates with major airlines to purchase tickets at reduced rates compared with the price of tickets sold directly by the airlines to the public.

• Travelpro agrees to buy a specific number of tickets and must pay for those tickets regardless of whether it is able to resell them. The reduced rate paid by Travelpro for each ticket purchased is negotiated and agreed in advance.

• Travelpro determines the prices at which the airline tickets will be sold to its customers. Travelpro sells the tickets and collects the consideration from customers when the tickets are purchased.

• Travelpro also assists the customers in resolving complaints with the service provided by the airlines. However, each airline is responsible for fulfilling obligations associated with the ticket, including remedies to a customer for dissatisfaction with the service.

Conclusion:

Travelpro is a principal and should record revenue gross.

To determine whether Travelpro’s performance obligation is to provide the specified goods or services itself (that is, Travelpro is a principal) or to arrange for those goods or services to be provided by another party (that is, the entity is an agent), Travelpro identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.

Travelpro concludes that with each ticket that it commits itself to purchase from the airline, it obtains control of a right to fly on a specified flight (in the form of a ticket) that Travelpro then transfers to one of its customers.

Consequently, Travelpro determines that the specified good or service to be provided to its customer is that right (to a seat on a specific flight) that Travelpro controls. The entity observes that no other goods or services are promised to the customer.

Travelpro controls the right to each flight before it transfers that specified right to one of its customers because the entity has the ability to direct the use of that right by deciding whether to use the ticket to fulfill a contract with a customer and, if so, which contract it will fulfill.

Travelpro also has the ability to obtain the remaining benefits from that right by either reselling the ticket and obtaining all of the proceeds from the sale or, alternatively, using the ticket itself.

The indicators also provide relevant evidence that Travelpro controls each specified right (ticket) before it is transferred to the customer.


a. Travelpro is primarily responsible for fulfilling the promise to provide the airline tickets to customers who purchase them.

b. Travelpro has inventory risk with respect to the ticket because the entity committed itself to obtain the ticket from the airline before obtaining a contract with a customer to purchase the ticket.

• Travelpro is obliged to pay the airline for that right regardless of whether it is able to obtain a customer to resell the ticket to or whether it can obtain a favorable price for the ticket.

c. Travelpro establishes the price that the customer will pay for the specified ticket.

Thus, Travelpro concludes that it is a principal in the transaction transactions with customers. Travelpro recognizes revenue in the gross amount of consideration to which it is entitled in exchange for the tickets transferred to the customers.

D. NON-REFUNDABLE UPFRONT FEES RECEIVED

In some contracts, an entity charges a customer a nonrefundable upfront fee at or near contract inception.

Examples include:

• Health and other club membership and initiation fees

• Telecommunication and cable entity activation fees

• Setup fees

• Premium web access fees

• Price club membership fees

1. An entity should assess whether the fee relates to the transfer of a promised good or service and should be recognized as revenue when received.

Note

ASC 606 states that in most cases, even though a nonrefundable upfront fee relates to an activity that the entity is required to undertake at or near contract inception to fulfill the contract, that activity does not result in the transfer of a promised good or service to the customer.

• Instead, the upfront fee is an advance payment for future goods or services and, therefore, would be recognized as revenue when those future goods or services are ultimately provided.


• The revenue recognition period would extend beyond the initial contractual period if the entity grants the customer the option to renew the contract and that option provides the customer with a material right.

When an upfront fee does not relate to the transfer of a promised good or service:

1. No revenue should be recognized upon receipt of an upfront fee, even if nonrefundable, if the fee does not relate to the transfer of a promised good or service.

a) The upfront fee is included as part of the transaction price in Step 2 of the five steps under the revenue standard.

b) The fee is treated as an advance payment for future goods or services, and the entity should recognize the fee as revenue when the future performance obligations (goods or services) are satisfied.

c) Prior to being recognized as revenue, the fee is recorded as a liability.

Note

ASC 606 does state that in many cases, even though a nonrefundable upfront fee relates to an activity that the entity is required to undertake at or near contract inception to fulfill the contract, that activity does not result in the transfer of a promised good or service to the customer.

Example 1: Upfront Fee

An entity enters into a contract with a customer for one year of transaction processing services.

The entity’s contracts have standard terms that are the same for all customers.

The contract requires the customer to pay an upfront fee to set up the customer on the entity’s systems and processes.

The fee received is a nominal amount and is nonrefundable.

The customer can renew the contract each year without paying an additional fee.

The entity concludes that the renewal option does not provide a material right to the customer that it would not receive without entering into that contract.

Conclusion:

The entity’s setup fee activities do not transfer a good or service to the customer and, therefore, do not give rise to a performance obligation.

The upfront fee is, in effect, an advance payment for the future transaction processing services.

Consequently, the entity should include this nonrefundable upfront fee in the determination of transaction price in Step 2 of the five steps under the revenue model.


Revenue should be recognized from the transaction processing services as those services are provided, which is likely to allocate the fee over the 12 months of the contract on a straight-line basis.

Example 2: Upfront Fee

An entity enters into a health club membership contract with a customer for one year.

The entity’s contracts have standard terms that are the same for all customers.

The contract requires the customer to pay an $500 nonrefundable upfront initiation fee, plus $700 for the annual membership.

The fee received is a nominal amount and is nonrefundable.

The customer can renew the contract each year at the market rate (currently $700) without paying an additional $500 initiation fee.

The entity concludes that the renewal option does not provide a material right to the customer that it would not receive without entering into that contract.

Conclusion:

The entity’s $500 initiation fee activities do not transfer a good or service to the customer and, therefore, do not give rise to a performance obligation.

The upfront $500 fee is, in effect, an advance payment for the future services.

Consequently, the entity should include this $500 nonrefundable upfront fee in the determination of transaction price in Step 2 and combine it with the $700 annual fee.

Revenue should be recognized from the transaction as follows:

Initiation fee $500Annual membership fees ($700 x 12) 8,400Total $8,900Number of months 12Monthly revenue recognized in year 1 $741.67

The initial fee of $500 should be included in the transaction price along with the annual membership of $8,400 for a total transaction price of $8,900.

Revenue should be recognized for the $8,900 when the future performance obligations (membership services) are satisfied, which is the first 12 months.

Impact of customer receiving a material right on the revenue recognition period- nonrefundable fees

There may be instances in which an upfront fee received from a customer grants that customer a material right, typically in the form of a right to renew the next year.


In such instances, ASC 606-10-55-51 states:

“The revenue recognition period would extend beyond the initial contractual period if the entity grants the customer the option to renew the contract and that option provides the customer with a material right.”

What the ASC states is that if an upfront fee provides a customer with a material right in the form of an option (such as an option to extend membership), the upfront fees should be recognized into revenue over a contract period beyond that initial contractual period, typically the estimated customer life.

In March 2015, the FASB’s Transition Resource Group (TRG) published a paper, entitled FASB-IASB Joint Transition Resource Group for Revenue Recognition Paper Topic: Accounting for a Customer’s Exercise of a Material Right, to address the issue of material rights.

In that paper, the TRG addressed the following question.

Over what period should an entity recognize a nonrefundable upfront fee?

The TRG responded as follows:

1. If the entity concludes that the [upfront] activation fee provides a material right, the entity would recognize the fee over the service periods during which the customer is expected to benefit from not having to pay the activation fee upon renewal of the service. Determining this period will require judgment.

2. If the entity concludes that the activation fee does not provide the customer with a material right, the activation fee is, in effect, an advance payment solely on the contracted services. Therefore, the entity would recognize the fee as part of the overall transaction price as revenue as those services are provided in the first month.

Thus, if there is an upfront fee received, the period over which that fee is recognized into revenue depends on whether the customer receives a material right from that fee. That right can be in the form of not having to pay the fee again in the subsequent years.

• If there is a material right, the upfront fee is recognized into revenue over the life of the customer (periods during which the customer is expected to benefit).

• If, on the other hand, there is no material right, the upfront fee is recognized in revenue as the services are provided, typically in the first period or year.

Following is an example illustrating the application referenced above.

Example 3: Golf Club

In 2020, Very Tight Golf Club (the Club) receives a $10,000 initiation fee from a new member. In addition, the member pays $5,000 annual fee.

The member does not receive any voting rights in the club.


The initiation fee is nonrefundable may be used to fund current or future operations of the club.

The $10,000 initiation fee does not have to be paid again.

The weighted-average expected length of time a member remains a member is 10 years.

Conclusion:

From the example, the $10,000 upfront fee does not relate to the transfer of a promised good or service.

Thus, ASC 606 states that the treatment for the upfront fee is as follows:

• The upfront fee is an advance payment for future goods or services and, therefore, would be recognized as revenue when those future goods or services are provided.

• The $10,000 upfront fee represents a material right for the member to renew again without paying the $10,000 fee again.

• No revenue should be recognized upon receipt of an upfront fee, even if nonrefundable, if the fee does not relate to the transfer of a promised good or service.

• The upfront fee is included as part of the transaction price in Step 2 of the five steps under the revenue standard.

The computation of revenue recognized in Step 5 follows:

Initiation fee: $10,000/10 years $1,000Annual membership fees- 2020 5,000Total – 2020 revenue recognized $6,000

In this example, the initial fee of $10,000 is considered a material right and is recorded over 10 years, the expected length of time of membership, on a straight-line basis. That is the period over which the future goods or services are provided.

The reason why the initiation fee is recorded over 10 years, instead of the one-year membership period, is because the initiation fee implicitly grants the member the right to renew in future years without paying the $10,000 fee again.

Total revenue recognized is $6,000. The remainder $9,000 ($15,000 less $6,000) is recorded as a deferred liability on the balance sheet.

When an upfront fee does relate to the transfer of a promised good or service:

1. If the upfront fees do transfer a good or service, it should be evaluated in Step 2 to determine whether to account for the good or service as a separate performance obligation.

2. If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the


option provides a material right to the customer that it would not receive without entering into that contract.

3. If the nonrefundable up-front fee provides a material right, the amount of the fee allocated to the material right is recognized over the period of benefit of the fee, which is likely to be the estimated customer life.

Examples of material rights that might be received from payment of an upfront fee include:

• Option to pay a renewal fee for the next year at a discount

• Voucher for a discount on future purchases

E. WARRANTIES

General:

Step 2 of ASC 606’s revenue model requires an entity to identify the performance obligations in a contract with a customer. In certain cases, a warranty related to a sold product might be considered a separate performance obligation.

There are generally two different types of warranties offered by a company to its customers:

Service-type warranty: A warranty that can be purchased by a customer in addition to the purchase of the underlying product or service. Such a warranty is in addition to an assurance-type warranty.

Assurance-type warranty: A warranty that is included with the sale of a product or service, providing assurance that the product will function as intended and in accordance with identified specifications.

In applying the new revenue model, an entity must determine the type of warranty it has offered to its customers.

Service-type warranty:

1. If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract.

2. In those circumstances:

• An entity should account for the promised warranty as a separate performance obligation, and

• Allocate a portion of the transaction price to that performance obligation

3. If there is both an assurance-type warranty and a service-type warranty, but the entity cannot reasonably account for the two warranties separately, the entity should account for the two warranties together as a single separate performance obligation.


Assurance-type warranty:

1. If a customer does not have the option to purchase a warranty separately, an entity should:

a) Not account for the (assurance-type) warranty as a separate performance obligation, and

b) Account for the costs of providing the warranty under FASB ASC 460-10 on guarantees.

2. If a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications:

a) The promised service is treated as a separate performance obligation.

b) A portion of the transaction price is allocated to the product sold and the warranty service provided.

Example: An entity sells a product and offers a lifetime warranty on parts and labor. In such an instance, the entity offers not only assurance that the product works in accordance with specifications, but also offers a service, and should account for the warranty as a separate identified performance obligation in Step 2 of the five-step revenue model. Once identified as a separate performance obligation, a portion of the transaction price should be allocated to that obligation.

3. ASC 606 states that in assessing whether an assurance-type warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, an entity should consider factors such as:

a) Whether the warranty is required by law: If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.

b) The length of the warranty coverage period: The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.

c) The nature of the tasks that the entity promises to perform: If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.

Example 1: A furniture manufacturer provides all customers with a one-year warranty that covers only manufacturing defects.


Conclusion: The warranty does not represent a separate performance obligation because it only provides assurance that the furniture will function as intended over a short period. This is an assurance-type warranty. Further, the entity should accrue costs associated with this warranty under ASC 460, Guarantees.

Example 2: A furniture manufacturer provides all customers with a lifetime warranty that covers all defects and damages, including those arising from normal wear and tear.

Conclusion: This warranty represents a separate performance obligation because the manufacturer has agreed to provide repairs for all damage (including parts and labor). That means the entity has agreed to provide a service of repairing the furniture for all damage, beyond assurance that the product complies with the agreed-upon specification (e.g., beyond typical manufacturing defects) and over a longer period than is customary (e.g., the life of the furniture).

As a result, the manufacturer should do the following:

In Step 2, identify the service as a separate performance obligation, and

In Step 3, allocate a portion of the transaction price to the performance obligation.

In Step 5, recognize the portion of the transaction price allocated to the performance obligation as revenue. Most likely, the revenue will be recognized over time as the service is delivered during the estimated lifetime of the product.

What if an entity is required to provide a product warranty under law?

State or Federal law might require an entity to provide a product warranty.

ASC 606-55-35 states:

“A law that requires an entity to pay compensation if its products cause harm or damage does not give rise to a performance obligation.”

Example: A state law holds a manufacturer of products liable for any damages (for example, to personal property) that might be caused by a consumer using a product for its intended purpose.

Conclusion: The warranty is not treated as a separate performance obligation of the manufacturer, so no portion of revenue should be allocated to the warranty embedded in the product sale.

Moreover, any costs related to providing the warranty should be accrued in accordance with ASC 460-10, Guarantees.

F. BILL-AND-HOLD ARRANGEMENTS

Bill-and-hold arrangements occur when a customer is billed for goods that have not yet been shipped to the customer.

In some instances, an entity may be required to recognize revenue on bill-and-hold arrangements even though the goods have not been physically transferred to the customer.


Example: A company may bill a customer for goods but not ship them to the customer because that customer lacks available space or due to the customer’s delayed production schedule.

1. ASC 606-10-55-81 defines a bill-and-hold arrangement as:

“a contract under which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future.”

2. Step 5 of ASC 606 states the following:

a) An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer.

b) A good or service is transferred when (or as) the customer obtains control of that good or service.

3. In bill-and-hold arrangements:

a) The customer may obtain control of the goods even though it does not have physical possession.

b) An entity must determine whether it has transferred control of the product to the customer.

4. For an entity to have transferred control of the product to the customer in a bill-and-hold arrangement, and to satisfy Step 5 for revenue recognition, all of the following four criteria must be met:

a) The reason for the arrangement must be substantive, such as the customer requesting the arrangement.

b) The product must be separately identified for the customer.

c) The product must be ready for physical transfer to the customer.

d) The entity cannot have the ability to use the product or direct it to another customer.

If the previous four criteria are met, the customer has control of the product, and the entity should recognize revenue even though the customer lacks physical possession of the product.

Note

ASC 606 provides four criteria that must be met so that a bill-and-hold arrangement is deemed to have transferred control to the customer. If there is a transfer of control, Step 5 of the revenue model is satisfied and revenue is recognized.


First, ASC 606 states that the arrangement must be substantive, which can be demonstrated by the customer requesting such an arrangement. The reasons for the request must also be considered. ASC 606 gives examples in which a customer lacks physical space for the goods or the production schedule is delayed as both being indicative of a substantive arrangement.

Second and third, the goods must be separately identified and ready for shipment to the customer. ASC 606’s example indicates that the goods should be physically separated (and earmarked for the specific customer) in the company’s warehouse and not commingled with other goods.

Lastly, the goods cannot be sold to another customer or used to fulfill other orders.

If these four elements exist, transfer of control is deemed to have occurred when the billing occurs and revenue is recognized. If the revenue is recognized on a bill-and-hold arrangement, a company should ensure that cost of goods sold is recorded and that the bill-and-hold goods are not counted as part of the ending inventory.

Example: Company Y (customer) orders materials from Company X (seller). Y has limited warehouse space and asks X to hold the goods in X’s warehouse until Y needs to use them for its manufacturing operation.

X bills Y for the sales price of the goods.

Upon billing, X separates the goods in its warehouse for the benefit of Customer Y so that they are not billed and shipped to other customers.

The goods are available to be shipped to Y with one day’s notice.

Conclusion: At the time X bills Y, X has transferred control to Customer Y, and X should recognize the sale as revenue in accordance with Step 5 of the revenue model. This is the case even though the physical control has not moved to X.

The reason for recognizing revenue is because X has satisfied the four criteria as follows:

1. The reason for the bill-and-hold arrangement is substantive, as evidenced by the fact that Customer Y requested the arrangement and Y lacks physical space for the goods;

2. The goods have been separately identified in X’s warehouse for Customer Y;

3. The goods are ready for physical transfer to Customer Y; and

4. X does not have the ability to use the product or direct it to another customer.

In recording the revenue at the time of billing, X should ensure that it also records cost of goods sold on the goods and does not count the goods as part of its ending inventory.

Example 2: Same facts as Example 1, except for the following changes:

X does not separate the goods billed to Y and commingles those goods with other goods available for sale to other customers.


Conclusion: Because the goods are not separately identified as belonging to Customer Y, the four criteria are not satisfied. Not only are the goods not separated, but in doing so, X has the ability to use the goods for another customer. Thus, X fails two of the four criteria required in order for a bill-and-hold arrangement to be considered to transfer control of goods.

Thus, in this situation, at the time of billing to Y, Company X should not recognize revenue and such recognition should not occur until the four criteria are met or the goods are physically transferred to Y.

G. CONSIGNMENT ARRANGEMENTS

Some entities engage in a consignment arrangement in which an entity ships goods to a customer, but the entity retains control of the goods until a future date. This arrangement is common with manufacturers who ship goods to a retailer or wholesaler.

In such instances, revenue is not recognized upon delivery of goods to the retailer or wholesaler because there is no transfer of control to the customer.

Following is guidance on the accounting for consignment arrangements found in ASC 606:

1. A consignment arrangement exists when a product is delivered to another party but the other party has not obtained control of the product.

a) The customer has physical possession of the goods but lacks control.

2. In such a case, an entity should not recognize revenue upon delivery if the product is held on consignment by the dealer (customer).

3. Indicators of a consignment arrangement include, but are not limited to, the following:

a) The product is controlled by the entity until a specified event occurs, such as the sale of the product to a customer of the dealer, or until a specified period expires.

b) The entity is able to require the return of the product or its transfer to a third party.

c) The dealer (customer) does not have an unconditional obligation to pay for the product, although it may be required to pay a deposit.

4. Revenue is recognized only when the entity transfers control of the goods to the customer.

Example: Home Depot received washer machines on a consignment basis from Machine Co., the manufacturer.

Home Depot does not take title to the goods until they are sold to its retail customer. The exception is that Home Depot takes title if the machines are damaged while in Home Depot’s possession.

Home Depot can return the goods anytime to Machine Co. Further, Machine Co. can demand that Home Depot return the machines.


Conclusion: When the machines are shipped to Home Depot, Machine Co. does not transfer control of the machines and revenue should not be recognized. The reasons are several:

• First, Machine Co. retains control of the machines even though Home Depot has physical possession of the machines.

• Second, Machine Co. can insist that Home Depot return the machines at any time.

• Third, Home Depot has no unconditional obligation to pay for the machines.

Machine Co. should recognize revenue from the machines when it transfers control to Home Depot, which occurs when Home Depot sells the machines to its customers or if machines are damaged while in Home Depot’s possession.




