Chapter 4 — Step 1: Identify the Contract
Chapter 4 — Step 1: Identify the Contract
4.1 Overview
For contracts within the scope of ASC 606, the first step of the
revenue standard is to determine whether a contract exists, for accounting purposes,
between an entity and its customer. The criteria that need to be in place to
establish that a contract exists are intended to demonstrate that there is a valid
and genuine transaction between an entity and its customer and that the parties to
the contract have enforceable rights and obligations that will have true economic
consequences. If, at contract inception, the criteria in ASC 606-10-25-1 are met,
the contract would be accounted for under the remaining provisions of the standard.
Because the rest of the provisions of the standard rely on a careful analysis of the
enforceable rights and obligations under the contract, if any of the five criteria
required to establish a contract for accounting purposes are not met, the rest of
the revenue recognition model cannot be applied. In these circumstances, any
consideration received from the customer would be recognized as a liability (see
Section 4.6), and
revenue can only be recognized once (1) the contract existence criteria are met
(under the assumption that the rest of the revenue recognition model supports the
recognition of revenue) or (2) the consideration received is nonrefundable and one
or more of the following have occurred:
-
All of the performance obligations in the contract have been satisfied and substantially all of the promised consideration has been received.
-
The contract has been terminated or canceled.
-
The entity has transferred control of the goods or services to which the consideration received is related and has stopped transferring (and has no obligation to transfer) additional goods or services to the customer.
The revenue standard also provides guidance on when two or more
contracts should be combined and evaluated as a single contract for determining
revenue recognition (see Section
4.7) as well as the accounting for contract modifications (see
Chapter 9).
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.
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 impairment 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 310 (or ASC 326, once
adopted5).
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, impairment (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
1
Quoted from paragraph BC36 of ASU 2014-09.
2
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.
3
As noted in Appendix A, the collectibility
threshold under U.S. GAAP differs from that under IFRS Accounting
Standards.
4
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.
5
See ASC 326-10-65-1 through 65-5 for effective date
and transition guidance related to ASC 326.
4.4 Contract Term
Determining the term of the contract is an important step in the
revenue recognition process since the contract term could affect the identification
of promises under the contract as well as the transaction price. ASC 606 provides
guidance on determining the contract duration, including the effect of termination
clauses and contract renewals. The contract term is determined on the basis of the
period over which the parties to the contract have present enforceable rights and
obligations. The contract term would not include optional renewal periods or the
delivery of optional goods or services. However, the existence of purchase options
in a contract with a customer could give rise to a material right. For further
discussion of material rights, see Chapter 11.
ASC 606-10
25-3 Some contracts with customers
may have no fixed duration and can be terminated or modified
by either party at any time. Other contracts may
automatically renew on a periodic basis that is specified in
the contract. An entity shall apply the guidance in this
Topic to the duration of the contract (that is, the
contractual period) in which the parties to the contract
have present enforceable rights and obligations. In
evaluating the criterion in paragraph 606-10-25-1(e), an
entity shall assess the collectibility of the consideration
promised in a contract for the goods or services that will
be transferred to the customer rather than assessing the
collectibility of the consideration promised in the contract
for all of the promised goods or services (see paragraphs
606-10-55-3A through 55-3C). However, if an entity
determines that all of the criteria in paragraph 606-10-25-1
are met, the remainder of the guidance in this Topic shall
be applied to all of the promised goods or services in the
contract.
4.4.1 Termination Clauses and Penalties
When contracts have termination clauses and penalties, 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 any termination penalty is
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). Substantive termination penalties suggest that the parties’ rights
and obligations extend for the duration of the contract term.
A contract’s accounting term could be less than the contract’s stated term if a
termination penalty is not substantive. For example, a 12-month stated contract
term could, in effect, be a month-to-month contract if the contract could be
terminated each month and the termination penalty is not substantive. An entity
will need to carefully consider the effect of nonsubstantive termination
penalties on the timing and amount of revenue to be recognized.
Because the assessment of termination clauses and penalties focuses on legally
enforceable rights and obligations, certain economic factors such as economic
compulsion should not be considered. Rather, the assessment depends on whether
the terminating party is required to compensate the other party. For example, an
entity may have a long-term agreement with a customer for a unique good or
service that is critical to the customer’s operations. If the agreement allows
the customer to terminate it at any point and there are no contractual penalties
if the customer does not purchase any goods or services, a contract for the
purchase of additional goods or services does not exist even if it is highly
likely that the customer will not terminate the agreement.
