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Revenue accounting reset – Recognizing revenue · PwC's accounting podcast

0:00
SPEAKER_00: Thought leadership from PWC's National Office.
0:06
SPEAKER_03: Hello, and welcome to PWC's Accounting Podcast.
0:10
SPEAKER_03: I'm Heather Horn.
0:11
SPEAKER_03: Today we're kicking off a new Revenue Accounting miniseries.
0:15
SPEAKER_03: And helping us break down this complex topic are Pat Gerbin and Mike Coleman, both from PWC's National Office.
0:22
SPEAKER_03: Also joining us again today.
0:24
SPEAKER_03: I'm happy to turn things over to guest host Diana Stoltzfiss, frequent podcast guest and also a partner in our national office.
0:32
SPEAKER_03: With that, over to Diana.
0:36
SPEAKER_04: So today we're going back to basics on revenue recognition, covering the last step in the five-step model, recognize revenue.
0:44
SPEAKER_04: I have Pat and Mike with me here today to help navigate the accounting guidance in this area, including areas where we tend to see the most questions and areas requiring significant judgment.
0:54
SPEAKER_04: So today, Pat, maybe I'll start with you.
0:56
SPEAKER_04: So we're going to focus on step five of the ASC model.
1:01
SPEAKER_04: But maybe before we dive into step five, you can give us an overview of the model overall.
1:07
SPEAKER_01: Sure.
1:07
SPEAKER_01: So as you alluded to, there's the five-step framework and ASC 606, the revenue standard.
1:14
SPEAKER_01: So step one is identifying the contract, essentially identifying what the party's rights and obligations are.
1:21
SPEAKER_01: Step two is identifying the performance obligations.
1:25
SPEAKER_01: What really did the vendor promise to do for the customer?
1:28
SPEAKER_01: And that's really important because performance obligations are sort of the building block of the whole revenue model.
1:34
SPEAKER_01: Step three is determine the transaction price.
1:37
SPEAKER_01: So how much does the vendor expect to be paid for doing the work that it agreed to do?
1:42
SPEAKER_01: Step four is allocating that transaction price to the performance obligations in the contract.
1:47
SPEAKER_01: And then we get to step five, which we'll talk more about today, which is actually recognizing revenue.
1:53
SPEAKER_01: And the objective there is to really attempt to depict the entity's performance in satisfying its performance obligations.
2:01
SPEAKER_01: And I think that's a key concept is really how do we best depict the transfer of these promised goods and services to our customers in an amount that reflects the consideration that we expect to be paid.
2:14
SPEAKER_01: That final step, step five, is based on the principle of control.
2:18
SPEAKER_01: When do we transfer control of the value we're providing to the customer?
2:24
SPEAKER_01: So it could be a good or a service, and that could happen over time or it could happen at a point in time, but that is when we recognize revenue.
2:32
SPEAKER_04: Okay.
2:33
SPEAKER_04: That's really helpful.
2:34
SPEAKER_04: Thank you, Pat.
2:35
SPEAKER_04: So you mentioned that this control principle is really critical in determining, you know, when we recognize revenue.
2:42
SPEAKER_04: So maybe you can talk to us a little bit more about like what does control mean in this context?
2:48
SPEAKER_01: Sure.
2:48
SPEAKER_01: And so I think that's, I mean, just again, probably repeat this a lot, but the the control principle is when we transfer control, that's the point at which we recognize revenue.
2:58
SPEAKER_01: As it's defined in the standard, the revenue standard, we have lots of control definitions and gaps, so it's important to know which one we're talking about.
3:05
SPEAKER_01: So in the the revenue context, the customer obtains control of good or service if it has the ability to direct the use of and obtain substantially all of the remaining benefits from that good or service.
3:20
SPEAKER_01: Whether and when the customer has obtained those rights and benefits is not always straightforward and sometimes requires us to make some judgments.
3:29
SPEAKER_01: But before we even get to that question of whether or when control has transferred, we first have to figure out how control will transfer for the particular type of performance obligation we're talking about.
3:42
SPEAKER_01: I mentioned before it could be over time or at a point in time.
3:46
SPEAKER_01: That's essentially our choices that the standard gives us.
3:50
SPEAKER_01: And it's a little weird because a lot of times you might think, well, it's pretty straightforward if it transfers at a point in time, but then there's some special things I'll have to think about if it might be over time.
3:59
SPEAKER_01: The way the standard's actually set up, it requires you to sort of figure out, well, does it transfer over time?
4:05
SPEAKER_01: If not, you sort of default to point in time.
4:08
SPEAKER_01: And we'll get into that a little bit later.
4:11
SPEAKER_01: But essentially the perform the performance obligations are satisfied over time.
4:15
SPEAKER_01: There are three sets of conditions where if any of those conditions are met, you're deemed to have a performance obligation that's satisfied over time.
4:24
SPEAKER_01: It's not optional, it's just that's a fact.
4:26
SPEAKER_01: Um, if none of those are present, then you have a performance obligation that transfers at a point in time.
4:32
SPEAKER_01: A couple of key reminders.
4:35
SPEAKER_01: Um, we're thinking about this from the customer's perspective.
4:39
SPEAKER_01: So when does the customer receive the right or the benefit of the good or service?
4:45
SPEAKER_01: Um, and that's important because what we don't want to have happen is recognizing revenue just by the company doing things that don't really actually transfer value to the customer.
4:58
SPEAKER_01: And then the other important point, and we reiterate this a lot, there are oftentimes contractual provisions that when you get to a certain point in the process, entitles you to bill the customer, entitles you to get paid.
