Revenue Recognition Timing Considerations for Contract Manufacturers

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers – known more commonly in the accounting lexicon as ASC 606. After years of revisions and delayed implementation, the new revenue recognition standard, which replaced most existing revenue recognition guidance, became effective for private companies starting January 1, 2019. This new standard presents a great number of challenges for middle-market companies, and their lenders and service providers, who struggle with the complexity and ambiguity of a principle-based standard like ASC 606.

Among those many challenges, is determining the appropriate time at which to recognize revenue. Under the five-step method of ASC 606, revenue is recognized as the reporting organization satisfies a performance obligation or, in other words, after goods or services have been provided to the customer. For a manufacturer in a pre-ASC 606 environment, the satisfied obligation was usually in the form of shipment or delivery of an item, depending on shipping terms. Until 2019, most manufacturers found themselves recognizing revenue at a point in time when title transferred to the customer. Now, manufacturers must consider whether the performance obligation or obligations within a contract are satisfied over a period of time or at a point in time.

A performance obligation is satisfied over a period of time if any one of the following criteria apply:

1. The customer simultaneously receives and consumes the benefits provided by the manufacturer’s performance, as the manufacturer performs.
2. The manufacturer’s performance creates or enhances an asset, like a work-in-process, which the customer controls as the asset is created or enhanced.
3. The manufacturer’s performance does not create an asset with an alternative use to the manufacturer, and the manufacturer has an enforceable right to payment for performance completed to-date, including a profit margin.

The third of the three scenarios above presents an opportunity for contract manufacturers who manufacture goods to unique customer specifications (i.e., could not be sold to another customer) to recognize revenue over time rather than upon physical transfer of the good, provided that the related contract contains the right language. The contract must provide for enforceable right to payment for performance completed to date, plus a reasonable profit margin. The profit margin need not be comparable to what would have been earned if the contract was fully delivered by the manufacturer, but it must be reasonable under the circumstances.

Reasonable in this case could be defined as either:

• A proportion of the expected profit margin of the contract that reasonably reflects the extent of the manufacturer’s performance under the contract prior to termination;
• A reasonable return on the manufacturer’s cost of the capital for similar contracts; or,
• The manufacturer’s typical operating margin for other similar contracts if the contract-specific margin is higher than the return the manufacturer usually generates from similar contracts.

Over-time revenue recognition may be desirable - from a management perspective - for certain entities because it will generally smooth out fluctuations in the revenue throughout the year, provided that the manufacturing process is ongoing and the manufacturer is consistently producing completed goods under the contract. The tax implications of over-time revenue recognition should be considered on a case-by-case basis. Manufacturers using the over-time recognition would generally incur an earlier tax bill than if they were to use the point-in-time recognition. This can be offset by making certain tax elections to change the cash basis method of accounting for tax purposes, provided the company meets certain criteria: average gross receipts of less than $25 million over the prior three-year period. The cash basis method can allow you to defer taxes on income until you receive it, rather than when you earn it, and can be helpful to all companies, but especially those transitioning from point in time to over time under ASC 606.

This is just one of the many complex issues ASC 606 has to offer to middle-market companies. Talk to your trusted accounting and business advisors to be sure you understand the full depth and breadth of this change and any other changes which may impact your company’s financial statements under the new revenue recognition guidance. Be sure your primary lender or lenders are aware of any significant changes prior to issuing the financial statements as of and for the year ended December 31, 2019.