Chapter 4 — Step 1: Identify the Contract

4.3 Criteria for Identifying a Contract With a Customer

As shown below, ASC 606-10-25-1 provides criteria that an entity should evaluate at contract inception to determine whether an arrangement should be accounted for under the revenue standard.

ASC 606-10

25-1 An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met:

The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
The entity can identify each party’s rights regarding the goods or services to be transferred.
The entity can identify the payment terms for the goods or services to be transferred.
The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).
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 (see paragraphs 606-10-55-3A through 55-3C). In evaluating whether collectibility of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession (see paragraph 606-10- 32-7).

In many instances, the evaluation of the criteria in ASC 606-10-25-1 should be straightforward. However, certain arrangements will require careful evaluation to determine whether the contract creates enforceable rights and obligations between an entity and its customer.

Sections 4.3.1 through 4.3.5.5 further discuss each of the five criteria required to establish a contract with a customer.

4.3.1 Each Party Has Approved the Contract and Is Committed to Perform

For a contract to be accounted for under the revenue standard, the parties must approve the contract and be committed to perform their respective obligations.

A party may approve a contract in writing, orally, or through its customary business practices. If both parties to a contract do not approve the contract, it is unclear whether that contract creates enforceable rights and obligations that bind the parties to perform their respective obligations. Paragraph BC35 of ASU 2014-09 states, in part, that “the form of the contract does not, in and of itself, determine whether the parties have approved the contract.” Entities will need to evaluate all relevant facts and circumstances, including their customary business practices, to determine whether both parties have approved the contract.

As noted above, each party must also be committed to perform under the contract. However, paragraph BC36 of ASU 2014-09 clarifies that each party will not always need to be committed to performing all of its obligations to meet this requirement. To illustrate, paragraph BC36 cites an example in which a customer is contractually required to make a minimum monthly purchase of goods provided by an entity. Despite the requirement, the customer does not always make the minimum monthly purchase and historically has not been forced by the entity to comply. In this example, the contractual requirement could still be met because the parties have demonstrated that they are “substantially committed to the contract.”1

ASC 606 does not apply to a wholly unperformed contract when each party has the unilateral ability to terminate the contract without compensating the other party. Accordingly, entities will need to carefully consider termination clauses when evaluating whether each party is committed to the contract. For further discussion, see Sections 4.4 and 4.8.

Sometimes, after a contract between two parties expires and before they execute a new contract, both parties will continue to perform under the terms of the expired contract, thereby indicating that even in the absence of a formally executed contract, a contract may exist since both parties remain committed to perform. Entities should use caution in making this assessment and ensure that a careful evaluation of the specific facts and circumstances is performed to determine whether an enforceable contract exists.

Example 4-1

On May 1, 20X7, Entity A entered into a 6-month contract with Customer B to provide services in exchange for $100 per month. The contract did not include any automatic extension provisions and expired on October 31, 20X7. After the contract expired, the parties commenced negotiations for a new contract, under which A would provide the same services to B. The price that A would charge B for the services was the main point of negotiations between the parties. The two parties completed negotiations and executed a new, 12-month contract on January 31, 20X8, that is retroactive to November 1, 20X7. The new contract requires B to pay $150 per month.

Entity A’s customary business practice is to continue providing services to a customer while negotiations for a new contract occur after the expiration of an existing contract. Accordingly, during the interim period (i.e., November 1, 20X7, through January 31, 20X8) in which contract negotiations occurred, A continued to provide services and B continued to pay $100 per month. The $100 monthly fee paid by B during the interim period is nonrefundable.

Aside from the increased fee and longer contract duration, all other contract attributes are the same between the expired contract and the new contract, and no disputes occurred during the interim period.

To determine whether a contract existed during the interim period while a new contract was being negotiated, A should evaluate whether each party had enforceable rights and obligations during the interim period. ASC 606-10-25-2 states, in part, that “[e]nforceability of the rights and obligations in a contract is a matter of law.” This assessment requires judgment, especially in the absence of automatic renewal provisions in the original contract. Accordingly, A should analyze the parties’ rights and obligations to determine the legal enforceability of the contract in the relevant jurisdiction.

