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Service contracts: Percentage of completion or proportional performance?

INSIGHT ARTICLE  | 

Many questions arise when accounting for revenue earned in connection with providing services to customers, particularly when those services are provided under a long-term contract. One of the initial questions asked is: When should the percentage of completion method be used to account for a service contract? The answer to this question depends on whether the service contract is within the scope of Subtopic 605-35, Revenue Recognition – Construction-Type and Production-Type Contracts, of the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC), which provides comprehensive revenue recognition guidance applicable only to contracts within its scope. Applying the guidance in ASC 605-35 results in using one of the following two accounting methods, depending on the facts and circumstances: (a) percentage of completion or (b) completed contract. As such, the percentage of completion method should only be applied to service contracts that fall within the scope of ASC 605-35 and for which the guidance in ASC 605-35 indicates the percentage of completion method should be used. As is often the case with an accounting question, this answer leads to additional questions, including the following:  

  • What types of service contracts fall within the scope of ASC 605-35?
  • What accounting guidance should be applied to service contracts that do not fall within the scope of ASC 605-35? 
  • How does the percentage of completion method in ASC 605-35 differ from the guidance applied to service contracts that do not fall within the scope of ASC 605-35 or other specific guidance in the ASC? 

As discussed in this article, the guidance needed to answer these questions can be found in ASC 605, Revenue Recognition. While the guidance in ASC 605 is currently effective, it will be superseded when the new revenue recognition guidance issued by the FASB in 2014 becomes effective. For public entities with a calendar year end, the new guidance is effective in the quarter and year beginning January 1, 2018. For all other entities with a calendar year end, the new guidance is effective in the year ending December 31, 2019 and interim periods in 2020. The accounting for a service contract under the new guidance may be very different from the accounting for the same contract under ASC 605. For additional information about the new guidance, refer to our summary, Revenue recognition: In motion.

What types of service contracts fall within the scope of ASC 605-35?

The population of service contracts that fall within the scope of ASC 605-35 is very narrow. In general, two overall types of service contracts fall within the scope of ASC 605-35. The first overall type includes service contracts that are essential to the construction or production of tangible property that itself is within the scope of ASC 605-35 (e.g., buildings, ships, complex aerospace equipment). As such, service contracts that provide design, engineering, procurement, construction management and (or) construction consulting services related to the construction of tangible property within the scope of ASC 605-35 are themselves within the scope of ASC 605-35. The service providers that typically enter into this type of contract include architects, engineers and (or) construction consultants. The second overall type of service contract that falls within the scope of ASC 605-35 includes those in which significant production, modification or customization of software is provided. 

Given the narrow scope of ASC 605-35, an entity should carefully evaluate a service contract in the context of the guidance in ASC 605-35-15 before applying the other guidance in that subtopic (which includes the percentage of completion method) to account for the services provided.

What accounting guidance should be applied to service contracts that do not fall within the scope of ASC 605-35?

If ASC 605-35 does not apply to a service contract, consideration should be given to whether any other specific guidance in the ASC (e.g., industry-specific guidance applicable to cable television, financial services, health care) applies to the service contract. If there is no other specific guidance in the ASC that applies to the service contract, the general revenue recognition guidance in ASC 605 should be applied. Under this guidance, revenue should be recognized when it is earned and realized or realizable. While there is specific guidance in ASC 605 to address certain issues (e.g., rights of return, sales subject to guaranteed minimum resale value), the only overall guidance around determining whether revenue has been earned and is realized or realizable is that provided by the staff of the Securities and Exchange Commission in Staff Accounting Bulletin (SAB) Topic 13, Revenue Recognition. The guidance in SAB Topic 13 is codified in ASC 605-10-S99 and must be followed when there is no other directly applicable guidance in the ASC. Under SAB Topic 13, the following four criteria must be met prior to recognizing revenue:

  • Persuasive evidence of an arrangement exists
  • Delivery has occurred or services have been rendered
  • The seller’s price to the buyer is fixed or determinable
  • Collectibility is reasonably assured

While the guidance in SAB Topic 13 is technically only applicable to public entities, it is also generally applied in practice by private companies. 

Determining when revenue from providing services should be recognized for accounting purposes can be a challenging exercise, particularly when long-term service contracts are involved. Unfortunately, neither the general revenue recognition guidance in ASC 605 nor SAB Topic 13 provides much guidance to help make this determination. Instead, a commonly used nonauthoritative resource used in practice is a FASB Invitation to Comment (ITC), Accounting for Certain Service Transactions, which was issued in 1978, but never finalized. The two primary accounting methods discussed in the ITC are referred to as the proportional performance and completed performance methods. Under the proportional performance method, revenue should be recognized as the service is performed by the entity, provided all of the SAB Topic 13 criteria are met. Conversely, under the completed performance method, revenue should be recognized when the entity completes its performance of the service, provided all of the SAB Topic 13 criteria are met. 

Before discussing the factors that are considered in determining whether the proportional performance or completed performance method should be applied to a service contract, it is important to note the need to consider whether the service contract consists of one unit of account or multiple units of account. This is important because the method that should be used is determined on a unit of account basis. In other words, if a service contract consists of two services that each represent a unit of account, whether the proportional performance or completed performance method should be applied is determined separately for each service. Conceivably, it may be appropriate to use the proportional performance method for one of the services and the completed performance method for the other service. Identifying the units of account in a service contract requires consideration of the guidance in ASC 605-25, Revenue Recognition – Multiple-Element Arrangements, and perhaps other specific multiple-element arrangement guidance in the ASC. While a detailed discussion of this guidance is beyond the scope of this article, we have a separate white paper, Accounting for multiple-deliverable revenue arrangements, which summarizes the guidance in ASC 605-25 and includes several examples illustrating the application of that guidance. For ease of discussion, the remainder of this article assumes that the service contract being discussed represents one unit of account.