5:11
SPEAKER_01: Ultimately, that is important, but that is not the most important principle for recognizing revenue.
5:17
SPEAKER_01: We're really trying to measure the entity's performance.
5:19
SPEAKER_01: So it's about when the entity does the work and performs, not simply when they have the right to get paid.
5:25
SPEAKER_04: Okay.
5:26
SPEAKER_04: I think that's that's a really helpful and important point to make.
5:29
SPEAKER_04: So thanks, Pat.
5:30
SPEAKER_04: So I guess we'll come back to the three criteria that you mentioned to evaluate if control transfers over a period of time.
5:38
SPEAKER_04: But maybe, Mike, I'll turn to you first and maybe you can talk about some of the considerations we need to think about when recognizing revenue at a point in time.
5:46
SPEAKER_02: Sure.
5:46
SPEAKER_02: So to Pat's point, it's about control and assessing the point in time control transfers.
5:53
SPEAKER_02: Uh sometimes it's obvious that control transfers in accordance with what the principal says to direct the use and obtain the benefit of the asset.
6:03
SPEAKER_02: Um, but there are cases where it's not so obvious.
6:07
SPEAKER_02: And the standard does provide factors or indicators to evaluate that help you determine whether control or when control transfers.
6:17
SPEAKER_02: Um the indic these are indicators and they're not required requirements.
6:21
SPEAKER_02: So you don't have to meet all of them before you can say control transfers.
6:26
SPEAKER_02: And the indicators are as follows.
6:29
SPEAKER_02: So an entity has a present right to payment, uh, the customer has legal title, the customer has physical possession, uh, the customer has significant risk and rewards of ownership, and the customer has accepted the asset.
6:43
SPEAKER_02: Now, as Pat uh mentioned, the important thing to keep in mind is that the objective is to depict the entity's performance in transferring the good or service, not when the entity is entitled to receive payment.
6:55
SPEAKER_02: So the present right to receive payment is an indicator, but again, it's not determinative, so you have to look at those indicators holistically.
7:02
SPEAKER_04: Okay.
7:03
SPEAKER_04: So you mentioned there's these five different indicators.
7:06
SPEAKER_04: It doesn't sound, you know, it's not like you have to meet three of the five or something like that for it to you know to meet the criteria to recognize the revenue.
7:14
SPEAKER_04: But are there any of these factors that maybe carry more weight in practice or are they all weighted equally?
7:19
SPEAKER_04: How would you think about these different considerations?
7:21
SPEAKER_02: Aaron Powell Yeah.
7:22
SPEAKER_02: So so again, it's once you consider the principle to direct the use, obtain the benefit of the asset, and you start looking at some of the indicators and evaluing them, um, there really isn't a weighting that the standard standard has.
7:37
SPEAKER_02: So it's all going to depend upon the specific company facts and circumstances.
7:42
SPEAKER_02: Now, having said that, title transfer is typically an important indicator, um, both because title conveys ownership, but then with ownership, there's a lot of rights that go along with ownership that influence whether a customer can direct that asset or direct the use of that asset or get the benefits.
8:03
SPEAKER_02: So oftentimes title is looked at.
8:06
SPEAKER_02: Again, it's not determinative, it's not more significant, but there it is a focus of that.
8:11
SPEAKER_02: Now, having said that, where title and possession are um you know focused on, there are cases where control can transfer when the customer doesn't have physical possession yet.
8:25
SPEAKER_02: So there are bill and hold transactions where uh that would be it could be a case where the control is transferred but the customer doesn't have the possession of it.
8:35
SPEAKER_02: Right.
8:35
SPEAKER_02: And on the other side, we're there are consignment arrangements where the customer has possession um but control hasn't transferred yet.
8:44
SPEAKER_02: So again, it's going to be facts and circumstances specific.
8:50
SPEAKER_02: And then on top of those indicators, you need to look at things like repurchase rights that can limit the customer's ability to direct the use the asset, and then acceptance clauses too.
9:02
SPEAKER_04: Aaron Ross Powell Okay.
9:03
SPEAKER_04: So maybe a little bit more complicated than than maybe you would initially think.
9:06
SPEAKER_04: So maybe you can talk about what are some of the common questions or challenges that we hear from teams when they're evaluating this point-in-time recognition.
9:15
SPEAKER_02: Aaron Ross Powell Yeah.
9:16
SPEAKER_02: So the questions we get typically align to the type of performance obligation that's being transferred.
9:24
SPEAKER_02: So for goods, we'll get questions along the lines of applying like a bill and hold criteria or a consignment arrangement.
9:34
SPEAKER_02: For services, we typically get different questions about point-and-time services and when control transfers.
9:43
SPEAKER_02: Because when you look at the indicators, so if it's not obvious and you look to those indicators, those indicators sound very product specific.
9:52
SPEAKER_02: Title transfer, possession.
9:55
SPEAKER_02: And the guidance basically says this is control for an asset, and it states a service can be an asset for this purpose.
10:04
SPEAKER_02: So you're looking at it for both point-in-time services and and you're looking at it for uh point-in-time products.
10:10
SPEAKER_02: So we get questions because they sound very tangible products.
10:15
SPEAKER_02: So people are like, okay, what do I do in the service?
10:17
SPEAKER_02: How do I think about that?
10:18
SPEAKER_02: Right, exactly.
10:19
SPEAKER_02: Um and then last, we'll get questions for licensing.