Entity A should also consider whether the negotiations and execution of the new contract are within the scope of the revenue standard’s guidance on contract modifications. ASC 606-10-25-11 notes that a contract modification may exist when a change in the scope or price of the contract has not yet been resolved. When a change in scope has been approved by the parties, an entity is required under ASC 606-10-25-11 to “estimate the change to the transaction price arising from the modification in accordance with paragraphs 606-10-32-5 through 32-9 on estimating variable consideration and paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration.”

In the situation described above, it appears that a contract existed during the interim period because A continued to provide services to B in a manner consistent with A’s customary business practice. Further, in exchange for the services and in accordance with the terms of the original contract, B continued to pay A $100 per month, which is nonrefundable. On the basis of these facts, it appears that both parties had enforceable rights and obligations during the interim period and that it would therefore be inappropriate to delay revenue recognition until the new agreement was signed on January 31, 20X8. Upon execution of the new agreement, A should analyze the revenue standard’s guidance on contract modifications to determine the appropriate accounting.

Certain arrangements provide a customer with free goods or services at the onset of the arrangement. The period over which such free goods or services are provided is sometimes referred to as a trial period. An entity must evaluate whether a contract exists during a trial period and, if so, the appropriate timing of revenue recognition during the trial period. In these circumstances, an entity must carefully evaluate whether all of the criteria in ASC 606-10-25-1 are met, particularly whether the parties have each approved the contract and are committed to perform their respective obligations. Factors to consider include whether the trial period is risk-free, whether the customer has an obligation to make further purchases beyond the trial period, and whether the goods or services transferred during the trial period are, in fact, performance obligations. This determination may require an entity to use judgment on the basis of the specific facts and circumstances of the arrangement.

Two types of trial periods that an entity may offer to solicit customers are (1) “risk-free” trials (i.e., the customer is not committed to a contract until some of the goods or services are delivered) and (2) the delivery of “free” goods or services upon execution of a contract (i.e., a contract under the revenue standard exists when the free goods or services are delivered). As noted above, it is essential to evaluate whether a contract with a customer exists under the revenue standard to determine whether the goods or services provided during the trial period are performance obligations to which revenue should be allocated and recognized when control of the promised goods or services is transferred to the customer. In addition, consideration should be given to whether the entity’s performance obligation to transfer the goods or services during the trial period is satisfied at a point in time or over time (i.e., partly during the trial period and partly during the contractual period). Such factors are likely to affect the determination of whether and, if so, when revenue is recognized for the goods or services provided during the trial period.

Example 4-2

Entity A has a marketing program that offers a three-month “trial period” during which a customer can obtain free issues of a monthly magazine. If the customer does not cancel at the end of three months, it will be charged the annual subscription fee of $144, or $12 per month (inclusive of the trial period).

Because the customer in the arrangement is not committed to perform, no contract exists during the free trial period unless and until the customer “accepts” the offer. Once the customer accepts the offer and has the intent and ability to pay $144 for an annual subscription to the monthly magazine (i.e., collectibility is probable), a valid contract exists and the rest of the revenue recognition model can be applied.

Questions have been raised about whether any of the transaction price should be allocated to the free goods or services once the existence of a contract is established. For further discussion, see Section 8.9.3.

4.3.2 The Entity Can Identify Each Party’s Rights

An entity must be able to identify each party’s rights related to the promised goods or services in the contract. Without knowing each party’s rights, an entity would not be able to identify its performance obligations and determine when control of the goods and services are transferred to the customer (i.e., when to recognize revenue). Parties to the contract have valid rights and obligations when both (1) the entity has a right to receive consideration from the customer in exchange for the transfer of goods or services and (2) the customer has a right to require the entity to perform (i.e., transfer goods or services).

4.3.3 The Entity Can Identify the Payment Terms

A contract must include payment terms for each of the promised goods and services in an arrangement for an entity to determine the transaction price. The payment terms do not need to be fixed, but the contract must contain enough information to allow an entity to reasonably estimate the consideration to which it will be entitled for transferring the goods and services to the customer. See Section 6.1 for more information on determining the transaction price and Section 6.3 for information about variable consideration.

