C.3 Step 1 — Identify the Contract With the Customer (Chapter 4 of the Roadmap)
C.3.1 Contract Enforceability and Termination Clauses — Implementation Q&As 7 and 8 (Compiled From TRG Agenda Papers 10, 11, 48, and 49)
The duration of a contract is predicated on the contract’s enforceable rights and
obligations. Accordingly, regardless of whether one or both parties have the
right to terminate the contract, an entity would need to evaluate the nature of
the termination provisions, including whether they are substantive. For example,
an entity would assess factors such as (1) whether the terminating party is
required to pay compensation, (2) the amount of such compensation, and (3) the
reason for the compensation (i.e., whether the compensation is in addition to
amounts due for goods and services already delivered).
The determination of whether a termination provision is substantive will require
judgment and would be evaluated both quantitatively and qualitatively. Data
about the frequency of contract terminations may be useful in such a
determination (i.e., a high frequency of payments made to terminate contracts
may suggest that the termination provision is not substantive).
When the term of a contract is less than the contract’s stated term (e.g., when
a 12-month contract is determined to be a month-to-month contract rather than
for a year, indicating that the penalty is not substantive), an entity would
have to (1) reassess the allocation of the transaction price, (2) include the
termination penalty in the transaction price (subject to the constraint on
variable consideration, if appropriate), and (3) assess whether the termination
provisions provide the customer with a material right (similarly to how the
entity would assess renewal options in a contract).
C.3.2 Collectibility — Implementation Q&As 9 and 10 (Compiled From TRG Agenda Papers 13 and 25)
A collectibility assessment should take the following considerations into
account:
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When collectibility is probable for a portfolio of contracts, the expected amount should be recognized as revenue, and the uncollectible amount should be recorded as an impairment loss.
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In determining when to reassess collectibility, an entity needs to exercise judgment on the basis of the facts and circumstances.
In May 2016, the FASB issued ASU 2016-12, which amends certain
aspects of the revenue standard. ASU 2016-12 clarifies the objective of the
entity’s collectibility assessment and contains new guidance on when an entity
would recognize as revenue consideration it receives if the entity concludes
that collectibility is not probable.
The following issues were discussed by the TRG but are not addressed in the
Implementation Q&As:
- The revenue standard clearly prohibits entities from recognizing revenue when collectibility is not probable despite any nonrefundable cash payments that may have been received. Essentially, cash-based accounting will no longer be permitted under the revenue standard.
- An assessment of whether a price adjustment is due to collectibility (i.e., credit) or a price concession is complex but can be performed in practice.
For additional information, see Chapter 4.
C.3.3 Legal Determination of Contract Enforceability — Implementation Q&A 11
As a result of various third-party published interpretations, and because the
guidance in ASC 606 refers to enforceability of rights and obligations as a
matter of law, some stakeholders have raised questions about whether legal
consultation is required as part of step 1. Although it is not a U.S. GAAP
requirement to consult with legal counsel for all revenue contracts, it may
sometimes be difficult to determine whether enforceable rights and obligations
have been established (e.g., when a contract is not written). In these cases, an
entity may need to perform additional steps, which may involve consultation with
legal counsel, to determine whether a contract exists for purposes of ASC 606.
In accordance with ASC 606-10-25-6, if the definition of a contract within the
scope of ASC 606 is not met at inception, the entity should continually reassess
its contract to determine whether the criteria for establishing the existence of
a contract under ASC 606 are subsequently met.