10:23
SPEAKER_02: Now licensing is a little different because licensing, as far as whether it's point in time or overtime, there's specific guidance and it depends upon the type of intellectual property that's being licensed.
10:36
SPEAKER_02: So um for the IP, if it's functional IP, so think of IP that has a standalone value that does something like software, like media licenses or drug formulas.
10:49
SPEAKER_02: That's functional IP and that transfers at a point in time.
10:53
SPEAKER_02: Uh versus symbolic IP, and think of brands, logos, uh franchise rights.
11:00
SPEAKER_02: That's recognized over time because that IP doesn't have significant standalone functionality, and its utility comes from the licensor's past and ongoing activities.
11:11
SPEAKER_02: So control to that transfers over time.
11:13
SPEAKER_04: Okay, that's great.
11:14
SPEAKER_04: Thanks, Mike.
11:15
SPEAKER_04: Um maybe Pat will shift back to you now.
11:17
SPEAKER_04: And you had mentioned earlier that there's three criteria that a seller needs to think about when they're they're determining how control transfers and this evaluation of whether control is transferring over time or at a point in time.
11:30
SPEAKER_04: Maybe can you talk to us a little bit more about those criteria?
11:34
SPEAKER_01: Yep.
11:34
SPEAKER_01: And um maybe I said this at the beginning.
11:36
SPEAKER_01: I know I said that performance obligations were the building block of the standard, but we have to make this assessment for every performance obligation.
11:43
SPEAKER_01: So you could have a contract that has multiple performance obligations, you have to do this for each of the performance obligations.
11:49
SPEAKER_04: And they could have a different conclusion for each of them.
11:51
SPEAKER_01: That's correct.
11:52
SPEAKER_04: Okay.
11:52
SPEAKER_01: So the three criteria that you have to evaluate for determining whether the performance obligation is satisfied over time.
12:00
SPEAKER_01: Um, and if none of those are met again, back to point in time, which we just talked through.
12:04
SPEAKER_01: Here are the three criteria.
12:06
SPEAKER_01: So the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs.
12:16
SPEAKER_01: So this is like the classic just service example.
12:19
SPEAKER_01: Um many services are going to fall in this category because as I do the work, the counterparty is in theory benefiting from my efforts.
12:28
SPEAKER_01: Um another concept in the standard is that if another vendor could hypothetically sort of take over the performance I already completed, they wouldn't have to re-perform.
12:38
SPEAKER_01: So that's the idea that the value has been transferred to the customer.
12:44
SPEAKER_01: The second uh criteria is criterion is that the entity's performance creates or enhances an asset that the customer controls.
12:54
SPEAKER_01: So if you think about it, like if they control the asset, anything I do to that asset, they have control of.
13:00
SPEAKER_01: So it's happening as I do the work.
13:03
SPEAKER_01: And the classic example of this is like I build a building on land that's owned by the customer.
13:08
SPEAKER_01: Well, they own the land, they own the building, as I build the building, they are you know benefiting from my efforts.
13:15
SPEAKER_01: Um, the third criterion, and this is the one that is sort of the a little bit of the catch-all for other things that feel like they're over time, um, but you know, don't fit in one of those first two categories, is the entity's performance creates an asset that has no alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date throughout the contract.
13:43
SPEAKER_01: So, an example of this would be something that I'm probably building inside my own facility, but it's very specific, highly customized to a customer's particular need.
13:54
SPEAKER_01: So we see this a lot in the contract manufacturing context, any sort of very highly customized specialized equipment.
14:02
SPEAKER_01: Um, that's where you're gonna meet this uh criterion.
14:06
SPEAKER_01: Um the the point on the um right to payment is an interesting one as well.
14:12
SPEAKER_01: And it's not just sort of that there's some termination payment if the contract were terminated.
14:17
SPEAKER_01: It means you're going to be entitled to payment, including you know, at the value you've uh delivered sort of on a selling price basis up to that point in time.
14:27
SPEAKER_01: And again, those are the three criteria you theoretically have to go through for every performance obligation before you conclude that none of those apply, and you go recognize revenue at at point in time.
14:38
SPEAKER_04: Okay.
14:39
SPEAKER_04: So, Mike, maybe back to you.
14:41
SPEAKER_04: Are there any common questions we see when we're evaluating these three different criteria?
14:47
SPEAKER_02: Yeah, the the last criterion is the one that gets the most focus as far as questions we get.
14:53
SPEAKER_02: And it's all centered around those highly customized uh products that are are created and manufactured and then eventually sold.
15:02
SPEAKER_02: Um, most manufacturers, or when you think of doing accounting for goods that are manufactured and sold, you think of a ship and bill type of accounting, a point in time where I transfer control of the good at the end to the customer, then I record revenue.
15:18
SPEAKER_02: So this gets a lot of discussion because it's different from what a typical manufacturer good, how the control would be transferred.
15:28
SPEAKER_02: So let's talk about two pieces of that criterion.
15:31
SPEAKER_02: First is the no alternative use, right?
15:34
SPEAKER_02: So this is is the vendor unable to redirect the asset to somebody else, either for contractual restrictions or for practical limitations.
15:44
SPEAKER_02: So think of a scenario where I'm building some type of equipment.
15:49
SPEAKER_02: Um maybe I it's specialized, but I do it for multiple customers.
15:55
SPEAKER_02: Not being able to have an alternative use might be contractually, once I start that particular one, I can't divert it anywhere else.
16:03
SPEAKER_02: Now, technically, ownership may not transfer, but it might not have alternative use to me because I can't divert it to somebody.
