Question

If an entity is performing its responsibilities under a contract to a customer in a manner where the performance obligations are being satisfied ‘over time’ (rather than at a ‘point in time’), then what are the alternative approaches to measuring the level of progress that depicts the transfer of goods and services to the customer?

Answer 1

Solution:-

When performance obligations are satisfied over time, an entity must determine a single method of measuring progress toward the completed satisfaction of the obligation. The objective is to transfer the control of the goods or services to the customer. To accomplish this, the entity selects either the output or input method and applies it consistently to similar performance obligations. Both methods are acceptable under the new standard, but they are not interchangeable.

The method used must be appropriate for the circumstances of the contract, as it can result in material differences in the timing of revenue recognition. Careful determination of which method best reflects the substance of the contract should be considered.

The Output method is based on the direct measurement of the value of the goods or services transferred to date, relative to the other goods or services promised under the contract.  In Oracle Projects, these measurements are referred to as Physical Percent Complete, Milestones and Schedule of Values, and Deliverables.

The Input method is based upon the entity’s efforts toward satisfying a performance obligation relative to the total expected input to the satisfaction of that performance obligation.  In Oracle Projects, these measurements are referred to as Cost to Cost Revenue and Time and Materials.

The Standard allows an entity, in certain contracts that have the right to bill an amount for each unit of service provided, to recognize revenue for the amount being billed. This is referred to in the Standard as a “practical expedient”. In this instance, the entity has the right to invoice a customer at an amount equal to its performance to date. This amount does not need to reflect the fixed amount per unit for this to be applied. The invoiced amount should directly correspond to the value that is transferred to the customer.

If an entity’s inputs are incurred evenly over time, then it may be appropriate to recognize revenue on a straight-line basis (for example in the case of a 1-year fixed amount contract).

Determining which measure of progress to apply is not a free choice.

An entity needs to exercise judgment in identifying a method that fulfills the stated object of the new standard. The Standard requires the entity to select a method consistent with the objective of depicting its performance. The entity needs to consider the nature of the good or service that it has promised to transfer to the customer.

Examples are given within the standard of circumstances where a particular method does not necessarily depict performance. (Units of production may not be appropriate where there is a material amount of work in progress.) In addition, an entity must be able to apply a method that is both reliable and relevant. If the information used to apply the output method is not directly observable or would require a large cost to obtain, then the input method may be appropriate. In these cases, judgment is required to identify the appropriate method to use.

Neither method is preferred over the other since both methods have advantages and disadvantages that make them more or less appropriate to the facts and circumstances of the contract. While the output method is generally preferable, a measure of output may not always be directly observable or provide an appropriate measure of performance. While the new standard does not prescribe which method to use, the entity should select an approach that depicts its performance in transferring control of goods and services promised to a customer.

Single Measure of Progress

Significant judgment and understanding of the nature of the promise to the customer is key to selecting a reasonable measure of progress. The new Standard requires a single method of measuring progress for each performance obligation. If multiple performance obligations are to be transferred to the customer over time, this may prove to be difficult.

The entity needs to consider the assessment of performance obligations and whether there are multiple distinct obligations or a single obligation. Using multiple methods of measuring progress for the same performance obligation is not appropriate. Therefore, for a single performance obligation, regardless of the number of goods or services and payment streams, the entity is required to identify a single measure of progress that appropriately depicts its progress toward complete satisfaction of that performance obligation.

Should it prove difficult to identify a single measure of progress that accurately determines progress toward satisfaction due to the number of goods and services that make up the performance obligation, the entity may need to reassess the performance obligations identified in the contract to see if there are more performance obligations than originally identified. If so, each performance obligation can be taken on its own merit when determining the appropriate method to use for revenue recognition.

In addition, when determining the appropriate method for measuring progress, an entity should be aware that the standard requires them to apply the same method to all similar performance obligations in similar circumstances.

Subsequent Measurement of Measure of Progress

Since estimates of an entity’s level of progress will change as the performance obligation is fulfilled, such estimates should be updated with the most current information available. Changes in estimates should be accounted for in a manner consistent with the guidance on accounting changes which states that changes in accounting estimates shall be accounted for in the period affected by the change and in future periods if the change affects both. This does not refer to a change in scope or price, but rather a change in an accounting estimate, so the new revenue standards for contract modifications would not apply.

For example: A company contracts for a fixed price of $2,000,000 and the entity concludes that a cost to cost revenue approach should be used for revenue recognition. To date, costs incurred total $450,000 with a total cost estimate of $900,000. If the total cost estimate is dropped to $800,000, the revenue would need to be adjusted to reflect the new estimate as shown here:

• Revenue recognized to date = ($450K/$900K) * $2M = $1M
• Adjusted revenue based on new estimate = ($450K/$900K) * $2M = $1.125M
• Increase in revenue recognized due to change in estimate = $125K.

Oracle Projects functionality allows for the automatic recalculation of recognized revenue. Oracle Projects posts the change to the total to be recognized ($125K) in the current accounting period. In addition, future revenue streams are calculated using the new accounting estimate, per the new Standards requirements.

Reasonable Measure of Progress

In some circumstances an entity may not be able to reasonably measure progress toward completion as it lacks the reliable information required to apply an appropriate method of measuring progress (such as a long-term contract). In some circumstances, an entity may not be able to reasonably measure progress but expects to recover the costs incurred in satisfying the performance obligation.

In those instances, the entity should recognize revenue for its progress by recognizing revenue solely in the amount of the costs incurred. This will result in a net margin of zero. This would only be appropriate until such time that the entity can reasonably measure progress or until the performance obligation becomes too arduous.

When the new revenue standard was being developed, the Board used legacy GAAP as well as measures of progress used in current practice. Two measures of progress were carried forward in the new standard and will be addressed in detail in a future release in this series.

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