4.2 Identifying a Contract With a Customer
An important step in the revenue standard is determining when an
agreement with a customer represents a contract for accounting purposes. A contract
creates enforceable rights and obligations between two or more parties.
Enforceability of the rights and obligations is a matter of law. An agreement does
not need to be in writing to constitute a contract. A contract may exist if parties
orally agree to an arrangement’s terms. Alternatively, a contract could be implied
through customary business practices if those practices create enforceable rights
and obligations.
ASC 606-10
25-2 A contract is an agreement
between two or more parties that creates enforceable rights
and obligations. Enforceability of the rights and
obligations in a contract is a matter of law. Contracts can
be written, oral, or implied by an entity’s customary
business practices. The practices and processes for
establishing contracts with customers vary across legal
jurisdictions, industries, and entities. In addition, they
may vary within an entity (for example, they may depend on
the class of customer or the nature of the promised goods or
services). An entity shall consider those practices and
processes in determining whether and when an agreement with
a customer creates enforceable rights and obligations.
Because the rest of the revenue model cannot be applied until a
valid contract is in place, it is important to determine when enforceable rights and
obligations are created between two or more parties. Varying contracting practices
can sometimes make this determination difficult. Even if two parties are in basic
agreement about the main terms of a contract, no contract would exist if the
parties’ rights and obligations under the contract are not legally enforceable.
Determining whether a contractual right or obligation is enforceable is a question of
law, and the factors that determine enforceability may differ between jurisdictions.
The best evidence of an enforceable agreement is a written contract, especially if
the seller’s standard practice is to use written contracts.
Although ASC 606 does not require a written contract as evidence of an agreement, a
contract that is being prepared but has not yet been signed may be evidence that an
agreement has not yet been reached. Entities should use caution before recognizing
revenue in such circumstances because the apparent absence of a contractual
understanding between the parties may make it unlikely that the conditions in ASC
606-10-25-1 have been met.