Services represent over half of the transactions completed in the U.S. economy, but there are no official pronouncements that provide specific accounting standards for them. Accounting for service transactions has evolved primarily through industry practice, and as a result, different accounting methods have developed to apply the fundamental principles of revenue and cost recognition. In fact, different accounting methods are used by similar entities for practically identical transactions.
The FASB have been pursuing a major project addressing revenue recognition, which would resolve the accounting for service transactions. In the interim, until definitive standards regarding revenue recognition are promulgated, this section can still provide relevant guidance on service industry issues.
In addition, the guidance provided by the SEC in Staff Accounting Bulletin 101 and its replacement, SAB 104, is highly relevant to accounting for service transactions and should be deemed pertinent to accounting even by nonpublic reporting entities, inasmuch as it reflects the current thinking by an authoritative source of generally accepted accounting principles (GAAP).
This post provides revenue recognition for services transaction with case examples. Enjoy!
The American Institute of Certified Public Accountants (AICPA) has defined service transactions as follows:
…transactions between a seller and a purchaser in which, for a mutually agreed price, the seller performs, agrees to perform, agrees to perform at a later date, or agrees to maintain readiness to perform an act or acts, including permitting others to use enterprise resources that do not alone produce a tangible commodity or product as the principal intended result.
GAAP requires that revenue generally be recognized when (1) it is realized or realizable and (2) it has been earned.
With respect to service transactions, the AICPA concluded:
…revenue from service transactions [is to] be based on performance, because performance determines the extent to which the earnings process is complete or virtually complete.
In practice, performance may involve the execution of a defined act, a set of similar or identical acts, or a set of related but not similar or identical acts. Performance may also occur with the passage of time. Accordingly, one of the following four methods [which is described later in the: Revenue Recognition Methods] can serve as a guideline for the recognition of revenue from service transactions:
- The specific performance method
- The proportional performance method
- The completed performance method
- The collection method
Service Vs. Product Transactions
Many transactions involve the sale of a tangible product and a service; therefore, for proper accounting treatment, it must be determined whether the transaction is primarily a service transaction accompanied by an incidental product, primarily a product transaction accompanied by an incidental service, or a sale in which both a service transaction and a product transaction occur. The following criteria apply:
- Service transactions. If the seller offers both a service and a product in a single transaction and if the terms of the agreement for the sale of the service are worded in such a manner that the inclusion or exclusion of the product would not change the total transaction price, the product is incidental to the rendering of the service; the transaction is a service transaction that is accounted for in accordance with one of the four methods presented. For example, fixed-price equipment maintenance contracts that include parts at no additional charge are service transactions.
- Product transactions. If the seller offers both a service and a product in a single transaction and if the terms of the agreement for the sale of the product are worded in such a manner that the inclusion or exclusion of the service would not change the total transaction price, the rendering of the service is incidental to the sale of the product; the transaction is a product transaction that is accounted for as such. For example, the sale of a product accompanied by a guarantee or warranty for repair is considered a product transaction.
- Service and product transactions. If the seller offers both a product and a service and the agreement states the product and service are separate elements such that the inclusion or exclusion of the service would vary the total transaction price, the transaction consists of two components: a product transaction that is accounted for separately as such, and a service transaction that is accounted for in accordance with one of the four accepted methods.
Revenue Recognition Methods For Services Transactions
Once a transaction is determined to be a service transaction, one of the following four methods is used to recognize revenue. The method chosen is to be based on the nature and extent of the service(s) to be performed:
1. Specific Performance Method
The specific performance method is used when performance consists of the execution of a single act. Revenue is recognized at the time the act takes place. For example: a stockbroker records sales commissions as revenue upon the sale of a client’s investment.
2. Proportional Performance Method
The proportional performance method is used when performance consists of a number of identical or similar acts. Here are the treatments:
- If the service transaction involves a specified number of identical or similar acts, an equal amount of revenue is recorded for each act performed. For example: a refuse disposal company recognizes an equal amount of revenue for each weekly removal of a customer’s garbage.
- If the service transaction involves a specified number of defined but not identical or similar acts, the revenue recognized for each act is based on the following formula: [Direct cost of individual act/Total estimated direct costs of the transaction] x Total revenues from complete transaction. For example: a correspondence school that provides lessons, examinations, and grading would use this method. If the measurements suggested in the preceding equation are impractical or not objectively determinable, revenue is recognized on a systematic and rational basis that reasonably relates revenue recognition to service performance.