16:09
SPEAKER_02: If somebody needed one, I couldn't say, all right, I'm going to give you the one I'm working on and start another one for that customer.
16:16
SPEAKER_02: So that's the type of scenario where it may not have alternative use.
16:20
SPEAKER_02: The other would be if it's so unique that the only application for this good based upon its specifications is that customer.
16:29
SPEAKER_02: Now, in that judgment, you have to think about rework, right?
16:34
SPEAKER_02: So um, for example, if I was um you know producing PwC mugs and it had paint on it and then the PwC logo, but that's all it was.
16:46
SPEAKER_02: The question would be, well, is that unique enough such that um it has no alternative use?
16:52
SPEAKER_02: And the the cup manufacturer would have to say, well, no, if I can repaint it and do another customer, and that's not hard to do, it's not very costly, it wouldn't be unique enough where we say it has no alternative use.
17:06
SPEAKER_02: Right.
17:06
SPEAKER_02: So there's the contractual where I'm not allowed to give it to anybody, or the practical, which how much rework or how unique is it?
17:13
SPEAKER_02: And that's a judgment, and that's where we get some of our questions.
17:16
SPEAKER_02: Okay.
17:17
SPEAKER_02: Okay.
17:17
SPEAKER_02: And then the second one is the right to payment.
17:21
SPEAKER_02: And so this is the right to payment for performance to date.
17:24
SPEAKER_02: And the idea is the right to payment should be the proportionate selling price, right?
17:30
SPEAKER_02: So usually thinking cost plus margin.
17:34
SPEAKER_02: What happens a lot of times in contracts is there may be the right to have a cost recovery if something happens.
17:42
SPEAKER_02: So I've expended some cost making this unique equipment.
17:46
SPEAKER_02: If something happens to the contract or if there's some cancellation type of activity, am I entitled to cost recovery or am I titled to proportionate price, which typically includes profit?
17:59
SPEAKER_02: So that's a big distinction that we make.
18:02
SPEAKER_02: The standards notion is you're trying to protect the seller, and that protection for performance as they complete includes typically profit.
18:12
SPEAKER_02: Right.
18:13
SPEAKER_02: Then the question we always get, well, what if the contracts break even?
18:16
SPEAKER_02: Or what if the contract's had a law?
18:17
SPEAKER_02: So it doesn't have to have profit, but the idea is you're getting your proportional price.
18:23
SPEAKER_02: Okay.
18:23
SPEAKER_02: Right.
18:23
SPEAKER_02: So you're entitled to that as you as you go.
18:26
SPEAKER_02: Not be paid just the right to title it.
18:29
SPEAKER_02: Yes.
18:30
SPEAKER_01: So maybe just one point here, and I think Mike mentioned it, but you know, we talked a lot about tangible goods in the context of point-in-time recognition, but we also just talked about tangible goods in the context of overtime.
18:42
SPEAKER_01: So I think it's important to just sort of default to it's a tangible good, it's going to be point-in-time.
18:48
SPEAKER_01: You know, there are a lot of even relatively short cycle time tangible goods that the appropriate conclusion is they should be recognized over time as you're producing them.
18:58
SPEAKER_01: Um, anytime you have sort of a highly customized situation going on.
19:03
SPEAKER_01: Um maybe another point, sort of the counterpoint to that, I guess, is on services, which maybe intuitively feel like they're delivered over time.
19:12
SPEAKER_01: Um, we do get some questions about whether certain services should be recognized at a point in time, because sometimes it feels like, well, I'm probably not really going to have a happy customer or be entitled to payment if I don't complete the service.
19:26
SPEAKER_01: Um, so shouldn't I think of that more in the point-in-time context?
19:31
SPEAKER_01: So professional services offered by a consulting company, for example, might come up if there's like a final deliverable.
19:38
SPEAKER_01: Technically, yes, you might need to deliver that final deliverable to get paid, but you're doing the work along the way to produce that.
19:46
SPEAKER_01: You know, that's sort of the ultimate outcome, but there is, you know, value being transferred by the activities you're performing.
19:52
SPEAKER_01: And while, you know, even though probably contractually, in many cases, another vendor wouldn't necessarily be able to come in and sort of step into your shoes to finish, the concept is the work you're doing doesn't actually need to be redone.
20:06
SPEAKER_01: You are performing as as you move along, and you should be recognizing your performance as you perform, even if there's some sort of culminating event.
20:15
SPEAKER_01: Um we sometimes see this also in the transportation space where you've got sort of a load of oil on a tanker or something, you know, halfway across the ocean.
20:24
SPEAKER_01: Well, realistically, it's going to be hard for somebody to come in, offload that tank, or load it onto another one and take over.
20:30
SPEAKER_01: But nevertheless, you're you're delivering those services, you know, as you perform, as that journey is is occurring.
20:36
SPEAKER_04: Aaron Powell Maybe one question is around you talked about services and we're in the professional services profession.
20:43
SPEAKER_04: Um, how do you think about contingent fees?
20:45
SPEAKER_01: Aaron Powell So contingent fees we'd think of sort of in the context of variable consideration, which is one of the earlier steps in the model, but wouldn't really affect the timing of revenue recognition.
20:57
SPEAKER_01: So I think it's a good point just to highlight.
20:59
SPEAKER_01: We we said earlier being entitled to payment is ultimately important, but isn't really the driver of the pattern of revenue recognition.
21:08
SPEAKER_01: You need to make an estimate of what you expect to be paid, but then you recognize revenue as you perform, not just when you get paid or when you're entitled to be paid.