1. Company X offers its customers the right to return goods for a refund within a certain specific time after purchase. Which of the following is correct as it relates to the accounting when the customer has the right of return:

A. GAAP requires revenue to be recorded at its gross amount with any refunds recorded to a sales expense

B. an entity’s promise to stand ready to accept a returned product should be accounted for as a separate performance obligation

C. GAAP provides that at the time of sale, an entity shall record an asset reflective of a right to recover products from customers on settling the refund liability

D. GAAP requires that returns be accounted on a cash basis at the time of the ultimate return of the goods by the customer

2. Steve’s Cinnamon Rolls (Steve) is a manufacturer that offers its retailers a refund if the customers achieve a volume purchase milestone on a cumulative unit basis. Which is the correct way in which the company should account for this refund:

A. Steve should record it as sales expense when the milestone is achieved by customer

B. Steve should record it as a refund liability when the entity receives consideration from a customer

C. Steve should record it as a return and allowance when the company fulfills the refund to the customer

D. Steve should record it as a contra-revenue account when the milestone is achieved and refund is processed


3. Company L is an Internet startup company. The company wants to attract investors and possibly do an IPO. Which factor is likely to be most important in attracting capital:

A. profitability

B. revenue

C. debt level

D. quality of patents

4. Dino’s Wholesaler sells some goods and also provides certain services. The Company is evaluating whether it should record its various revenue on a gross or net basis. In making the determination, the Company should perform the evaluation at what level:

A. for each specified good or service

B. for all goods combined, and for all services combined

C. in the aggregate for all goods and services combined at the entity level

D. for only goods as the evaluation does not apply to services

5. Company X sells a product and is trying to determine whether to record the transaction gross (as a principal) or net (as an agent). Which of the following criteria determines whether X is a principal:

A. X does not obtain legal title to the goods

B. X controls promised goods or services

C. X obtains a commission on the transaction

D. X does not set the price of the goods

6. When does a principal recognize revenue on a gross basis:

A. when the principal satisfies the performance obligation

B. when the goods are shipped

C. when the principal receives consideration in full for the product supplied

D. when the transaction is recorded


7. Sharon Stele CPA is reviewing whether her client is a principal or an agent. Which of the following is an indicator that her client is a principal and should record revenue gross:

A. company is primarily responsible for fulfilling the contract promise

B. company pays for the product

C. company does not take responsibility for establishing prices

D. company’s consideration is in the form of a commission

8. Over what period of time should an entity recognize nonrefundable upfront fees received as revenue:

A. in the year of receipt

B. over the service periods

C. over a minimum of five years on a straight-line basis

D. over no period, as upfront nonrefundable fees are not recognized as revenue

9. Company X has a bill-and-hold arrangement with a customer. In order for X to have transferred control of the goods to a customer and recognize revenue in Step 5, which of the following criteria must be met:

A. the customer cannot have any involvement in requesting the bill-and-hold arrangement

B. the product must be separately identified

C. the product must be held and not ready for transfer to the customer

D. X must have the ability to continue use of the product

10. Big Larry’s Wholesale sends goods to certain retail customers on consignment. Which of the following is an indicator that Larry has a consignment arrangement with a particular customer:

A. the product is controlled by the customer not by Big Larry

B. Big Larry is able to require that the customer return the goods

C. the customer has an unconditional obligation to pay for the product unless it is defective

D. Big Larry has billed the customer for the goods in full



1. A. Incorrect. Under GAAP, revenue is recognized only in the amount it expects to be entitled to, which is net, exclusive of any refunds.

B. Incorrect. Such a promise to stand ready to accept a returned product should not be accounted for as a separate performance obligation in the revenue model.

C. CORRECT. GAAP provides that at the time of sale, an entity should not only record a refund liability, but also an asset reflective of a right to recover products from customers on settling the refund liability.

D. Incorrect. GAAP requires that returns be accounted for at the time of sale, and not when the customer actually returns the goods.


2. A. Incorrect. ASC 606 reduces revenue for refunds to customers, and does not record the refund as a sales expense when the milestone is achieved by the customer.

B. CORRECT. ASC 606 states that an entity recognizes a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer. Thus, revenue is reduced for that portion expected to be refunded.

C. Incorrect. The refund is recorded as a reduction in revenue and booked as a refund liability, not as a return and allowance.

D. Incorrect. The refund is recorded as a reduction in revenue and included in a refund liability, not as a contra-liability account.


3. A. Incorrect. With Internet companies, investors are looking for market share, which is not necessarily indicated by profitability.

B. CORRECT. Historically, investors in Internet companies have sought companies that have captured market share within a segment. Typically, revenue, not profitability, is a key indicator of market share.

C. Incorrect. Although debt level may be important, it is not a driving factor from an investor’s perspective when the entity is in a high-tech environment. Investors want to know how the company is going to grow and debt is not a factor for measuring that growth.

D. Incorrect. Although quality of patents might be important, it does not necessarily address how a company is capturing market share.



4. A. CORRECT. ASU 2016-08 provides that an entity must determine if it is a principal or agent for each specified good or service promised to a customer.

B. Incorrect. ASU 2016-08 does not permit combining all goods, and then combining all services. Instead, each specified good or service is evaluated individually.

C. Incorrect. Goods and services must be evaluated separately for each item promised to a customer, not at the entity level.

D. Incorrect. ASU 2016-08 applies to both goods and services.


5. A. Incorrect. If X does not have title to the goods, X is likely not the principal and, instead, is an agent.

B. CORRECT. The key to being a principal is that X must control promised goods or services before they are transferred to a customer.

C. Incorrect. If X obtains a commission on the transaction, X is likely to be an agent, and not a principal.

D. Incorrect. If X does not set the price of the goods, X is likely an agent, and not a principal. By not being able to set the price, X is demonstrating that it does not control the product.


6. A. CORRECT. Once the principal satisfies the performance obligation, the entity recognizes revenue.

B. Incorrect. Although shipping of goods might be satisfaction of a performance obligation, there could be other obligations that are incomplete.

C. Incorrect. Although payment received is typically considered completion of a transaction, there could be other elements outstanding.

D. Incorrect. When a transaction is recorded, it has nothing to do with when the performance obligation is satisfied.



7. A. CORRECT. One indicator found in ASU 2016-08 is that the Company is primarily responsible for fulfilling the contract promise. Thus, it is an indicator supporting that the entity is a principal.

B. Incorrect. The fact that the entity pays for the product does not mean it is a principal. ASU 2016-08 does not list payment of the product as an indicator to consider.

C. Incorrect. The fact that the entity does not establish prices for the product or service is an indicator that it is an agent, not a principal.

D. Incorrect. One indicator removed by ASU 2016-08 is whether an entity’s consideration is in the form of a commission. That indicator no longer is found in ASU 2016-08 and, therefore, is not necessarily considered in the assessment of whether an entity is a principal or an agent.


8. A. Incorrect. If a fee provides a material right, the fee is recognized over the service periods, and not all in the year of receipt.

B. CORRECT. If an upfront fee provides a material right, the entity recognizes the fee over the service periods during which the customer expects to benefit.

C. Incorrect. ASC 606 does not provide a minimum number of years for recognition, although using a straight-line basis might be appropriate.

D. Incorrect. ASC 606 is clear in stating that upfront nonrefundable fees are included as part of the overall transaction price and as revenue in Step 5 of the revenue model.


9. A. Incorrect. One of the four criteria that must be met for revenue recognition in a bill-and-hold arrangement is that there must be a reason for the arrangement that is substantive, such as the customer requesting the bill-and-hold arrangement because the customer does not have physical room for the goods.

B. CORRECT. One criterion is that the goods/product must be separately identified for the customer.

C. Incorrect. One criterion is that the product must be ready for transfer to the customer upon request.

D. Incorrect. One of the criteria is that X must not have the ability to use of the product or direct it to another customer.



10. A. Incorrect. In a consignment arrangement, the goods are still controlled by the entity (Big Larry, in this case), and not the customer.

B. CORRECT. One indicator that there is a consignment arrangement is that the entity (Big Larry) is able to require that the customer return the goods or its transfer to a third party. Because of this factor, the customer does not have control of the goods.

C. Incorrect. One indicator is that the customer does not have an unconditional obligation to pay for the product, although the customer may be required to pay a deposit.

D. Incorrect. Billing the customer has no impact of whether there is a consignment arrangement. The key is whether there has been a transfer of control to the customer. Billing, by itself, does not mean that control has transferred.



H. LICENSING

A license of intellectual property (IP) grants a customer rights to the IP and the licensor’s obligations to provide such rights.

There are different types of licenses of IP with various terms and conditions.

The accounting for licenses depends on the nature of the license.

• Licenses that grant a customer access to the IP over the term of the license, and

• Licenses that grant a customer use (control) of the IP at a point of time.

There is also the issue as to whether the license is distinct or not distinct and whether the license should be treated as a separate performance obligation (Step 2). If so, a portion of the transaction price is allocated to the license in Step 4.

The licensing guidance also contains an exception to the general revenue model for sales- or usage-based royalties on a license of IP when the license is the sole or predominant item to which the royalty relates.

Licenses of intellectual property may include, but are not limited to, any of the following:

1. Software (other than software subject to a hosting arrangement that does not meet the criteria in ASC 985, Software), and technology

2. Motion pictures, music, and other forms of media and entertainment

3. Franchises, and

4. Patents, trademarks, and copyrights.

ASU 2016-10 adds language to clarify that the category “software and technology” excludes software subject to a hosting arrangement.

Applying Step 2 to licensing arrangements (identify the performance obligations in the contract)

1. When a contract with a customer includes a promise to grant a license in addition to other promised goods or services, an entity, in Step 2, should do the following:

a) Identify each of performance obligation in the contract, and

b) Determine whether the promise to grant the license is distinct or not distinct.

2. Definition of distinct:

ASC 606 states that a good or service is distinct if both of the following criteria are met:



b) Distinct within the context of the contract: The promise to transfer the good or service is separately identifiable from other promises in the contract.

In addition to a promise to grant a license (or licenses) to a customer, an entity may also promise to transfer other goods or services to the customer. Those promises may be explicitly stated in the contract or implied by an entity’s customary business practices, published policies, or specific statements.

Promise to grant license is not distinct

If, in Step 2, the promise to grant a license is not distinct from other promised goods or services in the contract, an entity should do the following:

1. Account for the promise to grant a license and those other promised goods or services together bundled as a single performance obligation in Step 2.

2. Examples of licenses that are not distinct from other goods or services promised in the contract include the following:

a) A license that forms a component of a tangible good and that is integral to the functionality of the good, and

b) A license that the customer can benefit from only in conjunction with a related service (such as an online service provided by the entity that enables, by granting a license, the customer to access content).

Promise to grant license is distinct

If the promise to grant a license is distinct from other promised goods or services in the contract, an entity should do the following:

1. Account for the promise to grant a license as a separate performance obligation in Step 2.

2. In applying Step 5, determine whether the performance obligation transfers to a customer over time or at a point in time.

Note

If a license is considered distinct, it is treated as a separate performance obligation in Step 2. Then, in Step 4, a portion of the transaction price must be allocated to that license based on estimating the standalone selling price of that license as compared with the total standalone prices of all performance obligations.

Applying Step 5 to licensing arrangements (recognize license revenue over time or at a point in time)

1. When a single performance obligation includes a license (or licenses) of intellectual property and one or more other goods or services, the entity should consider the following:


a) The nature of the combined good or service for which the customer has contracted.

b) Whether the license for intellectual property that is part of the single performance obligation provides the customer with a:

• Right to access, or

• Right to use.

c) Whether the combined good or service is satisfied over time or at a point in time.

2. In evaluating whether a license transfers to a customer over time or at a point in time, an entity should consider whether the nature of the entity’s promise in granting the license to a customer is to provide the customer with either a:

a) Right to access the intellectual property, as it exists throughout the license period, or its remaining economic life, if shorter (over time).

b) Right to use the intellectual property, as it exists at the point in time (at a point in time).

3. An entity should account for a promise to provide a customer with a right to access the entity’s intellectual property and the right to use intellectual property as follows:

a) Promise to provide customer with right to access the intellectual property:

1) A promise to provide a customer with a right to access intellectual property as a performance obligation is considered satisfied over time.

2) An entity should select an appropriate method to measure its progress toward complete satisfaction of that performance obligation to provide access to its intellectual property.

Note

The reason for the “over time” application is because the customer will simultaneously receive and consume the benefit from the entity’s performance of providing access to its intellectual property as the performance occurs.

b) Promise to provide a customer with the right to use its intellectual property:

1) A promise to provide a customer with the right to use its intellectual property is satisfied at a point in time.

2) The entity should apply the guidance in ASC 606 to determine the point in time at which the license transfers to the customer.


4. Regardless of the type of promise (right to access or right of use), revenue cannot be recognized from a license of intellectual property before both:

a) An entity provides (or otherwise makes available) a copy of the intellectual property to the customer.

b) The beginning of the period during which the customer is able to use and benefit from its right to access or its right to use the intellectual property.

Note

An entity would not recognize revenue before the beginning of the license period even if the entity provides (or otherwise makes available) a copy of the intellectual property before the start of the license period or the customer has a copy of the intellectual property from another transaction. For example, an entity would recognize revenue from a license renewal no earlier than the beginning of the renewal period.

Determining the nature of the entity’s promise with a license

To determine whether the entity’s promise is to provide a right to access intellectual property or a right to use intellectual property, an entity should consider the nature of the intellectual property to which the customer will have rights.

1. There are two types of intellectual property identified in ASU 2016-10. Intellectual property is either:

• Functional intellectual property- license revenue is recognized at a point in time.

• Symbolic intellectual property- license revenue is recognized over time.

2. Functional intellectual property:

a) Intellectual property that has significant standalone functionality and derives a substantial portion of its utility (its ability to provide benefit or value) from its significant standalone functionality.

b) Examples include software licenses, patents, media content, and movie rights.

c) Significant standalone function includes the ability to process a transaction, perform a function or task, or be played or aired.

d) Revenue from a license to functional intellectual property is recognized in Step 5 at a point in time.

e) A license to functional intellectual property grants a right to use the entity’s intellectual property as it exists at the point in time at which the license is granted.


Note

Because functional intellectual property has significant standalone functionality, the license right is delivered to the licensee immediately, up front. Thus, transfer of control occurs at inception and revenue is recognized at that point in time.

f) Exception: If the following two criteria are met, then the license related to the functionally intellectual property grants a right to access the entity’s intellectual property and it is recognized over time instead of at a point of time.

1) The functionality of the intellectual property to which the customer has rights is expected to substantively change during the license period as a result of activities of the entity that do not transfer a promised good or service to the customer, and

2) The customer is contractually or practically required to use the updated intellectual property resulting from the activities in criterion (f)(1) above.

Note

If a license to functional intellectual property is a separate performance obligation and does not meet the two criteria in paragraph (f)(1) and (2), it is still satisfied at a point in time.

3. Symbolic intellectual property:

a) Intellectual property that is not functional intellectual property by not having significant standalone functionality.

b) Examples include brand names, tradenames, and logos, etc.

c) Because symbolic intellectual property does not have significant standalone functionality, substantially all of the utility of symbolic intellectual property is derived from its association with the entity’s past or ongoing activities, including its ordinary business activities.

d) Revenue from a license to symbolic intellectual property is recognized in Step 5 over time.

e) A customer’s ability to derive benefit from a license to symbolic intellectual property depends on the entity continuing to support or maintain the intellectual property.


f) A license to symbolic intellectual property grants the customer a right to access the entity’s intellectual property, which is satisfied over time as the entity fulfills its promise to both:

• Grant the customer rights to use and benefit from the entity’s intellectual property, and

• Support or maintain the intellectual property.

g) Typically, the period over which the licensing revenue is recognized for symbolic intellectual property is the licensing period.

Example 1: Company X is a pharmaceutical company. It licenses several drug formulas to manufacturers.

In one case, X licenses the formula for Drug ABC to Company Y, with rights for Y to manufacture and distribute the drug. The license is for five years at a fixed fee of $10 million.

Conclusion: The license is functional intellectual property that licenses the right to use the formula. Thus, the licensing revenue should be recognized in full at a point in time when there is transfer of control of the license.

The reason is because Y can obtain significant standalone functionality from the license by manufacturing and selling the product. Further, there is no evidence that Company X’s activities are expected to substantively change the rights of Y during the license period.

Thus, $10 million revenue is recognized at a point in time when Company X transfers control of the license to Y.

Example 2: Company X owns a professional basketball team.

X licenses the team logo to various merchandise companies who place the logo on T shirts, and other apparel. For one particular customer, X receives a fixed fee of $1 million for a three-year license.

Conclusion: The license is for symbolic intellectual property because that property does not have a standalone functionality.

Because symbolic intellectual property (logo) does not have significant standalone functionality, substantially all of the utility of symbolic intellectual property is derived from its association with the sports team’s past or ongoing activities, including its ordinary business activities.

Thus, the $1 million licensing fee revenue is recognized over time during the three-year licensing period.

Example 3: A franchisee pays for a franchise license for Big Joe’s Juicy Burgers.

The license gives the franchisee access to:

• Name and logo

• Advertising and marketing activities local and nationwide


• Access to use the intellectual property of franchisor including accounting systems, processes, etc.

• Ongoing support from the franchisor

Conclusion: The license is for symbolic intellectual property because it is not functionally intellectual property (e.g., it does not have significant standalone functionality).

Thus, any revenue derived from the license is recognized over time which is likely to be the three-year licensing period.

Special Rule- Sales-Based or Usage-Based Royalties- Licenses

Licenses of intellectual property might include royalty fees charged based on the customer’s usage or product sales.

Typically, revenue from such licenses based on usage or product sales would be considered variable consideration to which an entity would estimate revenue to be generated over the license period.

However, ASC 606 provides a special royalty exception in paragraph 606-10-55-65, which is a deviation from the basic variable consideration rule, in situations in which royalties are received from the license of intellectual property.

Special rule for sales-based or usage-based royalties

1. An entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of intellectual property only when (or as) the later of the following events occurs:

a) The subsequent sale or usage occurs.

b) The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

2. The special rule for a sales-based or usage-based royalty applies when:

a) The royalty relates only to a license of intellectual property, or

b) A license of intellectual property is the predominant item to which the royalty relates.

Example: The license of intellectual property may be the predominant item to which the royalty relates when the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates.

3. When the predominant item criterion is met, revenue from a sales-based or usage-based royalty should be recognized wholly in accordance with the special rule.

4. When the predominant item criterion is not met, the sales-based or usage-based royalty should be recorded as variable consideration under those rules.


Why aren’t sales-based or usage-based royalties recorded as variable consideration under ASC 606?

Licenses of intellectual property might include royalty fees charged based on the customer’s usage or product sales.

Typically, revenue from such licenses based on usage or product sales would be considered variable consideration to which an entity would estimate revenue to be generated over the license period.

Under the variable consideration rules in ASC 606, in determining the transaction price in Step 3 of the revenue model:

• An entity is required to estimate the total amount of the variable consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

• The estimate should be determined using either of two methods: the expected value or most likely amount methods.

• The entity should include in the transaction price that portion of the variable consideration estimated only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is subsequently resolved.

Consequently, under the variable consideration rules, an entity with variable consideration is required to estimate that contract revenue as part of the transaction price in Step 3.

ASC 606 provides a special royalty exception in situations in which royalties are received from the license of intellectual property.

Under that special royalty exception:

1. In lieu of following the variable consideration revenue rules, an entity recognizes revenue for a sales-based or usage-based royalty promised in exchange for a license of intellectual property only when (or as) the later of the following events occurs:

a) The subsequent sale or usage occurs.

b) The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

When an entity does not meet the scope for the special royalty exception, the entity should recognize revenue from the sales-based or usage-based royalty using the variable consideration rules.


Observation

The special rule for recognizing revenue from sales-based or usage-based royalties results in a significant delay in recognition of that revenue as compared to the recognition timing if the revenue were recognized under the basic variable consideration rules. Under the variable consideration rules, revenue is recognized at inception based on an estimate of revenue to be received over the contract period. Yet, the special rule delays recognition until the later of a) actual sale or usage, or b) when the performance obligation is satisfied.

The FASB notes that it decided that for a license of intellectual property for which the consideration is based on the customer’s subsequent sales or usage, an entity should not recognize any revenue for the variable amounts until the uncertainty is resolved (that is, when a customer’s subsequent sales or usage occurs).

Example 1: Sales-Based Royalty Promised in Exchange for a License of Intellectual Property and Other Goods and Services

Company X is a movie distribution company that licenses Movie M to a customer.

The customer, an operator of cinemas, has the right to show the movie in its cinemas for six weeks.

Additionally, Company X has agreed to provide memorabilia from the filming to the customer for display at the customer’s cinemas before the beginning of the six-week airing period and to sponsor radio advertisements for Movie M on popular radio stations in the customer’s geographical area throughout the six-week airing period.

In exchange for providing the license and the additional promotional goods and services, Company X will receive a sales-based royalty in the form of a portion of the operator’s ticket sales for Movie M.

Company X concludes that the license to show Movie M is the predominant item to which the sales-based royalty relates because the entity has a reasonable expectation that the customer would assign significantly more value to the license than to the related promotional goods or services.