4.3.4 The Contract Has Commercial Substance

For a contract to have commercial substance, the risk, timing, or amount of an entity’s future cash flows must be expected to change as a result of the contract. That is, the transaction(s) between the parties should have economic consequences. Most business transactions will involve an entity’s sale of goods or services in exchange for cash; therefore, an entity’s future cash flows are expected to change as a result of the arrangement. Arrangements that include noncash consideration may require an entity to perform further analysis in evaluating whether the contract has commercial substance. The commercial substance requirement in the revenue standard is consistent with the principles of ASC 845 for evaluating whether a nonmonetary exchange has commercial substance; however, the criterion needs to be evaluated for all contracts (not just those with nonmonetary consideration).

Connecting the Dots

Exchange transactions involving nonmonetary consideration often require careful analysis to determine the substance of the arrangement. For example, a round-trip transaction is an arrangement in which an entity sells goods or services to a customer that in turn sells the same or similar goods or services back to the entity. The substance of the transaction is critical to determining the appropriate accounting. The individual transactions in a round-trip transaction are often entered into in contemplation of one another and may lack commercial substance. That is, the entity’s future cash flows are not expected to change as a result of the arrangement. If such a transaction is not accounted for properly, it can lead to artificial inflation of the revenues of each party to the contract.2

As noted above, the standard’s revenue model cannot be applied (and no revenue can be recognized) until a contract exists for accounting purposes. However, entities sometimes commence activities under a specific anticipated contract with a customer (e.g., construction of an asset) before the parties have agreed to all of the contract terms or before the criteria for identifying the contract in ASC 606-10-25-1 have been satisfied. No revenue can be recognized during the precontract phase since the contract existence criteria have not been met. See Section 8.9.2 for a discussion of how to account for these types of arrangements once the contract existence criteria are met. In addition, see Section 13.3 for further discussion of capitalization of certain costs that an entity incurred to fulfill a specific anticipated contract with a customer.

4.3.5 Collectibility Is Probable

ASC 606-10-25-1(e) requires an entity to evaluate whether it is probable3 that substantially all of the consideration to which the entity will be entitled for goods or services transferred to the customer will be collected. This analysis is performed at contract inception and is not revisited unless there is a significant change in facts and circumstances (see Section 4.5). Such an evaluation should take into account only the customer’s ability and intention to pay the consideration when it is due. All facts and circumstances should be considered in the evaluation of a customer’s ability and intention to pay amounts due. Such facts and circumstances could include past experience with the customer, class of customer, and expectations about the customer’s financial stability, as well as other factors.

4.3.5.1 Price Concessions

As part of determining whether a valid and genuine contract exists, an entity is required to evaluate whether it is probable that the entity will collect substantially all of the consideration to which it is entitled under the contract. However, the consideration to which an entity is ultimately entitled may be less than the price stated in the contract because the customer is offered a price concession. Price concessions are a form of variable consideration (see Section 6.3) and need to be analyzed when the transaction price is being determined (as part of step 3 of the standard’s revenue model). However, as part of step 1, an entity would evaluate whether it is probable that the entity will collect the consideration to which it will be entitled for providing goods or services to a customer after considering any price concessions. This evaluation requires aspects of step 3 to be performed in conjunction with step 1. Differentiating between credit risk (i.e., the risk of collecting less consideration than the amount the entity legitimately expected to collect from the customer) and price concessions (i.e., entering into a contract with a customer with the expectation of accepting less than the contractual amount of consideration in exchange for goods or services) may be difficult. Entities will need to use significant judgment on the basis of all relevant facts and circumstances in determining whether they have provided an implicit price concession (variable consideration to be estimated in step 3, as discussed in Chapter 6) or have accepted a customer’s credit risk (to be evaluated in step 1 herein). This is particularly true of entities in highly regulated industries, such as health care and consumer energy, which may be required by law to provide certain goods and services to their customers regardless of the customers’ ability to pay.

The following indicators may suggest that rather than accepting the customer’s credit risk, the entity has offered a price concession (which would be evaluated as variable consideration):

The entity has a customary business practice of providing discounts or accepting as payment less than the contractually stated price regardless of whether such a practice is explicitly stated at contract inception or specifically communicated or offered to the customer.
The customer has a valid expectation that the entity will accept less than that contractually stated price. This could be due to customary business practices, published policies, or specific statements made by the entity.
The entity transfers the goods or services to the customer, and continues to do so, even when historical experience indicates that it is not probable that the entity will collect the billed amount.
Other facts and circumstances indicate that the customer intends to pay an amount that is less than the contractually stated price, and the entity nonetheless enters into a contract with the customer.
The entity has a customary business practice of not performing a credit assessment before transferring goods or services to the customer (e.g., the entity is required by law or regulation to provide emergency medical services before assessing the customer’s ability or intention to pay).

