ASC 606 Over-Time Revenue: Measuring Progress, a Cost-to-Cost Example and Audit Tests

Once a performance obligation qualifies for over-time recognition, the revenue number depends entirely on the measure of progress. That measure is an estimate: a percent complete multiplied by a transaction price. This post covers the choice between input and output methods, a cost-to-cost example that includes costs that must be excluded and a change in estimate, and the audit tests. For contractors, see construction contractor audits under ASC 606 and estimate to complete and loss contracts.

When is revenue recognized over time?

Paragraph 606-10-25-27 allows over-time recognition if one of three criteria is met: the customer simultaneously receives and consumes the benefits as the entity performs; the entity's performance creates or enhances an asset the customer controls as it is created; or the performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. If none is met, revenue is recognized at a point in time. Audit the criterion first, then the measure.

What does the standard require for measuring progress?

• The objective is to depict the entity's performance in transferring control (606-10-25-31).
• One method is applied to each performance obligation and applied consistently to similar obligations and circumstances, with progress remeasured at the end of each period (25-32).
• Appropriate methods are output methods and input methods, chosen by considering the nature of what is promised (25-33).
• Goods or services for which control does not transfer are excluded from the measure; those for which it does are included (25-34).
• Changes in the measure are changes in accounting estimate under ASC 250 (25-35).
• Revenue is recognized only if progress can be reasonably measured (25-36). In early stages, when the outcome cannot be measured but costs are expected to be recovered, revenue is recognized only to the extent of costs incurred (25-37).

What are output and input methods?

Output methods (55-17) use direct measures of value transferred: surveys of performance, appraisals, milestones reached, time elapsed, units produced or delivered. They fail if the output ignores work in process the customer already controls. As a practical expedient (55-18), when the entity has a right to consideration that corresponds directly with value delivered to date, such as a fixed rate for each hour of service, it may recognize revenue at the amount it has a right to invoice.

Input methods (55-20) use the entity's efforts relative to total expected inputs: resources consumed, labor hours, costs incurred, time elapsed, machine hours. If inputs are expended evenly, straight-line may be appropriate. Paragraph 55-21 warns that inputs may not track transfer of control, and requires excluding inputs that do not depict performance. For a cost-based method, adjust for costs that do not contribute to progress (wasted materials, labor or other resources from significant inefficiencies not reflected in the price) and costs not proportionate to progress.

Worked example

A services firm signs a fixed-fee implementation for $600,000 satisfied over time, using cost-to-cost. At year-end, costs incurred are $260,000, of which $20,000 is rework from a staff error that the contract price did not anticipate. Total estimated cost at completion is $400,000, excluding that rework. Billings to date are $330,000.

The $20,000 of rework is excluded under 55-21(a). Progress is $240,000 / $400,000 = 60%. Revenue to date is 60% x $600,000 = $360,000. The rework is expensed as incurred but does not advance revenue.

What happens when the estimate changes?

In the next year, cumulative costs counted toward progress reach $330,000 and the estimate at completion rises to $450,000. Progress is $330,000 / $450,000 = 73.33%. Cumulative revenue is 73.33% x $600,000 = $440,000, so current-year revenue is $440,000 - $360,000 = $80,000. Under 25-35, this is a change in estimate, recognized in the period of change and not a restatement. The auditor's job is to decide whether the $400,000 estimate was reasonable on the information available at the prior year-end. Information that was available then and ignored may be an error, not an estimate change.

Audit procedures

Frame the work as an accounting estimate under AU-C 540, with revenue a presumed fraud risk under AU-C 240.

Testing the method

1. Confirm the over-time criterion in 25-27 is met by reading the contract, with particular attention to the right to payment for performance completed to date.
2. Obtain management's rationale for the method and compare it to the nature of the obligation. An input method suits work where effort tracks value; an output method suits milestone or unit deliverables. Check the same method is used for similar contracts and carried forward from prior periods.

Testing costs incurred

3. Reconcile the job cost ledger to the general ledger and the cost-to-cost schedule.
4. Vouch a sample of costs to invoices, timesheets and payroll records. For labor, test the rate and the allocation across jobs; labor moved onto an over-running contract to avoid a loss is a known manipulation.
5. Test cutoff on both sides: unrecorded costs at year-end understate progress, early recording of costs for work not yet performed overstates it.
6. Identify costs that do not depict progress under 55-21: abnormal waste, rework, and costs of goods the customer does not yet control. Ask for the schedule of such items and test it.

Testing the estimate at completion

7. Obtain the budget-to-actual by cost category and the approved estimate at completion. Compare the prior-year estimate to actual cost for contracts that finished. A pattern of upward revisions after year-end is a bias indicator; see retrospective review of prior-year estimates.
8. Interview the project lead and the finance lead separately. Compare their assessment of remaining work to the estimate, and read project status reports, change orders and customer correspondence for scope or schedule issues.
9. Test subsequent costs through the date of the report against the remaining estimate.
10. Recompute percent complete and revenue for every contract tested and tie the totals to the contract asset and liability balances. See WIP schedule testing of over and under billings for the balance sheet side.
11. Evaluate loss exposure: if estimated total cost exceeds the transaction price, assess the need for a loss provision under the guidance that applies to the contract type.

Frequently asked questions

Can a firm use cost-to-cost for some contracts and milestones for others?

Yes, if each obligation uses one method and the method is applied consistently to similar obligations in similar circumstances (25-32). Dissimilar obligations can use different methods.

What if the outcome cannot be measured early in the contract?

Paragraph 25-37 allows revenue only to the extent of costs incurred, as long as those costs are expected to be recovered.

Sources

• FASB, Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606), paragraphs 606-10-25-27, 25-31 to 25-37 and 55-16 to 55-21: https://viewpoint.pwc.com/dt/us/en/fasb_financial_accou/asus_fulltext/2014/asu_201409revenue_fr/asu_201409revenue_fr_US/asu_201409revenue_fr_US.html
• AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures: https://www.aicpa-cima.com/resources/landing/aicpa-professional-standards

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error