Revenue recognition: the five-step model and contract costs

The core principle and the five steps

Under FASB ASC Topic 606 (from ASU 2014-09), revenue is recognized as goods or services pass to the customer, measured at the consideration the seller expects to be entitled to for them. It gets there in five steps (FASB, In Focus: Revenue from Contracts with Customers):

1. Identify the contract with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when (or as) each performance obligation is satisfied.

Step 1: the contract

A contract exists for Topic 606 purposes when all of these are met (ASC 606-10-25-1): the parties have approved it and are committed to perform; each party's rights can be identified; the payment terms can be identified; it has commercial substance; and it is probable that the entity will collect substantially all the consideration it is entitled to for the goods or services that will be transferred. If the criteria are not met, consideration received is generally a liability until they are met or specified events occur.

Contracts with the same customer entered into at or near the same time are combined when, for example, they are negotiated as a package. A modification that adds distinct goods or services at their standalone selling prices is a separate contract; other modifications are folded into the existing contract (ASC 606-10-25-10 to 25-13).

Step 2: performance obligations

A performance obligation is a promise to transfer a distinct good or service (or a series of substantially the same distinct goods or services transferred in the same pattern, such as monthly cleaning). A good or service is distinct if both:

• it is capable of being distinct: the customer can benefit from it on its own or with readily available resources; and
• it is distinct within the context of the contract: it is separately identifiable from the other promises (for example, the entity is not integrating it with other goods into a combined output, it does not significantly modify another promised item, and it is not highly interdependent with others).

Common judgments:

Item	Usually
Assurance-type warranty (assures the product works as agreed)	Not a performance obligation; accrue the expected cost (ASC 460)
Service-type warranty (extra service, or sold separately)	A separate performance obligation; defer part of the price
Customer option for additional goods (loyalty points, discounts)	A performance obligation only if it gives a material right the customer would not get without the contract
Principal or agent	Principal if it controls the good or service before transfer (indicators: primarily responsible for fulfilment, inventory risk, pricing discretion); a principal reports revenue gross, an agent reports its fee or commission net

Step 3: the transaction price

The transaction price is the amount the entity expects to be entitled to, excluding amounts collected for third parties such as sales taxes. Adjust for:

• Variable consideration (discounts, rebates, refunds, bonuses, penalties): estimate using the expected value (probability-weighted, suited to many similar contracts) or the most likely amount (suited to binary outcomes), and include it only to the extent it is probable that a significant reversal of cumulative revenue will not occur when the uncertainty resolves (the constraint).
• Significant financing component: adjust for the time value of money when payment timing gives either party a significant financing benefit; not required when the period between transfer and payment is one year or less (practical expedient).
• Noncash consideration: at fair value.
• Consideration payable to a customer (coupons, slotting fees, credits): generally a reduction of the transaction price, unless it pays for a distinct good or service from the customer.

Example: a volume rebate. Coastline Supply sells a part at $100 per unit; if a customer buys more than 1,000 units in the year, the price becomes $90 for all units. In the first quarter the customer buys 200 units, and Coastline expects (and judges it probable) that the threshold will be met. It recognizes revenue at $90 × 200 = $18,000, with a refund liability of $2,000 for the expected rebate.

Step 4: allocation

Allocate the transaction price to each performance obligation in proportion to its standalone selling price (SSP), the price at which the entity would sell it separately. If SSP is not observable, estimate it using the adjusted market assessment approach, the expected cost plus a margin approach, or, in limited circumstances (highly variable or uncertain prices), the residual approach. A discount is allocated proportionately unless there is observable evidence that it belongs to particular obligations.

Example: a bundle. On January 1, Year 1, TechNova sells a machine, two years of maintenance and an operator training course for $90,000 cash. Standalone selling prices: machine $72,000; maintenance $24,000; training $4,000 (total $100,000).

Obligation	SSP	Allocation ($90,000 × SSP ÷ $100,000)	Satisfied
Machine	72,000	64,800	At delivery, January 1
Maintenance (2 years)	24,000	21,600	Over time, $10,800 a year
Training	4,000	3,600	When delivered, in January

Jan 1, Year 1	Debit	Credit
Cash	90,000
Revenue: equipment		64,800
Contract liability		25,200

When the training is given in January, $3,600 moves from the contract liability to revenue; the maintenance revenue is recognized month by month ($900 a month). Year 1 revenue = $64,800 + $3,600 + $10,800 = $79,200; the contract liability at year-end is $10,800.