21:16
SPEAKER_04: Okay, I think that's really helpful.
21:18
SPEAKER_04: Thank you.
21:19
SPEAKER_04: So now maybe talking about uh sellers made a conclusion that the control transfers over time.
21:25
SPEAKER_04: How do you determine the right pattern to recognizing that revenue?
21:28
SPEAKER_04: Are there different methods to choose?
21:30
SPEAKER_04: Um, what what does the guidance say about that?
21:33
SPEAKER_01: Yeah, so the you're right.
21:34
SPEAKER_01: The next step then is to figure out if it transfers over time, like how, like what what's the pattern of that transfer?
21:42
SPEAKER_01: And the standard refers to identifying or determining a measure of progress, you know.
21:47
SPEAKER_01: So how how far along am I at completing this performance obligation?
21:52
SPEAKER_01: And in the old days we called that percentage of completion accounting.
21:55
SPEAKER_01: It was a special type of accounting reserved only for really long term contracts, but Similar concept applies.
22:01
SPEAKER_01: You're effectively trying to figure out, okay, how far along am I?
22:04
SPEAKER_01: I need to figure out what's an appropriate measure of progress.
22:08
SPEAKER_01: And there could be a lot of different appropriate measures of progress.
22:11
SPEAKER_01: The standard is not prescriptive.
22:13
SPEAKER_01: It gives us some examples and some things to think about in determining an appropriate measure of progress, but it's not, you know, it doesn't mandate a particular one.
22:24
SPEAKER_01: What is important though is you're supposed to use the one that best depicts your your progress.
22:30
SPEAKER_01: It's not really an accounting policy.
22:31
SPEAKER_01: You can't just say, well, I feel like doing this on a time-based measure, or I feel like doing this on a cost to cost measure.
22:38
SPEAKER_01: You have to be satisfied that that's the best measure of your progress.
22:43
SPEAKER_01: So broadly speaking, there are two types of measures.
22:47
SPEAKER_01: One's uh referred to, or one type is referred to as an input measure or input measures.
22:53
SPEAKER_01: The other type are output measures.
22:56
SPEAKER_01: Output or output methods, rather, um, input methods, output methods.
23:00
SPEAKER_01: Output methods is really sort of like being able to look to see how far along you are.
23:04
SPEAKER_01: So if you think of like a construction activity, you might actually have engineering surveys, somebody judging like the physical progress that you've made, and you have that done periodically, and that that would drive your revenue recognition.
23:17
SPEAKER_01: Now that's complicated, right?
23:19
SPEAKER_01: You need a whole separate team of people, presumably, to do that.
23:22
SPEAKER_01: Um, you need to have some framework for assessing like how far along you really are.
23:26
SPEAKER_01: It could be pretty complicated.
23:28
SPEAKER_01: Um, but that is one of the measures that's allowed.
23:31
SPEAKER_01: Um sometimes contractual milestones could be viewed as an output measure because you've achieved something.
23:39
SPEAKER_01: Importantly, though, there's a lot of like milestones in contracts that aren't necessarily correlated to the actual progress or proportionate to the actual progress.
23:49
SPEAKER_01: So you can't just default to those contractual milestones.
23:52
SPEAKER_01: You'd have to be satisfied that they were substantive and that they really correlated to the actual progress that you're making.
23:59
SPEAKER_01: Um, another one that might be viewed as a an output method would just be the passage of time.
24:06
SPEAKER_01: Um, you know, a certain amount of time has passed when you've been doing something or stood ready to do something.
24:11
SPEAKER_01: You could almost view that as sometimes that's an input measure, too, because I spent a certain amount of time doing something.
24:17
SPEAKER_01: Um so we do see that, but that's usually in the case of something that's uh happening sort of in the same way over that period of time.
24:25
SPEAKER_01: Uh a lot of times we talk about stand-ready obligations where I'm standing ready to perform.
24:30
SPEAKER_01: That would be uh the type of method.
24:32
SPEAKER_01: The other method are um input methods.
24:36
SPEAKER_01: Um, the most classic one is um what we refer to as the cost-to-cost method.
24:41
SPEAKER_01: How much cost have I incurred, my input, my effort input to the completion in relation to the total cost that I expect to incur?
24:50
SPEAKER_01: That's a very simple math equation.
24:52
SPEAKER_01: I can figure out a percentage, I can apply that to revenue and recognize my revenue.
24:56
SPEAKER_01: Um so it's it's very objective, practically easier.
25:00
SPEAKER_01: And so I would say that's probably the majority of the cases we see people using some version of that.
25:06
SPEAKER_01: You might, instead of being all costs, you might just look at maybe labor costs because that's the best correlation of your effort.
25:12
SPEAKER_01: Maybe you exclude material costs.
25:14
SPEAKER_01: Um, you might look at just hours applied to the job.
25:18
SPEAKER_01: So something that's just very specific on measuring your effort.
25:23
SPEAKER_01: Um and again, this is sort of a judgment that you know correlates to your business, whatever makes the most sense in the context of your um activities.
25:32
SPEAKER_01: Importantly, though, you have to you do have to think about if you're especially if you're using a cost-to-cost measure, to not include costs that um are sort of disproportionate to the value transferred to the customer.
25:43
SPEAKER_01: So sometimes you have like mobilization or setup activities, or you might go out and buy a whole bunch of materials you need, but you haven't actually done anything with them yet.
25:52
SPEAKER_01: You wouldn't want to include those costs in your measure of progress.
