Partially Satisfied Performance Obligations at Contract Inception

In some arrangements, an entity performs activities that transfer control of goods or services to a customer prior to having a formalized contract with the customer that meets the requirements listed under Step 1: Identify the contract with a customer. Revenue for these partially completed performance obligations cannot be recognized until the contract is established. There has been some discussion regarding how revenue should be recognized when performance obligations are partially satisfied before the contract establishment date.

This article outlines two potential revenue recognition patterns for partially satisfied performance obligations at contract inception and demonstrates how revenue would be recognized under the method we believe is most appropriate. The article also discusses how to account for the costs resulting from activities performed before contract inception that relate to the transfer of a good or service to a customer.

Recognizing Revenue from Partially Satisfied Performance Obligations at Contract Inception

The date on which the criteria for a contract under ASC 606-10-25-1 are met is referred to in this article as the contract establishment date (CED). Activities performed by an entity before the CED are referred to as “pre-CED activities.” Three primary types of pre-CED activities exist:

Administrative activities that do not result in transferring control of goods or services to a customer or fulfilling the anticipated contract
Activities, such as set-up costs, to fulfill an anticipated contract that do not result in transferring control of goods or services to the customer
Activities performed before the CED that result in goods or services being transferred to the customer once the contract is established.

The first two types of activities do not transfer goods or services to a customer and should not have any revenue allocated to them. This article deals with the accounting treatment for the third type of pre-CED activities. Below are examples from Transition Resource Group (TRG) Memo No. 33 that illustrate the issue:

Example 1: Contract Manufacturer

A manufacturer enters into a long-term contract with a customer to manufacture a highly customized good. The customer issues purchase orders for 30 days of supply on a rolling calendar basis (that is, every 30 days, a new purchase order is issued). Purchase orders are non-cancellable, and the manufacturer has a contractual right to payment for all work in process for goods once an order is received. The manufacturer will pre-assemble some goods to meet the anticipated demand from the customer based on a non-binding forecast provided by the customer. At the time the customer issues a purchase order, the manufacturer has some goods on hand that are completed and others that are partially completed. The entity has determined that each customized good represents a performance obligation satisfied over time because the customized goods have no alternative use and the manufacturer has an enforceable right to payment once it receives the purchase order (Accounting Standards Codification (ASC) 606-10-25-27(c)).

Example 2: Real Estate Developer

An entity begins constructing an apartment building and pre-sells 60 percent of the units. In this particular territory, the contracts satisfy the criteria for a performance obligation satisfied over time in accordance with ASC 606-10-25-27(c).

The remaining 40 percent of the units are constructed for inventory. After construction of the common areas and the shells of all the rooms have been completed, the entity enters into a new contract with a customer to sell one of the remaining units on the same terms as the original contracts. Thus, at inception of the new contract, a portion of the new customer’s unit has already been constructed.

The preferred method of revenue recognition includes a cumulative catch-up adjustment in which the entity recognizes revenue for the portion of the good or service that has been transferred to the customer. In the first example, this is the inventory that has been created in anticipation of the contract. In the second example, it is the percentage of the contracted-for apartment that is completed at the CED. In the Real Estate Developer example, after the catch-up adjustment, the amount of revenue recognized for the new contract would be the same percentage of total revenue as the original contracts.

As an illustration, assume the real estate company determines that when the remaining 40 percent of the units are sold (the CED), it has already completed 30 percent of each unit. If the total transaction price for those units is $10,000,000, the company would recognize $3,000,000 at the CED. This amount reflects revenue for the portion of the units for which control has effectively transferred to the customer as of contract inception, rather than merely a mechanical catch-up adjustment. The remaining $7,000,000 would then be recognized over time as the entity continues to satisfy the performance obligation.

The treatment of the costs incurred to perform these pre-CED activities that transfer a good or service to the customer is another issue resulting from such situations. Generally, the most appropriate method is to capitalize such costs as costs to fulfill an anticipated contract. The costs are then immediately expensed at the CED if they relate to performance obligations that have been transferred to the customer. This would be the case in both examples given above.

Diversity in Thought

This issue was discussed by the FASB’s Transition Resource Group at its March 2015 meeting during the implementation of ASC 606 and continues to provide useful interpretive guidance for how entities should account for pre-contract activities.

In the memo that addressed this topic, two issues were presented and discussed.