The economic considerations related to forgoing a discount on optional purchases
would not be viewed as a substantive penalty suggesting that the parties’ rights
and obligations extend for a longer contract term. The discount on optional
purchases should be assessed for the existence of a material right instead.
Therefore, while an “economic” penalty may be incurred by a customer that elects
not to purchase future but optional goods at a discount, that economic penalty
would not rise to the level of a substantive penalty that lengthens the contract
term.
The determination of whether a termination penalty is
substantive requires judgment and would be evaluated both quantitatively and
qualitatively. For example, 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 penalty is not
substantive). Determining the enforceable term of a contract that includes
termination provisions (e.g., cancellation fees) may be challenging,
particularly when only the customer has a right to terminate the contract. When
a customer has a right to terminate the contract without penalty, such
termination provision is substantively the same as a renewal provision, as
supported by paragraph BC391 of ASU 2014-09 (as well as by
Implementation Q&A 8). The example below illustrates
how an entity should consider a fixed-term contract that allows a customer to
terminate the contract without penalty after a certain period.
Example 4-3
Company A has a contract to deliver various goods and
services to Customer B. The contract includes pricing
for the goods or services for a two-year period but
allows B to cancel the contract at any time after six
months without paying a penalty. In this scenario, we
generally believe that the enforceable rights and
obligations of the contract are for six months;
therefore, the contract term is six months. Since the
pricing terms of the arrangement are fixed for two
years, A would also need to evaluate whether a material
right exists for purchases beyond six months.
Connecting the Dots
As discussed above, enforceable rights and obligations
in a contract are only those for which the entity has legal rights and
obligations under the contract and would not take certain economic
factors into account (e.g., economic compulsion). Accordingly, the
economic considerations related to forgoing a discount on optional
purchases would not be viewed as a substantive penalty suggesting that
the parties’ rights and obligations extend for a longer contract term.
The discount on optional purchases should be assessed for the existence
of a material right instead. This approach is consistent with the
discussion in Implementation Q&A 8, which states that “an
entity would still evaluate whether the termination right (which is akin
to an option for additional goods or services) gives rise to a material
right.” Therefore, while an “economic” penalty may be incurred by a
customer that elects not to purchase future but optional goods at a
discount, that economic penalty would not rise to the level of a
substantive penalty that lengthens the contract term.
The above issue is addressed in Implementation Q&As 7 and 8 (compiled from previously
issued TRG Agenda Papers 10, 11, 48, and 49). For additional information and Deloitte’s summary of
issues discussed in the Implementation Q&As, see Appendix C.
4.4.1.1 Termination Clauses in License Arrangements
As noted in Section 4.4.1, an entity needs to
evaluate the nature of termination provisions, including whether any
penalties are substantive (i.e., whether the transfer of any consideration,
including noncash consideration, from the customer to the entity is
substantive). Careful consideration is required in the evaluation of whether
giving up license rights is a form of penalty.
Implementation Q&As 7 and 8 include the following
factors that an entity should consider when determining whether a
termination penalty is substantive:
-
Whether the terminating party is required to pay compensation.
-
The amount of such compensation.
-
The reason for the compensation (i.e., whether the compensation is in addition to amounts due for goods and services already delivered).
The two examples below illustrate how an entity would determine whether a
license arrangement includes a substantive termination penalty.
Example 4-4
License
Arrangement Includes a Substantive Termination
Penalty
Company A, a pharmaceutical company
in the United States, owns and maintains a portfolio
of patents related to an antibiotic that treats
life-threatening diseases. On February 23, 20X8, A
grants Customer B (a pharmaceutical company in
Ireland) the exclusive right to use its patented
drug formula to commercialize and supply the
antibiotic in Europe. The IP is fully developed, and
regulatory approval has been obtained; therefore, B
is able to commercialize the IP. Company A has
determined that the patented drug formula is
functional IP and that therefore, the license grants
B the right to use the IP. In exchange for the
exclusive right to use the patented drug formula, B
agrees to pay A the following amounts:
-
An up-front fee of $300 million.