Examples 2 and 3 in ASC 606 illustrate how an entity would evaluate implicit price concessions when assessing whether the collectibility criterion is met.

ASC 606-10

Example 2 — Consideration Is Not the Stated Price — Implicit Price Concession

55-99 An entity sells 1,000 units of a prescription drug to a customer for promised consideration of $1 million. This is the entity’s first sale to a customer in a new region, which is experiencing significant economic difficulty. Thus, the entity expects that it will not be able to collect from the customer the full amount of the promised consideration. Despite the possibility of not collecting the full amount, the entity expects the region’s economy to recover over the next two to three years and determines that a relationship with the customer could help it to forge relationships with other potential customers in the region.

55-100 When assessing whether the criterion in paragraph 606-10-25-1(e) is met, the entity also considers paragraphs 606-10-32-2 and 606-10-32-7(b). Based on the assessment of the facts and circumstances, the entity determines that it expects to provide a price concession and accept a lower amount of consideration from the customer. Accordingly, the entity concludes that the transaction price is not $1 million and, therefore, the promised consideration is variable. The entity estimates the variable consideration and determines that it expects to be entitled to $400,000.

55-101 The entity considers the customer’s ability and intention to pay the consideration and concludes that even though the region is experiencing economic difficulty it is probable that it will collect $400,000 from the customer. Consequently, the entity concludes that the criterion in paragraph 606-10-25-1(e) is met based on an estimate of variable consideration of $400,000. In addition, based on an evaluation of the contract terms and other facts and circumstances, the entity concludes that the other criteria in paragraph 606-10-25-1 are also met. Consequently, the entity accounts for the contract with the customer in accordance with the guidance in this Topic.

Example 3 — Implicit Price Concession

55-102 An entity, a hospital, provides medical services to an uninsured patient in the emergency room. The entity has not previously provided medical services to this patient but is required by law to provide medical services to all emergency room patients. Because of the patient’s condition upon arrival at the hospital, the entity provides the services immediately and, therefore, before the entity can determine whether the patient is committed to perform its obligations under the contract in exchange for the medical services provided. Consequently, the contract does not meet the criteria in paragraph 606-10-25-1, and in accordance with paragraph 606-10-25-6, the entity will continue to assess its conclusion based on updated facts and circumstances.

55-103 After providing services, the entity obtains additional information about the patient including a review of the services provided, standard rates for such services, and the patient’s ability and intention to pay the entity for the services provided. During the review, the entity notes its standard rate for the services provided in the emergency room is $10,000. The entity also reviews the patient’s information and to be consistent with its policies designates the patient to a customer class based on the entity’s assessment of the patient’s ability and intention to pay. The entity determines that the services provided are not charity care based on the entity’s internal policy and the patient’s income level. In addition, the patient does not qualify for governmental subsidies

55-104 Before reassessing whether the criteria in paragraph 606-10-25-1 have been met, the entity considers paragraphs 606-10-32-2 and 606-10-32-7(b). Although the standard rate for the services is $10,000 (which may be the amount invoiced to the patient), the entity expects to accept a lower amount of consideration in exchange for the services. Accordingly, the entity concludes that the transaction price is not $10,000 and, therefore, the promised consideration is variable. The entity reviews its historical cash collections from this customer class and other relevant information about the patient. The entity estimates the variable consideration and determines that it expects to be entitled to $1,000.

55-105 In accordance with paragraph 606-10-25-1(e), the entity evaluates the patient’s ability and intention to pay (that is, the credit risk of the patient). On the basis of its collection history from patients in this customer class, the entity concludes it is probable that the entity will collect $1,000 (which is the estimate of variable consideration). In addition, on the basis of an assessment of the contract terms and other facts and circumstances, the entity concludes that the other criteria in paragraph 606-10-25-1 also are met. Consequently, the entity accounts for the contract with the patient in accordance with the guidance in this Topic.