Conclusion: First, the license is for symbolic intellectual property and represents a promise to provide the customer with a right to access intellectual property (the movie) over a defined period of time of six weeks. Revenue from such a license is recognized over time.

Company X should recognize revenue from the sales-based royalty using the special sales-based royalty rules found in ASC 606.

The special sales-based royalty rule applies when:

• The royalty relates only to a license of intellectual property, or

• A license of intellectual property is the predominant item to which the royalty relates.


In this example, the movie license is identified as the predominant item to which the royalty relates.

The special rule requires the royalty to be recognized as revenue only when (or as) the later of the following events occurs:

a. The subsequent sale or usage occurs (e.g., ticket sales occur), and

b. The performance obligation to which some or all of the sales-based royalty has been allocated has been satisfied (e.g., transfer of license on the movie).

Under the special royalty rule, Company X should recognize the revenue over time as the ticket sales occur, which is the later of a) the sales occurring or b) transfer of the movie license to the customer.

The revenue is recognized over time (and not at a point in time) because the license is for symbolic intellectual property and represents a promise to provide the customer with a right to access intellectual property (the movie) over a defined period of time (which is six weeks in this example).

Moreover, if the license, the memorabilia, and the advertising activities were separate performance obligations, the entity would allocate the sales-based royalties to each performance obligation.

Example 1A: Same facts as Example 1 except that the sales-based royalty due to Company X has a minimum of $200,000 for the movie.

Is X permitted to recognize the minimum $200,000 revenue on the day it transfers the license for the movie (e.g., day one of the six-week licensing period)?

Conclusion: X is not permitted to record the minimum revenue on day one. The reason is because the sales-based royalty rules require the revenue to be recognized as a percentage of ticket sales per the contract. The variable consideration rules, which require the inclusion of an estimated amount of revenue in the transaction price, do not apply. Thus, the fact that there is a $200,000 revenue minimum is moot.

Instead, had the licensing not qualified for the special sales-based royalty rule (e.g., the license is not predominant), X would be required to estimate variable consideration and the $200,000 revenue minimum.

What if the special sales-based royalty rule did not apply?

Using the previous example, assume the movie license is not the predominant item to which the royalty applies, and therefore, the special sales-based royalty rule does not apply. In such a case, the royalty revenue is accounted for as variable consideration and estimated as part of the transaction price in Step 3 of the revenue model.

I. PRESENTATION OF SALES TAXES AND OTHER SIMILAR TAXES COLLECTED FROM CUSTOMERS

It is typical for entities, particularly retailers, to collect taxes from customers, such as sales tax, for remittance to the local or state taxing authorities.


Step 2 of the revenue model requires an entity to determine the transaction price of a contract.

The transaction price is defined as:

“the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes)…”

The general rules found in ASC 606 (through amendments made by ASU 2014-09) state that in determining the transaction price in Step 2, the transaction price excludes “amounts collected on behalf of third parties (for example, some sales taxes).”

Special accounting policy election- exclude taxes assessed from the transaction price

ASU 2016-12 amends ASC 606 to broaden the types of taxes that are excludable from the transaction price, and to permit an entity to make an accounting policy election to exclude from the transaction price “all taxes assessed by a governmental authority…”

Specifically, the revised guidance is found in ASC 606-10-32-2 and consists of the following new rules:

1. An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both:

a) Imposed on and concurrent with a specific revenue producing transaction, and

b) Collected by the entity from a customer.

Examples of such taxes that may be excluded under the election consist of:

• Sales tax

• Use tax

• Value-added tax, and

• Certain excise taxes.

2. Taxes assessed on an entity’s total gross receipts or imposed during the inventory procurement process shall be excluded from the scope of the election.

3. An entity that makes this election shall, in Step 3, exclude from the transaction price all taxes in the scope of the election and shall comply with the applicable accounting policy guidance, including the disclosure requirements.

4. There is no requirement under the election to disclose the amount of taxes withheld and paid to taxing authorities.


Observation

Prior to the effective date of the new revenue model in ASC 606, entities have been required to disclose the presentation of taxes in their notes to financial statements.

Specifically, ASC 605-45-50-3, Revenue Recognition- Principal Agent Considerations- Disclosures- Taxes Collected From Customers and Remitted to Governmental Authorities, stated:

“The presentation of taxes….. on a gross basis (included in revenue and costs) or a net basis (excluded from revenues), is an accounting policy decision that shall be disclosed…”

It has been up to the company to determine whether taxes should be presented on a gross or net basis.

Most companies continue to record sales and other taxes collected through a liability account (on a net basis) and do not recognize the cash receipts and payments through revenue and expense accounts.

Example 1- new ASC 606: Company X records sales taxes on a net basis by excluding both the sales tax withholding and payments from revenue and expenses. Instead, X records taxes collected and paid through a liability withholding account.

Conclusion: Under ASC 606 requirements, the Company should disclose the accounting policy for accounting for sales taxes on a net basis.

Sample Note:

NOTE X: Summary of Significant Accounting Policies

Sales Tax

The company is required to collect, on behalf of certain states, sales tax based on a percentage of qualifying sales. The company’s policy is to exclude sales taxes from the transaction price of all revenue when collected, and from expenses when paid. Instead, the company records the collection and payment of sales taxes through a liability account.

J. SHIPPING AND HANDLING ACTIVITIES- STEP 2 IDENTIFYING PERFORMANCE OBLIGATIONS

It is common for an entity to perform shipping and handling activities in connection with a contract for its goods. In some cases, shipping and handling activities are performed after it transfers control of the goods to the customer, while in other cases, the activities occur prior to transfer of control.

The issue is whether an entity should treat shipping and handling activities as a separate performance obligation in applying Step 2 of the revenue model.


Thus, there are two possible outcomes in accounting for shipping and handling activities:

1. Treat them as a separate performance obligation with a portion of the transaction price allocated to the shipping and handling activities, or

2. Exclude them from the transaction price altogether, and treat the costs as a fulfillment cost.

ASC 606, as amended by ASU 2016-10, states that if an entity performs shipping and handling activities related to a promised good, the following rules apply:

1. If the shipping and handling activities are performed before the customer obtains control of the good, then the following shall apply:

a) The shipping and handling activities are not a separate promised service to the customer.

b) The shipping and handling are part of the activities to fulfill the entity’s promise to transfer the good (and are treated as a fulfillment cost).

2. If shipping and handling activities are performed after a customer obtains control of the good, then the following rules apply:

a) The shipping and handling activities may be treated as a separate performance obligation, or

b) The entity may make an election to account for shipping and handling as part of the activities to fulfill the promise to transfer the good (e.g., account for the costs as a fulfillment cost).

1) The shipping and handling costs are not treated as a separate performance obligation and are part of the promise to transfer the goods.

2) The entity shall apply this accounting policy election consistently to similar types of transactions.

3) An entity that makes this election is required to evaluate whether shipping and handling activities are promised services to its customers.

4) If revenue is recognized for the related good before the shipping and handling activities occur, the related costs of those shipping and handling activities shall be accrued and treated as fulfillment costs.

5) An entity that applies this accounting policy election shall comply with the accounting policy disclosure requirements in ASC 235, Notes to Financial Statements (paragraphs 235-10-50-1 through 50-6).


Sample Note:

NOTE X: Summary of Significant Accounting Policies

Shipping and handling expenses:

Effective January 1, 2019, the Company made an accounting policy election to include all shipping and handling activities as part of the underlying promise to transfer goods to customers, and not to treat them as a separate performance obligation. In making this election, no portion of revenue received from customers is allocated to shipping and handling activities. All shipping and handling costs are classified as fulfillment costs.

Under the new ASC 606, is an entity still required to disclose its policy for classifying shipping and handling costs?

No.

Prior to the effective date of ASC 606, entities have been required to include a disclosure related to the classification of shipping and handling costs on the income statement.

Specifically, ASC 605-45-50-3, Revenue Recognition- Principal Agent Considerations- Disclosures- Shipping and Handling Fees and Costs, stated:

“The classification of shipping and handling costs is an accounting policy election that must be disclosed pursuant to [ASC] Topic 235, Notes to Financial Statements.”

Thus, prior to 2019 (for nonpublic companies), entities have been required to disclose the income statement line item on which it presented its shipping and handling costs. If the presentation location was other than cost of goods sold, the disclosure had to include both the income statement line item where the shipping and handling costs were presented, and the total amount of shipping and handling costs.

Effective with the new ASC 606, the shipping and handling cost disclosure has been eliminated.

Thus, effective in calendar year 2019 financial statements (for nonpublic entities), an entity is no longer required to disclose the policy for presenting shipping and handling expenses in its income statement. However, nothing precludes an entity from retaining that disclosure on an optional basis.




1. Company X obtains revenue by selling a promise to provide its customers with a right to access X’s various intellectual property. In terms of recognizing revenue, how does the amendment made by ASU 2016-10 state that X’s performance obligation (promise) should be satisfied:

A. at a point in time

B. over time

C. at the beginning of the contract

D. once the revenue is collected

2. The general rule is that revenue cannot be recognized from a license of intellectual property before certain dates or actions are satisfied. What is one of those dates or actions:

A. the date at the end of the period during which the customer is able to use the intellectual property

B. the date on which the parties agree the intellectual property will be supplied to the customer

C. the date on which a copy of the intellectual property is given to the customer

D. the date on which the contract is executed

3. The general rule is that an entity recognizes revenue for a sales-based royalty promised when the later of two dates or events occurs, one of which is:

A. the performance obligation is satisfied

B. the contract has been executed

C. the subsequent sale has not yet occurred

D. the intellectual property on which the royalty is generated is completed


4. Which one of the following taxes qualifies for the accounting policy election in ASC 606-10-32-2:

A. federal corporate income taxes

B. state corporate income taxes

C. personal property tax

D. sales tax collected

5. ASU 2016-12 amends ASC 606 with respect to taxes assessed by a governmental authority and an election that can be made. Which of the following is correct with respect to this amendment:

A. an entity may make an accounting policy election to include all taxes in the transaction price

B. ASU 2016-12 excludes taxes imposed during the inventory procurement process from the election

C. any taxes for which the election is made are included in the transaction price

D. the election and amendment apply to corporate income taxes

6. Company Z sells goods to customers. As part of that activity, Z also performs shipping and handling activities related to the promise to provide the goods. Z does its shipping after it obtains control of the goods it is selling. Which of the following is correct with respect to an election Z may make in ASU 2016-10 regarding how the shipping and handling activities should be accounted for under the amendments made by ASU 2016-10:

A. the shipping and handling are automatically activities to fulfill Z’s promise to transfer the goods

B. Z may make an election to account for the shipping and handling as part of the activities to fulfill the promise to transfer the goods

C. if Z makes an election, it would still have to evaluate whether shipping and handling activities are promised services to customers

D. Z must treat the shipping and handling as a separately promised good or service



1. A. Incorrect. The right to use the intellectual property warrants being satisfied at a point in time. However, the right to access the intellectual property is over time.

B. CORRECT. When a promise is to provide a customer with the right to access (rather than use) an entity’s intellectual property, the performance obligation is deemed satisfied over time. The reason is because the customer will also receive and consume the benefit from the performance over time through access to the intellectual property.

C. Incorrect. The revenue rules do not offer the option of satisfying a performance obligation based on the beginning of the contract date.

D. Incorrect. There is generally no correlation between when a performance obligation is satisfied and the actual collection of the revenue provided that the revenue is collectible.


2. A. Incorrect. A date at the beginning, not end, of the period during which the customer is able to use the intellectual property is one of the two requirements.

B. Incorrect. One of the dates is the date on which the entity makes the intellectual property available to the customer, not the date the parties agree on the date.

C. CORRECT. One of the dates is the date on which a copy of the intellectual property is given to the customer or made available to the customer.

D. Incorrect. The date on which the contract is executed has nothing to do with the recognition of revenue and satisfying a performance obligation.


3. A. CORRECT. One of the dates is when the performance obligation to which some or all of the sales-based royalty has been allocated has been satisfied.

B. Incorrect. Executing a contract is not a date used for recognizing revenue as it has nothing to do with completing the performance obligation.

C. Incorrect. One event or date is that the subsequent sale has occurred.

D. Incorrect. It is assumed that the intellectual property on which the royalty is generated is completed as inception. Thus, recognizing revenue is based on a later date.



4. A. Incorrect. The accounting policy election permits an entity to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both imposed and collected from the customer. Federal corporation income taxes are not collected from the customer.

B. Incorrect. Because state corporate income taxes are not collected from the customer, they do not qualify for the exclusion election.

C. Incorrect. Because personal property taxes are not collected from the customer, they do not qualify for the exclusion election.

D. CORRECT. Sales tax collected qualify for the election to be excluded from the transaction price. The reason is because sales tax is both imposed by a governmental authority and are collected from the customer.


5. A. Incorrect. The election is to exclude, not include, most taxes in the transaction price.

B. CORRECT. Taxes assessed on an entity’s total gross receipts or imposed during the inventory procurement process shall be excluded from the scope of the election.

C. Incorrect. Any taxes for which the election is made are excluded, not included, in the transaction price.

D. Incorrect. The election and amendment apply to all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue producing transaction and collected by the entity from a customer. Those taxes include sales, use, value added, and some excise taxes, but do not include corporate income taxes which are not collected from the customer.


6. A. Incorrect. The shipping and handling are activities to fulfill Z’s promise to transfer the goods only if an election is made to do so.

B. CORRECT. ASU 2016-10 amends ASC 606 to permit an entity to elect to account for the shipping and handling as activities to fulfill the promise to transfer the goods.

C. Incorrect. If Z makes an election, it would not be required to evaluate whether shipping and handling activities are promised services to customers.

D. Incorrect. Because there is an election to account for shipping and handling as part of the activity to fulfill the promise to transfer the goods, Z is not required to treat the shipping and handling as a separate promised good or service. If Z does not make the election, the shipping and handling would be considered a separate promise.



K. BREAKAGE IN PREPAID GIFT CARDS

Prepaid stored-value products are products in physical and digital forms with stored monetary values that are issued for the purpose of being commonly accepted as payment for goods or services.

The typical form of a prepaid stored-value product is a prepaid gift card issued by a retail store, but such products can consist of prepaid telecommunication cards and traveler’s checks.

Recently, use of prepaid gift cards has become more popular as customers seek flexible gift and purchase arrangements, while businesses welcome the upfront cash flow that these products afford them.

When an entity sells a prepaid stored-value product that is redeemable at a merchant, it recognizes a liability for its obligation to provide the customer with the ability to purchase goods or services at that merchant.

At the date of sale of the prepaid store-valued product, the issuer makes the following entry:

Cash XXLiability- prepaid cards XX

When the customer redeems the prepaid stored-value product, the entity’s liability (or part of that liability) to the customer is extinguished with the following entry:

Liability- prepaid cards XXSales XX

Dealing with breakage

In a perfect situation, each customer timely redeems his or her prepaid card and the liability is extinguished to zero. Yet, the reality is that a portion of prepaid cards are never redeemed. This portion is referred to as breakage.

Customers fail to redeem prepaid cards for numerous reasons, including:

• The cards are lost

• Customers forget to redeem them

• Cards are damaged

• Cards expire

In some cases, a prepaid stored-value product may be unused wholly or partially for an indefinite time period.

Some states require businesses to submit the portion of unredeemed cards as lost property so that the state receives the proceeds from breakage. Other states have no lost property law so that businesses may retain the breakage as sheer profit.


In states that do not require submission of unredeemed card proceeds as lost property, selling prepaid cards is a “can’t lose” situation for the merchant or retail store:

1. If the card is redeemed, the business receives upfront working capital followed by a sales and profit from the sale, and

2. If the card is not redeemed, the business receives the entire proceeds are profit from breakage.

Either way, selling prepaid stored-value cards is a lucrative business and one that is expanding.

How to account for breakage

ASU 2016-04: Liabilities- Extinguishments of Liabilities (Subtopic 405-20) Recognition of Breakage for Certain Prepaid Stored-Value Products, provides guidance on how to account for prepaid stored-value cards (prepaid gift cards).

ASU 2016-04 makes the following amendments to ASC 405, Liabilities:

1. Prepaid stored-value product liabilities (prepaid gift cards) are financial liabilities in that it is likely to be settled and extinguished through payment of cash paid or product provided.

a) ASU 606, Revenue from Contracts with Customers, does have breakage guidance for transactions within its scope. However, financial liabilities are excluded from the ASC 606 scope.

2. General rule for derecognizing (removing) all liabilities- ASC 405

a) Unless addressed by other guidance, a debtor shall derecognize (remove) a liability if and only if it has been extinguished.

3. A liability has been extinguished if either of the following conditions is met:

a) The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:

• Delivery of cash

• Delivery of other financial assets

• Delivery of goods or services, or

• Reacquisition by the debtor of its outstanding debt securities.

b) The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor.

4. Exceptions to the general rule for prepaid stored-value products:

a) ASC 405 provide an exception to the general rule of derecognition with respect to breakage on prepaid stored-value products (prepaid gift cards).

b) Prepaid stored-value products are defined as:


“Products in physical and digital forms with stored monetary values that are issued for the purpose of being commonly accepted as payment for goods or services.”

c) Examples of prepaid stored-value products include:

• Prepaid gift cards issued on a specific payment network and redeemable at network-accepting merchant locations

• Prepaid telecommunication cards, and

• Traveler’s checks.

d) Exception to the general rule- breakage: The derecognition guidance does not apply to liabilities related to any of the following:

• Prepaid stored-value products (or portions of those products) for which any breakage (that is, the portion of the dollar value of prepaid stored-value products that ultimately is not redeemed by product holders for cash or not used to purchase goods and/or services) must be remitted in accordance with unclaimed property laws.

• Prepaid stored-value products that are attached to a segregated bank account like a customer depository account.

• Customer loyalty programs or transactions within the scope of other GAAP.

• Products that only can be redeemed by the product holder for cash (such as, nonrecourse debt, bearer bonds, or trade payables).

e) Breakage rules for prepaid stored-value products- ASC 405:

1) If an entity expects to be entitled to a breakage amount for a liability resulting from the sale of a prepaid stored-value product, the entity shall do the following:

Derecognize (remove) from the liability the amount related to the expected breakage in proportion to the pattern of rights expected to be exercised by the product holder only to the extent that it is probable that a significant reversal of the recognized breakage amount will not subsequently occur.

2) The revised breakage rules found in ASC 405 follow the guidance for breakage previously issued in ASC 606.

3) If an entity does not expect to be entitled to a breakage amount for prepaid stored-value products, the entity shall derecognize the amount related to breakage when the likelihood of the product holder exercising its remaining rights becomes remote.

Example: In a first year of business, a retail entity sells prepaid gift cards to customers and has no history of breakage amounts.


Conclusion: Because there is no history of breakage in its first year, the entity cannot expect to be entitled to any breakage. Thus, it must wait to derecognize (remove) a portion of the liability for breakage until the likelihood that customers will not use gift cards is remote. That remote threshold might not occur for several years in the future.

4) At the end of each period, an entity shall update the estimated breakage amount to reflect changes in circumstances during the period.

• Changes to an entity’s estimated breakage amount shall be accounted for as a change in accounting estimate.

5. An entity that recognizes a breakage amount shall disclose the methodology used to recognize breakage and significant judgments made in applying the breakage methodology.

What if the state in which an entity operates has an unclaimed property law for breakage on prepaid cards?

Many states have unclaimed property laws under which a company must remit to the state that portion of prepaid stored-value products (cards) that is not redeemed (e.g., breakage). ASU 2016-04 specifically states that the breakage rules created by ASU 2016-04 do not apply to prepaid stored-value products (prepaid gift cards) that must be remitted in accordance with unclaimed property laws.

That means that an entity is not permitted to derecognize (remove) a portion of the liability for breakage because the entity will be required to pay that liability portion to the state after a certain period of time.

Example 1:

Jimmy Steak House (Jimmy) has been in business for ten years and has been selling gift cards to its customers.

Jimmy retains a history of the percentage of gift cards that are redeemed and the percentage of breakage representing those customers who do not redeem the cards.

Jimmy’s state of Massachusetts does not have a requirement that unredeemed card proceeds must be remitted to the state as lost property.

During 20X1, Jimmy sells $100,000 of gift cards.

Activity in 20X1 follows:

• Customers have redeemed $20,000 of the $100,000 of gift cards that were issued in 20X1.

