The Financial Accounting Standards Board in conjunction with the International Accounting Standards Board (IASB) has issued an exposure draft, which will likely take effect for fiscal years commencing after January 2015, that addresses revenue recognition. This update to the standard (topic 650) has direct applicability to government contractors and may affect the timing and amount of revenue recognized under long-term contracts. In particular, the updated standard serves to clarify a key element in the recording of revenue, namely; the transfer of ownership and control of the asset or service to the customer. This transfer may occur “over time” or at “point in time”. This is perhaps easily understood for tangible goods but less clear for services.
Does your service contract transfer ownership and control “over time” or at a “point in time”?
Transfer – Transfer over time might be evident if your services create or enhance a customer asset. If it does and the customer controls the asset or directly benefits from the service as it is created then a transfer has taken place. Let’s focus on services. If you are providing staff augmentation for example, the customer is receiving and directly benefiting from the services and a transfer has taken place. The fact that a contractor may have lien rights to compel payment does not matter and effectively the customer has control of the asset or service.
Alternatively, it may not be clear that an asset is controlled by the customer or that an asset is created or enhanced. The Boards resolved this issue by identifying when a transfer did not take place. Circumstances would suggest that if the contractual activity has an alternate use by the contractor and the contractor can redirect the resulting effort to another customer, a transfer has not taken place. If the contractual effort is so highly customized that redirecting the effort to another customer is not possible without significant cost, then the presumption is that an alternate use does not exist. Finally, if no alternate use exists for the contractor’s asset or service, then evidence of transfer might be indicated if another contractor would be required to reperform the work completed to fulfill the contract. If fulfillment of the contract does not require work to be reperformed then the presumption is that the customer received a benefit and a transfer has taken place. For example, if the contractor performed IT services under a long-term contract to provide facility support and the customer were to terminate the contract, reperformance of the contractor’s work would be highly unlikely. Therefore a presumption of benefit and transfer would be supported. Further evidence of benefit and transfer would be supported by the customer’s contractual obligation to pay the contractor (for example, milestone payments as contrasted to deposits).
Transfer and control over time supports the contractor’s basis for utilizing a percentage of completion method of accounting. Otherwise, revenue should be recorded at the time transfer occurs.
A more detailed discussion of the Boards conclusions follow:
The FASB and IASB (The Boards) provides the following criteria:
Ability—A customer must have the present right to direct the use of and obtain substantially all the remaining benefits from an asset for an entity to recognize revenue. For example, in a contract that requires a manufacturer to produce an asset for a particular customer, it might be clear that the customer ultimately will have the right to direct the use of and obtain substantially all the remaining benefits from the asset. However, the entity should not recognize revenue until the customer has obtained that right (which, depending on the contract, might occur during production or afterwards).
Direct the use of—A customer’s ability to direct the use of an asset refers to the customer’s right to deploy that asset in its activities, to allow another entity to deploy that asset in its activities, or to restrict another entity from deploying that asset.
Obtain the benefits from—The customer must have the ability to obtain substantially all the remaining benefits from an asset for the customer to obtain control of it. In concept, the benefits from a good or service are potential cash flows (either an increase in cash inflows or a decrease in cash outflows). An entity can obtain the benefits directly or indirectly in many ways, such as by using, consuming, disposing of, selling, exchanging, pledging, or holding an asset.
The Boards observed that the assessment of when control has transferred could be applied from the perspective of either the entity selling the good or service or the customer purchasing the good or service. Consequently, revenue could be recognized when the seller surrenders control of a good or service or when the customer obtains control of that good or service. Although in many cases both perspectives lead to the same result, the Boards decided that control should be assessed primarily from the perspective of the customer. That perspective would minimize the risk of an entity recognizing revenue from undertaking activities that do not coincide with the transfer of goods or services to the customer.
