15.2 Allocation and Satisfaction of Performance Obligations

15.2 Allocation and Satisfaction of Performance Obligations

Once an entity has identified the performance obligations and determined the transaction price under ASC 606, it must perform the final two steps of the revenue recognition process: Step 4 (allocating the transaction price to the performance obligations) and Step 5 (recognizing revenue as those obligations are satisfied). This section details the methodologies for relative standalone selling price allocation, the determination of over-time versus point-in-time revenue recognition, and the accounting for long-term construction contracts.

---

Step 4: Allocate the Transaction Price to the Performance Obligations

The transaction price must be allocated to each performance obligation identified in a contract based on the relative standalone selling price (SSP) of the underlying goods or services at contract inception. The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer.

Determining Standalone Selling Price

The best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers.

If a standalone selling price is not directly observable, the entity must estimate it. ASC 606 permits three primary estimation methods:

1. Adjusted Market Assessment Approach: The entity evaluates the market in which it sells the goods or services and estimates the price that a customer in that market would be willing to pay. This approach often involves referencing prices of competitors for similar goods or services and adjusting those prices to reflect the entity's costs and market share.
2. Expected Cost Plus a Margin Approach: The entity forecasts its expected costs of satisfying a performance obligation and adds an appropriate margin for that good or service. This is commonly used for customized products or services where market data is sparse.
3. Residual Approach: The entity estimates the standalone selling price by referencing the total transaction price minus the sum of the observable standalone selling prices of other goods or services promised in the contract.
   • Strict Restriction: The residual approach is permitted only if the entity sells the same good or service to different customers for a broad range of amounts (highly variable) or if the entity has not yet established a price for that good or service and it has not been sold on a standalone basis (highly uncertain).

Allocation of Discounts and Variable Consideration

Discounts and variable consideration are generally allocated proportionally to all performance obligations in the contract based on their relative standalone selling prices. However, if there is observable evidence that the discount or variable consideration relates to only one or some specific performance obligations, it must be allocated only to those obligations.

Relative Standalone Selling Price Calculation Example

An entity enters into a contract to sell a bundle containing a hardware device, a software license, and a one-year maintenance plan for a total package price of $1,200. The observable standalone selling prices are:

• Hardware: $800
• Software: $400
• Maintenance: $300
• Total Standalone Selling Price: $1,500
• Total Bundle Discount: $300 ($1,500 - $1,200)

The transaction price is allocated as follows:

---

Step 5: Satisfy Performance Obligations and Recognize Revenue

An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service (which is an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Control is the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.

Revenue Recognition Over Time

An entity recognizes revenue over time if at least one of the following three criteria is met:

1. Simultaneous Consumption: The customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs (e.g., routine custodial services, payroll processing, or security services).
2. Customer-Controlled Asset: The entity's performance creates or enhances an asset (such as work in progress) that the customer controls as the asset is created or enhanced (e.g., building a factory on land owned by the customer).
3. No Alternative Use and Enforceable Right to Payment: The entity's 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.
   • No Alternative Use: The entity is restricted contractually or practically from directing the asset for another use.
   • Enforceable Right to Payment: If the customer terminates the contract for convenience, the entity has a right to be paid for costs incurred to date plus a reasonable profit margin.

Measuring Progress for Over-Time Recognition

For performance obligations satisfied over time, the entity must select a method that depicts the transfer of control.

• Input Methods: Revenue is recognized based on the entity's inputs or efforts (e.g., costs incurred, labor hours, machine hours) relative to the total expected inputs. The most common input method is the cost-to-cost method.
• Output Methods: Revenue is recognized based on direct measurements of value transferred to the customer (e.g., units produced, units delivered, milestones achieved).

Accounting for Long-Term Construction Contracts (Cost-to-Cost Input Method)

Under the cost-to-cost method, the percentage of completion is: Percentage of Completion = Cumulative Costs Incurred to Date / Total Estimated Project Costs

Journal Entries for Long-Term Construction

Assume an entity enters into a $1,000,000 contract to build a bridge over two years.

• Year 1: Costs incurred are $300,000; estimated remaining costs to complete are $500,000 (total estimated costs = $800,000). Progress is 37.5% ($300,000 / $800,000).
• Year 1 Billings: $350,000. Cash collected: $320,000.

1. To record construction costs incurred:

   Dr. Construction in Progress (CIP) (Asset)     300,000
     Cr. Cash / Accounts Payable / Materials               300,000
   

2. To record progress billings to the customer:

   Dr. Accounts Receivable                         350,000
     Cr. Billings on Construction Contract (Contra-Asset)  350,000
   

3. To record cash collections:

   Dr. Cash                                        320,000
     Cr. Accounts Receivable                               320,000
   

4. To record revenue and gross profit for Year 1:
   • Revenue to recognize = 37.5% * $1,000,000 = $375,000
   • Cost of sales = $300,000
   • Gross profit (added to CIP) = $375,000 - $300,000 = $75,000

   Dr. Construction Expenses                       300,000
   Dr. Construction in Progress (CIP)               75,000
     Cr. Construction Revenue                              375,000
   

Balance Sheet Presentation of Long-Term Contracts

At the end of Year 1:

• Construction in Progress (CIP) Balance: $300,000 + $75,000 = $375,000
• Billings on Construction Contract Balance: $350,000
• Net Position: $375,000 (CIP) - $350,000 (Billings) = $25,000 positive balance.
• Because the CIP balance exceeds Billings, the net amount of $25,000 is reported as a Contract Asset (under current assets) on the Balance Sheet. If Billings had exceeded CIP, the net amount would be reported as a Contract Liability (under current liabilities).

---

Revenue Recognition at a Point in Time

If a performance obligation is not satisfied over time, it is satisfied at a point in time. To determine the point in time at which control transfers, an entity considers the following indicators of control transfer:

• The entity has a present right to payment for the asset.
• The customer has legal title to the asset.
• The entity has transferred physical possession of the asset.
• The customer has the significant risks and rewards of ownership of the asset.
• The customer has accepted the asset.