4.3.5.2 Evaluating Credit Risk

The existence of the collectibility requirement does not eliminate credit risk in a contract with a customer. Not all differences between the contractually stated price and the amount ultimately collected by the entity will be due to explicit or implied concessions. Entities may (1) assume collection risk and (2) incur bad debt.

The following indicators may suggest that rather than granting a price concession, the entity has incurred a bad debt:

The entity has the ability and intent to stop transferring goods or services to the customer and has no obligation to transfer additional goods or services in the event of nonpayment for goods or services already transferred to the customer (e.g., in the event of nonpayment by a utility customer, the utility provider ceases to provide further services to the customer).
The entity believes that it will collect the consideration due and intends to enforce the contract price, but it knowingly accepts the risk of default by the customer. For example, the entity is able to conclude that the criterion in ASC 606-10-25-1(e) is met, but it is aware of the customer’s increased risk of bankruptcy and chooses to provide the contractually agreed-upon goods or services to the customer despite this fact.
The customer’s financial condition has significantly deteriorated since contract inception.
The entity has a pool of homogeneous customers that have similar credit profiles. Although it is expected that substantially all of the customers will be able to pay amounts when due, it is also expected that a small (not currently identifiable) number of customers may not be able to pay amounts when due.

The criterion in ASC 606-10-25-1(e) acts as a collectibility threshold and requires an entity to assess its customer’s credit risk in determining whether a valid contract exists. The term “probable” is defined in the ASC 606 glossary as the “future event or events are likely to occur.”

4.3.5.3 Collectibility Assessment — Other Considerations

Paragraph BC46 of ASU 2014-09 notes that the FASB and IASB intended the collectibility assessment to be made only for consideration to which an entity would be entitled in exchange for the goods or services that will be transferred to the customer. That is, if the customer fails to pay for goods or services transferred and the entity reacts by not transferring any additional goods or services to the customer, only the consideration associated with the goods or services already transferred to the customer should be assessed for collectibility.

In ASU 2016-12,4 the FASB (1) further clarified the objective of the collectibility threshold, (2) provided implementation guidance on how to evaluate circumstances in which credit risk is mitigated, and (3) added guidance on when revenue should be recognized if a contract fails to meet the requirements in ASC 606-10-25-1 (see Section 4.6).

ASU 2016-12 added the following implementation guidance to assist in the analysis of the collectibility threshold:

ASC 606-10

55-3A Paragraph 606-10-25-1(e) requires an entity to assess whether 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. The assessment, which is part of identifying whether there is a contract with a customer, is based on whether the customer has the ability and intention to pay the consideration to which the entity will be entitled in exchange for the goods or services that will be transferred to the customer. The objective of this assessment is to evaluate whether there is a substantive transaction between the entity and the customer, which is a necessary condition for the contract to be accounted for under the revenue model in this Topic.

55-3B The collectibility assessment in paragraph 606-10-25-1(e) is partly a forward-looking assessment. It requires an entity to use judgment and consider all of the facts and circumstances, including the entity’s customary business practices and its knowledge of the customer, in determining whether 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 the entity expects to transfer to the customer. The assessment is not necessarily based on the customer’s ability and intention to pay the entire amount of promised consideration for the entire duration of the contract.

55-3C When assessing whether a contract meets the criterion in paragraph 606-10-25-1(e), an entity should determine whether the contractual terms and its customary business practices indicate that the entity’s exposure to credit risk is less than the entire consideration promised in the contract because the entity has the ability to mitigate its credit risk. Examples of contractual terms or customary business practices that might mitigate the entity’s credit risk include the following:

Payment terms — In some contracts, payment terms limit an entity’s exposure to credit risk. For example, a customer may be required to pay a portion of the consideration promised in the contract before the entity transfers promised goods or services to the customer. In those cases, any consideration that will be received before the entity transfers promised goods or services to the customer would not be subject to credit risk.
The ability to stop transferring promised goods or services — An entity may limit its exposure to credit risk if it has the right to stop transferring additional goods or services to a customer in the event that the customer fails to pay consideration when it is due. In those cases, an entity should assess only the collectibility of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer on the basis of the entity’s rights and customary business practices. Therefore, if the customer fails to perform as promised and, consequently, the entity would respond to the customer’s failure to perform by not transferring additional goods or services to the customer, the entity would not consider the likelihood of payment for the promised goods or services that will not be transferred under the contract.