Respondents to the exposure draft stated that the additional guidance for assessing the transfer of control proposed in the 2010 proposed Update was most helpful when applied to performance obligations for the transfer of goods. They commented that applying the concept of control is intuitive in those cases because, typically, it is clear that an asset has transferred from the entity to its customer. But they noted that the guidance was less intuitive and more difficult to apply to performance obligations for services and construction-type contracts because it could be difficult to determine when a customer obtains control of a service. That is because in many service contracts the service asset is simultaneously created and consumed and, therefore, it is never recognized as an asset by the customer. And even in the case of a construction contract in which there is a recognizable asset, it can be difficult to assess whether a customer has the ability to direct the use of and obtain substantially all the remaining benefits from a partially completed asset that the seller is in the process of creating. Consequently, many respondents in the construction industry were concerned that they would be required to change their revenue recognition policy from using a percentage-of-completion method to a completed contract method (on the basis that the transfer of assets occurs only upon transfer of legal title or physical possession of the finished asset, which typically occurs upon contract completion).
The Boards developed the additional guidance in paragraph 35 of the proposed Update to assist an entity in determining when goods or services are transferred over time and, thus, when a performance obligation is satisfied over time. That proposed guidance is divided into two categories—one for when the entity’s performance creates or enhances an asset of the customer and another for when the entity’s performance does not create an asset with alternative use to the entity.
The Boards decided that if an entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced, the entity’s performance transfers goods or services to the customer. Accordingly, in such cases a performance obligation is satisfied over time as the entity creates or enhances that asset. For example, the performance obligation is satisfied over time in many construction contracts when the customer controls any work-in-process (tangible or intangible) arising from the entity’s performance.
This criterion is consistent with the proposed implementation guidance in the 2010 proposed Update on determining whether a good or service is transferred over time. That guidance stated that goods or services would be transferred over time if the customer controls the work-in-process as it is created. Many respondents to the 2010 proposed Update agreed with that concept but thought it needed to be articulated more prominently in the standard itself. In the Boards’ view, the concept of control is similar to the basis for percentage-of-completion accounting in accordance with paragraph 22 of AICPA Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts:
Under most contracts for construction of facilities, production of goods, or provision of related services to a buyer’s specifications, both the buyer and the seller (contractor) obtain enforceable rights. The legal right of the buyer to require specific performance of the contract means that the contractor has, in effect, agreed to sell his rights to work-in-progress as the work progresses. This view is consistent with the contractor’s legal rights; he typically has no ownership claim to the work-in-progress but has lien rights. Furthermore, the contractor has the right to require the buyer, under most financing arrangements, to make progress payments to support his ownership investment and to approve the facilities constructed (or goods produced or services performed) to date if they meet the contract requirements. The buyer’s right to take over the work-in-progress at his option (usually with a penalty) provides additional evidence to support that view. Accordingly, the business activity taking place supports the concept that in an economic sense performance is, in effect, a continuous sale (transfer of ownership rights) that occurs as the work progresses.
This second criterion was developed for performance obligations for which it may not be clear whether any asset that is created or enhanced is controlled by the customer or for which the entity’s performance does not result in a recognizable asset.
In developing this criterion, the Boards decided that it would be easier to determine when the entity’s performance results in a transfer of goods or services to the customer by first eliminating the circumstances in which the entity’s performance would not result in a transfer of goods or services to the customer. The Boards decided that an entity’s performance would not result in a transfer of goods or services to the customer if the entity’s performance creates an asset with an alternative use to the entity. If an asset has an alternative use to an entity, the entity could readily direct the asset to another customer. For instance, in many cases an asset will have an alternative use because it is a standard inventory-type item and the entity has discretion to substitute the item across contracts with customers. Because the entity has discretion to substitute the asset being created for a similar item, the customer cannot control the asset.
Conversely, if an entity creates an asset that is highly customized for a particular customer, then the asset would be less likely to have an alternative use because the entity likely would incur significant costs to reconfigure the asset for sale to another customer (or would need to sell the asset for a significantly reduced price). The Boards observed that the level of customization might be a helpful factor to consider when evaluating whether an asset has an alternative use. However, the Boards decided that it should not be a determinative factor because, in some cases (for example, some real estate, software, or some manufacturing contracts), an asset might be standardized but yet still might not have an alternative use to an entity as a result of contractual or practical limitations that preclude the entity from readily directing the asset to another customer. If a contract precludes the entity from transferring an asset to another customer, the entity does not have an alternative use for that asset because it is legally obliged to direct the asset to the customer.
