The New Revenue Recognition Standard: Step 1 – Identify the Contract with a Customer (Part I)
As mentioned in our previous blog, on May 28th the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers: Topic 606 The new standard creates a whole new codification topic (ASC 606) and ushers in a new era of revenue recognition by replacing hundreds of pages of industry specific guidance with a single comprehensive standard applicable to virtually all industries, and will significantly change how we recognize revenue. ASU 2014-09 isn’t effective for private entities until reporting periods beginning after December 15, 2017, but will be effective for public entities a year earlier.
ASC 606 creates a five-step process for recognizing revenue. The first step is to identify the contract with the customer.
Simple enough, we all know what a contract is, right? Unfortunately, determining when you have a contract might be more complicated than one might think.
Under ASC 606, a contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. The FASB went back and forth on whether a contract had to create legally enforceable rights and obligations. The final standard states that enforceability is “a matter of law.”
A contract under ASC 606 exists only when all of the following five elements have been met:
1. Approval and commitment of the parties. Approval can be in writing, orally or in accordance with customary business practices. For example, if an entity provides customer support for a period of one year, which automatically renews every year unless the customer cancels within 30 days of the automatic renewal, then a new contract would be created automatically once the cancellation window has lapsed.
2. Identification of the rights of the parties.
3. Identification of the payment terms. Notice this does not require the payment terms to be fixed or determinable as required under previous generally accepted accounting principles (GAAP). ASC 606 allows for variable consideration which is a significant change to GAAP. We will explore this topic in our blog on Step 3: “Determining the Transaction Price.”
4. The contract has commercial substance. What does commercial substance mean exactly? It means the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract. For example, some entities, typically in high-growth industries, engaged in transactions in which goods and services were transferred back and forth between the same entities in an attempt to show higher transaction volume and gross revenue (also known as “round-tripping”). Under ASC 606, this would not be considered a contract with a customer.
5. Collection is probable. Probable is defined as “likely to occur.” The FASB went back and forth over whether collectability was a requirement. At one point, FASB proposed that collectability wasn’t required but that bad debt expense should be an “above the line” deduction separately presented from revenue. Consequently, gross revenue would reflect contracts where collectability was unlikely but gross profit would not be impacted. The FASB settled on the idea that if at inception of the contract collection wasn’t likely, then no contract existed.
It is important to note that the amount of consideration which the entity believes is probable (i.e. “likely to occur”) of collection does not have to be the contractually stated amount. Rather, the contractually stated amount less expected price concessions. This is particularly important for entities in industries which historically have lower collection rates, such as the health care industry.
Interestingly, ASC 606 specifies that “an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due.” This leaves open the possibility that revenue could be recognized even if a customer currently does not have the ability to pay, but is likely to have the ability to pay when contractual amounts become due.
It’s also important to note that in this step of the revenue recognition process an entity will only consider credit risk, not other uncertainties, such as those related to performance or measurement, as these are accounted for separately in Step 3: Determining the Transaction Price and Step 5: Recognizing Revenue when (or as) the Performance Obligation is Satisfied.
The practices and processes for meeting the above criteria and establishing a contract under ASC 606 will vary across legal jurisdictions, industries, and entities. Importantly, it may also vary within an entity based on a class of customer, or the nature of the promised goods or services.
A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed (i.e. no goods/services yet transferred and no consideration has been or is entitled to be received) contract without compensating the other party.
Once a contract meets the above criteria, then it is not required to be reassessed unless there are indications of a significant change. For example, if a customer’s ability to pay the consideration deteriorated significantly subsequent to the contract formation. The key word and judgment is significant. Bad debt expense isn’t going away. Credit losses arising from a contract that was probable of collection at inception will be recognized as an expense in the income statement no differently than before. Judgment is required to determine the accounting when there is a significant deterioration in a customer’s ability to pay after the inception of an arrangement. Management will have to assess whether the deterioration relates to performance obligations previously satisfied, performance obligation to be performed in the future, or both.
However, if a contract doesn’t meet the above criteria at inception, then it should be reassessed each reporting period to determine whether the criteria have been met.
How to Account for Consideration Received When No Contract Exists
If consideration is received, and the contract criteria above have not been or are no longer met, then the entity should record a liability and revenue can only be recognized when either of the following has occurred:
- The entity has no remaining obligations to transfer goods/services, and substantially all of the consideration has been received and is nonrefundable.
- The contract has been terminated and the consideration received is nonrefundable.
This has important implications. Consider if an entity enters into a legal contract, but after fulfilling some of the performance obligations the customer declares bankruptcy and the entity now believes there that collection of the remaining consideration is not probable. Unless the entity decides to terminate the contract and the consideration already received is nonrefundable, then any amounts subsequently received cannot be recognized as revenue until one of the two above criteria are met.
An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties to the customer) and account for the contracts as a single contract, if one or more of the following criteria 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.
- Some of the goods or services promised in the contracts are a single performance obligation.
When evaluating Step 1, entities should review their standardized contracts, and contract formation policies and procedures with legal counsel to ensure that under the governing law contracts are properly approved and legally enforceable. In addition, entities should modify their current processes and policies surrounding granting credit and accounts receivable allowance determinations, and consider if a contract exists when collectability is not probable. The board has indicated that it expects “the population of transactions that would fail to meet the collectability criterion would be small.” In circumstances where entities believe that not all of the contract consideration will be received, entities should consider if a price concession has been granted and thus the transaction price is not the contractually stated price, but rather a lessor amount. Step 1 can get more complicated when contract modifications are considered, which will be the subject of our next blog.