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Identifying Contracts with a Customer Under ASC 606 (Revenue Recognition Step 1)

Written by Michelle Sanchez on October 28, 2019

Warren Averett revenue recognition step 1

Revenue recognition can be a difficult topic to navigate. This is especially true when intent, timing, receipt of payments and delivery of goods or services don’t always align. When it comes to ASC 606, Revenue from Contracts with Customers (which became effective for public entities for fiscal years beginning after December 15, 2017 and for private entities for fiscal years beginning after December 15, 2018), it gets even murkier.

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The core tenet of ASC 606 is that companies should base revenue recognition on transferring what was promised to the customer and on the  quantifiable consideration they expect to receive in return. Because customers might not always make new contracts with every transaction, there has been much confusion as to whether a contract, binding or not, exists with the customer. This also affects how and when revenue from those transactions will be recognized. ASC 606 lays out five steps to follow when applying the core principle to transactions generating revenue:

  1. Identify the contract with the customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations
  5. Recognize revenue when (or as ) each performance obligation is satisfied

Exploring Step One: Identifying a Contract for ASC 606 Purposes

ASC 606 provides guidance on how a company should account for customer contracts, which makes it vital to be able to determine whether or not a contract exists.

A contract can be defined as “an agreement between two or more parties that creates enforceable rights and obligations.” In order to account for revenue resulting from contracts with customers under ASC 606, contracts must meet the following criteria:

  1. Approval and Commitment to the Contract
  2. and 3. Identification of Each Party’s Rights and Payment Terms
  3. Commercial Substance
  4. Collectability Threshold

What actually constitutes a contract? How does it become enforceable, and how would it change the way that your organization currently recognizes revenue from similar transactions?

Criterion 1: Approval and Commitment to the Contract

Both parties must approve the contact and be committed to their performance obligations. Per ASC 606, contracts don’t always have to be written. They can be oral or even implied by the typical way that a company does business or deals with a specific customer. These norms also vary by location and industry, such as IP-heavy businesses like film and video games that would have wildly different contractual norms from wholesale goods providers.

While it may be more difficult to prove the existence of an oral contract than a written contract, a contract is considered to not exist if both parties “have the unilateral and enforceable right to terminate a wholly unperformed contract without compensating the other party.” A contract would be considered wholly performed if the company never delivered the goods or services and never got paid for them.

The presence of contractual obligations is going to vary based on industry norms, state and local laws, and other factors. More frequent collaboration between the accounting and legal departments will likely be needed when implementing ASC 606. More legal guidance will be needed to develop company policies regarding approval requirements for different types of contracts, and whether they are legally enforceable.

Criteria 2 and 3: Identification of Each Party’s Rights and Payment Terms

The second and third criteria are fairly simple to understand in that each party’s obligations must be clearly identifiable, and payment terms must be specified.

However, both parties also must be able to objectively identify both explicit and implicit rights in the contract. For instance, if your company previously let a customer return goods to you, it should be considered an implicit right in the new contract even if the contract does not explicitly state this.

As long as there is an enforceable right to payment and the contract has enough information to determine a transaction price, then the contract is likely to require ASC 606 treatment, providing that the rest of the criteria are met.

As different customers may have specific deals and terms that they negotiated, make sure that all contracts clearly define implicit and explicit rights, as well as payment terms.

Criterion 4: Commercial Substance

It’s safe to say that most transactions will have commercial substance, but there may be cases where this doesn’t apply, such as artificially inflating sales volume by “round-tripping” transactions.

Commercial substance means that “the risk, timing or amount of an entity’s cash flows must be likely to change as a result of the contract.” This definition of commercial substance is consistent with current U.S. GAAP. Additional legal interpretation may be required for certain transactions.

Criterion 5: Collectability Threshold

It has to be probable that the company will collect all or most of the consideration it is contractually entitled to in exchange for the goods or services it is obligated to give to the customer.

To satisfy this criterion, the customer’s ability and intent to pay the consideration outlined in the contract has to be adequately assessed. While this doesn’t necessarily mean that the company must expect to collect all of the consideration promised in the contract, it should be reasonably expected to receive the consideration relative to what is expected to be transferred to the customer.

Such assessments could include running credit checks on the customer first, collecting a deposit upfront, utilizing milestone payments or maintaining the ability to discontinue service upon nonpayment. Customary business practices should be taken into account as well. While collectability isn’t considered in the transaction price, payment “likely to occur” under US Generally Accepted Accounting Principles relative to the goods and services outlined in the contract is an important factor in determining whether a valid contract exists.

When Should the Five Criteria Be Reassessed?

According to ASC 606, if the customer contract meets all of the criteria from the get-go, then there’s no need to reassess unless there’s a significant change in facts and circumstances. However, if the contract doesn’t satisfy all five criteria, then the contract should continue to be assessed to determine if the five criteria are subsequently met. If it doesn’t satisfy all five criteria and you’ve already received some form of consideration from the customer, revenue should only be recognized when one of the following events take place:

Consideration received from contracts like these should be recorded as an unearned revenue liability until one of the above events occurs, or the five criteria under ASC 606 have been satisfied.

Combining Contracts and Contract Modifications

Per ASC 606, two or more contracts with the same customer (or related parties) that were entered into around the same time can be accounted for as a singular contract if one or more of the following criteria are met:

  • “The contracts are negotiated as a package with just one commercial objective;
  • The amount of consideration to be paid in one contract 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 significantly change the price, scope or both, and they may be referred to as a change order, variation or amendment. Both parties must approve these changes.

It’s a modification and not a combination when both parties approve changes that create new enforceable rights and obligations or change the existing rights and obligations.

Oral and implied modifications can be approved; although, if one party has not yet approved the modification, then the guidance under ASC 606 must be applied to the existing contract until the modification is approved.

Contract modifications would be accounted for as a separate contract if both of the following conditions are met:

  1. “The contract’s scope increases due to distinct additions of promised goods or services;
  2. The price in the contract increases by an amount of consideration that reflects the standalone sale prices of the additional goods or services, and any appropriate adjustments pertinent the particular contract.”

If both of these conditions are not met, then the promised goods or services that weren’t yet transferred to the customer yet can be accounted for either of these ways:

  1. Account for the modification as “a termination of the existing contract and the creation of a new contract if the remaining goods or services are distinct from the goods or services transferred before the date of the modification;
  2. Account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the modification.”

Implementing Step One of ASC 606

Once you’ve defined if the contract exists, and then if it meets the contract existence criteria, we can move to Step Two of ASC 606: Identify the Performance Obligations in the Contract.

Read more about revenue recognition Step 2, Step 3, Step 4 and Step 5.

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This blog was originally written on October 2, 2017. It was most recently updated on October 28, 2019.

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