Having decided that a performance obligation can be satisfied over time only if the entity’s performance does not create an asset with alternative use to the entity, the Boards then developed the three additional criteria in paragraph 35(b). The Boards decided that those criteria were necessary to determine that control of the good or service transfers to the customer over time as the entity performs and, hence, the performance obligation is satisfied over time.
In some cases in which an entity’s performance does not create an asset with an alternative use to the entity, the customer simultaneously receives a benefit and consumes that benefit as the entity performs. In those cases, the entity is transferring goods or services as it performs, thereby satisfying its performance obligation over time. For example, consider an entity that promises to process transactions on behalf of a customer. The entity’s processing of each transaction does not create an asset with an alternative use to the entity and the customer simultaneously receives and consumes a benefit as each transaction is processed. Consequently, the entity would satisfy its performance obligation over time as those transactions are processed for the customer.
In other cases in which the entity’s performance does not create an asset with an alternative use to the entity, it is less clear that the customer benefits from the entity’s performance as it occurs. To address this issue, the second criterion would require an entity to consider whether another entity would need to substantially reperform the work completed to date to fulfill the remaining obligation. That is because a customer must have benefited from the entity’s performance completed to date (that is, received goods or services) if another entity could simply fulfill the remaining obligation to the customer without substantially reperforming the work completed to date. For example, consider a freight logistics company that has an obligation to transport a customer’s asset by road from Vancouver to New York. If the company transports the asset halfway to its destination (or perhaps to a hub that may be further away from the asset’s destination), another company could fulfill the remaining obligation to the customer without having to reperform the transportation service provided to date.
The Boards decided that when determining whether another entity would need to reperform any work, it is important to disregard the benefit of any assets related to the contract (for example, work-in-process) that are controlled by the entity. For instance, in a construction contract, another entity would not be able to fulfill the remaining obligation without reperforming work completed to date if the entity controls the work-in-process. It would be able to do so only if the customer controls the work-in-process.
In practice, there may be contractual or other constraints on an entity’s ability to transfer a (partially satisfied) performance obligation to another entity. However, the Boards decided that the application of this criterion should not be constrained by contractual or practical limitations of transferring the performance obligation because the objective is to determine whether goods or services are transferred to the customer as the entity performs.
For some performance obligations for which performance does not create an asset with an alternative use to the entity, the criteria of a “customer simultaneously receives and consumes the benefits” and “another entity would not need to substantially reperform” will not help the entity in determining whether its performance transfers goods or services over time. To address these circumstances, the Boards decided that the entity should consider whether it has a right to payment for performance completed to date. The Boards decided that if an entity’s performance completed to date does not create an asset with an alternative use to the entity (for example, an asset that could readily be directed to another customer) and the customer is obliged to pay for that performance to date, then the customer could be regarded as receiving the benefit from that performance.
In using the term right to payment, the Boards mean a payment that is intended to compensate an entity for its performance completed to date rather than, for example, payment for a deposit or to compensate the entity for inconvenience or loss of profit. Accordingly, an entity would not have a right to payment for its performance completed to date if the entity could recover only compensation from the customer for a loss of profit that would occur as a result of the customer terminating the contract and the entity incurring significant rework costs to be able to redirect the asset to another customer. In addition, the Boards do not mean that the entity must have a present unconditional right to payment. In many cases, an entity will have that right only at an agreed-upon milestone or on complete satisfaction of the performance obligation. Therefore, in assessing whether it has that right, the entity should consider whether it is entitled to payment for performance completed to date, assuming that it will fulfill the remaining performance obligation(s) (unless it does not expect to fulfill the contract as promised, in which case the entity may not be entitled to payment for performance completed to date).
For example, consider a consulting contract in which the consulting entity agrees to provide a report at the end of the contract for an amount that is conditional on successfully providing that report. If the entity is performing under that contract, it would have a right to payment if the terms of the contract (or the contract law in the entity’s jurisdiction) require the customer to compensate the entity for its work completed to date if the customer terminated the contract.
