Revenue Recognition: When Do Manufacturers Have a Right to Payment?
Under the Accounting Standard Codification (ASC 606), Revenue from Contracts with Customers, entities may be required to recognize revenue over the life of a contract rather than at a point in time. This could apply to manufacturing companies that make a product with no alternative use (highly customized) and that also have an enforceable right to payment for performance to date.
Regardless of the duration, manufacturers meeting these criteria will have to recognize revenue over the production cycle on some contracts rather than when the product is shipped. On contracts that do not have enforceable right to payment, revenue will be recognized at shipment, consistent with revenue recognition rules prior to ASC 606.
Short-Cycle Manufacturers
The switch of recognizing revenue will impact certain short-cycle manufacturers, since many are manufacturing customized products for customers but have given little thought to whether an enforceable right to payment exists. Many entities may not have a system of controls in effect, specific to identifying which contracts, if any, create an enforceable right to payment.
How Do I Know If I Have Enforceable Right to Payment?
Evaluating whether an entity has an enforceable right to payment should be straightforward. However, some common questions that arise are:
Does the ability to progress bill over the course of the production process count as an enforceable right to payment for work done to date?
No, progress billing is simply a matter of managing cash flow and is not necessarily directly dependent on the amount of work done. An enforceable right to payment for performance to date specifically means that the entity can bill for work done to date, at cost plus a reasonable profit margin.
What is a reasonable profit margin?
The new standard does not define “reasonable”, which means best judgement is required when determining whether a specified margin in the contract is reasonable. It should be determined by comparison to the entity’s expected profit margin.
Does an entity need to consider its intent or past practice related to enforcement of contractual or legal rights?
No, entities past practice of enforcing payment should not be a factor on whether the entity has enforceable right to payment. The determination is evaluated under the terms of the contractual arrangement as a matter of law.
Would a deposit or prepayment represent an enforceable right to payment?
No, because it is not compensating the entity for performance completed to date. Although, if the customer pays in full up front, this could be a right to payment in the event the contract is terminated.
Does a contract need to explicitly specify an entity’s right to payment upon terminating?
The position of the Financial Accounting Standards Board (FASB) is that if the contractual right to payment for work done to date is not stated, it can be presumed that there is no enforceable right to payment and the contract does not meet the criteria.
If you have any questions on revenue recognition, contact your BSSF advisor.