An entity’s ability to repossess an asset transferred to a customer should not be considered for the purpose of assessing the entity’s ability to mitigate its exposure to credit risk.

The objective of the collectibility assessment is to determine whether there is a substantive transaction between the entity and the customer. There is deemed to be a substantive transaction between the two parties if it is probable that the entity will collect substantially all of the consideration attributed to goods or services that will be transferred to the customer. If the entity has an ability, and an established business practice, to mitigate collection risk by not transferring additional goods or services to a nonpaying customer, the entity would assess collectibility of only the consideration associated with the goods or services that will be transferred to the customer. Once the criteria in ASC 606-10-25-1 are met, the remainder of the guidance in ASC 606 should be applied to all of the promised goods or services in the contract. That is, an entity will assume that it will transfer all goods or services promised under the contract with its customer for purposes of identifying performance obligations, determining and allocating the transaction price, and recognizing revenue.

The following examples in ASC 606, which were added by ASU 2016-12, further illustrate the collectibility assessment:

ASC 606-10

Example 1 — Collectibility of the Consideration

Case A — Collectibility Is Not Probable

55-95 An entity, a real estate developer, enters into a contract with a customer for the sale of a building for $1 million. The customer intends to open a restaurant in the building. The building is located in an area where new restaurants face high levels of competition, and the customer has little experience in the restaurant industry.

55-96 The customer pays a nonrefundable deposit of $50,000 at inception of the contract and enters into a long-term financing agreement with the entity for the remaining 95 percent of the promised consideration. The financing arrangement is provided on a nonrecourse basis, which means that if the customer defaults, the entity can repossess the building but cannot seek further compensation from the customer, even if the collateral does not cover the full value of the amount owed.

55-97 The entity concludes that not all of the criteria in paragraph 606-10-25-1 are met. The entity concludes that the criterion in paragraph 606-10-25-1(e) is not met because it is not probable that the entity will collect substantially all of the consideration to which it is entitled in exchange for the transfer of the building. In reaching this conclusion, the entity observes that the customer’s ability and intention to pay may be in doubt because of the following factors:

The customer intends to repay the loan (which has a significant balance) primarily from income derived from its restaurant business (which is a business facing significant risks because of high competition in the industry and the customer’s limited experience).
The customer lacks other income or assets that could be used to repay the loan.
The customer’s liability under the loan is limited because the loan is nonrecourse.

55-98 The entity continues to assess the contract in accordance with paragraph 606-10-25-6 to determine whether the criteria in paragraph 606-10-25-1 are subsequently met or whether the events in paragraph 606-10-25-7 have occurred.

Case B — Credit Risk Is Mitigated

55-98A An entity, a service provider, enters into a three-year service contract with a new customer of low credit quality at the beginning of a calendar month.

55-98B The transaction price of the contract is $720, and $20 is due at the end of each month. The standalone selling price of the monthly service is $20. Both parties are subject to termination penalties if the contract is cancelled.

55-98C The entity’s history with this class of customer indicates that while the entity cannot conclude it is probable the customer will pay the transaction price of $720, the customer is expected to make the payments required under the contract for at least 9 months. If, during the contract term, the customer stops making the required payments, the entity’s customary business practice is to limit its credit risk by not transferring further services to the customer and to pursue collection for the unpaid services.

55-98D In assessing whether the contract meets the criteria in paragraph 606-10-25-1, the entity assesses whether it is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the services that will be transferred to the customer. This includes assessing the entity’s history with this class of customer in accordance with paragraph 606-10-55-3B and its business practice of stopping service in response to customer nonpayment in accordance with paragraph 606-10-55-3C. Consequently, as part of this analysis, the entity does not consider the likelihood of payment for services that would not be provided in the event of the customer’s nonpayment because the entity is not exposed to credit risk for those services.

55-98E It is not probable that the entity will collect the entire transaction price ($720) because of the customer’s low credit rating. However, the entity’s exposure to credit risk is mitigated because the entity has the ability and intention (as evidenced by its customary business practice) to stop providing services if the customer does not pay the promised consideration for services provided when it is due. Therefore, the entity concludes that the contract meets the criterion in paragraph 606-10-25-1(e) because it is probable that the customer will pay substantially all of the consideration to which the entity is entitled for the services the entity will transfer to the customer (that is, for the services the entity will provide for as long as the customer continues to pay for the services provided). Consequently, assuming the criteria in paragraph 606-10-25-1(a) through (d) are met, the entity would apply the remaining guidance in this Topic to recognize revenue and only reassess the criteria in paragraph 606-10-25-1 if there is an indication of a significant change in facts or circumstances such as the customer not making its required payments.