25:56
SPEAKER_01: It needs to be really depicting the transfer of value to the customer.
26:01
SPEAKER_01: Um, just a couple of other points on this topic.
26:04
SPEAKER_01: Um, so you have to select a measure of progress for each performance obligation, and you have to use that one measure for that performance obligation.
26:13
SPEAKER_01: You only have one measure for a performance obligation.
26:15
SPEAKER_01: You can't have multiple measures of progress for the same performance obligation.
26:20
SPEAKER_01: And if you have similar performance obligations in your business, like you can have different performance obligations in a contract that could have different measures of progress.
26:29
SPEAKER_01: But if you have similar types of performance obligations across your business, you should be using the same measure of progress.
26:36
SPEAKER_01: You shouldn't just be picking and choosing different measures for different uh contracts if they're the same or similar.
26:43
SPEAKER_04: Okay.
26:44
SPEAKER_04: And then maybe one thing is you know, there's a lot of contracts sometimes that have billing schedules in them that you have to make payments at on a certain schedule.
26:52
SPEAKER_04: And maybe to your point, like that may or may not coincide with you know the amount of progress or work that's been performed or the you know, the transfer of value to the to the customer over that period of time.
27:03
SPEAKER_04: I assume like you couldn't just use a billing schedule.
27:05
SPEAKER_04: You need to do this kind of analysis to make sure that if you know, to determine if that like matched some sort of progress that was made under the contract.
27:12
SPEAKER_01: That's correct.
27:13
SPEAKER_01: And typically if it's just I'll call like scheduled billing milestones, those are rarely going to be an appropriate measure of progress.
27:19
SPEAKER_01: I mean, there is a concept of a right to invoice practical expedient, which I think we might uh want to touch on uh briefly later.
27:26
SPEAKER_01: But in general, like when you're billing the customer in one of these arrangements isn't really relevant.
27:32
SPEAKER_04: Okay, that's helpful.
27:33
SPEAKER_04: Maybe another concept we hear about sometimes is like straight line recognition.
27:38
SPEAKER_04: Is that an option here?
27:40
SPEAKER_01: Aaron Powell So by default, no.
27:42
SPEAKER_01: I mean, it's you know, like you you have to come up with um a measure of progress that again is correlated to your performance.
27:50
SPEAKER_01: Now, it might end up looking like straight line, but that's not purely just because we thought that was easy or that it was a one-year contract, so I'm gonna recognize a twelfth of the revenue every month.
28:00
SPEAKER_01: I'd have to be satisfied that my performance is basically being completed evenly throughout the period, and so I would get something that looks like straight line, um, but not.
28:11
SPEAKER_01: I mean, the one case where it probably is something pretty close to straight line would be in the stand ready example, where you know, let's say I've agreed to provide maintenance services over the year for an appliance.
28:26
SPEAKER_01: Um, well, you may need service, you may not.
28:29
SPEAKER_01: Every day I stand ready to provide the service whether you need it or not.
28:33
SPEAKER_01: So every day my performance looks pretty much the same, um, or that's my expectation.
28:38
SPEAKER_01: So I'm going to recognize that radically over the period.
28:40
SPEAKER_01: Now, interestingly, if I was doing sort of long-term extended warranty type contracts and I had data that suggested, hey, nothing really happens for the first three years, but then in the last two years of that contract, that's when I do all the work.
28:54
SPEAKER_01: Well, the straight line model probably wouldn't be right because it doesn't really depict your your efforts in satisfying that.
29:00
SPEAKER_01: You probably likely know that you're going to spend more of that effort later in the period and you should recognize the revenue then in those later periods.
29:09
SPEAKER_02: Yeah, there's there's a lot of we get a lot of questions about stand-ready obligations.
29:14
SPEAKER_02: And a lot of times it it's viewed as a look, I'm standing ready to provide something.
29:21
SPEAKER_02: And normally stand-ready contracts do get a rateable recognition, but it's typically when they're an unlimited amount of good or service I'm standing ready to provide.
29:33
SPEAKER_02: Um so that's an important distinction when you're looking at stand-ready contracts.
29:38
SPEAKER_02: Is it standing ready to provide unlimited?
29:40
SPEAKER_02: And like a health club, you can use it whenever you want.
29:44
SPEAKER_02: 24-7, I'm standing ready to provide that.
29:46
SPEAKER_02: I get the same amount whether you use a lot or use none.
29:49
SPEAKER_02: It's available all the time, you can use it all the time.
29:52
SPEAKER_02: That would be the typical my obligation is relieved as days go by.
29:58
SPEAKER_02: Different from you have the health club membership and you can use a hundred times in the year.
30:06
SPEAKER_02: So it's okay.
30:07
SPEAKER_02: I'm standing ready to provide a hundred times.
30:08
SPEAKER_02: In that, it's like, well, it sounds like you're providing a hundred access points to it.
30:14
SPEAKER_02: And we see that more not in a health club, we see it more like in SaaS or IT services, where there's a some unit of capacity that you have a limit of.
30:24
SPEAKER_02: Okay.
30:24
SPEAKER_02: And then once you have that limit, the guidance typically says, well, it's really the price per that unit, and you're delivering each of those units as opposed to just over time.
30:38
SPEAKER_02: Now there are cases, and and Pat alluded to this, where if you have a pattern for like a maintenance contract where a straight line, even if it's unlimited, may not work.
30:48
SPEAKER_02: The most obvious example that comes to mind, especially on a 99-degree day in New York, is if you had um a snow removal service for a year.