- If the service transaction involves an unspecified number of acts over a fixed time period for performance, revenue is recognized over the period during which the acts will be performed by using the straight-line method unless a better method of relating revenue and performance is appropriate. For example: a health club might recognize revenue on a straight-line basis over the term of a member’s membership. Many professional service firms record revenues on their engagements on an “as-performed basis” by valuing labor time, as expended, at a standard hourly billing rate and accumulating these amounts as an asset, work-in-progress (WIP). For periodic reporting, ending balances of WIP (and the related revenue recognized) must be adjusted by recording valuation allowances for un-billable or unrealizable WIP.
Example Of Proportional Performance Revenue Recognition
The Putra Snow Removal Company enters into a contract with the London Office Tower to plow its parking lot. The contract states that Putra will receive a fixed payment of $500 to clear London’s central parking lot whenever snowfall exceeds two inches. Following an unusually snowy winter, London elects to cap its snow removal costs by tying Putra into an annual $18,000 fixed price for snow removal, no matter how many snowstorms occur. Snowfall is not predictable by month, and can occur over as much as a six-month period. London pays the full amount in advance, resulting in the following entry by Putra:
[Debit]. Cash = 18,000
[Credit]. Customer advances = 18,000
Though Putra could recognize revenue on a straight-line basis through the contract period, it chooses to tie recognition more closely to actual performance with the proportional performance method. Its total estimated direct cost through the contract period is likely to be $12,600, based on its average costs in previous years. There is one snowstorm in October, which costs Putra $350 for snow removal under the London contract. Putra’s revenue recognition calculation in October is:
[$350 direct cost / $12,600 total direct cost] x $18,000 total revenue = $500 revenue recognition
Thus, Putra recognizes a gross margin of $150 during the month. By the end of February, Putra has conducted snow removal 28 times at the same margin, resulting in revenue recognition of $14,000 and a gross margin of $4,200. Putra’s cumulative entry for all performance under the London contract to date is as follows:
[Debit]. Customer advances = 14,000
[Debit]. Direct labor expense = 9,800
[Credit]. Revenue = 14,000
[Credit]. Cash = 9,800
In March, Putra removes snow 12 more times at a cost of $4,200. Its initial revenue recognition calculation during this month is:
[$4,200 direct cost / $12,600 total direct cost] x $18,000 total revenue = $6,000 revenue recognition.
However, this would result in total revenue recognition of $20,000, which exceeds the contract fixed fee by $2,000. Accordingly, Putra only recognizes sufficient revenue to maximize the contract cap, resulting in a loss of $200 for the month:
[Debit]. Customer advances = 4,000
[Debit]. Direct labor expense = 4,200
[Credit]. Revenue = 4,000
[credit]. Cash = 4,200
3. Completed Performance Method
The completed performance method is used when more than one act must be performed and when the final act is so significant to the entire transaction taken as a whole that performance cannot be considered to have taken place until the performance of that final act occurs. For example: a moving company packs, loads, and transports merchandise; however, the final act of delivering the merchandise is so significant that revenue is not recognized until the goods reach their intended destination. If the services are to be performed in an indeterminable number of acts over an indeterminable period of time and if an objective measure for estimating the degree to which performance has taken place cannot be found, revenue is recognized under the completed performance method.
4. Collection Method
The collection method is used in circumstances when there is a significant degree of uncertainty surrounding the collection of service revenue. Under this method, revenue is not recognized until the cash is collected. For example: personal services may be provided to a customer whose ability to pay is uncertain.
Service Revenue Disclosures
A membership organization should describe the types of membership fees charged and the method used to recognize revenue. The footnote can also reveal the amount of unrecognized revenue currently listed as a liability.
Two examples are as follows:
- The club charges a onetime nonrefundable membership fee of $10,000, as well as monthly dues of $300. Since members have no right to the return of the initial fee, the club recognizes this amount in its entirety when paid. Monthly dues are recognized when billed. There is no liability associated with unrecognized revenue shown on the balance sheet.
- The club charges a onetime membership fee of $10,000, which can be repaid to members if they choose to resign from the club, less a $500 termination fee. The club holds all membership fees in escrow and only recognizes the termination fee when members resign from the club. The total amount of membership fees currently held in escrow is $1,620,000, and is listed under the Membership Fees Held in Reserve liability account. The club also charges $300 monthly dues, which are recognized when billed.
As is the case with any long-term service revenue contract, the period over which warranty revenues are calculated should be described, if this is a significant proportion of revenues. For many companies, this is a small revenue component not requiring separate disclosure. If it is disclosed, note the term over which warranty revenues are recognized and the amount of unrecognized warranty revenues. A sample footnote is as follows:
The company sells a one-year warranty agreement with its kitchen appliances; warranty revenues comprise approximately 8% of total revenues. These revenues are recognized ratably over their service periods, with the unrecognized balance listed as a short-term liability in the Unrecognized Warranty Revenues account. The unrecognized balance of these sales was $850,000 as of the balance sheet date.