• At the end of 20X1, Jimmy estimates (based on history) that there is $10,000 of estimated breakage and it is probable that there will not be a reversal of the breakage in the future. That is, it is probable that customers will not redeem the gift cards for the $10,000 of estimated breakage.


Conclusion:

In 20X1, Jimmy should record the $100,000 as a new liability and should record the $20,000 as a reduction of the liability reflective of the gift cards redeemed in 20X1.

As for the breakage, Jimmy has a long history of tracking breakage percentages. It has estimated that out of the $100,000 of new 20X1 gift cards, $10,000 represents breakage for which it is probable that there will not be a significant reversal (redemption). That is, if the company derecognizes (removes) $10,000 of the liability for breakage, it is probable that customers will not redeem the $10,000 of gift cards in the future. That information is based on the company having a strong history of tracking the breakage percentages.

Entries in 20X1: dr cr

Cash 100,000Liability for gift cards 100,000

To record the issuance of the gift cards.

Liability for gift cards 20,000Revenue 20,000

To record those gift cards that were redeemed by customers in 20X1 related to 20X1 gift card sales.

Liability for gift cards 10,000Breakage revenue 10,000

To record breakage on gift card sales for which it is probable the customers will not redeem the certificates in the future.

After making the above 20X1 entries, the liability has a balance of $70,000 at December 31, 20X1 as follows:

20X1 liability for new 20X1 gift card sales $100,000Redeemed by customers (20,000)Estimated breakage (10,000)Balance 12-31-X1 $70,000

The $70,000 represents that portion of the $100,000 of sold gift cards that the company expects will be redeemed by customers in the future.

Example 2:

Same facts as Example 1 except that Jimmy’s Steak House is a new business started in 20X1 for which it has no history of percentage breakage on gift cards.

Therefore, it cannot estimate breakage for which it is probable that a significant reversal of the breakage amount will not subsequently occur.


Conclusion:

In 20X1, Jimmy’s makes the entries for the $100,000 sale of gift cards and the $20,000 redemption of gift cards.

However, Jimmy’s cannot make an entry for estimated breakage because it cannot meet the probable threshold. That is, it cannot estimate an amount of breakage for which it is probable that a significant reversal (redemption) will not subsequently occur.

Thus, Jimmy’s must follow the rule of ASU 2016-04, which states:

“If an entity does not expect to be entitled to a breakage amount for prepaid stored-value products, the entity shall derecognize the amount related to breakage when the likelihood of the product holder exercising its remaining rights becomes remote.”

That means that Jimmy’s must wait until future years in which it becomes remote that any remainder liability will be exercised.


Cash 100,000Liability for gift cards 100,000

To record the issuance of the gift cards in 20X1.

Liability for gift cards 20,000Revenue 20,000

To record those gift cards that were redeemed by customers in 20X1 related to 20X1 gift card sales.

Assume further that in 20X4, $95,000 of the $100,000 of 20X1 gift cards have been redeemed and there is a remainder of $5,000 unredeemed.

The company believes that the likelihood of the remainder $5,000 being redeemed is remote.

Conclusion:

In 20X4, the company should make the following entry to record the remainder of gift cards issued in 20X1 that is breakage.


Liability for gift cards 5,000Breakage revenue 5,000

To record breakage on 20X1 gift card sales for which the likelihood of redemption is remote.


How should one record the discount on the gift cards issued?

To entice customers to purchase their prepaid gift cards, many companies offer a purchase price that is a discount off the face value of the prepaid card.

For example, a customer may be able to purchase a $100,000 gift card at a discount price of $75,000.

How should a company record this transaction at inception?

The FASB has not addressed this issue. The author believes that the discount should be recorded as an expense (or contra revenue) at the date of purchase.

Example:

In 20X1, Outback Steak House issued $100,000 of gift cards at a discounted price to its customers of $75,000. That means that customers receive more than they paid for in the gift cards.

What should Outback Steak House do with the $25,000 discount that occurs at the time the gift cards are issued?


Cash 75,000Expense or contract revenue 25,000

Liability for gift cards 100,000To record the issuance of the gift cards at a discount.

Conclusion:

The previous entry is non-authoritative as FASB has yet to address the discounts issue. The author suggests that the $25,000 discount be recorded either as an expense or as a contra revenue account similar to a sales discount.

Some commentators believe the discount should be deferred as an asset and matched against future breakage on the $100,000 liability. Such an approach ignores the concept of conservatism that requires that an unrealized loss be recorded at the time of the transaction.




1. The amendments in ASU 2016-04 conclude that a prepaid stored-value product is which of the following:

A. a nonfinancial liability

B. a deferred revenue

C. an element of other comprehensive income (OCI)

D. a financial liability

2. Which of the following is an example of a prepaid stored-value product:

A. traveler’s checks

B. nonrecourse debt

C. bearer bonds

D. trade payables

3. Stefano’s Italian Restaurant opens its doors in January 20X1. In 20X1, it sells $100,000 of prepaid stored-value products. It has no history of what percentage of the $100,000 will be breakage. Under the ASU 2016-04 rules, how and when should Stefano’s record breakage:

A. it can record the breakage immediately because it is probable there will not be a significant reversal

B. when the likelihood of the customer exercising the prepaid products is remote

C. no breakage can ever be recorded as the business has no history

D. when it is more likely than not that the breakage will not reverse



1. A. Incorrect. The ASU finally resolved the issue and concluded that a prepaid stored-value product is a financial liability because it is likely to be settled and extinguished through payment of cash or a product provided.

B. Incorrect. Nothing in ASU 2016-04 permits the funds received from a prepaid stored-value product to be credited to deferred revenue as there is an obligation to repay the liability either through payment of cash or by giving a product.

C. Incorrect. Funds received from a customer for a prepaid stored-value product are not part of other comprehensive income (OCI) per the language found in ASU 2016-04. There are a limited number of specifically identified elements that are part of OCI and funds received from a prepaid stored-value product is not one of them.

D. CORRECT. The ASU resolves the issue as to whether the prepaid product is a financial liability. The ASU categorizes it as a financial liability, which means that it is not within the scope of ASC 606.


2. A. CORRECT. Traveler’s checks are one category of prepaid stored-value products because they can be commonly accepted as payment for goods or services.

B. Incorrect. The term “prepaid stored-value product” excludes any products that can only be redeemed for cash, which is the case with nonrecourse debt.

C. Incorrect. Bearer bonds are an example of a product that can only be redeemed for cash, which is excluded from the definition of a prepaid stored-value product. A prepaid stored-value product must be accepted for payment for both goods and services.

D. Incorrect. Trade payables can only be redeemed (paid) in cash, which is not the definition of a prepaid stored-value product that is redeemable for cash or goods or services.



3. A. Incorrect. Because the company is a new business, it is not possible for it to reach a probable threshold in 20X1. Thus, the immediate derecognition for breakage is not possible.

B. CORRECT. Because the company is new, it has no history to support any conclusion other than it cannot be expected to be entitled to any breakage amount. Based on that fact, breakage is recorded only when the likelihood of the customer exercising the prepaid products is remote. Reaching the remote threshold is likely to occur in years after the first year of business.

C. Incorrect. Even though it is a new business, it can ultimately derecognize a portion of the liability for estimated breakage once the likelihood of the customer exercising the prepaid products is remote. That is likely to occur sometime during a future year.

D. Incorrect. ASU 2016-04 does not use a more likely than not threshold to measure breakage.




• Recall how certain contract costs are accounted for under the revenue standard.• Recognize certain disclosures required by the revenue standard for nonpublic entities.• Recall an applicable financial statement (AFS).

VIII. CONTRACT COSTS

In most instances, entities must incur costs to obtain a contract with a customer. Some, but not all, of those costs would not otherwise have been incurred had it not been for seeking and obtaining the contract.

ASC 606 offers guidance on how an entity should account for the costs to obtain and fulfill a contract. In certain instances, such costs are expensed as period costs while in others, the costs must be capitalized and amortized over the period that the related goods and services transfer to the customer.

ASU 2014-09 amends ASC 606 and adds a new subtopic, ASC 340-40, Other Assets and Deferred Costs: Contracts with Customers, which deals with the capitalization as assets of costs incurred to obtain or fulfill a contract with a customer. ASC 340-40 specifically addresses certain situations in which an asset is required to reflect those costs.

There are two categories of costs that are addressed in ASC 340 that might be capitalized in certain cases:

• Incremental costs to obtain a contract

• Costs to fulfill a contract

Here are the general rules for accounting for costs to obtain a contract found in ASC 606 and ASC 340-40.

1. Incremental costs of obtaining a contract

a) Incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained.

Examples of such incremental costs include:

• Sales commissions and fringe benefits related to obtaining the original contract


• Sales commissions and fringe benefits related to obtaining contract renewals10

b) An entity shall recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.

c) Practical expedient: An entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less.

2. Costs not considered incremental costs to obtain a contract

a) Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained are not incremental costs and shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained.

1) Examples of costs that are not incremental costs include the following because they would be incurred regardless of whether the deal is ultimately completed and the contract executed. Such costs are expensed:

• Selling and marketing costs

• Bid and proposal costs in pursuit of the contract

• Legal costs incurred to review a transaction and create and submit a proposal for a contract

• Fixed salaries and wages for employees

3. Costs to fulfill a contract

a) Costs to fulfill the obligations under a contract once it is obtained, but before transferring goods or services to the customer are considered costs to fulfill a contract.

b) An entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet all of the following criteria:

1) The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify.

Example: Costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved.

2) The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.

10. Joint Transition Resource Group for Revenue Recognition (TRG) Memo No. 23, Issue 1(a) (January 2016) concludes that an entity should capitalize the new commission for each contract renewal because it is considered an incremental cost that would not have been incurred if the renewal contract was not obtained.


3) The costs are expected to be recovered.

c) Costs that relate directly to a contract (or a specific anticipated contract) include any of the following:

1) Direct labor (such as salaries and wages of employees who provide the promised services directly to the customer)

2) Direct materials (consisting of supplies used in providing the promised services to a customer)

3) Allocations of costs that relate directly to the contract or to contract activities such as:

• Costs of contract management and supervision

• Insurance, and

• Depreciation of tools and equipment used in fulfilling the contract.

4) Costs that are explicitly chargeable to the customer under the contract

5) Other costs that are incurred only because an entity entered into the contract (for example, payments to subcontractors)

Note

If costs incurred in fulfilling a contract with a customer are covered within the scope of another ASC topic, an entity should account for those costs under that other topic and not under the guidance of ASC 606 and 340-40.

Observation

ASC 340 provides an opportunity for abuse with respect to the capitalization of costs to fulfill a contract. An entity is permitted to allocate costs that relate directly to the contract, such as costs of contract management and supervision. This allocation appears arbitrary and might motivate companies to over allocate certain overheads to costs to fulfill a contract in order to capitalize those costs as assets.

4. Other costs

a) An entity shall recognize the following costs as expenses when incurred:

1) General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract, and capitalized as costs to fulfill the contract);


2) Costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract;

3) Costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance); and

4) Costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations).

5. Subsequent measurement of capitalized costs

a) There are two categories of costs that are capitalized as assets in ASC 340:

• Incremental costs to obtain a contract

• Costs to fulfill a contract

b) An asset recognized due to the capitalization of incremental costs of obtaining a contract, or costs to fulfill a contract, shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.

Examples of amortization periods include the following:

• Contract term

• Average customer life11

Note

The FASB stated that the amortization period could be longer than the initial contract term if the costs also relate to an anticipated future contract or renewal. That is, the amortization period could include the initial contract term plus options to renew. However, amortizing the asset over a longer period than the initial contract (e.g., to include option renewal periods) would not be appropriate in situations in which an entity pays a commission on a contract renewal that is commensurate with the commission paid on the initial contract.12

c) An entity shall update the amortization to reflect a significant change in the entity’s expected timing of transfer to the customer of the goods or services to which the asset relates. Such a change shall be accounted for as a change in accounting estimate in accordance with ASC 250-10, Accounting Changes and Error Corrections.

11. In TRG Memo 57 (December 2016), entitled Capitalization and Amortization of Incremental Costs of Obtaining a Contract, FASB Transition Resource Group for Revenue Recognition stated that it does not think the new revenue standard requires an entity to amortize the asset over the average customer term (or life). Further, it states that entities should not default to using the average customer life when determining the amortization period for costs to obtain a contract.12. See Paragraph BC309 of FASB Board conclusions in ASU 2014-09.


d) An entity shall recognize an impairment loss in its income statement to the extent that the carrying amount of an asset capitalized exceeds:

1) The remaining amount of consideration that the entity expects to receive in exchange for the goods or services to which the asset relates, less the costs that relate directly to providing those goods or services and that have not been recognized as expenses.

Note

An entity shall not recognize a reversal of an impairment loss previously recognized.

6. Disclosures of capitalized contract costs

a) Per ASC 340-40-50-2 and 50-3, Other Assets and Deferred Costs, the following disclosures are required for costs capitalized related to contracts with customers.

1) The judgments made in determining the amount of costs to obtain or fulfilling a contract with a customer;

2) The method it used to determine the amortization for each reporting period;

3) The closing balances of assets recognized from the costs incurred to obtain or fulfill a contract with a customer, by main category of asset (such as costs to obtain contracts with customers, precontract costs, and setup costs); and

4) The amount of any amortization costs and impairment losses recognized in the reporting period.

Examples:

Following examples are extracted from ASC 606, as modified by the Author.

Example 1: Incremental Costs of Obtaining a Contract

An entity, a provider of consulting services, wins a competitive bid to provide consulting services to a new customer.

The entity incurred the following costs to obtain the contract:


External legal fees for due diligence $15,000Travel costs to deliver proposal 25,000Commissions to sales employees 10,000

$50,000

The entity also pays discretionary annual bonuses to sales supervisors based on annual sales targets, overall profitability of the entity, and individual performance evaluations.

Conclusion:

The entity recognizes an asset for the $10,000 incremental costs of obtaining the contract arising from the commissions to sales employees because the entity expects to recover those costs through future fees for the consulting services. Once capitalized, the $10,000 should be amortized in a systematic and rational manner that is consistent with the way in which the underlying revenue is recognized.

The external legal fees ($15,000) and travel costs ($25,000) would have been incurred regardless of whether the contract was obtained. The fact that they relate to the transaction and original proposal and due diligence is not relevant because they would have been incurred if the entity had not won the contract. Therefore, the external legal fees and travel costs are recognized as expenses when incurred.

The entity does not recognize an asset for the bonuses paid to sales supervisors because the bonuses are not incremental to obtaining a contract. The amounts are discretionary and are based on other factors, including the profitability of the entity and the individuals’ performance. The bonuses are not directly attributable to identifiable contracts.

Example 2: Costs That Give Rise to an Asset

An entity enters into a service contract to manage a customer’s information technology data center for five years.

The contract is renewable for subsequent one-year periods beyond the initial five-year period.

The average customer term is seven years.

The entity pays an employee a $10,000 sales commission upon the customer signing the contract.

Before providing the services, the entity designs and builds a technology platform for the entity’s internal use that interfaces with the customer’s systems. That platform is not transferred to the customer, but will be used to deliver services to the customer.

The initial costs incurred to set up the technology platform, which will continue to be owned by the entity, are as follows:

Design costs $40,000Hardware 120,000Software 90,000Migration and testing of data center 100,000

$350,000


In addition to the initial costs to set up the technology platform, the entity also assigns two employees who are primarily responsible for providing the service to the customer.

Conclusion:

The entity recognizes an asset for the $10,000 incremental costs of obtaining the contract for the sales commission because the entity expects to recover those costs through future fees for the services to be provided.

The entity amortizes the $10,000 asset over seven years because the asset relates to the services transferred to the customer during the contract term of five years and the entity anticipates that the contract will be renewed for two subsequent one-year periods.

The initial setup costs relate primarily to activities to fulfill the contract but do not transfer goods or services to the customer.

The entity accounts for the initial setup costs as follows:

1. Hardware costs: $120,000: Should be capitalized, depreciated, and accounted for in accordance with ASC 360, Property, Plant, and Equipment.

2. Software costs: $90,000: Should be accounted for in accordance with ASC 350-40 on internal-use software.

3. Costs of the design, migration, and testing of the data center: $140,000 total. Should be assessed to determine whether they are costs to fulfill the contract to be capitalized and amortized.

Those costs will be capitalized as an asset only if those costs meet all of the following criteria:

1. The costs relate directly to the contract or to an anticipated contract that the entity can specifically identify.

2. The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.

3. The costs are expected to be recovered.

Any resulting asset would be amortized on a systematic basis over the seven-year period (that is, the five-year contract term and two anticipated one-year renewal periods) that the entity expects to provide services related to the data center.

Although the costs for these two employees are incurred as part of providing the service to the customer, the entity concludes that the costs do not generate or enhance resources of the entity. Therefore, the costs do not meet the criteria and cannot be recognized as an asset. In addition, the entity recognizes the payroll expense for these two employees when incurred.


IX. PRESENTATION- GENERAL RULES IN ASC 606

ASC 606 identifies certain balance sheet assets and liabilities that are used in connection with executing the revenue standard.

They include:

Contract asset: An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Contract liability: An entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer.

Receivable: An entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due. A receivable differs from a contract asset in that a receivable has an unconditional right to consideration, while a contract asset is conditional on something other than the passage of time.

Refund liability: The portion of consideration received from a customer that an entity expects to refund.

ASC 606 offers the following rules for recording of revenue transactions and presenting them on the financial statements.

1. When either party to a contract has performed, an entity shall present the contract in the statement of financial position as a contract asset or a contract liability, depending on the relationship between the entity’s performance and the customer’s payment.

a) An entity shall present any unconditional rights to consideration separately as a receivable, and not as a contract asset.

2. If a customer pays consideration, or an entity has a right to an amount of consideration that is unconditional (that is, a receivable), before the entity transfers a good or service to the customer, the entity shall present the contract as a contract liability when the payment is made or the payment is due (whichever is earlier).

a) A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.

3. If an entity performs by transferring goods or services to a customer before the customer pays consideration or before payment is due, the entity shall present the contract as a contract asset, excluding any amounts presented as a receivable. A contract asset is an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer.


4. An entity shall assess a contract asset for impairment in accordance with ASC 310, Receivables. An impairment of a contract asset shall be measured, presented, and disclosed in accordance with ASC 310.

5. A receivable is an entity’s right to consideration that is unconditional.

a) A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due.

Example: An entity would recognize a receivable if it has a present right to payment even though that amount may be subject to refund in the future.

b) An entity shall account for a receivable in accordance with ASC 310, Receivables.

c) Upon initial recognition of a receivable from a contract with a customer, any difference between the measurement of the receivable in accordance with ASC 310 and the corresponding amount of revenue recognized, shall be presented as an expense (for example, as an impairment loss).

Note

This guidance uses the terms contract asset and contract liability but does not prohibit an entity from using alternative descriptions in the statement of financial position for those items. If an entity uses an alternative description for a contract asset, the entity shall provide sufficient information for a user of the financial statements to distinguish between receivables and contract assets.

6. Other balance sheet accounts:

a) Costs to obtain and fulfill a contract that are capitalized should be presented on the balance sheet separate from other assets, if material.

Why is there a difference between a contract asset and a receivable?

In paragraphs BC322-326 of ASC 606, the FASB discusses in detail the difference between a contract asset and a receivable, and the importance of keeping them separate.

The FASB notes the following with respect to the two types of assets:

1. When an entity performs first by satisfying a performance obligation before a customer performs by paying the consideration, the entity has a contract asset, which is a (conditional) right to consideration from the customer in exchange for goods or services transferred to the customer.

2. In most cases, a contract asset has a conditional right to consideration, and requires two actions to be fulfilled:


a) The passage of time is required before payment of that consideration is due, and

b) The satisfaction of a performance obligation.

3. The conditional right becomes unconditional (and a receivable) once there is the satisfaction of a performance obligation so that the only remainder requirement is the passage of time before payment is received from the customer.

4. The FASB also noted that in separating the contract asset and a receivable, it did so in order to provide users of financial statements with information about the risks associated with the entity’s rights in a contract. Although both would be subject to credit risk, a contract asset also is subject to other risks, for example, performance risk.

Presentation of ASC 606 elements on the financial statements

Balance sheet

ASC 606 provides limited guidance as to how contract assets and liabilities should be presented on the balance sheet.