30:59
SPEAKER_02: So I'll remove as much snow as you have for a year.
31:03
SPEAKER_02: Okay, should it be rateable over the year?
31:05
SPEAKER_02: It's unlimited.
31:06
SPEAKER_02: Well, probably not, because we're not removing snow in a lot of those months.
31:11
SPEAKER_02: So it might be rateable, but not over the contract period over a shorter period of time.
31:15
SPEAKER_02: So you really have to think, and it gets back to a comment Pat said, is you're trying to depict your performance.
31:23
SPEAKER_02: So we always a little bit skeptical, or you want to want to dig in when it's I'm just going rateable.
31:29
SPEAKER_02: Well, we have to make sure your performance is not knowable, it's you know, unlimited, and you really truly are standing ready.
31:38
SPEAKER_04: Yeah.
31:39
SPEAKER_04: Okay.
31:39
SPEAKER_04: Those are great points.
31:41
SPEAKER_04: So maybe, Mike, is there like common methods then that companies are using to measure progress?
31:47
SPEAKER_04: Or or maybe can you highlight some of the areas where we see more judgment?
31:50
SPEAKER_02: I know we just talked through one, but yeah, I mean, you know, cost to cost is the most common one.
31:58
SPEAKER_02: Um so again, just the cost to cost is basically this notion, and and and Pat touched on it, of I'm gonna use cost that I do as I deliver my service as a percentage of the cost it takes me as a percentage of the total expected cost.
32:20
SPEAKER_02: Okay.
32:21
SPEAKER_04: Well, I think one thing that would come up is maybe as we've talked about here, like at the beginning of a contract, you're gonna estimate you know your total cost and then what you expect the cost to be over time, and then you know, as you incur those costs, then you're gonna apply that percentage to your revenue.
32:35
SPEAKER_04: But as we've just talked about, the the world's not perfect and those costs can be different, and then we can have other factors that are external that that change.
32:44
SPEAKER_04: So like if you have this, so you're like estimate what your your cost is for your contract, you say it's like a hundred dollars, right?
32:50
SPEAKER_04: And then you've incurred twenty-five percent.
32:53
SPEAKER_04: So you say I'm gonna recognize twenty-five percent of my revenue, and then something happens, and now you think that it's gonna cost you two hundred dollars to complete it, and now you've like how do you think about it.
33:07
SPEAKER_02: So if there's a circumstance where you've recognized a certain percentage of your contract value and revenue, and then your forecast of cost goes way up.
33:18
SPEAKER_02: Yeah.
33:19
SPEAKER_02: Such that the next measurement period, the next quarter, your percentage is actually less.
33:25
SPEAKER_02: Like that's how the math goes.
33:28
SPEAKER_02: Well, you can have negative revenue.
33:30
SPEAKER_02: You would record a negative in that period to right size your total percent complete to date to what your best estimate of the percent complete to date is.
33:42
SPEAKER_04: Okay.
33:42
SPEAKER_04: Okay, that's really helpful.
33:44
SPEAKER_04: Thank you.
33:45
SPEAKER_04: So now that we've talked a little bit about changes in cost, um, is there anything else worth highlighting, Pat, related to um you know evaluating the recognition over time?
33:56
SPEAKER_01: Yeah, so there's a couple of um I maybe exceptions um to the basic model we've talked about that's probably worth touching on.
34:03
SPEAKER_01: And I think one maybe gets sometimes used a little bit too too frequently or in places maybe where it shouldn't.
34:11
SPEAKER_01: Um it's referred to as the right to invoice practical expedient.
34:16
SPEAKER_01: Um so essentially this was an accommodation for I'll say just like a classic time and materials service arrangement where literally every hour I spend, every out-of-pocket cost I incur, my contract allows me to bill the customer for that hour at a contracted rate, that amount of out-of-pocket expense at whatever the value is.
34:40
SPEAKER_01: So I have the right to invoice throughout the contract basically for the work that I've done.
34:45
SPEAKER_04: Like legal services.
34:47
SPEAKER_01: Right.
34:47
SPEAKER_01: And so a lot of times we would say, you know, as I was saying before, like billing terms don't matter.
34:53
SPEAKER_01: They don't drive revenue recognition.
34:55
SPEAKER_01: But this is a case where because of the way the contract's set up and because of the nature of the activities, the right to bill actually aligns directly with the performance.
35:04
SPEAKER_01: So you don't really have to develop a separate measure.
35:07
SPEAKER_01: You can just say, hey, the contract allows me to bill, I'm gonna recognize my revenue when I bill.
35:10
SPEAKER_01: That's practically very simple, you know, makes life easy for a lot of people, so so people like it.
35:16
SPEAKER_01: But importantly, you have to have that type of contract, right?
35:19
SPEAKER_01: You can't just say, well, it's convenient, obviously, because my system works really well when I can debit accounts receivable and credit revenue, and I don't have to worry about any of these other side calculations or measures or progress or any of that.
35:31
SPEAKER_01: But it only works if that's how the contract works and that's how your performance works as well.
35:37
SPEAKER_01: That wouldn't be appropriate, obviously, if you have upfront payments of significant amounts or billings that don't happen very frequently or that you aren't able to bill until you get to particular milestones, even if they happen to occur sort of on a regular interval.
35:54
SPEAKER_01: The second area, which is um also sort of an exception to the model, um, is around licenses of intellectual property.
36:01
SPEAKER_01: And Mike touched on the sort of the different types of intellectual property, but there's also an aspect of most licensing arrangements where the consideration will often include royalties for the use of that intellectual property in the licensees' future sales.
