The New Revenue Recognition Model – Step 1: Identifying the Contract with a Customer

Written on October 2, 2017

We are nearing the effective dates of the highly anticipated revenue recognition standard,

Revenue from Contracts with Customers (ASC 606). For public entities, the effective date of fiscal years beginning after December 15, 2017 is quickly approaching. For everyone else, there is an additional year to get ready, with an effective date of fiscal years beginning after December 15, 2018. Of course, early adoption is permitted for those who can’t wait to get started.

The core principle of the standard is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Sounds simple, right?  Well, as they say, the devil is often in the details.  To help you understand these details, we are issuing a series of articles, each one taking a closer look at one of the five steps in the revenue recognition model. For this article, we will be focusing on step 1 – identifying the contract(s) with a customer.

 

A contract can be defined as an agreement between two or more parties that creates enforceable rights and obligations. Under ASC 606, an entity should account for a contract with a customer that is within its scope only when all of the following criteria are met:

  1. The parties to the contract have approved the contract and are committed to perform their respective obligations.
  2. The entity can identify each party’s rights regarding the goods or services to be transferred.
  3. The entity can identify the payment terms for the goods or services to be transferred.
  4. The contract has commercial substance.
  5. 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 (collectability threshold).

As a practical expedient, ASC 606 allows for application of the guidance to a portfolio of contracts (or performance obligations) with similar characteristics, if an entity reasonably expects that the effects on the financial statements of applying the guidance to the portfolio would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio.

Criterion #1 – Approval and Commitment to the Contract
Under the first criterion, both parties must approve the arrangement and be committed to perform.  In other words, a contract creates enforceable rights and obligations between two parties. Enforceability of the rights and obligations in the contract is a matter of law. Contracts can be written, oral or implied by an entity’s customary business practices. These practices may vary across different legal jurisdictions, industries and entities.

A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party. A contract is wholly unperformed if both of the following criteria are met:

  • The entity has not yet transferred any promised goods or services to the customer.
  • The entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.

Key takeaway: Develop and document policies regarding approval requirements for different types of contracts. This may involve obtaining legal advice as to whether a contract is legally enforceable, particularly in the case of oral or implied contracts.

Criterion #2 and #3 – Identification of each Party’s Rights and Payment Terms
The second and third criteria are fairly straight forward – in that each party must be able to identify their rights regarding the goods or services to be transferred as well as the payment terms.

Entities need to be able to objectively identify both explicit and implicit rights in the contract.  For example, an entity’s past business practices of offering a general right of return would need to be considered as an implicit right in a contract, even when the contract is silent as to returns.

Under the new guidance, identifying the payment terms does not require that the transaction price be fixed or stated in the contract with the customer. Rather, provided there is an enforceable right to payment, and the contract contains sufficient information to estimate the transaction price, the contract is likely to qualify for accounting under ASC 606, provided all the other criteria are met.

Key takeaway: Thoroughly review all contracts, and discern both explicit and implicit rights as well as payment terms. These rights and payment terms could vary among different customers, industries or even among different contracts with the same customers.

Criterion #4 – Commercial Substance
The fourth criterion requires that the contract have commercial substance. In order to have commercial substance, the risk, timing or amount of an entity’s cash flows must be likely to change as a result of the contract. The commercial substance criterion was established to prevent entities from artificially inflating revenue, such as grossing up revenues through round-tripping transactions, whereby the parties exchange the same goods and services to show higher volume.

Key takeaway: The commercial substance determination is consistent with current US GAAP, and in some cases, could require significant judgement or legal interpretation. Entities should ensure that their contracts pass the commercial substance test.

Criterion #5 – Collectability Threshold
The fifth criterion requires that it be probable that the entity will collect substantially all of the consideration it is entitled to in exchange for the goods or services that will be transferred. The term probable is defined consistently with Current US GAAP, which is “likely to occur.”

This requires an assessment of both the customer’s ability and intent to pay substantially all of the consideration promised in exchange for the goods or services that will be transferred to the customer. In other words, an expectation of collecting all of the consideration promised in the contract is not required, only the consideration related to goods or services that will be transferred to the customer. As part of this assessment, an entity should consider its exposure to credit risk and its ability to mitigate that credit risk. Examples of contractual terms or customary business practices that might mitigate credit risk include the following:

  • Requiring up-front payment terms whereby the entity receives consideration before the transfer of the promised goods or services.
  • The ability to stop transferring the promised goods or services. (e.g. the ability to discontinue providing service in the third month of a 12 month contract in the event of customer nonpayment.)

Key takeaway: The collectability assessment requires judgement and consideration of all the facts and circumstances, including the entity’s customary business practices and its knowledge of the customer, in determining whether it is probable that an entity will collect substantially all of the consideration to which it expects to be entitled. Collectability is not considered in the transaction price, however, it is an important factor in determining whether a valid contract exists.

To Reassess or Not Reassess, That is the Question 
If a contract meets all of the above criteria at contract inception, those criteria should not be reassessed unless there is an indication of a significant change in facts and circumstances.

If a contract does not meet the above criteria, than the contract should continue to be assessed to determine whether the criteria are subsequently met. When a contract does not meet the criteria to be considered a contract under ASC 606 and consideration is received from the customer, the entity should recognize the consideration received as revenue only when one or more of the following have occurred:

  • The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
  • The contract has been terminated, and the consideration received from the customer is nonrefundable.
  • The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.

Consideration received from the customer should be recognized as a liability until one of the events above occurs or until the contract meets the criteria to be considered a contract with a customer under ASC 606. The liability recognized represents the entity’s obligation to transfer goods or services, or to refund the consideration received.

Combining Contracts
Two or more contracts that are entered into at or near the same time with the same customer (or related parties) should be accounted for as a single contract if any 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 contracts depends on the price or performance of the other contract,
  • The goods and services promised in the contracts (or some goods or services promised in the contracts) represent a single performance obligation.

Contract Modifications
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 (sometimes called a change order, a variation or an amendment). A modification exists when the parties approve a modification that either creates new, enforceable rights and obligations of the parties within the contract, or changes the existing rights and obligations. A contract modification could be approved in writing, through oral agreement or implied by customary business practice. If the parties to a contract have not approved a contract modification, an entity should continue to apply the guidance in the Standard to the existing contract until the contract modification is approved.

The contract modification would be accounted for as a separate contract if both the following conditions are present.

  • There is a promise of additional goods or services that are distinct; and
  • The price of the contract increases by an amount that represents the entity’s standalone selling price of the additional promised goods or services.

If both of the above criteria are not present, an entity should account for the promised goods or services not yet transferred (the remaining goods or services) in one of the following ways:

  • An entity should account for the modification as a termination of the original contract and the establishment of a new contract if the remaining goods or services are distinct from the goods or services transferred before the date of the modification.
  • An entity should account for the modification as if it were a part of the original contract if the remaining goods or services are not distinct and are part of a single performance obligation that is partially satisfied at the date of the modification.
  • If the remaining goods or services are a combination of the above items, then the entity should account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations in the modified contract in a manner that is consistent with the objectives within the above paragraphs.

In summary, there are several steps to go through to determine whether a contract exists. Some of these steps are straightforward, and others may require a significant amount of judgement. It is a good idea for entities to be proactive and review their existing contract terminology to determine whether they will indeed qualify as contracts under ASC 606. Please contact your local Warren Averett advisor with any questions regarding revenue recognition under ASC 606.

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