Here are some basic rules that might be followed, some of which are codified in ASC 606, some of which are not:

1. Contract assets and liabilities should be shown separate from receivables.

2. Contract assets and liabilities should not be netted or combined with other assets and liabilities.

3. Contract assets and contract liabilities should be netted per contract at the contract level.13

4. Receivables should be shown separately and not be netted or combined with contract assets and liabilities.

5. Refund liabilities should be shown separately and not netted or combined with contract assets and liabilities.

6. Contract assets and liabilities should be shown current or long-term based on the traditional rules of presenting assets and liabilities, which is based on the operating cycle of the business.

7. Per ASC 606-10-45-5, entities are permitted to use “alternative descriptions” for the terms contract assets and contract liabilities on the balance sheet.

Examples of alternative descriptions include:

13. In BC317 of ASU 2014-09, the FASB decided that the remaining rights and performance obligations in a contract should be accounted for and presented on a net basis, as either a contract asset or a contract liability.


Possible Alternative Descriptions

Contract Assets Contract Liabilities• Conditional right to consideration• Deferred revenue

• Unbilled receivable• Unearned revenue

Which balance sheet accounts can be netted and which must be presented separately in ASC 606

The FASB is clear that it seeks to ensure that the user of financial statements understands the amount of contract assets and liabilities, and that the net amount of contract assets and liabilities for a particular contract are presented separately from other balance sheet accounts.

Contract assets and liabilities for a contract should be netted and shown as a net contract asset or liability.

As for receivables, they must be presented separately from contract assets and liabilities. One reason is because the risks associated with receivables are different from those of contract assets. Although both contract assets and receivables have credit/collection risk, contract assets have the additional performance risk. Moreover, receivables have an unconditional right to the consideration on the contract, subject only to the passage of time.

Lastly, ASC 606 suggests that refund liabilities should not be combined with contract liabilities. In ASC 606-10-45-1, the FASB states “when either party to a contract has performed, an entity shall present the contract in the statement of financial position as a [net] contract asset or a contract liability….” There is no authority as to netting or combining the refund liability with the contract liability.

The result is the following for each contract:

• Contract assets and liabilities are combined and shown as one net contract asset or liability.

• Receivables are shown as a single asset.

• Refund liabilities are shown as a single liability.

Should contract assets and liabilities be presented current or long term on the balance sheet?

ASC 606 is silent on this issue. Therefore, the net contract asset or liability for each contract is shown current or long term based on the typical business operating cycle approach to determining whether any asset or liability is current or long term.

Here are a few thoughts on how to present the contract assets and liabilities:

1. Compute a net contract asset or contract liability for each contract at the contract level.

2. Separate each net contract asset or liability into current or long term.

3. Combine all net contract receivables that are current and all that are long term.


4. Combine all net contract liabilities that are current, and all that are long term.

5. Place four (4) amounts on the balance sheet as follows:

• Net contract asset- current

• Net contract asset- long term

• Net contract liability- current

• Net contract liability- long term

Of course, the above analysis is theoretical and does not consider materiality. Assuming any of the amounts are not material, they should be combined.

Statement of income and comprehensive income

ASC 606 makes few substantive changes to the way in which revenue and related expenses are displayed on the statement of income and comprehensive income.

1. There are requirements to separate revenue in the disclosures, but that requirement does not extend to the display on the statement of income and comprehensive income.

2. An entity shall present the effects of financing (interest income or interest expense) separately from revenue from contracts with customers in the statement of comprehensive income (statement of activities).

Example 1: Contract Liability and Receivable

[From Example 38 in ASU 2014-09, as modified by the Author]

Case A: Cancellable Contract

On January 1, 20X9, Company X enters into a cancellable contract to transfer a product to a customer on March 31, 20X9.

The contract requires the customer to pay consideration of $1,000 in advance on January 31, 20X9.

In performing Step 5, the performance obligation qualifies for point-in-time recognition because it fails to qualify for over-time recognition.

The customer pays the consideration on March 1, 20X9, in advance of X transferring the product to the customer.

Conclusion:

X transfers (ships) the product on March 31, 20X9 which is considered the date on which there is a transfer of control to the customer.

The following journal entries illustrate how the entity accounts for the contract:


Entries- Point in Time Recognition- Step 5 dr cr

X receives cash of $1,000 on March 1, 20X9Cash 1,000

Contract liability 1,000To record cash received in advance of performance by X

X transfers the product to customer on March 31, 20X9 Contract liability 1,000

Revenue 1,000To record satisfaction of performance obligation- point in time

Case B: Noncancellable Contract

Assume the same facts as in Case A except that the contract becomes noncancellable on January 31, 20X9.

Conclusion:

The following journal entries illustrate how the entity accounts for the contract:


January 31, 20X9: Record receivable for unconditional right to consideration

Accounts receivable 1,000Contract liability 1,000

To record a receivable for the amount of consideration due on January 31, 20X9, the date on which there is an unconditional right to consideration under the contract.

X receives cash of $1,000 on March 1, 20X9Cash 1,000

Accounts receivable 1,000To record cash received in advance of performance by X

X transfers the product to customer on March 31, 20X9 Contract liability 1,000

Revenue 1,000To record satisfaction of performance obligation- point in time


Note

In Case B, if the entity issued the invoice before January 31, 20X9 (the due date of the consideration), the entity would not recognize the receivable and the contract liability on a gross basis in the statement of financial position because the entity does not yet have a right to consideration that is unconditional (the contract is cancellable before January 31, 20X9).

Example 2: Contract Asset Recognized for the Entity’s Performance

[From Example 39 of ASU 2014-09, as modified by the Author]

On January 1, 20X8, Company X enters into a contract to transfer Products A and B to a customer in exchange for $1,000.

The contract requires Product A to be delivered first and states that payment for the delivery of Product A is conditional on the delivery of Product B. That is, the consideration of $1,000 is due only after the entity has transferred both Products A and B to the customer.

Consequently, the entity does not have a right to consideration that is unconditional (a receivable) until both Products A and B are transferred to the customer which does not occur until Product B is transferred.

The entity identifies the promises to transfer Products A and B as performance obligations and allocates the $1,000 and allocates the amount to Product A and B based on their relative standalone selling prices as follows:

• $400 to the performance obligation to transfer Product A

• $600 to the performance obligation to transfer Product B

In Step 5, X determines that revenue for both Product A and B should be recognized at a point in time because it does not qualify for over-time treatment. Thus, revenue for each performance obligation (Product A and B) is recognized when X transfers control to the customer.

Conclusion:

On February 28, 20X8, the entity transfers (delivers) Product A and satisfies the performance obligation for Product A.

On March 31, 20X8, X transfers (delivers) Product B and satisfies that performance obligation in full.



February 28, 20X8: X transfers Product A:Contract asset- Product A 400

Revenue- Product A 400To record transfer of Product A and recognition of revenue on Product A at a point in time, when control is transferred to customer.

March 31, 20X8: X transfers Product B:Contract asset- Product B 600

Revenue- Product B 600To record transfer of Product B and recognition of revenue on Product B at a point in time when control is transferred to customer.

March 31, 20X8: Record receivable for Product A and BReceivable 1,000

Contract asset- Product A 400Contract asset- Product B 600

To record receivable when X has unconditional right to consideration for Product A and B, which occurs on March 31, 20X8, the date that both Products A and B have been transferred to the customer.

Observation

A critical change found in ASC 606 is the use of the contract asset or receivable depending on whether an entity has an unconditional right to the consideration from the customer. A contract receivable is a conditional right to consideration while a receivable is recorded once the entity has an unconditional right to consideration under the contract.

Example 3: Receivable Recognized for the Entity’s Performance

[From Example 40 of ASU 2014-09, as modified by the Author]

Company X enters into a contract with a customer on January 1, 20X9, to transfer Product A to the customer for $150 per unit.

If the customer purchases more than 1 million of Product A in a calendar year, the contract indicates that the price per unit is retrospectively reduced to $125 per unit.

Consideration is due when control of the products transfer to the customer. Therefore, the entity has an unconditional right to consideration (and the recording of a receivable) for $150 per unit at the time of each shipment, until the retrospective price reduction applies (that is, after 1 million units are shipped).


In determining the transaction price, the entity concludes at contract inception that the customer will meet the 1 million units threshold and, therefore, estimates that the transaction price is $125 per unit.

Consequently, on March 15, 20X9, upon the first shipment to the customer of 100 units, X should recognize the following.


March 15, 20X9Receivable 15,000

Revenue 12,500Refund liability (1) 2,500

To record transfer of 100 units of Product A and recognition of refund liability for discount as follows:

$150 x 100 units = $15,000$125 x 100 units = $12,500

(1): The refund liability of $2,500 represents a refund of $25 per product, which is expected to be provided to the customer for the volume-based rebate (that is, the difference between the $150 price stated in the contract that the entity has an unconditional right to receive and the $125 estimated transaction price).

ASC 606-10-32-10 states:

1. An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer.

2. A refund liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price).

The refund liability (and corresponding change in the transaction price and, therefore, the contract liability) shall be updated at the end of each reporting period for any changes.

Observation

Example 3 illustrates an important point. Even though the entity expects to pay the customer some form of a refund, reflective of the refund liability, that fact does not impact the booking of the receivable. That is, there is no offset of the receivable and the refund liability. The receivable represents an unconditional right to the consideration which, in theory, should be enforceable under law. The refund liability is an amount the entity expects to have to refund based on anticipation that the customer will reach a milestone and be due a discount or other benefit. The two elements are not netted together.


Example 4: Presentation on the Balance Sheet

Company X has four contracts with separate customers. On December 31, 20X1, balance sheet accounts related to those contracts follow:

Contract 1 Contract 2 Contract 3 Contract 4 TotalContract asset $1,000,000 $300,000 $2,000,000 $375,000 $3,675,000Contract liability (600,000) (800,000) (900,000) (650,000) (2,950,000)

Net per contract $400,000 $(500,000) $1,100,000 $(275,000) $725,000

Current asset

Long-term liability

Current asset

Current liability

Breakout:Current asset $400,000 $1,100,000 (1) $1,500,000Current liability (275,000) (2) (275,000)Long-term liability (500,000) (3) (500,000)

$725,000

Receivable- current $1,200,000 $700,000 $200,000 $325,000 (4) $2,425,000

Refund liability $ (100,000) $(200,000) $(175,000) $(50,000) (5) $525,000)

Conclusion:

The basic rules in ASC 606 for presenting the various accounts related to contracts follow:

1. Contract asset and liability should be netted for each contract to create a net contract asset or liability.

2. After netting the contract assets and liabilities, per contract, similar net contract amounts are combined (current assets combined, current liabilities combined, long-term assets combined, and long-term liabilities combined).

3. Receivables are presented separately from contract assets and liabilities.

4. Refund liabilities are not combined with contract assets and liabilities and are likely presented as a separate line item.

5. Assets and liabilities are presented current or long-term based on the typical approach of following the operating cycle.

With this said, the following is the suggested presentation of the assets and liabilities related to the four contracts:


Company X Balance Sheet

December 31, 20X1ASSETS

Current assets:Cash $XXReceivables (4) 2,425,000Inventories XXContract receivables- current (2) 1,500,000

Total current assets XXLong-term assets:

Contract receivables- long-term 0LIABILITIES AND EQUITY

Current liabilities:Refund liabilities (5) $525,000Accounts payable and accrued expenses XXContract liability- current (2) 275,000

Total current liabilities XXLong-term liabilities:

Contract liability- long-term (3) 500,000Stockholders’ equity:

Common stock XXRetained earnings XX

Total stockholders’ equity XX

In reviewing the balance sheet above, consider the following:

1. Contract assets and liabilities are netted by contract and then combined by classification.

2. Receivables are aggregated and shown current in the amount of $2,425,000. Receivables are not combined with contract receivables and payables.

3. Refund liabilities are aggregated for all contracts and shown as a current liability.

Note that the author did not present an analysis as to whether elements should be shown current or long term as that is beyond the scope of this course and not within the framework of ASC 606. Classifications as current or long-term are given for simplicity.




1. Company Q has incurred certain costs to fulfill a contract. Q wants to record the costs as an asset and needs to know the criteria for doing so. Which of following is one of the criteria that must be satisfied in order for Q to capitalize the costs as an asset:

A. the costs do not enhance resources of Company Q

B. the costs may not be recoverable

C. the costs must provide no future value to Q

D. the costs must relate directly to a contract

2. Company P is identifying types of costs that are directly related to a contract it has. Which of the following costs is a cost directly related to a contract:

A. indirect labor

B. indirect materials

C. general overhead

D. specific salaries of employees working on the contract

3. Company L has assets and liabilities pertaining to customers sales contracts. How should those assets and liabilities be presented on L’s balance sheet:

A. contract assets should be combined with receivables

B. contract assets and liabilities should be shown separate from receivables

C. contract assets should be combined with other assets

D. contract liabilities should be combined with other liabilities



1. A. Incorrect. In order to capitalize asset costs to fulfill a contract, those costs must generate or enhance resources that will be used in satisfying performance obligations in the future.

B. Incorrect. ASC 606 requires that Q expect the costs to be recoverable.

C. Incorrect. ASC 606 does not state that the costs cannot provide any future value.

D. CORRECT. ASC 606 states that one key criterion for capitalizing the costs as an asset is that the costs must relate directly to a contract or to an anticipated contract that the entity can specifically identify. The theory behind this criterion is that if the costs can be linked to a contract, the costs to fulfill that contract should be matched with the revenue generated.


2. A. Incorrect. Direct labor, but not indirect labor, is considered a cost directly related to the contract.

B. Incorrect. Only direct materials, not indirect materials, are considered a cost directly related to the contract.

C. Incorrect. General overhead that is not directly allocated to the contract is not a direct cost per ASC 606.

D. CORRECT. ASC 606 states that salaries and wages of employees who provide promised services directly to the customer are considered direct costs.


3. A. Incorrect. Because contract assets are conditional while receivables are unconditional, the two should not be combined per ASC 606.

B. CORRECT. ASC 606 states that contract assets and liabilities should be shown separate from receivables because of the fact that contract assets and liabilities are conditional and receivables are not.

C. Incorrect. ASC 606 provides that contract assets should not be combined with other assets.

D. Incorrect. ASC 606 provides that contract liabilities should not be combined with other liabilities.



X. DISCLOSURES

A. GENERAL

ASC 606 states that an entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required about:

a) Contracts with customers, including revenue and impairments recognized, disaggregation of revenue, and information about contract balances and performance obligations (including the transaction price allocated to the remaining performance obligations).

b) Significant judgments and changes in judgments, determining the timing of satisfaction of performance obligations (over time or at a point), and determining the transaction price and amounts allocated to performance obligations.

c) Assets recognized from the costs to obtain or fulfill a contract.

1. The objective of the disclosure requirements in ASC 606 is for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. To achieve that objective, an entity shall disclose qualitative and quantitative information about all of the following:

a) Its contracts with customers

b) The significant judgments, and changes in the judgments, made in applying the guidance in ASC 606 to those contracts, and

c) Any assets recognized from the costs to obtain or fulfill a contract with a customer.

2. An entity shall consider the level of detail necessary to satisfy the disclosure objectives and how much emphasis to place on each of the various requirements. An entity shall aggregate or disaggregate disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or the aggregation of items that have substantially different characteristics.

3. Amounts disclosed are for each reporting period for which a statement of comprehensive income (statement of activities) is presented and as of each reporting period for which a statement of financial position is presented. An entity need not disclose information if it has provided the information in accordance with another ASC topic.

B. DETAILED DISCLOSURES REQUIRED BY ASC 606

Following are the disclosures required for all companies. Disclosures exempt for nonpublic entities are identified separately.


1. Contracts with Customers

a) An entity shall disclose all of the following amounts for the reporting period unless those amounts are presented separately in the statement of comprehensive income (statement of activities) in accordance with other ASC Topics:

1) Revenue recognized from contracts with customers, which the entity shall disclose separately from its other sources of revenue.

2) Any impairment losses recognized (in accordance with ASC 310, Receivables) on any receivables or contract assets arising from an entity’s contracts with customers, which the entity shall disclose separately from impairment losses from other contracts.

2. Disaggregation of Revenue

a) An entity shall disaggregate revenue recognized from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors.

b) When selecting the type of categories to use to disaggregate revenue, an entity should consider how information about the entity’s revenue has been presented for other purposes, including all of the following:

1) Disclosures presented outside the financial statements (for example, in earnings releases, annual reports, or investor presentations)

2) Information regularly reviewed by the chief operating decision maker for evaluating the financial performance of operating segments, and

3) Other information that is similar to the types of information identified in (a) and (b) and that is used by the entity or users of the entity’s financial statements to evaluate the entity’s financial performance or make resource allocation decisions.

c) Examples of categories that might be appropriate include, but are not limited to, all of the following:

• Type of good or service, such as major product lines

• Geographical region, including country or region

• Market or type of customer, including government and nongovernment customers

• Type of contract, such as fixed-price and time-and-materials contracts

• Contract duration, for example, short-term and long-term contracts


• Timing of transfer of goods or services (for example, revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred over time)

• Sales channels, such as goods sold directly to consumers and goods sold through intermediaries.

d) An entity shall disclose sufficient information to enable users of financial statements to understand the relationship between the disclosure of disaggregated revenue and revenue information that is disclosed for each reportable segment, if the entity applies ASC 280, Segment Reporting.

e) Special election for nonpublic entities:14

A nonpublic entity may elect not to apply the quantitative disaggregation disclosure in this section.

1) If an entity elects not to provide these quantitative disclosures, the entity shall disclose, at a minimum:

a. Revenue disaggregated according to the timing of transfer of goods or services such as:

• Revenue transferred at a point in time

• Revenue transferred over time

b. Qualitative information about how economic factors affect the nature, amount, timing, and uncertainty of revenue and cash flows, such as:

• Type of customer

• Geographic location of customers

• Type of contract

3. Contract Balances

a) An entity shall disclose all of the following:

1) The opening and closing balances of receivables, contract assets, and contract liabilities from contracts with customers, if not otherwise separately presented or disclosed, and

2) Revenue recognized in the reporting period that was included in the contract liability balance at the beginning of the period.

14. The special election applies to an entity, except for a public business entity, a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, or an employee benefit plan that files or furnishes financial statements with or to the Securities and Exchange Commission (SEC). That definition essentially consists of nonpublic entities.


b) An entity shall explain how the timing of satisfaction of its performance obligations relates to the typical timing of payment and the effect that those factors have on the contract asset and the contract liability balances. The explanation provided may use qualitative information.

c) An entity shall provide an explanation of the significant changes in the contract asset and the contract liability balances during the reporting period. The explanation shall include qualitative and quantitative information.

Examples of changes in the entity’s balances of contract assets and contract liabilities include any of the following:

1) Changes due to business combinations

2) Cumulative catch-up adjustments to revenue that affect the corresponding contract asset or contract liability, including adjustments arising from a change in the measure of progress, a change in an estimate of the transaction price (including any changes in the assessment of whether an estimate of variable consideration is constrained), or a contract modification

3) Impairment of a contract asset

4) A change in the time frame for a right to consideration to become unconditional (that is, for a contract asset to be reclassified to a receivable)

5) A change in the time frame for a performance obligation to be satisfied (that is, for the recognition of revenue arising from a contract liability).

d) Special nonpublic entity election:

A nonpublic entity15 may elect not to provide any or all of the disclosures in this section 3(a) to (c), regarding contract balances.

1) However, if a nonpublic entity elects not to provide the disclosures in this section, the entity shall provide the disclosure in Paragraph 3(a)(1) above, which requires the disclosure of the opening and closing balances of receivables, contract assets, and contract liabilities from contracts with customers, if not otherwise separately presented or disclosed.

4. Performance Obligations

a) An entity shall disclose information about its performance obligations in contracts with customers, including a description of all of the following:

15. The definition of a nonpublic entity used in this paragraph is an entity, except for a public business entity, a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, or an employee benefit plan that files or furnishes financial statements with or to the SEC.


1) When the entity typically satisfies its performance obligations (for example, upon shipment, upon delivery, as services are rendered, or upon completion of service), including when performance obligations are satisfied in a bill-and-hold arrangement

2) The significant payment terms (such as: when payment typically is due, whether the contract has a significant financing component, whether the consideration amount is variable, and whether the estimate of variable consideration is typically constrained)

3) The nature of the goods or services that the entity has promised to transfer, highlighting any performance obligations to arrange for another party to transfer goods or services (that is, if the entity is acting as an agent)

4) Obligations for returns, refunds, and other similar obligations, and

5) Types of warranties and related obligations.

b) An entity shall disclose revenue recognized in the reporting period from performance obligations satisfied (or partially satisfied) in previous periods (for example, changes in transaction price).16

c) Special nonpublic entity election:

A nonpublic entity17 may elect not to provide the disclosure in Paragraph 4(b).