36:19
SPEAKER_01: And so if you have a if you have a right to a future royalty payment that's based on the licensee's sales or usage of that IP, there's actually an exception.
36:30
SPEAKER_01: It's not a choice, it's not, you know, uh an expedient, it's just an exception to the model that says you don't recognize revenue for those royalties until the underlying usage or sale occurs.
36:42
SPEAKER_01: Now, importantly, that's when the usage or sale occurs, not when you find out about it, not when you get paid for it.
36:47
SPEAKER_01: You have to, so you might still have to estimate something, but you're not estimating all those future royalties until the underlying sale or usage occurs.
36:56
SPEAKER_01: So that's just an exception to the model, specific only to licenses of intellectual property.
37:02
SPEAKER_01: And if you have an arrangement that has other things in it, you have to determine that the license is the predominant item and that the royalty relates to the IP in order to be able to apply that exception.
37:13
SPEAKER_01: Only applies to royalties, wouldn't apply to other sort of milestone payments or otherwise, only to sales or usage-based royalties.
37:21
SPEAKER_04: And so like when we talked about earlier that like you could have a contract that has multiple performance obligations, could a royalty be a separate performance obligation, or is it like that that in that instance, like the whole contract has to be evaluated?
37:34
SPEAKER_01: Aaron Powell So the royalty wouldn't be the performance obligation.
37:37
SPEAKER_01: The license of the IP would be the performance obligation, but you could have a license of IP along with something else, and then you'd say, okay, I have this license of IP, and now I also have a royalty, and I conclude that that royalty relates to the use of the IP, I would apply this exception to that consideration that I'm receiving.
37:58
SPEAKER_02: Okay.
37:58
SPEAKER_02: But your your question is a common type of question that we get, especially in contracts that have a single performance obligation, but multiple ways to get paid.
38:10
SPEAKER_02: The focus oftentimes is on when to record the ways to get paid.
38:15
SPEAKER_02: Instead of saying don't focus on how you're getting paid, focus on what you're delivering.
38:21
SPEAKER_02: Right.
38:21
SPEAKER_02: And when control to what you're delivering transfers.
38:24
SPEAKER_02: All the ways you get paid relate to relate to how much you're you're entitled to for that performance obligation.
38:33
SPEAKER_02: Now figure out when you deliver that and when does control to that performance obligation transfer?
38:38
SPEAKER_04: Okay.
38:39
SPEAKER_04: Okay, good.
38:39
SPEAKER_04: Thank you.
38:40
SPEAKER_04: Okay.
38:41
SPEAKER_04: Well, I think we've covered a lot of ground today and a lot of different things.
38:44
SPEAKER_04: So thank you both very much.
38:46
SPEAKER_04: But maybe one thing before we close out, maybe I'll turn to each of you if you have any key takeaways for our listeners that they should be thinking about when they're thinking about uh revenue recognition.
38:55
SPEAKER_04: And maybe maybe Mike, I'll start with you first.
38:58
SPEAKER_02: Uh yeah, I have two.
39:00
SPEAKER_02: Um one is again, cost to cost is a very common measure.
39:05
SPEAKER_02: Um, and so just a reminder.
39:08
SPEAKER_02: It's you apply cost to cost to the revenue, it's independent of cost.
39:13
SPEAKER_02: Um just make sure you keep that in mind.
39:17
SPEAKER_02: And then the second one, again, back to the stand ready obligation, we get a lot of questions and we have companies making the assertion we're standing ready.
39:28
SPEAKER_02: And and I I would argue most companies are always standing ready to provide everything they have for you.
39:34
SPEAKER_02: And so the focus is really on what are you delivering and are you delivering something that's unlimited or a limited amount of what you're delivering?
39:43
SPEAKER_04: Aaron Powell It also seems like historical experience or some of the seasonality, you know, maybe that we touched on too is also important when you're thinking about that.
39:50
SPEAKER_04: And Pat?
39:51
SPEAKER_01: Yeah, so I think we talked a lot about this.
39:53
SPEAKER_01: I mean, the whole subject of this discussion has been around the step in the process where we recognize revenue.
40:00
SPEAKER_01: And again, that's intended to depict the entity's performance and satisfying its obligations to the customer.
40:06
SPEAKER_01: So just keeping that principle in mind that it's about when the entity performs, not when you get paid.
40:13
SPEAKER_01: There are a lot of things in any contract that are going to inform a lot of aspects of the model, but I think it's really important when you're thinking about performance that you really understand the customer's perspective and how they're receiving value from the entity's performance.
40:29
SPEAKER_01: Um, because at the end of the day, that's really what we're striving for is to measure the entity's performance in delivering that value to the customer.
40:36
SPEAKER_04: Okay.
40:37
SPEAKER_04: Well, thank you both so much.
40:38
SPEAKER_04: But one one more quick thing.
40:40
SPEAKER_04: Um, Pat, if people want to learn more about revenue recognition, where should they go for more information?
40:46
SPEAKER_01: Yeah, so our revenue guide obviously covers the whole model comprehensively, and specifically chapter six addresses this um recognition of revenue step in the model.
40:56
SPEAKER_04: Okay.
40:56
SPEAKER_04: Well, Pat, Mike, thank you so much for joining me today.
40:59
SPEAKER_04: It was a great conversation.
41:00
SPEAKER_04: Yep.
41:00
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41:02
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41:24
SPEAKER_03: From Thought Leadership at PwC, I'm Heather Horn.
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