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Journal entry — Revenue — Redeliberations inch ahead

Published on: Oct 22, 2012

At their joint meeting last week, the FASB and IASB (the “boards”) continued redeliberating their November 2011 exposure draft (ED) Revenue From Contracts With Customers. During the meeting, the boards discussed the following topics: (1) contract modifications and (2) measuring progress toward complete satisfaction of a performance obligation.

Contract Modifications

In response to questions raised by constituents regarding the application of guidance on contract modifications to contract claims in which changes in price and scope are disputed or not approved, the boards tentatively agreed to clarify the requirements for recognizing revenue from contract modifications resulting from these contract claims by adding an illustrative example. While they did not approve specific clarifying language, they tentatively agreed on the following general approach to accounting for contract modifications:

  1. Assess whether a contract modification is enforceable. (The boards acknowledged that the approval of a contract modification could be in the form of written or oral acceptance or based on an entity’s customary business practice.)
  2. If the modification is enforceable, an entity would apply the ED’s guidance on contract modifications.

The boards instructed the staffs to draft an illustrative example to demonstrate the agreed-upon approach.

Editor’s Note: The boards acknowledged that “unpriced” contract modifications can be enforceable; however, the transaction price would be considered variable and subject to the ED’s guidance on the revenue constraint. The boards are expected to discuss the constraint guidance at a future meeting.

Further, to avoid inconsistent accounting between contract modifications that only affect the transaction price and other contract modifications, the boards tentatively decided to remove the guidance in paragraph 20 of the ED (which required that contract modifications resulting only in a change in transaction price be treated as variable consideration, generally necessitating full reallocation of the transaction price to all performance obligations). Rather, the boards agreed that all contract modifications resulting from a change in price, scope, or both should be evaluated in accordance with the ED’s remaining modification guidance. As noted in the FASB staff’s Summary of Board Decisions for the October 18 meeting, the boards tentatively agreed that paragraph 22(a) of the ED should be clarified to state that the transaction price available for allocation should be “the amount of consideration received from the customer but not yet recognized as revenue plus the amount of any remaining consideration that the customer has promised to pay that has not been recognized as revenue” (emphasis added). Finally, the boards tentatively decided to clarify that modifications, which are discussed in paragraph 22(a) of the ED, would generally be accounted for prospectively, while variable consideration related to satisfied performance obligations would be accounted for on a cumulative catch-up basis (in a manner consistent with the requirements in paragraphs 77–80 of the ED).

Measuring Progress Toward Complete Satisfaction of a Performance Obligation

During the meeting, the boards discussed concerns raised by contract manufacturers that the guidance in the ED would not allow them to use a “units of delivery” method for recognizing revenue on the sale of goods and would require them to instead recognize revenue as they produce each good for a customer. The boards discussed various alternatives that would allow the use of such a method in certain circumstance but ultimately tentatively decided to make no change to the guidance on measuring progress toward complete satisfaction of a performance obligation. Therefore, when a performance obligation in a contract with a customer meets the criteria for revenue recognition over time (which would be the case in most contract manufacturer and other custom manufacturing arrangements), an entity would be precluded from recognizing revenue as units are delivered to the customer unless work in progress or undelivered finished goods are immaterial at a period end. Instead, the entity would have to select a method for measuring progress toward complete satisfaction of the performance obligation that depicts the transfer of control of the good or service over time to the customer (i.e., as the good is being produced).

Editor’s Note: As a result of the boards’ decisions on measuring progress toward complete satisfaction of a performance obligation (as described above), contract manufacturers, suppliers of customized products, and other similar manufacturers may see a dramatic change in the manner in which revenue is recognized for contracts with their customers. If an entity’s obligation to produce a customized product meets the criteria in paragraph 35 of the ED for revenue recognition over time (the entity’s performance does not create an asset with an alternative use and the entity has right to payment for performance to date if the customer terminates the contract), revenue related to that product would be recognized as the product is produced, not when the product is delivered to the customer.

For example, an entity that has a contract with an original equipment manufacturer (OEM) to produce a customized part for the OEM’s product would probably meet the criteria for revenue recognition over time (the customized part probably has no alternative use other than as a part on the OEM’s product, and the contract most likely ensures the entity’s right for payment for performance to date if the OEM terminates the contract). The entity would then be required to select a method of recognizing revenue over time that most faithfully depicts the entity’s performance to date for producing the product. Such methods may include units produced (if the entire contract is deemed a single performance obligation) or other measures of progress to completing production of the product (such as percentage of labor hours or costs complete). Therefore, under the proposed guidance, the entity would recognize revenue (and relieve inventory to cost of goods sold) as the products are produced rather than when the product is delivered to the customer (which is when revenue is generally recognized under current U.S. GAAP).

Entities with these type of contracts that ship products to customers immediately after production may not see as dramatic a change in the manner in which revenue is recognized (or the impact may not be material); however, other entities that maintain finished customer goods for a certain time after production could see a more dramatic change since revenue and the related cost of goods sold would be recognized much earlier than they are under existing guidance.

It is unclear whether the boards will discuss this topic further.

The boards also discussed the ED’s guidance on recognizing revenue for uninstalled materials and the impact of costs for wasted materials and other inefficiencies on measuring progress toward complete satisfaction of a performance obligation. The boards tentatively decided to refine the illustrative example and guidance on uninstalled materials to help entities apply the cost-to-cost measure of progress method of revenue recognition. Further, the boards tentatively agreed to clarify the ED to emphasize the objective of measuring progress toward complete satisfaction of a performance obligation (in paragraph 38 of the ED). The boards specifically acknowledged that if an input method such as cost-to-cost is used, an entity would need to adjust the cost-to-cost calculation if some of the costs incurred do not contribute to the progress in the contract (i.e., clearly state that costs related to wasteful materials should not be included in an entity’s cost-to-cost calculation since this would skew the recognition of revenue).

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