5. Transaction Price Allocated to the Remaining Performance Obligations

a) An entity shall disclose the following information about its remaining performance obligations:

1) The aggregate amount of the transaction price allocated to the performance obligations that are unsatisfied (or partially unsatisfied) as of the end of the reporting period.

2) An explanation of when the entity expects to recognize as revenue the amount disclosed in accordance with Paragraph 5(a)(1) above, which the entity shall disclose in either of the following ways:

a. On a quantitative basis using the time bands that would be most appropriate for the duration of the remaining performance obligations, or

b. By using qualitative information.

16. New disclosure added by ASU 2016-20.17. The definition of a nonpublic entity used in this paragraph is an entity, except for a public business entity, a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange for an over-the-counter market, or an employee benefit plan that files or furnishes financial statements with or to the SEC.


b) As a practical expedient, an entity is not required to disclose the information in Paragraph 5(a) above for a performance obligation if either of the following conditions is met:

1) The performance obligation is part of a contract that has an original expected duration of one year or less.

2) The entity recognizes revenue from the satisfaction of the performance obligation in accordance with the right-to-invoice practical expedient in Step 5.

Note

The special exemption in Paragraph (b)(2) does not apply to fixed consideration.

c) An entity is not required to disclose the information in Paragraph 5(a) for variable consideration for which either of the following conditions is met:18

1) The variable consideration is a sales-based or usage-based royalty promised in exchange for a license of intellectual property accounted for under the sales-based or usage-based royalty rules found in ASC 606.

2) The variable consideration is allocated entirely to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise to transfer a distinct good or service that forms part of a single performance obligation.

Note

This special exemption in Paragraph 5(c) does not apply to fixed consideration.

d) An entity shall disclose which optional exemptions in Paragraph 5 it is applying.

18. New disclosure exemption added by ASU 2016-20.


1) In addition, an entity applying the optional exemptions in Paragraph 5 above shall disclose the nature of the performance obligations, the remaining duration, and a description of the variable consideration (for example, the nature of the variability and how that variability will be resolved) that has been excluded from the information disclosed in Paragraph 5(a) above.

• Information shall include sufficient detail to enable users of financial statements to understand the remaining performance obligations that the entity excluded from the information disclosed in Paragraph 5(a).

• In addition, an entity shall explain whether any consideration from contracts with customers is not included in the transaction price and, therefore, not included in the information disclosed in accordance with Paragraph 5(a).

e) Special nonpublic entity election:

A nonpublic entity19 may elect not to provide the disclosures in Paragraphs 5(a) to (d), above.

6. Significant Judgments

a) An entity shall disclose the judgments, and changes in the judgments, made in applying the guidance in this Topic that significantly affect the determination of the amount and timing of revenue from contracts with customers. In particular, an entity shall explain the judgments, and changes in the judgments, used in determining both of the following:

1) The timing of satisfaction of performance obligations.

2) The transaction price and the amounts allocated to performance obligations.

Note

For nonpublic entities, the significant judgments disclosure requirements point to Paragraphs 606-10-50-18, 19 and 20, which are part of a special nonpublic entity exemption found in Paragraphs 7 and 8 below. Therefore, a nonpublic entity is exempt from having to disclose significant judgments in this Paragraph 6(a).

19. The definition of a nonpublic entity used in this paragraph is an entity, except for a public business entity, a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, or an employee benefit plan that files or furnishes financial statements with or to the SEC.


7. Determining the Timing of Satisfaction of Performance Obligations

a) For performance obligations that an entity satisfies over time, an entity shall disclose both of the following:

1) The methods used to recognize revenue (for example, a description of the output methods or input methods used and how those methods are applied).

2) An explanation of why the methods used provide a faithful depiction of the transfer of goods or services. (OPTIONAL FOR NONPUBLIC ENTITIES)

b) For performance obligations satisfied at a point in time, an entity shall disclose the significant judgments made in evaluating when a customer obtains control of promised goods or services. (OPTIONAL FOR NONPUBLIC ENTITIES)

8. Determining the Transaction Price and the Amounts Allocated to Performance Obligations

a) An entity shall disclose information about the methods, inputs, and assumptions used for all of the following:

1) Determining the transaction price, which includes, but is not limited to, estimating variable consideration, adjusting the consideration for the effects of the time value of money, and measuring noncash consideration. (OPTIONAL FOR NONPUBLIC ENTITIES)

2) Assessing whether an estimate of variable consideration is constrained.

3) Allocating the transaction price, including estimating standalone selling prices of promised goods or services and allocating discounts and variable consideration to a specific part of the contract (if applicable). (OPTIONAL FOR NONPUBLIC ENTITIES)

4) Measuring obligations for returns, refunds, and other similar obligations. (OPTIONAL FOR NONPUBLIC ENTITIES)

9. Other Disclosures

a) A nonpublic entity may elect not to provide any of the disclosures in Paragraphs 7 and 8 that are identified as “OPTIONAL FOR NONPUBLIC ENTITIES.”

b) If an entity elects to use the practical expedient about the existence of a significant financing component or about the incremental costs of obtaining a contract, the entity shall disclose that fact. (OPTIONAL FOR NONPUBLIC ENTITIES)


10. Capitalized Contract Costs

a) Per ASC 340-40-50-2 and 50-3, Other Assets and Deferred Costs, the following disclosures are required for contract costs capitalized related to contracts with customers.

1) The judgments made in determining the amount of costs to obtain or fulfilling a contract with a customer.

2) The method it used to determine the amortization for each reporting period.

3) The closing balances of assets recognized from the costs incurred to obtain or fulfill a contract with a customer, by main category of asset (such as costs to obtain contracts with customers, precontract costs, and setup costs).

4) The amount of any amortization costs and impairment losses recognized in the reporting period.

11. Election to Exclude All Taxes Assessed (Including Sales Tax)

a) An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both:

1) Imposed on and concurrent with a specific revenue producing transaction, and

2) Collected by the entity from a customer.

b) An entity that makes this election shall comply with the applicable accounting policy guidance, including the disclosure requirements. There is no requirement under the election to disclose the amount of taxes withheld and paid to taxing authorities.

12. Election to Account for Shipping and Handling Costs as Part of Activities to Fulfill the Promise to Transfer Goods

a) The entity may make an accounting policy election to account for shipping and handling as part of the activities to fulfill the promise to transfer the goods (e.g., account for the costs as a fulfillment cost).

b) An entity that makes this accounting policy election shall disclose the policy.


Summary of Disclosures Required by ASC 606

Description

Applies to all Entities

Practical Expedient Available

Nonpublic Exemption

Comments

1. Contracts with Customers Revenue recognized from contracts with customers, which the entity shall disclose separately from its other sources of revenue.

X

Any impairment losses recognized (in accordance with ASC 310, Receivables) on any receivables or contract assets arising from an entity’s contracts with customers, which the entity shall disclose separately from impairment losses from other contracts.

X

2. Disaggregation of Revenue An entity shall disaggregate revenue recognized from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors.

Note: An entity shall disclose sufficient information to enable users of financial statements to understand the relationship between the disclosure of disaggregated revenue and revenue information that is disclosed for each reportable segment, if the entity applies ASC Topic 280, Segment Reporting.

X Nonpublic entity may elect not to apply the quantitative disaggregation disclosure but must include disclosures about a) revenue disaggregated by the timing of transfer of goods or services, and b) qualitative information about economic factors



Description



Nonpublic Exemption

Comments

3. Contract Balances The opening and closing balances of receivables, contract assets, and contract liabilities from contracts with customers, if not otherwise separately presented or disclosed.

X

Revenue recognized in the reporting period that was included in the contract liability balance at the beginning of the period.

X

Explain how the timing of satisfaction of its performance obligations relates to the typical timing of payment and the effect that those factors have on the contract asset and the contract liability balances. The explanation provided may use qualitative information.

X

Explain the significant changes in the contract asset and the contract liability balances during the reporting period. The explanation shall include qualitative and quantitative information.

X

4. Performance Obligations An entity shall disclose information about its performance obligations in contracts with customers, including a description of all of the following:



Description



Nonpublic Exemption

Comments

a. When the entity typically satisfies its performance obligations (for example, upon shipment, upon delivery, as services are rendered, or upon completion of service) including when performance obligations are satisfied in a bill-and-hold arrangement.

X

b. The significant payment terms (for example, when payment typically is due), whether the contract has a significant financing component, whether the consideration amount is variable, and whether the estimate of variable consideration is typically constrained.

X

c. The nature of the goods or services that the entity has promised to transfer, highlighting any performance obligations to arrange for another party to transfer goods or services (that is, if the entity is acting as an agent).

X

d. Obligations for returns, refunds, and other similar obligations.

X

e. Types of warranties and related obligations.

X



Description



Nonpublic Exemption

Comments

Disclose revenue recognized in the reporting period from performance obligations satisfied (or partially satisfied) in previous periods (for example, changes in transaction price).

X

5. Transaction Price Allocated to the Remaining Performance Obligations a. An entity shall disclose the following information about its remaining performance obligations (1)

X X Practical expedient: An entity need not disclose the information in paragraph 5(a) a performance obligation if either of the following conditions is met:

• The performance obligation is part of a contract that has an original expected duration of one year or less.

• The entity recognizes revenue using the right-to-invoice practical expedient.

1) The aggregate amount of the transaction price allocated to the performance obligations that are unsatisfied (or partially unsatisfied) as of the end of the reporting period.

X



Description



Nonpublic Exemption

Comments

2) An explanation of when the entity expects to recognize as revenue the amount disclosed in accordance with paragraph 5(a)(1) above, which the entity shall disclose in either of the following ways:

a) On a quantitative basis using the time bands that would be most appropriate for the duration of the remaining performance obligations.

b) By using qualitative information.

X

b. Disclose which optional exemptions in Paragraph 5 it is applying.

X

6. Significant Judgments a. Disclose the judgments, and changes in the judgments, made that significantly affect the determination of the amount and timing of revenue from contracts with customers.

Explain the judgments, and changes in the judgments, used in determining both of the following:

• The timing of satisfaction of performance obligations.

• The transaction price and the amounts allocated to performance obligations.

X



Description



Nonpublic Exemption

Comments

7. Determining the Timing of Satisfaction of Performance Obligations a. For performance obligations that an entity satisfies over time, an entity shall disclose both of the following:

1) The methods used to recognize revenue.

2) An explanation of why the methods used provide a faithful depiction of the transfer of goods or services.

X

b. For performance obligations satisfied at a point in time, an entity shall disclose the significant judgments made in evaluating when a customer obtains control of promised goods or services.

X

8. Determining the Transaction Price and the Amounts Allocated to Performance Obligationsa. Disclose information about the methods, inputs, and assumptions used for all of the following:

1) Determining the transaction price, which includes, but is not limited to, estimating variable consideration, adjusting the consideration for the effects of the time value of money, and measuring noncash consideration.

2) Assessing whether an estimate of variable consideration is constrained.

X



Description



Nonpublic Exemption

Comments

3) Allocating the transaction price, including estimating standalone selling prices of promised goods or services and allocating discounts and variable consideration to a specific part of the contract (if applicable).

4) Measuring obligations for returns, refunds, and other similar obligations.

9. Othera. A nonpublic entity, may elect not to provide any of the disclosures in Paragraphs 7 and 8.

X

b. If an entity elects to use the practical expedient about the existence of a significant financing component or about the incremental costs of obtaining a contract, the entity shall disclose that fact.

X

10. Capitalized Contract Costsa. Per ASC 340-40-50-2 and 50-3, Other Assets and Deferred Costs, the following disclosures are required for costs capitalized related to contracts with customers:

1) The judgments made in determining the amount of costs to obtain or fulfill a contract with a customer, and

X



Description



Nonpublic Exemption

Comments

2) The method it used to determine the amortization for each reporting period.

3) The closing balances of assets recognized from the costs incurred to obtain or fulfill a contract with a customer, by main category of asset (such as costs to obtain contracts with customers, precontract costs, and setup costs).

4) The amount of any amortization costs and impairment losses recognized in the reporting period.11. Election to Exclude All Taxes Assessed (Including Sales Tax)a. An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both:

1) Imposed on and concurrent with a specific revenue producing transaction, and

2) Collected by the entity from a customer.

X



Description



Nonpublic Exemption

Comments

b. An entity that makes this election shall comply with the applicable accounting policy guidance, including the disclosure requirements. There is no requirement under the election to disclose the amount of taxes withheld and paid to taxing authorities.12. Election to Account for Shipping and Handling Costs as Part of Activities a. An entity may make an election to account for shipping and handling as part of the activities to fulfill the promise to transfer the good (e.g., account for the costs as a fulfillment cost).

b. An entity that makes this accounting policy election shall disclose the policy.

X

(1) Disclosure in 5(a) does not apply to:

• The variable consideration is a sales-based or usage-based royalty promised in exchange for a license of intellectual property accounted for under the sales-based or usage-based royalty rules found in ASC 606.

• The variable consideration is allocated entirely to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise to transfer a distinct good or service that forms part of a single performance obligation.

C. DISCLOSURES REQUIRED FOR NONPUBLIC ENTITIES

In reviewing the previous chart, ASC 606 exempts nonpublic entities from many of its arduous disclosures.

In this section, the author focuses on those disclosures required for nonpublic entities.

Following are the disclosures required for nonpublic entities.


Summary of Disclosures Required by ASC 606 Nonpublic Entities Only

Description of Disclosure Required for Nonpublic EntitiesDisclosure

CodeContracts with Customers

1. Revenue recognized from contracts with customers, which the entity shall disclose separately from its other sources of revenue

Note: This requirement can be achieved by presenting revenue on the statement of income separately from other sources of revenue. Thus, a separate footnote disclosure is unnecessary. 2. Any impairment losses recognized (in accordance with ASC 310, Receivables) on any receivables or contract assets arising from an entity’s contracts with customers, which the entity shall disclose separately from impairment losses from other contracts

Disaggregation of Revenue – Modifications for Nonpublic Entities1. Revenue disaggregated according to the timing of transfer of goods or services (for example, revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred to customers over time)

2. Qualitative information about how economic factors (such as type of customer, geographical location of customers, and type of contract) affect the nature, amount, timing, and uncertainty of revenue and cash flows

A

Contract Balances 1. The opening and closing balances of receivables, contract assets, and contract liabilities from contracts with customers, if not otherwise separately presented or disclosed

B

Performance Obligations1. An entity shall disclose information about its performance obligations in contracts with customers, including a description of all of the following:

C

a. When the entity typically satisfies its performance obligations (for example, upon shipment, upon delivery, as services are rendered, or upon completion of service), including when performance obligations are satisfied in a bill-and-hold arrangement

C

b. The significant payment terms (for example, when payment typically is due, whether the contract has a significant financing component, whether the consideration amount is variable, and whether the estimate of variable consideration is typically constrained)

C

c. The nature of the goods or services that the entity has promised to transfer, highlighting any performance obligations to arrange for another party to transfer goods or services (that is, if the entity is acting as an agent)

C

d. Obligations for returns, refunds, and other similar obligations Ce. Types of warranties and related obligations C


Summary of Disclosures Required by ASC 606 Nonpublic Entities Only

Description of Disclosure Required for Nonpublic EntitiesDisclosure

Code2. For performance obligations that an entity satisfies over time, an entity shall disclose the following: a. The methods used to recognize revenue (for example, a description of the output methods or input methods used and how those methods are applied)

C

3. Disclose information about the methods, inputs, and assumptions used for the following: a. Assessing whether an estimate of variable consideration is constrained D

Election to Exclude Taxes Assessed (Including Sales Tax)1. An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both:

a. Imposed on and concurrent with a specific revenue producing transaction, and

b. Collected by the entity from a customer

2. An entity that makes this election shall comply with the applicable accounting policy guidance, including the disclosure requirements. There is no requirement under the election to disclose the amount of taxes withheld and paid to taxing authorities

E

Capitalized Contract Costs1. Per ASC 340-40-50-2 and 50-3, Other Assets and Deferred Costs, the following disclosures are required for costs capitalized related to contracts with customers.

a. The judgments made in determining the amount of costs to obtain or fulfill a contract with a customer

b. The method it used to determine the amortization for each reporting period

c. The closing balances of assets recognized from the costs incurred to obtain or fulfill a contract with a customer, by main category of asset (such as costs to obtain contracts with customers, precontract costs, and setup costs)

d. The amount of any amortization costs and impairment losses recognized in the reporting period

F

Election to Account for Shipping and Handling Costs as Part of Activities1. An entity may make an election to account for shipping and handling as part of the activities to fulfill the promise to transfer the good (e.g., account for the costs as a fulfillment cost)

2. An entity that makes this accounting policy election shall disclose the policy

G

Example 1: Nonpublic Company Disclosures


Company X, a nonpublic entity, is a plumbing supply and installation company.

X generates revenue from several sources:

• Sales of plumbing supplies and products to retail customers

• Sales of service contracts to retail customers

• Installation sales and service to wholesale contractors and real estate developers

Revenue is generated at a point in time (retail sales) and over time (service contracts and installation sales).

Company X offers rebates (variable consideration) to installation customers and permits return of goods by its retail customers, both recorded as a refund liability.

Company X capitalizes costs to obtain and fulfill contracts with customers.

Conclusion:

Following are sample disclosures of Company X (a nonpublic entity), pertaining to this fact pattern:

• Disaggregation of Revenue

• Contract Balances

• Performance Obligations

• Election to Exclude Taxes Assessed (including sales tax)

• Capitalized Contract Costs

• Election to Account for Shipping and Handling Costs as Part of Activities

Please see the codes identified in each of the following disclosures that link to the “Summary of Disclosures” chart previously presented.


Company X Notes to Financial Statements December 31, 20X2 and 20X1

NOTE 1: Nature of Business

The Company is a retail plumbing supply provider, and plumbing installation wholesaler. Sales are generated principally from three sources consisting of retail sales of plumbing supplies to retail customers, sale of service contracts to retail customers, and plumbing installation services sold to contractors and real estate developers.

NOTE 2: Summary of Significant Accounting Policies

Revenue:

Revenue is derived from several sources: sales of plumbing supplies and products principally to retail customers, sales of service contracts to retail customers, and wholesale sales of plumbing installations to contractors and real estate developers.

Sales tax:

The Company is required to collect, on behalf of certain states, sales tax based on a percentage of qualifying sales. The company’s policy is to exclude sales taxes from the transaction price of all revenue when collected, and from expenses when paid. Instead, the company records the collection and payment of sales taxes through a liability account. [E]

Capitalized contract costs:

The Company’s policy is to capitalize commissions and other direct costs representing incremental costs to obtain and fulfill customer contracts. Costs capitalized are amortized on a straight-line basis over the life of the customer contract. Costs attributable to contracts with a life of one year or less, and costs that are not directly related to customer contracts, are expensed as incurred. On December 31, 20X2, capitalized contract costs presented as a long-term asset on the balance sheet were $400,000, consisting of costs to obtain contracts of $250,000 and costs to fulfill contracts of $150,000. In 20X2, amortization expense related to the costs capitalized was $200,000 and is included in sales and marketing expense. [F]

Shipping and handling expenses:

Effective January 1, 20X2, the Company made an accounting policy election to include all shipping and handling activities as part of the underlying promise to transfer goods to customers, and not to treat them as a separate performance obligation. In making this election, no portion of revenue received from customers is allocated to shipping and handling activities. All shipping and handling costs are classified as fulfillment costs. [G]


NOTE 3: Disaggregation of Revenue [A]

Revenue, disaggregated by timing of transfer of goods and services follows:

20X2 20X1Revenue recognized based on goods and services transferred to customers at a point in time

$XX

$XX

Revenue recognized based on goods and services transferred over time

XX

XX

$XX $XX

Revenue recognized at a point in time includes sales of goods to retail customers located nationwide. Sales to these customers are typically recognized at the date at which control of the goods transfers to the customer. Typically, control is deemed to transfer at the date at which the goods are shipped, title has passed to the customer, and the customer accepts the goods.

Revenue recognized over time consist of sales of service contracts sold to retail customers who also purchase the underlying goods from the company. In addition, a portion of revenue recognized over time consists of larger, wholesale installation contracts with contractors and real estate developers. Revenue is recognized over time as control of the service transfers to the customer, which is typically the life of the service contract or the installation period.