Case C — Credit Risk Is Not Mitigated

55-98F The same facts as in Case B apply to Case C, except that the entity’s history with this class of customer indicates that there is a risk that the customer will not pay substantially all of the consideration for services received from the entity, including the risk that the entity will never receive any payment for any services provided.

55-98G In assessing whether the contract with the customer meets the criteria in paragraph 606-10-25-1, the entity assesses whether it is probable that it 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. This includes assessing the entity’s history with this class of customer and its business practice of stopping service in response to the customer’s nonpayment in accordance with paragraph 606-10-55-3C.

55-98H At contract inception, the entity concludes that the criterion in paragraph 606-10-25-1(e) is not met because it is not probable that the customer will pay substantially all of the consideration to which the entity will be entitled under the contract for the services that will be transferred to the customer. The entity concludes that not only is there a risk that the customer will not pay for services received from the entity, but also there is a risk that the entity will never receive any payment for any services provided. Subsequently, when the customer initially pays for one month of service, the entity accounts for the consideration received in accordance with paragraphs 606-10-25-7 through 25-8. The entity concludes that none of the events in paragraph 606-10-25-7 have occurred because the contract has not been terminated, the entity has not received substantially all of the consideration promised in the contract, and the entity is continuing to provide services to the customer.

55-98I Assume that the customer has made timely payments for several months. In accordance with paragraph 606-10-25-6, the entity assesses the contract to determine whether the criteria in paragraph 606-10-25-1 are subsequently met. In making that evaluation, the entity considers, among other things, its experience with this specific customer. On the basis of the customer’s performance under the contract, the entity concludes that the criteria in 606-10-25-1 have been met, including the collectibility criterion in paragraph 606-10-25-1(e). Once the criteria in paragraph 606-10-25-1 are met, the entity applies the remaining guidance in this Topic to recognize revenue.

Case D — Advance Payment

55-98J An entity, a health club, enters into a one-year membership with a customer of low credit quality. The transaction price of the contract is $120, and $10 is due at the beginning of each month. The standalone selling price of the monthly service is $10.

55-98K On the basis of the customer’s credit history and in accordance with the entity’s customary business practice, the customer is required to pay each month before the entity provides the customer with access to the health club. In response to nonpayment, the entity’s customary business practice is to stop providing service to the customer upon nonpayment. The entity does not have exposure to credit risk because all payments are made in advance and the entity does not provide services unless the advance payment has been received.

55-98L The contract meets the criterion in paragraph 606-10-25-1(e) because it is probable that the entity will collect the consideration to which it will be entitled in exchange for the services that will be transferred to the customer (that is, one month of payment in advance for each month of service).

Connecting the Dots

As noted in ASC 606-10-55-3B, the collectibility assessment is partly a forward-looking assessment that requires an entity to evaluate a customer’s intention and ability to pay promised consideration when due. An entity may need to consider both the current and future financial condition of a customer when making this assessment. For example, in a situation involving a license of intellectual property (IP) for which consideration due is in the form of sales- and usage-based royalties, the entity may determine that the customer does not currently have the financial capacity to pay all of the expected sales- and usage-based royalties at contract inception; however, once the customer generates cash flows from the usage of the IP, it is expected that the customer will have the financial capacity to make the required payments when due. When performing its analysis, the entity would need to consider the customer’s other payment obligations in addition to the royalty payments. That is, the entity could not solely rely on the cash generated from the use of the IP to conclude that it is probable that the customer will pay amounts when due. Rather, the entity would need to consider all relevant facts and circumstances when evaluating whether the customer has the intention and ability to pay amounts when due.

An entity may evaluate the collectibility criterion by analyzing its collection history with the same customer or similar types of customers (e.g., similar industry, size, geographic region). It should also consider any specifically identified events or circumstances related to the customer (e.g., the customer’s significantly deteriorating financial position or a default on the customer’s loan covenant).