-
Annual fixed fees of $50 million payable at the end of each year in which the contract is effective.
-
Sales-based royalties of 5 percent of B’s sales of the antibiotic in Europe (recognized in accordance with the sales-based royalty exception in ASC 606-10-55-65).
The contract states that B has the
exclusive right to use the patented drug formula
through the patent term, which expires in 10 years
(i.e., the contract ends when the patent expires).
Notwithstanding the stated contract term, the
contract states that B may terminate the contract
before the expiration of the patent by providing
three months’ notice to A. All amounts already paid
by B are nonrefundable in the event of early
termination. The contract does not include an
explicit termination penalty (i.e., B is not
required to pay additional cash consideration to A
upon early termination); however, upon early
termination, the right to the patented drug formula
in Europe would revert back to A, and A would be
able to relicense the patented drug formula to a
different pharmaceutical company in Europe. Unless B
terminates the contract before the end of the stated
term, A would not be able to benefit from licensing
the patented drug formula to a different
pharmaceutical company in Europe (i.e., A would
receive this benefit only upon B’s early termination
of the contract).
Under these facts, A’s contract to
license the exclusive right to use its patented drug
formula to B contains a substantive termination
penalty. As previously discussed in Section
4.4.1, it is important for an entity to
evaluate the nature of the termination provisions in
its contracts to determine the appropriate contract
term for applying ASC 606.
In this example, A’s contract to
license the patented drug formula to B does not
include an explicit termination penalty. That is, B
can terminate the contract before the end of the
stated term by providing three months’ notice
without paying additional cash consideration to A.
Although the contract does not require B to pay
additional cash consideration to A upon early
termination, in the event that B terminates the
contract early, the exclusive license rights related
to the patented drug formula would revert back to A.
Company A would then be able to license the patented
drug formula to another customer in Europe for the
remainder of the patent term, which it would not
have been able to do if B had not terminated the
contract. Therefore, although B is not paying
additional cash to A upon termination, B is
providing consideration (i.e., something of value)
to A, and A is receiving something of value from B
(i.e., the right to relicense the patented drug
formula), upon termination. Although Implementation
Q&As 7 and 8 focus on compensation as additional
cash that an entity’s customer would pay to the
entity upon termination, compensation may also
include noncash consideration that is of value to
the entity. The fact that B is forfeiting its rights
to the patented drug formula and providing A with
something of value (i.e., the ability to relicense
the patented drug formula to another customer in
Europe) from the forfeiture upon early termination
represents a substantive termination penalty in the
contract.
In accordance with Implementation Q&As 7 and 8,
the substantive termination penalty suggests that
the parties’ rights and obligations extend for the
duration of the stated contract term. That is, the
contract term is 10 years.
Example 4-5
License
Arrangement Does Not Include a Substantive
Termination Penalty
Company X, a multinational software
company, is a provider of financial software that
can be used to track a user’s investments. On June
29, 20X8, X grants Customer Y a nonexclusive license
to use X’s financial software to track Y’s personal
investments for five years. The contract also
includes postcontract customer support (PCS) for the
five-year term. Company X also grants other
customers a similar license to use its financial
software (i.e., the license is not exclusive).
In exchange for the right to use X’s
financial software, Y agrees to pay X the following
amounts:
-
An up-front fee of $500.
-
An annual fee of $50, payable at the beginning of each year.
The contract states that Y may
terminate the contract before the expiration of the
five-year stated term by providing three months’
notice to X. All amounts already paid by Y are
nonrefundable in the event of early termination. The
contract does not include an explicit termination
penalty (i.e., Y is not required to pay additional
cash consideration to X upon early termination).
Upon early termination, Y must forfeit its right to
use X’s financial software (and, accordingly,
terminate the PCS arrangement).
Under these facts, X’s contract to
license its financial software to Y does not contain
a substantive termination penalty. Like the contract
in Example 4-4, X’s contract with Y does
not contain an explicit termination penalty (i.e., Y
is not required to pay additional cash consideration
to X upon early termination). However, as
illustrated in that example, it is important to
consider whether the licensor is receiving other
forms of compensation (i.e., noncash consideration
that represents value to the licensor from the
licensee upon termination) to determine whether the
contract includes a substantive termination penalty.
