Over the past several months we have provided information about the new revenue recognition standard released by the Financial Accounting Standards Board (FASB); (Revenue from Contracts with Customers: Topic 606). The standard replaces the current revenue guidance found in multiple places in the FASB codification, and provides a single comprehensive standard that will apply to nearly all industries and will significantly change how revenue is recognized.
The standard provides a five step process for recognizing revenue, as follows:
- Identify the contract with the customer
- Identify the performance obligations in the contract
- Determine the transaction price for the contract
- Allocate the transaction price to each specific performance obligation
- Recognize the revenue when the entity satisfies each performance obligation
The first step of identifying the contract with the customer may sound easy as we all know when we have a contract in place, right?
ASC 606 has some nuances which make this more complicated than it may seem. This new standard defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. The standard also states that enforceability is “a matter of law.” As such, there are five elements that have to be present in order to have a contract under ASC 606:
- The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices), and are committed to perform their respective obligations.
- The entity can identify each party’s rights regarding the goods or services to be transferred.
- The entity can identify the payment terms for the goods or services to be transferred. This step is a substantial change from current generally accepted accounting principles (GAAP) which requires fixed and determinable payment terms. ASC 606 allows for variable consideration. The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).
- It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. Recognizing whether a contract exists requires some evaluation of the customer, and if collection is likely to occur. For example, the amount of consideration likely to be collected does not have to be the contractually stated amount. It can be the contractually stated amount less anticipated price concessions based on history or industry practice. In determining whether a contract exists, an entity only needs to consider the customer’s ability and intention to pay or, in other words, credit risk. Other uncertainties related to performance or measurement are considered in Step 3: Determining the Transaction Price and Step 5: Recognizing Revenue when the Performance Obligation is satisfied.
ASC 606 states that the process of establishing existence of contracts with customers will vary across legal jurisdictions, industries and entities. The existence of enforceable rights and obligations may depend on the class of customer or the nature of the goods or services.
Right to Cancel
It is important to know that a contract does not exist if either party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party. The new standard defines a wholly unperformed contract as one in which:
- The entity has not transferred any promised goods or services to the customer
- The entity has not received and is not yet entitled to receive any consideration for promised goods or services
Subsequent Accounting for a Contract
Once an entity determines that there is a contract based on the above criteria, there is no requirement to reassess the existence of a contract unless there is a significant change in circumstances. One of the examples given in the standard refers to substantial deterioration in a customer’s ability to pay for the goods or services after a contract begins. In this instance an entity may have to reassess whether it will collect the consideration to which it is entitled in exchange for the remaining goods or services in the contract. If the ability to pay for future obligations is not probable, then the criteria for a contract are not met. Clearly, an assessment like this involves significant judgment. The concept of bad debt expense and credit losses still exists and will be recognized as an expense in the income statement, as it is today. However, an entity will have to consider if credit deterioration of a customer relates to performance obligations that were already satisfied (bad debt) or performance obligations of the future which may impact the existence of a contract.
When a contract does not exist because the criteria above are not met, or are no longer met, a contract liability is measured and recorded at the amount of consideration received from the customer until revenue can be recognized. The standard allows revenue recognition in these circumstances when one of the following occurs:
- The entity has no remaining obligations to transfer goods or services to the customer and substantially all of the consideration promised has been received and is non-refundable
- The contract has been terminated and the consideration received is non-refundable
- The entity has transferred control of the goods or services to which the consideration received relates, and there is no obligation under the contract to transfer additional goods or services, and the consideration received is non-refundable
Two or more contracts entered into at or near the same time, with the same customer, can be accounted for as a single contract if one or more of the following are met:
- The contracts are negotiated as a package with a single commercial objective
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract
- The goods or services promised in the contracts are a single performance obligation
A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties to the contract. In some industries and jurisdictions, a contract modification may be described as a change order, a variation, or an amendment. A contract modification exists when the parties to a contract approve a modification that either creates new, or changes existing, enforceable rights and obligations of the parties to the contract. A contract modification could be approved in writing, by oral agreement, or implied by customary business practices.
A contract modification under the new standard has several different accounting treatments depending on the circumstances. It may be treated:
- As a separate contract
- As a termination of an existing contract and creation of a new contract
- As part of the existing contract
In evaluating the seemingly simple Step 1 – Identifying the Contract with the Customer there are some important things to keep in mind. First, an entity should review each of their contracts, possibly engaging the services of legal counsel to ensure that the contracts create legally enforceable rights and obligations. Attention should also be given to an entity’s credit policies to make sure that collectability of consideration under customer contracts is probable. The guidance on contract modifications briefly mentioned above is complex and may require careful consideration if this is common practice in your company or industry.