4.3.5.4 Whether to Assess Collectibility at the Portfolio Level or the Individual Contract Level

Collectibility should be assessed at the individual contract level. For each individual contract, if it is considered probable that the entity will collect the consideration to which it will be entitled, the general requirements of ASC 606 should be applied. However, if an entity has a portfolio of contracts that are all similar, particularly in terms of collectibility, and historical evidence suggests that a proportion of the consideration due from contracts in the portfolio will not be collected, the entity may evaluate that portfolio to assess whether an individual contract is collectible.

For example, if the entity has a portfolio of 100 similar contracts and historical experience has indicated that the entity will only collect amounts due on 98 of those contracts, this does not suggest that there are two contracts that should not be accounted for under the general requirements of ASC 606. Rather, the entity should consider collectibility in the context of the individual contracts. If there is a 98 percent probability that amounts due under each contract will be collected, each contract will meet the criterion in ASC 606-10-25-1(e).

However, consideration should be given to any evidence that collection of amounts due under any specific contract is not probable. That is, an entity should not ignore information that suggests that there is a specific (i.e., identified) contract within a portfolio for which collectibility is not considered probable. If that is considered to be the case, the specific contract should be excluded from the portfolio and evaluated on an individual basis; if the contract does not meet the collectibility criterion, it should be accounted for in accordance with ASC 606-10-25-7.

When a contract meets the criteria in ASC 606-10-25-1, including collectibility, the entity should recognize revenue as it satisfies its performance obligations under the contract on the basis of the amount of consideration to which it expects to be entitled (rather than the amount that it expects to collect). Therefore, for example, if the entity expects to be entitled to consideration of $500 from each of its contracts, it should recognize that $500 as revenue notwithstanding its historical experience of a 2 percent level of default.

The entity should then evaluate any associated receivable or contract asset for credit losses and present any difference between the measurement of the contract asset or receivable and the corresponding amount of revenue as an expense in accordance with ASC 326.

In the circumstances under consideration, this will result in recognized revenue of $50,000 ($500 × 100) and, under the assumption that the estimated 98 percent collection rate proves accurate, credit losses (bad debts) of $1,000 ($50,000 × 2%).

The above issue is addressed in Q&A 9 (compiled from previously issued TRG Agenda Papers 13 and 25) of the FASB staff’s Revenue Recognition Implementation Q&As (the “Implementation Q&As”). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

4.3.5.5 Assessing Collectibility in Real Estate Sales

As noted in Section 4.2, the contract existence criteria need to be met before a sale can be recorded in accordance with ASC 606 or ASC 610-20 (see Chapter 17). Collectibility of substantially all of the consideration to which the entity expects to be entitled affects the evaluation of whether a contract exists for accounting purposes. Upon a determination that it is not probable that the entity will collect substantially all of the consideration to which it will be entitled (i.e., a determination that the collectibility threshold is not met), no contract is deemed to exist and no sale can be recorded.

ASC 606 contains an example of a real estate sale (see Section 4.3.5.3) in which the buyer pays a 5 percent nonrefundable deposit for the property and the seller finances the remaining purchase price. The buyer’s ability to pay the outstanding purchase price is contingent solely on its ability to generate profits from the use of the real estate. In the original example in ASU 2014-09, on the basis of the facts and circumstances, the seller concludes that the collectibility threshold in ASC 606-10-25-1 is not met because the buyer’s intent and ability to pay the outstanding amount are not probable. In the example (as modified by ASU 2016-12), the contract existence criteria are deemed not to have been met. Further, control of the building is not transferred to the buyer. Entities will need to use considerable judgment when evaluating the criteria for determining (1) whether a contract exists and (2) whether and, if so, when control is transferred for accounting purposes.

Footnotes

Quoted from paragraph BC36 of ASU 2014-09.

ASC 845 addresses purchases and sales of inventory with the same counterparty and the circumstances in which nonmonetary exchanges of inventory in the same line of business are recognized at the carrying amount of the inventory transferred.

As noted in Appendix A, the collectibility threshold under U.S. GAAP differs from that under IFRS Accounting Standards.

The IASB did not amend IFRS 15 to clarify the Board’s intent with respect to collectibility. However, the FASB and IASB do not expect significant differences in application. See Appendix A for a summary of differences between U.S. GAAP and IFRS Accounting Standards on revenue-related topics.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.