The Milestone Method (#107)
/In this podcast episode, we discuss the details of the milestone method of recognizing revenue. Key points made are noted below.
Reason for the Milestone Method
This is a new revenue recognition method, and the FASB even gave it a new heading in the accounting codification. The new code for it is 605-28, in case you want to look it up. The milestone method is designed for recognizing research and development situations where you get paid only if a milestone event occurs. A milestone might be something like completing a certain phase in a drug study, and once that happens, you receive payment from a third party.
A key part of the milestone method is that it’s designed for situations not just where there’s a milestone event, but also where the event is uncertain. That means the milestone method does not apply when you’re going be paid just after some time goes by. Instead, you have to perform something, and there is some uncertainty about whether you can perform whatever it is.
Revenue Recognition
Under the milestone method, you recognize all of that payment as revenue as soon as you complete the related milestone, but only if the situation meets all of these criteria: First, the consideration being paid should only relate to past performance, so there’s no advance payment involved. Second, the consideration has to be reasonable in relation to the deliverables. In other words, you can’t set up an arrangement where there’s this massive payment tied to an early deliverable, just so you can recognize the revenue early. No such luck. Third, the consideration has to be reasonable in relation to either the work you performed or enhancing the value of the product. And finally, if even a portion of a payment made under a milestone arrangement can potentially be refunded under some sort of future penalty or clawback arrangement, then you can’t use that, either.
Since the second and third items are judgmental, you can expect auditors to review them pretty closely. If you try something really outlandish in this area, I’d expect the auditors to ask for a lot of documentation to support what you did.
Now, the measurement is not exactly precise. That means there’s some wiggle room, and if someone wants to build a little extra into the payments linked to early milestones, they can probably get away with it. I’m not advocating that, just saying that it’s possible.
Documentation Requirements
And another point is that you’re supposed to document all of this at the start of the arrangement. Payments that are linked to milestones are normally written into the contract with whichever third party is making the payments, so this pretty easy in terms of documentation.
However, that also means that if the contract is not clear about when payments are supposed to be made, you’ll have problems justify any revenue recognition under the milestone method. So if you do have a contract where payments aren’t clearly linked to milestones, you may want to create a contract amendment with the third party that makes this more clear.
Another issue is that you can choose to use the milestone method for one contract, but then recognize revenue in some other way for another contract, as long as it has different deliverables. So there’s no need to be monolithic about this and force everyone to use the milestone method everywhere. Having said that, though, you may be introducing too much complexity if the accounting staff has to deal with multiple recognition methods.
In some cases, you may have no choice. If a contract simply has no milestones, other than a single payment at the end, then you can’t use the milestone method.
There is a small twist on the ability to use a different revenue recognition method, though. If you use something other than the milestone method, it’s OK to do so, unless you end up recognizing all of the revenue in the period when the milestone occurs. In other words, you cannot use a different method if it massively accelerates recognition.
Disclosure Requirements
So what do you have to disclose?
If you’re using the milestone method, you should describe the overall arrangement, and each milestone and the related payments. You also have to disclose the amount of consideration recognized in the period for specific milestones.
Parting Thoughts
At a general level, the milestone method isn’t necessarily new, it’s just that there wasn’t any GAAP guidance for it at all – so people came up with their own milestone methods. By issuing this standard, everyone now has to do it the same way.
So how does this compare to international financial reporting standards? It doesn’t compare, because there’s nothing to compare it to. IFRS does not cover this area at all.