Determining whether the proportional performance or completed performance method should be applied to a service contract that does not fall within the scope of ASC 605-35 or other specific guidance in the ASC requires consideration of the nature of the acts being performed by the entity to provide the service and the relative value of those acts to the customer. If the customer is receiving value as each act is performed, the proportional performance method should be used. An important element in applying this method is measuring the proportion of the acts in the service contract that have been performed by the entity (i.e., measuring progress to completion). Key to this measurement is the value transferred to the customer as the acts are performed. For example, if the entity agrees to provide 100 hours of temporary labor (all of the same type), the customer is receiving the same relative value as each hour is performed. As such, the proportional performance method should be used and the measurement of progress to completion should be based on the labor hours provided. However, consideration must be given to how the entity is compensated prior to recognizing revenue. If the entity is compensated on a per labor hour basis, revenue would be recognized as each labor hour is provided. The converse of the proportional performance method is the completed performance method, which should be used if the customer receives most of the relative value from the entity’s performance of the final act required to deliver the service under the contract. For example, while a real estate agent performs many acts in connection with selling a house (e.g., listing the house, holding open houses, vetting potential buyers), the relative value of the final act of actually selling the house is so significant to the customer that the completed performance method should be used. 

In many cases, determining whether the proportional performance or completed performance method should be used to account for a service contract requires exercising significant judgment.

How does the percentage of completion method in ASC 605-35 differ from the guidance applied to service contracts that do not fall within the scope of ASC 605-35 or other specific guidance in the ASC? 

If a service contract does not fall within the scope of ASC 605-35 or other specific guidance in the ASC, consideration must be given to whether the proportional performance or completed performance method should be applied to recognize revenue. A common misconception is that the percentage of completion method and proportional performance method are the same. While the two methods may produce the same accounting results in some cases, in many other cases they may produce very different accounting results. The fundamental difference between the two is that the mechanics of the percentage of completion method should result in a constant gross margin percentage over the contract term, all other things being equal, while the proportional performance method may or may not produce a constant gross margin percentage over the contract term. This is primarily due to the predominant use of a cost-to-cost method to measure the percentage complete under the percentage of completion method compared to the use of a value-based measure of progress to completion under the proportional performance method. Examples of situations in which the proportional performance method would give rise to a gross margin percentage that is not constant include:

  • While the nature of the acts performed throughout the contract are the same, the gross margin related to the acts performed early in the contract is lower than the gross margin associated with the acts performed later in the contract given the efficiencies the entity expects to gain over time.
  • The gross margin percentage related to acts performed in the current reporting period is less than the gross margin percentage related to the same acts performed in an earlier reporting period because of cost overruns experienced in the current reporting period.

As mentioned earlier, the population of service contracts that fall within the scope of ASC 605-35 is very narrow, which means that only a relatively small population of service contracts should be accounted for using the percentage of completion method. 

If the proportional performance method is used to account for a service contract that does not fall within the scope of ASC 605-35 or other specific guidance in the ASC, the SAB Topic 13 criteria must also be met prior to recognizing revenue. Other potential differences between accounting for a service contract under the percentage of completion method in ASC 605-35 and the combination of the proportional performance method and SAB Topic 13 criteria include the following:

  • Contingent consideration. Under ASC 605-35, contingent consideration (e.g., a bonus for early completion) is included in the total contract price (which is the amount ultimately recognized as revenue) when it is reasonably estimable. As a result, when applying the percentage of completion method, contingent consideration that is reasonably estimable is recognized as revenue based on the percentage of the contract that is complete. One of the SAB Topic 13 criteria that must be met to recognize revenue requires the fee to be fixed or determinable. As a result, under that guidance, contingent consideration is generally not included in the contract price until the underlying contingency is resolved. The difference in how contingent consideration is handled could result in the earlier recognition of contingent consideration under ASC 605-35. 
  • Underbillings when revenue recognized is greater than contract billings. The mechanics of the percentage of completion method may result in the recognition of an unbilled receivable as an asset when the revenue recognized based on the percentage complete is greater than the amount the entity has billed in accordance with the contract. If the amount of revenue that would otherwise be recognized under the proportional performance method is greater than the amount the entity has the right to bill the customer under the contract, consideration must be given to whether the difference meets the definition of an asset prior to recognizing it as such. A primary consideration in this regard is whether the customer is legally obligated to pay the amount that would be recognized as an asset. As a result, it may not be appropriate to record an unbilled receivable as an asset in certain cases when the proportional performance method is applied to a service contract.  
  • Loss contracts. When the current estimate of total contract revenue is less than the current estimate of total contract costs under the percentage of completion method, the entity should recognize the entire estimated loss on that contract. Conversely, it would not be appropriate to accrue these losses on a service contract accounted for using the proportional performance method unless there is other applicable guidance in the ASC that requires accrual of the loss on the contract. Typically, this would not be the case for contracts accounted for using the proportional performance method. Instead, when these contracts are in a loss position, they should be accounted for similar to other executory contracts in a loss position, which is to only recognize a loss on the contract when it has been incurred. The difference in how loss contracts are handled could result in the earlier recognition of a loss under ASC 605-35. 

Given the fundamental difference between the percentage of completion method and the proportional performance method as well as the effects of these other differences between the percentage of completion method and the combination of the proportional performance method and SAB Topic 13 criteria, it is very important to carefully consider whether a service contract falls within the scope of ASC 605-35. Failure to do so could have significant accounting consequences.

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