Revenue Recognition

Accounting Standards Codification (ASC) 606 is the new revenue recognition standard affecting all entities getting into contracts with customers to transfer goods or services. These entities include the public, private, and non-profit entities and should be ASC 606 compliant. ASC 606 was developed by the Financial Accounting Standard’s Board (FASB) along with the International Accounting Standards Board (IASB). It provides the framework in which businesses should recognize revenue more consistently.

Before 2018, revenue was calculated in several ways, depending on the particular revenue recognition method applied by an institution. The most common revenue recognition approaches included the percentage-of-completion, completed contract, installment, and cost recovery methods. However, all the other ways were prohibited, leaving only percentage-of-completion, which follows a 5-step model framework.

In the percentage-of-completion method, revenue is either recorded under:

• percentage of completion cost-to-cost, which recognizes revenue as the cost incurred in the contract is incurred; or
• percentage of completion units-of-delivery, which recognizes revenue as the various units of the contract are delivered to a customer.

Revenue Calculation

The IFRS 15 and ASC 606 provide a 5-step model framework that has been in use since 2018. This revenue recognition method is in line with the percentage-of-completion method. It proposes the recognition of revenue in the following steps:

The Five-Step Model Framework

Step I: Identify the Contract(s) With a Customer

A contract is an agreement between two or more parties that provides enforceable rights and obligations. At this stage, a business entity should ensure that it has an agreement with a customer concerning the delivery of goods or services and the terms of payment.

Step II: Identify the Performance Obligations in the Contract

This step involves the assessment of the promised goods and services by a business entity. The entity identifies each promise to transfer good(s) or service(s). In fact, the promise, in this context, can include service(s) that is(are) distinct or a series of distinct goods or services that are mostly the same and have the same pattern of transfer to the customer.

Step III: Set the Transaction Price

A transaction price is the amount of consideration that a business entity expects to receive for the transfer of a product to a customer. At this stage, the business entity sets the transaction price for the performance obligations in the contract. The business entity determines that the terms of the consideration relate specifically to their efforts to transfer goods or services to the customer. Therefore, as each distinct service is completed within a specific timeline (daily or monthly), the consideration allocated to that period may be recognized.

Step IV: Allocate the Set Transaction Price to the Performance Obligations in the Contract

This step comes into play when a contract has more than one performance obligation. The business entity, in this instance, allocates the total amount of the transaction price to each performance obligation based on its relative stand-alone selling price (SSP). ASC 606 Standard permits any method of allocation of the SSP provided that the estimation is the accurate representation of what the price would be when the transactions are charged separatetly.

Step V: Recognize the Revenue upon Satisfaction of a Performance Obligation

Satisfaction of performance obligation occurs when (or as) control of the goods or services is transferred to the customer. Entities inolved in the transaction should determine whether each performance obligation in the contract is satisfied over time.  Any obligations that are not completed over time are assumed to be satisfied at a point in time. The revenue is then recognized upon satisfactory performance of the obligations.

Example: Percentage of Completion Cost-to-Cost

Company XYZ has a contract to build a machine for a total sales price of $5 million. It will take three years to build the machine, with costs estimated to be $3 million. The company estimates the percentage complete based on the expense incurred as a percentage of total estimated expenses. If at the end of year 1, company XYZ has spent $1 million, how much revenue will company XYZ recognize in year 1?

Solution:

After year 1,

Percentage completed = \( \frac{\text{Expense incurred}}{\text{Total estimated expenses}} = \frac{$1 \text{ million}}{$3 \text{ million}} = 0.33\)

Therefore, the revenue recognized in year 1 = 0.33 × $5 million = $1.67 million.

Question

Alcapo Ltd. is a construction firm based in the US. It has undertaken the long-term contract to build a warehouse for a client in 4 years for $12 million. The yearly costs of the project are given in the following table:

$$
\begin{array}{c|c}
\text{Year 1} & \text{\$2,000,000} \\
\hline
\text{Year 2} & \text{\$1,500,000} \\
\hline
\text{Year 3} & \text{\$1,500,000} \\
\hline
\text{Year 4} & \text{\$3,000,000} \\
\end{array}
$$

Alcapo’s net income for the 1st year of the project is closest to:

1. $1 million.
2. $2 million.
3. $3 million.

Solution

The correct answer is A.

According to the converged standard, the revenues and expenses are measured as the percentage of total costs incurred to date divided by the total costs of the project.

Total cost of the project (in $ million) = $2 + 1.5 + 1.5 + 3 = $8

Revenue for Year 1 = $2 million/$8 million × $12 million = $3 million

The cost of the project for the first year is $2 million.

Net income for Year 1 = $3 – $2 = $1 million