NOTE 4: Contract Balances [B]

The Company records contract assets and liabilities, receivables, and refund liabilities related to customer contracts.

Contract assets consist of the Company’s right to payment from customers for goods or services that have been provided to those customers, with the right to collection conditional on something other than the passage of time.

Contract liabilities consist of the Company’s obligations to transfer goods or services to customers for which the Company has received consideration from customers, including advance payments received from customers for future goods and services.

In addition to contract assets, the Company records receivables representative of the Company’s unconditional right to payment.

The Company records a refund liability for a portion of consideration received from its retail and wholesale customers that the Company expects to refund for returns, allowances, rebates, and incentive programs.

A summary of the balances of contract assets, contract receivables, receivables and refund liabilities on December 31, 20X2 and 20X1 follows:


December 31,Assets (Liabilities) 20X2 20X1

Contract assets $XX $XX

Contract liabilities (XX) (XX)

Receivables from customers XX XX

Refund liabilities (XX) (XX)

NOTE 5: Performance Obligations [C and A]

A summary and description of performance obligations in contracts with customers follows:

Retail sales of plumbing supplies:

With respect to retail sales of plumbing supplies and products to retail customers, revenue is recognized at a point in time, when control of the goods transfers to the customer in an amount that reflects the consideration the company expect to be entitled to in exchange for those products. Typically, control is deemed to transfer at the date at which the goods are shipped, title has passed to the customer, and the customer accepts the goods.

In connection with retail plumbing supply sales, customers pay at the time the order is placed.

The Company offers a return policy in the form of a merchandise credit, for retail customers who return purchased plumbing supplies in tact within 30 days. At the time of a retail sale, the Company records a percent of sales as a refund liability to reflect returns expected, with the recording of a corresponding return asset for the cost of the goods expected to be returned.

Retail customers have the option to purchase an extended manufacturer warranty contract directly from the plumbing supply manufacturers, at an additional cost. The Company has no involvement in these extended product warranties.

Retail sales of service contracts:

Revenue related to retail customer service contracts is recognized over time evenly on a straight-line basis, as control transfers to the retail customer over the life of the service contract, which is from one to three years, depending on the contract. In exchange for advance payment by retail customers, the Company provides customers plumbing services on call for the duration of the service contract. In connection with the sale of retail service contracts, customers pay in advance at the time each service contract is executed. There is no right to termination of the service contracts once executed.

Wholesale plumbing installation services:

For wholesale plumbing installations services, revenue is recognized over time as control of the service transfers to the customer, which is typically throughout the life of the installation contract period. The


Company uses a cost-based input method to recognize revenue over time, which reasonably measures progress toward complete satisfaction of the performance obligation. Using the cost-based input method, revenue is recognized based on the ratio of actual contract costs to date, as a percentage of estimated total costs. Costs used in the formula generally include direct costs to fulfill a contract.

In connection with wholesale plumbing installation services sales, in the normal course of business, the Company grants credit to its contractor and real estate developer customers ranging from 30 to 60 days, depending on the financial strength of each customer. In general, revenue recognized does not have a significant financing component because payment terms are relatively short. From time to time, the Company receives payments from contractors and real estate developer customers in advance of the Company providing goods and services These amounts are recorded as contract liabilities until the goods and services are provided to the customer and revenue is recognized.

Variable consideration: [D]

For selected high-volume contractors and real estate developers, the company gives a retroactive rebate if those customers achieve a cumulative volume of installation sales. The rebate is variable consideration which reduces revenue and is credited to the customer once the customer achieves a predetermined level of sales activity.

The company estimates the amount of rebate as a reduction in revenue, using the most likely amount method, under which the amount of the rebate recorded as a reduction in revenue is the single most likely amount within a range of possible amounts. The estimated amount of rebates is included as a reduction in revenue to the extent it is probable that a significant reversal of revenue recorded will not occur when the actual rebate is earned and resolved.

-End of disclosure-

Observation

ASC 606 requires an entity to disclose the opening and closing balances of receivables, contract assets, and contract liabilities with customers, if not otherwise separately presented or disclosed. In the previous disclosure, the Author expands upon the minimum information that is required by ASC 606. First, there is no requirement to define contract assets, contract liabilities, receivables and refund liabilities. Yet, the Author has included definitions to make the information more meaningful to the user. Second, there is no requirement to include refund liabilities in the disclosure as the disclosure is limited to contract assets, contract liabilities, and receivables. The Author suggests including refund liabilities in the disclosure because they are integral to the other asset and liability components. Third, the disclosure of assets and liabilities is not required at all if the components are otherwise presented elsewhere such as in the case where they are separately presented on the balance sheet.


Example 2: Disaggregation of Revenue- Public Entity

The following is an example of the quantitative disclosure required for public entities in disclosing the disaggregation of revenue. Nonpublic entities are exempt from this disclosure.

Disaggregation of Revenue—Quantitative Disclosure

[Source: From Example 41 of ASU 2014-09]

Facts: An entity reports the following segments: consumer products, transportation, and energy, in accordance with ASC 280, Segment Reporting. When the entity prepares its investor presentations, it disaggregates revenue into primary geographical markets, major product lines, and timing of revenue recognition (that is, goods transferred at a point in time or services transferred over time).

The entity determines that the categories used in the investor presentations can be used to meet the objective of the disaggregation disclosure, which is to disaggregate revenue from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors.

Following is a sample disclosure of disaggregation of revenue.

Note X: Disaggregation of Revenue

The following table illustrates the disaggregation disclosure by primary geographical market, major product line, and timing of revenue recognition, including a reconciliation of how the disaggregated revenue ties in with the consumer products, transportation, and energy segments.

Segments

Consumer Products

Transportation

Energy

Total

Primary Geographical Markets: $990 $2,250 $5,250 $8,490North America 300 750 1,000 2,050Europe 700 260 0 960Asia $1,990 $3,260 $6,250 $11,500

Major Goods/Service Lines:Office supplies $600 $0 $0 $600Appliances 990 0 0 990Clothing 400 0 0 400Motorcycles 0 500 0 500Automobiles 0 2,760 0 2,760Solar panels 0 0 1,000 1,000Power plant 0 0 5,250 5,250

$1,990 $3,260 $6,250 $11,500Timing of Revenue Recognition:Goods transferred at a point in time $1,990 $3,260 $1,000 $6,250Services transferred over time 0 0 5,250 5,250

$1,990 $3,260 $6,250 $11,500


XI. TRANSITION AND EFFECTIVE DATE

1. Effective Dates - ASU 2014-09

The following represents the transition and effective date information related to ASC 606:

a) Public business entity, a not-for-profit entity: that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and an employee benefit plan that files or furnishes financial statements with or to the Securities and Exchange Commission:

Apply ASC 606 for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is not permitted.

b) All other entities (nonpublic entities):

Apply ASC 606 for annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019.

c) ASC 606 offers entities an early adoption option to apply the changes as early as the annual reporting period beginning after December 15, 2016.

Delayed effective date due to COVID-19- ASU 2020-05

In June 2020, the FASB issued ASU 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842), Effective Dates for Certain Entities. In response to the impact of COVID-19 on the ability of companies to implement certain new standards, ASU 2020-05 offers a limited deferral of the effective dates of the following:

The new implementation date based on ASU 2020-05 with respect to the new revenue standard, is as follows:

1. Public entities: No change. The implementation date remains for annual reporting periods beginning after December 15, 2017 (calendar year 2018).

2. All other entities, including nonpublic entities, that have not yet issued financial statements or made financial statements available for issuance as of June 3, 2020: The implementation date is delayed for one year to the following dates:

a) Annual reporting periods beginning after December 15, 2019 (calendar year 2020), and interim reporting periods within annual reporting periods beginning after December 15, 2020.

b) However, all other entities (including nonpublic entities) may elect to implement ASU 2014-09 earlier using the original implementation date (calendar year 2019 or other period) to either:


• An annual reporting period beginning after December 15, 2016, including interim reporting periods within that reporting period, or

• An annual reporting period beginning after December 15, 2016, and interim reporting periods within annual reporting periods beginning one year after the annual reporting period in which an entity first applies the amendments in ASU 2014-09.

2. Methods to adopt ASC 606 changes:

a) An entity shall apply ASC 606 using one of the following two methods:

1) Full retrospective method: Apply the new standard retrospectively to the beginning of the earliest year presented, with a cumulative effect to retained earnings at the beginning of the earliest year presented.

2) Modified retrospective method: Apply the new standard retrospectively to the beginning of the current implement year only, with the cumulative effect to retaining earnings at the beginning of the current implementation year.

3. Full retrospective method:

a) An entity that elects to use the full retrospective method does the following:

1) Changes are made retrospectively to the beginning of the earliest year presented.

2) All prior periods are restated in accordance with ASC 250, Accounting Changes and Error Corrections.

3) Financial statements are comparative for all periods presented, in that each year presented reflects the new ASC 606 revenue standard.

Example: Company X adopts ASC 606 for calendar year 2020 under the delayed implementation date in ASU 2020-05, and presents comparative financial statements for 2020 and 2019.

Conclusion: If the full retrospective method is used, 2019 and 2020 financial statements are restated retrospectively to January 1, 2019, with the adjustment made to the January 1, 2019 retained earnings.

b) If an entity elects to apply the ASC using the full retrospective method, the entity shall provide the disclosures required in ASC 250-10-50-1 through 50-2 (exclusive of ASC 250-10-50-1(b)(2)20 in the period of adoption.

Those disclosures in ASC 250 include:

20. An entity is not required to disclose the effects of the changes on the current period which is required in ASC 250-10-50-1(b)(2).


1) The nature of and reason for the change in accounting principle, including an explanation of why the newly adopted accounting principle is preferable.

2) The method of applying the change, including all of the following:

• A description of the prior-period information that has been retrospectively adjusted, if any.

• The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented.

• If retrospective application to all prior periods is impracticable, disclosure of the reasons therefore, and a description of the alternative method used to report the change.

3) If indirect effects of a change in accounting principle are recognized, both of the following shall be disclosed:

• A description of the indirect effects of a change in accounting principle, including the amounts that have been recognized in the current period, and the related per-share amounts, if applicable.

• Unless impracticable, the amount of the total recognized indirect effects of the accounting change and the related per-share amounts, if applicable, that are attributable to each prior period presented. Compliance with this disclosure requirement is practicable unless an entity cannot comply with it after making every reasonable effort to do so.

4) An entity that issues interim financial statements shall provide the required disclosures in the financial statements of both the interim period of the change and the annual period of the change.

c) If the full retrospective method is used, an entity may use one or more of the following practical expedients when applying ASC 606, retrospectively:

1) An entity need not restate contracts that begin and end within the same annual reporting period.

2) For completed contracts that have variable consideration, an entity may use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative reporting periods.

3) For all reporting periods presented before the date of initial application, an entity need not disclose the amount of the transaction price allocated


to the remaining performance obligations and an explanation of when the entity expects to recognize that amount as revenue.

4) For contracts that were modified before the beginning of the earliest reporting period presented, an entity need not retrospectively restate the contract for those contract modifications. Instead, an entity shall reflect the aggregate effect of all modifications that occur before the beginning of the earliest period presented when:

• Identifying the satisfied and unsatisfied performance obligations

• Determining the transaction price, and

• Allocating the transaction price to the satisfied and unsatisfied performance obligations.

d) For any of the practical expedients in Paragraph (c) that an entity uses, an entity shall apply that expedient consistently to all contracts within all reporting periods presented. In addition, the entity shall disclose all of the following information:

1) The expedients that have been used.

2) To the extent reasonably possible, a qualitative assessment of the estimated effect of applying each of those expedients.

4. Modified retrospective method:

a) An entity that elects to use the modified retrospective method follows these rules:

• Changes are applied retrospectively to the beginning of the current implementation year financial statements only.

• There is no restatement of comparative year financial statements.

• Financial statements are not comparative for all periods presented. so that any prior years presented are not comparative with the current year.

• An entity may choose to apply ASC 606 either to all contracts or only to contracts not completed at the date of adoption.

Example: Company X adopts ASC 606 for calendar year 2020 under the delayed implementation date in ASU 2020-05, and presents comparative financial statements for 2020 and 2019.

Conclusion: If the modified retrospective method is used, 2019 financial statements are not restated retrospectively. Instead, financial statements are restated as of January 1, 2020, with an adjustment to January 1, 2020 retained earnings.


Financial statements for 2019 are not comparative with 2020 because 2019 is presented on the old pre-ASC 606 revenue standard, while 2020 reflects the new ASC 606 standard.

b) An entity that elects to use the modified retrospective method recognizes the cumulative effect of initially applying ASC 606 as an adjustment to the opening balance of retained earnings of the annual reporting period that includes the date of initial application (e.g., January 1, 2020 for a nonpublic entity). The adjustment must be made, net of the tax effect.

1) Under the modified retrospective method, an entity may elect to apply this guidance retrospectively either to:

• All contracts at the date of initial application (for example, January 1, 2020 for a nonpublic entity), or

• Only to contracts that are not completed at the date of initial application (e.g., January 1, 2020).

2) An entity shall disclose whether it has applied the guidance to all contracts or only to contracts not completed.

c) For reporting periods that include the date of initial application, an entity shall provide the nature of and reason for the change in accounting principle, and provide both of the following additional disclosures if ASC 606 is applied retrospectively using the modified retrospective method:

1) The amount by which each financial statement line item is affected in the current reporting period by the application of the ASC as compared with the guidance that was in effect before the change.

2) An explanation of the reasons for significant changes identified in (c)(1).

3. An entity may elect to apply the implementation method (full or modified retrospective method) as follows:

a) Apply one method to all of the contracts.

b) Apply one method to all contracts with customers and another method to all noncustomers.

Example: Company X uses the full retrospective method for all contracts with customers in ASC 606 and 340, and the modified retrospective method for all contracts with noncustomers, such as contracts covered in ASC 610 for nonfinancial assets.


Note

If an entity elects to use different methods, it shall disclose that election and provide the appropriate disclosures associated with each transition method. An entity may also elect to use different practical expedients to contracts with customers than to contracts with noncustomers.

Observation

Most nonpublic entities will use the modified retrospective method to implement ASC 606. The first effective date for nonpublic entities is the year ending December 31, 2019, with the retrospective adjustment to retained earnings on January 1, 2019. There will be no restatement of 2018 if shown comparatively.

If the delayed effective date is used under ASU 2020-05, the first effective date is the year ending December 31, 2019, with the retrospective adjustment to retained earnings on January 1, 2020. There will be no restatement of 2019 if shown comparatively.

Example 1: Transition Using Modified Retrospective Method

Company X, a nonpublic entity, adopts ASC 606 for year-end December 31, 2020 under the delayed implementation provision in ASU 2020-05. X uses the modified retrospective method. X elects to apply to modified retrospective method to contracts that are not complete on January 1, 2020.

Thus, X restates its financial statements as of January 1, 2020, to reflect any adjustments to contracts that are not complete, with the adjustment to January 1, 2020. In applying the restatement, X compares its balance sheet on December 31, 2019 under existing pre-ASC 606 GAAP, with what the balance sheet should be under ASC 606.

X identifies several adjustments to contracts that are not complete that need to be made to adopt ASC 606 on January 1, 2020:

1. Under ASC 606, bill and hold revenue of $100,000 would have been recorded as of December 31, 2019, while it has not been recorded under pre-ASC 606 accounting.

2. Variable consideration due to X would have been estimated and recorded under ASC 606 in the amount of $250,000, while none has been recorded under pre-ASC 606 accounting.

3. The company has a contract with a customer for which it has not recorded revenue to date. Under ASC 606, that contract qualifies for over-time treatment for which $300,000 of revenue would have been recorded under ASC 606.


Revenue Recognized on December 31, 2019

Revenue

Existing Pre- ASC 606

ASC 606

Bill-and-hold arrangements $100,000 $0Variable consideration 0 250,000Revenue now over time 0 300,000Total cumulative revenue $100,000 $550,000

Net revenue adjustment on January 1, 2020 $450,000

Assuming the tax rate is 21% federal, with no state tax, the adjustment is a follows:

Net adjustment $450,000Tax effect 21% (95,000)

Net adjustment to retained earnings Jan. 1, 2020 $355,000

Entry to restate balance sheet and retained earnings on January 1, 2020:dr cr

Contract asset 450,000Deferred tax liability 95,000Retained earnings 355,000

To restate X’s balance sheet on January 1, 2020 under the modified retrospective method in ASC 606

Following is a sample disclosure for 2020 with comparative 2019 presented:

NOTE X: Adoption of New Revenue Standard

Effective January 1, 2020, the Company adopted ASU 2014-09, Revenue from Contracts with Customers, and subsequent amendments. The amendments are required by U.S. GAAP, and collectively create a new Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, which replaces most of the existing revenue recognition guidance found in U.S. GAAP.

ASC 606 establishes a new, single revenue framework to recognize revenue from contracts with customers, and offers expanded disclosures for revenue transactions.

The Company adopted ASC 606 using the modified retrospective method applied to all contracts not complete as of January 1, 2020. Under the modified retrospective method, the Company adjusted January 1, 2020 retained earnings to reflect the cumulative effect of adopting the new revenue standard on prior years.


The adoption of the revenue standard resulted in an increase in beginning retained earnings of approximately $355,000 (net of the tax effect of $95,000), and a corresponding increase in the contract asset of $450,000, on January 1, 2020. The net adjustment in retained earnings is due primarily to the new revenue standard accelerating the recognition of revenue related to variable consideration, bill-and-hold arrangements, and certain contracts recording revenue over time instead of at a point in time.

The financial statements for reporting periods beginning after January 1, 2020 are presented under the new ASC 606, while the comparative 2019 financial statements continue to reflect the prior revenue standard.

The financial statement impact of applying the new revenue standard for year ended December 31, 2020, was to increase 2020 revenue and corresponding net contract assets by approximately $2,000,000, as compared with amounts that would have been recognized under the previous revenue standard. These increases were due primarily to accelerating revenue related to bill-and-hold arrangements, variable consideration, and certain long-term customer contracts.




1. Company Y is a nonpublic entity. Under the new revenue standard, which of the following disclosures is Y not required to include under ASC 606:

A. the opening and closing balances of receivables

B. obligations for returns, refunds, and other similar obligations

C. types of warranties

D. for performance obligations satisfied at a point in time, the significant judgments made

2. Company D, a nonpublic entity, is implementing the revenue standard in calendar year 2020. D presents comparative financial statements for 2020 and 2019. If D elects to use the modified retrospective method to adopt the standard, which of the following is the correct approach that D must use:

A. D should restate the financial statements for both years 2020 and 2019

B. the changes to adopt the revenue standard should be applied prospectively

C. the changes should be made retrospectively to January 1, 2020

D. the changes should be made retrospectively to January 1, 2019



1. A. Incorrect. ASC requires all entities, including nonpublic entities, to disclose the opening and closing balances of receivables, contract assets, and contract liabilities from contracts with customers, if not otherwise separately presented or disclosed.

B. Incorrect. All entities must disclose the obligations for returns, refunds, and other similar obligations.

C. Incorrect. ASC requires all entities to include disclosure of the types of warranties as part of its disclosures of performance obligations.

D. CORRECT. ASC 606 provides an exception under which a nonpublic entity is not required to disclose, for performance obligations satisfied at a point in time, the significant judgments made in evaluating when a customer obtained control of the promised goods or services.


2. A. Incorrect. Under the modified retrospective method, there is no restatement of the comparative year financial statements. Thus, no restatement of 2019 financial statements is required.

B. Incorrect. Changes to adopt the revenue standard should be applied retrospectively, not prospectively, per ASC 606.

C. CORRECT. Under the modified retrospective method, the changes should be made retrospectively to the beginning of the current year, January 1, 2020.

D. Incorrect. The modified retrospective method does not result in a restatement of the prior year comparative financial statements. Thus, the changes should not be made retrospectively to January 1, 2019, the beginning of the prior comparative year.



XII. APPLICABLE FINANCIAL STATEMENT (AFS) AND IMPACT OF TAX ACT ON ASC 606

Rarely does the timing and treatment of revenue recognition for GAAP collide with the Internal Revenue Code. Typically, revenue is recognized for GAAP, then for tax, and the difference is treated as a Schedule M-1 item. If the entity is a C corporation, deferred income taxes are recorded on the temporary difference.

With the Tax Cuts and Jobs Act (TCJA) becoming effective in 2018, while GAAP’s ASC 606 being implemented in either 2018 (SEC companies) or 2019 (nonpublic entities), the differences will likely continue.