Issue 1: How should revenue arising from pre-CED activities be recognized?
Issue 2: How should an entity account for fulfillment costs incurred before the CED?

Issue 1: Pre-CED Activities

View A: Cumulative Catch-Up Method

This view supports the cumulative catch-up method as outlined above. Proponents of this view believe that it is most consistent with the standard’s goal to depict the transfer of goods and services. The cumulative catch-up method reflects that, as with the CED, control of some of the goods or services has already passed to the customer.

View B: Prospective Revenue Recognition

This view states that an entity should recognize revenue on a prospective basis, beginning to measure progress toward completion of performance obligations only after the contract establishment date (CED) and disregarding pre-CED activities. Proponents of this view cite ASC 606-10-25-8, which references transferring “goods or services in the future,” and interpret this to support recognizing revenue only for performance occurring after the CED. Under this approach, a catch-up adjustment is viewed as inconsistent with recognizing revenue over time.

The cumulative catch-up method (View A) more faithfully represents the transfer of control of goods or services to the customer. The prospective approach does not fully reflect the portion of goods or services already transferred as of the CED. The reference to “goods or services in the future” is more appropriately interpreted in the context of contract liabilities, rather than as a basis for excluding pre-CED performance from revenue recognition.

A catch-up adjustment is not inconsistent with recognizing revenue over time. In these scenarios, a portion of the goods or services has already been transferred to the customer at the CED, with the remainder transferred over time. Accordingly, revenue recognition should reflect both the immediate transfer of control at contract inception and the ongoing transfer thereafter.

Issue 2: Fulfillment Costs Incurred Prior to the CED

Most members of the TRG concluded that View A represents the most appropriate accounting for fulfillment costs incurred prior to the contract establishment date (CED). This conclusion is based on the premise that pre-CED activities do not change the underlying performance obligations in the contract. If the performance obligations are the same as those in an identical contract without pre-CED activities, then costs should be recognized in a manner consistent with the transfer of control of the related goods or services.

View A: Capitalize, Then Expense at the CED

Under this view, costs are capitalized as costs to fulfill an anticipated contract. These costs are then expensed at the CED to the extent they relate to goods or services already transferred to the customer. Any remaining capitalized costs are amortized over the period in which the remaining goods or services are transferred (for example, a capitalized commission cost would still be amortized over the full contract period).

This approach is consistent with ASC 340-40-25-8, which requires costs related to satisfied (or partially satisfied) performance obligations to be recognized as an expense. Because a performance obligation is not identified until the CED, qualifying costs may be capitalized prior to that date. However, once the contract is established, any portion of those costs related to goods or services already transferred should be recognized immediately. Additionally, ASC 340-40-35-1 requires that capitalized costs be amortized on a systematic basis consistent with the transfer of goods or services, supporting immediate expense recognition for the portion satisfied at the CED.

View B: Capitalize and Amortize Prospectively

Under this view, costs are capitalized as costs to fulfill an anticipated contract and amortized over the period in which the remaining goods or services are transferred. This approach aligns with prospective revenue recognition, under which performance obligations are considered to consist only of activities occurring after the CED. As a result, no immediate expense recognition occurs at contract inception.

View C: Expense as Incurred

Under this view, costs are expensed as incurred because they relate to activities performed prior to obtaining a contract and do not contribute to satisfying future performance obligations. Unless the costs qualify for capitalization under other guidance (such as inventory), they are not eligible for capitalization under ASC 340-40-25-5(b), which requires that costs relate to future performance. However, because a performance obligation is not identified until the CED, pre-CED activities cannot be considered to satisfy a performance obligation prior to that date.

Conclusion

When companies have partially completed performance obligations at the CED, a cumulative catch-up adjustment for the completed portion, followed by recognition of the remaining revenue over time as the entity continues to satisfy the performance obligation, is generally the most appropriate accounting treatment. Although other views have been expressed, most TRG members support the cumulative catch-up approach.

Editor’s Note

This article reflects guidance under ASC 606, Revenue from Contracts with Customers, as currently codified, including subsequent amendments. While originally published in January 2016, the concepts discussed remain relevant, as ASC 606 has not undergone substantive changes affecting the topics involved in this article.

Resources

ASC 606-10-25-1, 8, 27(c)
ASC 340-40-25-1, 5(b)
FASB TRG Memo 33: "Partially Satisfied Performance Obligations." 30 March 2015