Over-time revenue for customer-specific manufacturing

Made-to-order goods with no alternative use, where the manufacturer has an enforceable right to payment for work done, earn revenue as production progresses rather than at delivery. Getting the classification wrong in either direction misstates the timing of revenue and margin between periods, distorts backlog and WIP disclosures relied on by lenders and investors, and is a frequent audit and restatement risk for custom industrial manufacturers because the enforceable-right-to-payment conclusion hinges on legal interpretation, not just accounting policy.

At contract inception, could the item being produced be readily redirected to another customer without significant rework or economic loss? Does the contract give an enforceable right to payment for work performed to date, including a reasonable profit margin, if the customer cancels - and is this enforceable under the governing local law? Is the cost-to-cost progress measure being reassessed each period for changes in estimated total cost?

1. First test alternative use: assess at contract inception whether the asset being produced could be readily redirected to another customer without significant rework or economic loss - consider both physical customization (branding, unique specs) and contractual restrictions preventing redirection.
2. If the asset has an alternative use, revenue is recognized at the point control transfers to the customer (typically delivery/acceptance); stop the over-time analysis here.
3. If the asset has no alternative use, test the enforceable right to payment: determine whether, at all times during the contract, the entity has a right to payment for performance completed to date, including a reasonable profit margin, not merely recovery of costs.
4. This right-to-payment test depends on the contract terms interpreted under the governing law - obtain legal input on termination clauses, cancellation penalties and local contract law where the answer is not clear from the wording alone.
5. If both the no-alternative-use and enforceable-right-to-payment tests are met, recognize revenue over time using a method that faithfully depicts progress (input method such as cost-to-cost, or an output method such as units produced/milestones, whichever better reflects transfer of value).
6. If either test fails, recognize revenue at the point in time control transfers (usually delivery or customer acceptance).
7. Reassess the alternative-use and right-to-payment conclusions if contract terms are amended (e.g. a cancellation clause is added or removed) since this can flip the recognition pattern mid-contract.

Measurement basis: for over-time contracts, revenue equals total transaction price multiplied by the percentage of progress achieved; for point-in-time contracts, revenue equals the full transaction price recognized at the transfer date. Included in the cost-to-cost progress base: labor, materials actually consumed/installed, allocated production overhead directly attributable to the contract. Excluded/adjusted: uninstalled bulk materials not yet incorporated into the specific unit, and any costs that do not depict transfer of control (e.g. abnormal waste, rework due to the manufacturer's own error). Subsequent measurement / remeasurement triggers: revise the total estimated cost and expected margin at each reporting date as actual costs emerge; a cumulative catch-up adjustment to revenue is required when a change in estimated total costs alters the progress percentage; if a loss-making position emerges, assess for an onerous contract provision under IAS 37 for the unavoidable excess of cost over the remaining contract revenue.

Disclosure of the judgment made on alternative use and enforceable right to payment, including the legal basis relied upon; the measure of progress used (cost-to-cost or output method) and why it faithfully depicts performance; contract assets (unbilled revenue) and contract liabilities (billings in excess of revenue) presented separately, with a reconciliation of movements; disaggregation of revenue between over-time and point-in-time contracts; remaining performance obligations / order backlog for significant custom-manufacturing contracts.

• Defaulting to over-time recognition simply because the product is customized, without a documented enforceable right-to-payment analysis under the actual governing law of the contract
• conversely, defaulting to point-in-time (delivery) recognition out of habit and missing genuine over-time contracts, which understates revenue and distorts period-to-period comparability
• using a cost-to-cost measure without excluding uninstalled or bulk-purchased materials that would otherwise overstate progress before the related work is actually performed
• failing to re-assess the analysis when contract addenda change cancellation or penalty clauses part-way through production
• not distinguishing contract assets from unconditional trade receivables in the balance sheet.