On its face, once both the TCJA and ASC 606 are implemented by the end of 2019, there will likely be several significant differences between the timing of revenue recognition for GAAP and tax return purposes.

Some of the key differences are:

1. Variable consideration: ASC 606 requires companies to accelerate the recording of variable consideration, while IRC 451 does not recognize variable consideration as revenue until the all-events test is satisfied.

2. Bill-and-hold arrangements: In some bill-and-hold arrangements, ASC 606 requires an entity to recognize revenue early as there is a transfer of control to the customer, while the IRC does not recognize revenue until the all-events test is satisfied.

3. For some revenue contracts: For ASC 606’s GAAP, an entity may be required to record revenue over time while, for tax purposes, it may not be recorded until the goods are shipped and title passes.

4. Capitalized contract costs: ASC 606 requires certain incremental costs to obtain and fulfill a contract (such as commissions) to be capitalized and amortized. For tax purposes, most of these costs are deductible in the year incurred.

The previous list represents just a few book-tax differences that are likely to continue to exist. In fact, they are likely to expand as ASC 606 now requires companies to accelerate revenue related to variable consideration (such as performance bonuses or rebates) and bill-and-hold arrangements. Thus, many companies will see larger book-tax differences than prior to the effective date of the TCJA and ASC 606.

General Rule of Revenue Recognition- IRC 451(b)- All-Events Test

Before continuing, let’s review the general rule for recognizing revenue for tax purposes when an entity is on the accrual basis.

The general rule for recognizing revenue for tax purposes on an accrual basis is called the all-events test, which has been found in IRC 451(b) for years.

Under the all-events test, taxpayers recognize revenue on an accrual basis when the all-events test is met, which occurs when two elements are satisfied:


1. When all the events have occurred that fix the right to receive such income, and

2. The amount can be determined with reasonable accuracy.

Typically, the right to receive income is considered fixed at the earlier of the date on which the income is:

• Earned, (provided performance or the event has taken place)

• Due to the taxpayer (based on contract terms), or

• Received by the taxpayer.

The all-events test has been used in the Internal Revenue Code independent of the GAAP rules for recognizing revenue. Prior to the TCJA, methods used to recognize revenue for GAAP and tax purposes were separate from each other.

That changed with the TCJA effective in 2018.

TCJA Amends IRC 451- Looks at GAAP to Determine Timing of Revenue for Tax Purposes

Prior to the changes made by TCJA, there was little reference in the IRC as to how revenue should be recognized for GAAP purposes, and vice versa.

That changed in 2018 when the TCJA amended IRC 451 as follows:

1. The amendments to IRC 451 by TCJA alter the relationship between how and when revenue is recognized for tax purposes and GAAP.

2. In certain instances, new IRC 451(b) uses GAAP to determine the timing of when revenue is recorded for tax purposes.

3. New IRC 451(b) provides a new book-tax conformity requirement as follows:

a) An accrual basis taxpayer may not treat the all-events test as being met for any item any later than when the item is recorded as revenue on:

• Its applicable financial statement (AFS), or

• Another financial statement the Secretary of the Treasury may specify.

Specifically, new IRC 451(b) states:

“In the case of a taxpayer, the taxable income of which is computed under an accrual method of accounting, the all events test with respect to any item of gross income (or portion thereof) shall not be treated as met any later than when such item (or portion thereof) is taken into account as revenue in:

• An applicable financial statement (AFS) of the taxpayer, or

• Such other financial statement as the Secretary [of the Treasury] may specify for purposes of this subsection.”


4. The IRC 451(b) conformity requirement does not apply to:

a) An entity that does not have an applicable financial statement (AFS) or income related to a mortgage servicing contract.

b) Use of a special tax method (other than accrual), such as installment sales or long-term contract method, or nonrecognition provisions, such as a IRC 351 and 721.

5. Applicable Financial Statement (definition found in IRC 451(b)(3)):

IRC 451(b)(3) defines an applicable financial statement (AFS) as any of the following:

a) A GAAP Audited Financial Statement:

A financial statement which is certified as being prepared in accordance with generally accepted accounting principles and which is either:

1) A 10–K (or successor form), or annual statement to shareholders, required to be filed by the taxpayer with the U.S. SEC, or

2) An audited financial statement of the taxpayer which is used for:

• Credit purposes,

• Reporting to shareholders, partners, or other proprietors, or to beneficiaries, or

• Any other substantial nontax purpose, but only if there is no statement filed with the SEC described in clause (a)(1) above, or

3) Filed with any other Federal agency for purposes other than Federal tax purposes, but only if there is no statement of the taxpayer described in clause (a)(1) or (2), above.

b) An IFRS financial statement:

A financial statement on the basis of international financial reporting standards (IFRS) that is filed by the taxpayer with an agency of a foreign government which is equivalent to the U.S. SEC and which has reporting standards not less stringent than the standards required by the SEC, but only if there is no statement of the taxpayer described in paragraph (a), or

c) A financial statement filed with another governmental body:

A financial statement filed by the taxpayer with any other regulatory or governmental body specified by the Secretary of the Treasury, but only if there is no statement of the taxpayer described in paragraph (a) or (b).


6. Changes made by GAAP’s ASC 606 could accelerate revenue for tax purposes.

a) There could be instances in which GAAP accelerates revenue, thereby accelerating revenue for tax purposes in IRC 451.

Examples:

• Variable consideration is now estimated and recorded early under new GAAP ASC 606

• Bill-and-hold arrangements might result in revenue being recognized earlier than existing GAAP

What is the overall impact of the TCJA changes to IRC 451(b) and the all-events test?

The change made to IRC 451(b) by the TCJA is rarely discussed by authors and speakers. Yet, this change could have a profound impact on the timing of revenue recognized for tax purposes. In some cases, revenue will be accelerated for tax purposes solely because an entity has an audited financial statement.

Let’s address the key changes made to IRC 451(b) and its impact when one considers the simultaneous changes made to GAAP revenue recognition by ASC 606.

1. ASC 606 accelerates the recognition timing of certain types of revenue for GAAP, including:

a) Variable consideration

b) Bill-and-hold arrangements, and

c) Certain contracts that qualify for revenue recognized over time instead of at a point in time.

2. New IRC 451(b) states that an accrual-basis taxpayer may not treat the all-events test as being met for any item any later than when the item is recorded as revenue on:

a) Its applicable financial statement (AFS), or

b) Another financial statement the Secretary may specify.

Following is a chart that identifies types of financial statements that are classified as an AFS in IRC 451(b):


Applicable Financial Statements- IRC 451(b)

Applicable Financial Statement (AFS)

NOT Applicable Financial Statement

• Audited GAAP financial statements • Audited non-GAAP financial statements (such as tax-basis FS)

• IFRS financial statements • Reviewed financial statements on GAAP or non-GAAP framework

• Financial statements filed with another governmental body

• Compiled financial statements on GAAP or non-GAAP framework

• Prepared financial statements on GAAP or non-GAAP framework

• No FS issued at all

In looking at the chart, an audited GAAP financial statement is considered an applicable financial statement (AFS), while reviewed and compiled financial statements are not. Moreover, a non-GAAP audited financial statement (such as tax basis) is not an AFS.

What this means is that if an entity has audited GAAP financial statements, and accelerates revenue for GAAP under ASC 606 (such as variable consideration, bill-and-hold arrangements, etc), that revenue is also accelerated for tax purposes.

If, instead, an entity has reviewed or compiled financial statements (and not audited GAAP financial statements), if revenue is accelerated for GAAP under ASC 606, it is not accelerated for tax purposes.

These facts could make the issuance of audited GAAP financial statements expensive for a company as it might catapult the company into accelerating revenue on its tax return. If, instead, a company has a review or compilation engagement performed on its GAAP financial statements, or has any kind of reporting on tax-basis financial statements, that revenue accelerated for GAAP is not also accelerated for the tax return.

Example 1: Company Has an Applicable Financial Statement (AFS)

Company X enters into a 5-year contract that provides X with a performance bonus of $500,000 in year 5 if certain conditions are met.

1. X records this variable consideration at $500,000 and records it over time at $100,000 per year.

2. X pays an employee a commission of $200,000 in Year 1 when the contract is signed, capitalizes it, and amortizes it over five years to expense.

3. X issues audited financial statements to its creditors.


Conclusion:

1. X has an applicable financial statement (AFS) because it has audited GAAP financial statements.

2. Under GAAP’s ASC 606, variable revenue is accelerated and recorded over time in Step 5 at $100,000 per year for five years.

3. For tax purposes, because there is an AFS, the $500,000 of variable revenue is recognized no later than when the revenue is recognized for GAAP. Thus, revenue for tax purposes is recorded in the same periods in which it is recorded for GAAP in the audited GAAP financial statements (AFS), which is $100,000 per year.

4. For GAAP, commissions are capitalized and amortized over the five years in which the variable revenue is recorded. For tax purposes, the commissions are expensed when paid in Year 1.

Following is a chart that summarizes how the revenue and expense is recognized for GAAP and tax purposes:

EXAMPLE 1: AUDITED GAAP FINANCIAL STATEMENTS (AFS) NEW GAAP ASC 606 AND NEW TCJA IRC 451(b)

YEAR1 2 3 4 5 Totals

GAAP:Revenue $100,000 $100,000 $100,000 $100,000 $100,000 $500,000

Commission Expense

(40,000)

(40,000)

(40,000)

(40,000)

(40,000)

(200,000)

Net Profit $60,000 $60,000 $60,000 $60,000 $60,000 $300,000

TAX:Revenue $100,000 $100,000 $100,000 $100,000 $100,000 $500,000

Commission Expense

(200,000)

(0)

(0)

(0)

(0)

(200,000)

Net Profit $100,000 $100,000 $100,000 $100,000 $100,000 $300,000


Observation

In looking at the previous chart in Example 1, tax return revenue follows the GAAP revenue, recorded at $100,000 per year. For tax purposes, the $200,000 commission is expensed as incurred and paid in Year 1, while for GAAP, the $200,000 is amortized to expense over five years, the period over which the revenue is recognized for GAAP.

Consequently, there is a price to having an audit of GAAP financial statements. Once there is an AFS (audited GAAP financial statement), the timing of recording revenue for tax purposes follows the timing for GAAP, as required by the all-events test in IRC 451(b).

Example 2: Company Has a Reviewed Financial Statements (not an AFS)

Same facts as Example 1, except that the company has reviewed GAAP financial statements.

Conclusion:

Because there are reviewed GAAP financial statements, there is no AFS.

Without an AFS, the timing of recognizing revenue for tax purposes is not linked to the way in which it is recognized for GAAP.

EXAMPLE 2: REVIEWED GAAP FINANCIAL STATEMENTS (NO AFS) NEW GAAP ASC 606 AND NEW TCJA IRC 451(b)

YEAR1 2 3 4 5 Totals

GAAP:Revenue $100,000 $100,000 $100,000 $100,000 $100,000 $500,000

Commission Expense

(40,000)

(40,000)

(40,000)

(40,000)

(40,000)

(200,000)

Net Profit $60,000 $60,000 $60,000 $60,000 $60,000 $300,000

TAX:Revenue $0 $0 $0 $0 $500,000 $500,000

Commission Expense

(200,000)

(0)

(0)

(0)

(0)

(200,000)

Net Profit $200,000 $0 $0 $0 $500,000 $300,000


Observation

Example 2 illustrates the importance of avoiding issuing an AFS, such as an audit of GAAP financial statements. By reducing the engagement from a GAAP audit to a GAAP review, the company no longer has an AFS. Once there is no AFS, the special rule found in IRC 451(b) does not apply. Thus, revenue for tax purposes does not follow the timing of recognition for GAAP in ASC 606. For tax purposes, the $500,000 of revenue is not recorded until the all events test is met in Year 5. The all events test is not satisfied until Year 5 when the right to receive the income is fixed, and the amount can be determined with reasonable accuracy.

What is the moral of the story?

There is a moral to this story. A company should avoid having an audit performed on its GAAP financial statements in situations in which the company has GAAP revenue that is accelerated, such as variable consideration, bill-and-hold arrangements, or revenue recognized over time.


TEST YOUR KNOWLEDGE #10The following question is designed to ensure that you have a complete understanding of the information presented in the chapter (assignment). It is included as an additional tool to enhance your learning experience and does not need to be submitted in order to receive CPE credit.

We recommend that you answer the question and then compare your response to the suggested solution on the following page before answering the final exam question(s) related to this chapter (assignment).

1. Which of the following are considered applicable financial statements (AFS) in IRC 451(b):

A. audited tax-basis financial statements

B. reviewed GAAP financial statements

C. compiled GAAP financial statements

D. audited GAAP financial statements


SOLUTION AND SUGGESTED RESPONSES #10Below is the solution and suggested responses for the question on the previous page. If you choose an incorrect answer, you should review the page(s) as indicated for the question to ensure comprehension of the material.

1. A. Incorrect. Audited non-GAAP financial statements (such as tax-basis financial statements) are not considered an applicable financial statement in IRC 451(b).

B. Incorrect. Reviewed financial statements of all kinds, including GAAP financial statements, are not included in the list of applicable financial statements (AFS) in IRC 451(b).

C. Incorrect. Compiled GAAP financial statements are not included in the list of applicable financial statements (AFS) in IRC 451(b).

D. CORRECT. Audited GAAP financial statements are included in IRC 451(b)’s list of applicable financial statements (AFS).


Glossary • 251

GLOSSARY

Assurance-Type Warranty: A warranty that is included with the sale of a product or service, providing assurance that the produce will function as intended and in accordance with identified specifications.

Bill-and-Hold Arrangement: A contract under which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future.

Contract: An agreement between two or more parties that creates enforceable rights and obligations.

Contract Asset: An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Contract Liability: An entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer.

Customer: A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.

Functional Intellectual Property: Intellectual property that has significant standalone functionality and derives a substantial portion of its utility (its ability to provide benefit or value) from its significant standalone functionality.

Not-for-Profit Entity: An entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity:

a. Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return

b. Operating purposes other than to provide goods or services at a profit

c. Absence of ownership interests like those of business entities.

Performance Obligation: A promise in a contract with a customer to transfer to the customer either:

a. A good or service (or a bundle of goods or services) that is distinct

b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Probable: The future event or events are likely to occur.

252 • Glossary

Public Business Entity: A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.

a. It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).

b. It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.

c. It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of, or, for purposes of issuing securities that are not subject to contractual restrictions on transfer.

d. It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.

e. It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to satisfy this criterion.

Receivable: An entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due. A receivable differs from a contract asset in that a receivable has an unconditional right to consideration, while a contract asset is conditional on something other than the passage of time.

Refund Liability: The portion of consideration received from a customer that an entity expects to refund.

Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Service-Type Warranty: A warranty that can be purchased by a customer in addition to the purchase of the underlying product or service. Such a warranty is in addition to an assurance-type warranty.

Standalone Selling Price: The price at which an entity would sell a promised good or service separately to a customer.

Symbolic Intellectual Property: Intellectual property that is not functional intellectual property by not having significant standalone functionality.

Transaction Price: The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.

Index • 253

INDEX

Aadjusted market assessment approach 64, 67agent 8, 37, 119, 120, 122, 124, 125, 126, 127,

142, 143, 146, 147, 205, 212, 219all-events test 239, 240, 242, 245applicable financial statement 240, 241, 242,

243, 244, 249assurance-type warranty 133, 134, 135, 252at a point in time 39, 61, 69, 70, 72, 73, 74, 77,

83, 84, 85, 87, 95, 99, 100, 103, 107, 109, 110, 111, 117, 136, 150, 151, 152, 153, 154, 158, 163, 165, 192, 193, 203, 208, 215, 219, 221, 223, 224, 226, 234, 235, 237, 242

Bbill-and-hold arrangements 3, 102, 135, 136,

234, 239, 243, 246breakage 8, 167, 168, 169, 170, 171, 172, 173,

175, 178

Ccontract asset 55, 118, 186, 187, 188, 189, 190,

193, 195, 204, 211, 234contract costs 6, 107, 183, 209, 222, 225, 239contract liability 27, 55, 117, 186, 187, 189, 190,

192, 194, 203, 204, 211core principle 11, 13, 15

Ddistinct 10, 35, 38, 39, 40, 41, 51, 52, 53, 55,

56, 58, 59, 60, 63, 64, 65, 66, 91, 120, 133, 149, 150, 206, 218

Eenforceable right to payment 70, 74, 76, 77, 79,

81, 82, 83, 84, 85, 86, 88, 109, 111expected cost plus a margin approach 67

Ffinancial liability 175, 177fulfillment costs 161, 162, 222full retrospective method 228, 229, 231functional intellectual property 152, 153, 154

IIncremental costs 179, 182input methods 72, 90, 91, 208, 220intellectual property 149, 150, 151, 152, 153,

154, 155, 156, 157, 158, 163, 165, 206, 218

Llicense 38, 39, 149, 150, 151, 152, 153, 154,

155, 156, 157, 158, 163, 206, 218licensing 8, 149, 150, 154, 155, 158

Mmodified retrospective method 230, 231, 232,

233, 235, 237

Nnoncash consideration 8, 41, 47, 48, 49, 50, 65,

208, 215

Ooutput methods 89, 90, 91, 208, 220over time 1, 35, 39, 40, 46, 47, 50, 69, 70, 71,

72, 73, 74, 75, 76, 77, 78, 79, 82, 83, 84, 85, 86, 87, 88, 89, 90, 92, 94, 95, 96, 97, 98, 99, 103, 104, 105, 107, 109, 110, 111, 135, 150, 151, 152, 153, 154, 155, 157, 158, 163, 165, 201, 203, 208, 215, 219, 220, 221, 223, 224, 225, 226, 233, 234, 239, 242, 243, 244

254 • Index

Pperformance obligation 8, 11, 13, 15, 19, 35, 37,

39, 40, 46, 55, 56, 57, 58, 59, 60, 61, 62, 67, 69, 70, 71, 72, 75, 76, 77, 78, 79, 81, 82, 83, 84, 85, 86, 87, 88, 89, 90, 91, 93, 94, 95, 96, 98, 99, 100, 102, 103, 105, 106, 107, 109, 110, 111, 112, 114, 119, 120, 121, 122, 124, 125, 127, 129, 130, 132, 133, 134, 135, 136, 141, 142, 145, 146, 149, 150, 151, 153, 155, 156, 157, 158, 160, 161, 162, 163, 165, 187, 188, 190, 191, 192, 193, 204, 206, 213, 218, 222, 225

prepaid stored-value products 168, 169, 170, 172, 175, 177

principal 8, 36, 91, 119, 120, 121, 122, 123, 124, 126, 127, 128, 142, 143, 146, 147

probable 18, 19, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, 31, 33, 41, 44, 45, 46, 47, 64, 66, 156, 169, 170, 171, 172, 175, 178, 225

Rreceivable 22, 23, 25, 28, 30, 50, 55, 116, 117,

118, 122, 186, 187, 188, 189, 191, 192, 193, 194, 204

refund liability 114, 115, 116, 117, 118, 141, 145, 189, 194, 221, 223, 224

remote 79, 169, 170, 172, 175, 178residual approach 57, 58, 64, 67retrospectively 193, 228, 229, 230, 231, 235,

237

Sservice-type warranty 133shipping and handling costs 161, 162, 222standalone selling price 41, 50, 56, 57, 58, 59,

61, 64, 67, 150symbolic intellectual property 153, 154, 155,

157, 158

Ttransaction price 6, 11, 13, 39, 40, 41, 42, 43,

44, 45, 46, 47, 48, 49, 50, 51, 52, 53, 54, 55, 56, 57, 59, 60, 61, 62, 63, 64, 65, 66, 67, 69, 96, 97, 105, 106, 107, 117, 118, 129, 130, 131, 132, 133, 134, 135, 147, 149, 150, 156, 158, 159, 160, 161, 164, 166, 194, 201, 204, 205, 207, 208, 209, 213, 214, 215, 216, 217, 220, 222, 229, 230

Uupfront fee 128, 129, 130, 131, 132, 133, 147

Vvariable consideration 41, 42, 43, 44, 45, 46, 47,

48, 49, 51, 56, 59, 60, 63, 64, 66, 106, 115, 155, 156, 157, 158, 204, 205, 206, 207, 208, 212, 215, 216, 218, 219, 220, 221, 225, 229, 234, 239, 243, 246

implementing the new revenue standard

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