Step 5: over time or at a point in time

A performance obligation is satisfied over time if any of these is met (ASC 606-10-25-27):

1. the customer simultaneously receives and consumes the benefits as the entity performs (routine services);
2. the entity's performance creates or enhances an asset the customer controls (building on the customer's land);
3. the entity's performance creates an asset with no alternative use to the entity, and it has an enforceable right to payment for performance completed to date.

Otherwise revenue is recognized at the point in time when control passes, judged by indicators such as a present right to payment, legal title, physical possession, transfer of the significant risks and rewards, and customer acceptance. In a bill-and-hold arrangement, control can pass while the seller still holds the goods only if strict conditions are met; in a consignment, the consignor does not recognize revenue on delivery to the consignee.

Progress toward completion is measured with an output method (units delivered, milestones) or an input method (costs incurred relative to total expected costs).

Example: cost-to-cost. BuildRight agrees to construct a warehouse on the customer's land for $5,000,000. Estimated total costs: $4,000,000.

BuildRight	Year 1	Year 2
Costs incurred to date	1,200,000	3,150,000
Estimated total costs	4,000,000	4,200,000
Percent complete	30%	75%
Cumulative revenue	1,500,000	3,750,000
Revenue for the year	1,500,000	2,250,000
Cost for the year	1,200,000	1,950,000
Gross profit for the year	300,000	300,000

The change in estimated total costs in Year 2 is a change in estimate, reflected in the current and future periods through the cumulative catch-up. If total costs were expected to exceed the contract price, the whole expected loss would be recognized as soon as it became evident (ASC 605-35, which still governs provisions for losses on such contracts).

Contract balances

Balance	Arises when
Receivable	The entity has an unconditional right to consideration (only the passage of time is required)
Contract asset	The entity has performed but its right to consideration is conditional on something other than time (for example, completing another obligation)
Contract liability	The customer has paid (or payment is due) before the entity performs

If BuildRight billed $1,300,000 in Year 1 (all unconditional) against $1,500,000 of revenue, it would report a $1,300,000 receivable (less collections) and a $200,000 contract asset for revenue earned but not yet billable.

Sales with a right of return are a form of variable consideration: recognize revenue only for the goods not expected to be returned, a refund liability for expected refunds, and an asset for the right to recover returned goods (see the cash and receivables lesson).

Contract costs (ASC 340-40)

Cost	Treatment
Incremental costs of obtaining a contract (costs that would not have been incurred without it, such as a sales commission)	Capitalize if expected to be recovered. Practical expedient: expense them if the amortization period would be one year or less
Costs that would have been incurred anyway (salaries of sales staff, bid costs)	Expense, unless explicitly chargeable to the customer
Costs to fulfil a contract not covered by another Topic (such as inventory or PP&E)	Capitalize only if they (1) relate directly to a contract or specific anticipated contract, (2) generate or enhance resources used to satisfy future performance obligations, and (3) are expected to be recovered

Capitalized contract costs are amortized on a basis consistent with the transfer of the related goods or services, and an impairment loss is recognized when the carrying amount exceeds the remaining consideration expected less the costs still to be incurred.

Example. A software firm pays a salesperson a $30,000 commission for winning a three-year service contract. It capitalizes the $30,000 and amortizes it at $10,000 a year. A $4,000 commission on a one-year contract is expensed under the practical expedient.

Common traps

• Allocating a discount entirely to the item sold at a loss, rather than proportionately by SSP.
• Recognizing variable consideration in full without applying the constraint.
• Treating an assurance-type warranty as a separate performance obligation (or a separately sold extended warranty as a cost accrual).
• Reporting gross revenue when the entity is an agent.
• Calling a conditional right to payment a receivable (it is a contract asset).
• Expensing a commission on a multi-year contract (capitalize unless the amortization period is one year or less).

Check yourself

• Name the five steps. (Contract; performance obligations; transaction price; allocation; recognition.)
• Name the three criteria for recognition over time. (Customer simultaneously receives and consumes; entity enhances an asset the customer controls; no alternative use plus an enforceable right to payment.)
• Payment is due 10 months after delivery. Adjust for financing? (No; the practical expedient covers one year or less.)
• A customer prepays $12,000 for a 12-month subscription on October 1. Contract liability at December 31? ($9,000.)
• An agent sells a $500 ticket and keeps a $40 fee. Revenue? ($40.)