In the proposed guidance for determining when a performance obligation is satisfied over time, the Boards decided that the criterion of whether an entity has a right to payment for performance completed to date was necessary only in cases in which the entity’s performance does not create an asset with an alternative use to the entity and neither of the criteria in paragraphs 35(b)(i) or (ii) is met. The Boards considered whether they should specify a right to payment for performance completed to date as a more overarching criterion in determining when a performance obligation is satisfied. However, they decided against this for the following reasons:
(a) An entity must have a contract to recognize revenue in accordance with the proposed guidance, and a component of a contract is a right to payment.
(b) The core revenue recognition principle is about determining whether goods or services have been transferred to a customer, not whether the entity has a right to payment. Including a right to payment as an overarching criterion could potentially obscure that revenue recognition principle.
(c) A right to payment does not necessarily determine a transfer of goods or services (for example, in some contracts, customers are required to make nonrefundable upfront payments and do not receive any goods or services in exchange).
(d) In cases in which the customer clearly receives benefits as the entity performs, as in many service contracts, the possibility that the entity will not ultimately retain the payment for its performance is dealt with in measuring revenue. For example, in some service contracts that would meet the combination of the criteria in paragraph 35(b) and paragraphs 35(b)(i) or (ii), the customer may be able to terminate the contract and receive a full refund of its consideration. In such cases, the Boards decided that because the entity is transferring services to the customer, it should recognize revenue subject to being reasonably assured of being entitled to the consideration.
The Boards decided that all performance obligations that do not meet the criteria for being satisfied over time should be accounted for as performance obligations satisfied at a point in time. For performance obligations satisfied at a point in time, an entity should apply the indicators of control to determine the point in time when the performance obligation is satisfied.
The 2010 proposed Update included indicators to assist an entity in determining when the customer obtains control of a good or service. Because many respondents commented that this guidance was useful for contracts for the sales of goods, the Boards decided to carry forward those indicators to assist an entity in determining when it has transferred control of an asset (whether tangible or intangible), with some amendments for clarification.
Some respondents to the 2010 proposed Update questioned whether all of the indicators would need to be present for an entity to conclude that it had transferred control of a good or service or what an entity should do if some but not all of the indicators were present. In their redeliberations, the Boards emphasized that the guidance in paragraph 37 is not a checklist. Rather, it is a list of factors that are often present when a customer has control of an asset and is provided to assist entities in applying the principle of control in paragraph 31.
In the proposed guidance, the Boards added the indicator “the customer has the significant risks and rewards of ownership of the asset” in light of comments from respondents who disagreed with the Boards’ proposal to eliminate considerations of the “risks and rewards of ownership” from the recognition of revenue. Respondents observed that risks and rewards can be a helpful factor to consider when determining the transfer of control, as highlighted by the IASB in IFRS 10, Consolidated Financial Statements, and is often a consequence of controlling an asset. The Boards decided that adding risks and rewards as an indicator would provide additional guidance but would not change the principle of determining the transfer of goods or services on the basis of the transfer of control.
The Boards also added the indicator “the customer has accepted the asset.” The 2010 proposed Update included that notion as implementation guidance; however, the Boards decided to relocate that guidance to the indicators of control in this proposed Update.
Many respondents to the 2010 proposed Update were concerned about the application of the indicator that the “design or function of the good or service is customer-specific” (which was proposed in paragraph 30(d) of the 2010 exposure draft). For many, it was not clear how the indicator related to the objective of determining the transfer of control because the customer might clearly control an asset even though the design or function of that asset is not customer-specific. Conversely, a customer might not control an asset with a customer-specific design or function. The Boards noted that because the indicator had been developed mainly for service contracts, that indicator would not be necessary if separate guidance were developed for determining when performance obligations are satisfied over time. Thus, the Boards decided to eliminate this as an indicator of control. As described in paragraph BC94, the notion of customer-specific design or function has been developed into the criterion of “an asset with no alternative use to the entity.”