Unlike the license in that example, X’s license to
use its financial software is not exclusive to one
customer. In addition to licensing the software to
Y, X licenses the software to other customers at the
same time. Although Y must forfeit its right to use
X’s financial software upon termination of the
contract, Y is not providing anything of value to X,
and X is not receiving anything of value from Y,
upon early termination. Therefore, the contract does
not contain a substantive termination penalty. In a
manner consistent with the discussion in Section
4.4.1, this would suggest that X and Y
have enforceable rights and obligations for only the
first three months of the contract because three
months is the amount of time that Y would need to
provide as notice to X to terminate the contract.
Refer to Section
4.4.1.1.2 for further considerations
related to the evaluation of termination provisions
in licensing arrangements.
4.4.1.1.1 Termination Clauses That Include Refunds for Prepayments in Software Arrangements
In some software arrangements, a customer prepays for a term-based
license and maintenance (i.e., PCS). If a customer prepays but can
terminate at any point and receive a pro rata refund for the portion of
the term-based license and PCS that is unused, the arrangement would be
accounted for as a daily contract. Undelivered performance obligations
associated with such arrangements would generally be excluded from
deferred revenue and instead be classified as some other liability
account (e.g., “refund liability” or “customer arrangements with
termination rights”). They would also generally be excluded from the
requirement in ASC 606 to disclose “remaining performance obligations,”
although an entity would not necessarily be precluded from specifying
amounts that are subject to termination in the notes to its financial
statements if it properly describes these GAAP amounts.
The examples below illustrate how an entity might determine the
contractual term in various software arrangements with termination
clauses.
Example 4-6
Term-Based Software License With Pro Rata
Refund Upon Termination
On March 1, 20X1, a vendor sells a one-year
term-based license with PCS for $1,200. The
vendor’s customer has the right to terminate the
arrangement at its convenience at the end of each
month. If the customer terminates, it is entitled
to a pro rata refund and loses the right to use
the software. The vendor concludes that it has two
distinct performance obligations: (1) the license
and (2) the PCS. If there was no termination
provision, the vendor would have allocated $800 to
the license and $400 to the PCS (on the basis of
their stand-alone selling prices). Further, it
would have recognized the license fee ($800) up
front and the PCS ratably over time ($33 per
month).
In this circumstance, the vendor should account
for the arrangement as 12 individual monthly
contracts since the term is the lesser of the
contractual period or the period in which the
contract cannot be terminated without substantive
penalty. Accordingly, the arrangement would
continue to be accounted for ratably ($100 per
month).6
Example 4-7
Term-Based Software License Sold to Reseller
With Pro Rata Refund Upon Termination
Assume the same facts as in
Example 4-6, except that the
customer is a reseller that has a committed
(noncancelable) contract with its end-user
customer for the duration of the arrangement (one
year).
Since the vendor is not a party
to the reseller’s end-user arrangement (i.e., the
reseller, not the end user, is the vendor’s
customer), the end-user agreement is not relevant
in the performance of step 1 under ASC 606 (i.e.,
identifying the contract with the customer). The
vendor should therefore account for the
arrangement in the same manner as it does for the
arrangement discussed in Example 4-6.
Example 4-8
Perpetual Software License With Pro Rata
Refund Upon Termination
A vendor sells a perpetual license with one year
of PCS for $6,000. The vendor’s customer has the
right to terminate the arrangement at its
convenience at the end of each month. The
contractual prices of the license and the PCS are
$5,000 and $1,000, respectively. Upon termination,
the customer will be entitled to a pro rata refund
for the PCS and a computed pro rata refund for the
perpetual license, which has a three-year life. If
the customer exercises its termination right, it
loses the right to use the software. The vendor
concludes that it has two distinct performance
obligations: (1) the license and (2) the PCS. If
there was no termination provision, the vendor
would have allocated $5,000 to the license and
$1,000 to the PCS on the basis of their
stand-alone selling prices. Further, it would have
recognized the license fee ($5,000) up front and
the PCS ratably over time ($83 per month).
The vendor should account for the license as 36
individual monthly contracts and for the PCS as 12
individual monthly contracts. As a result, the
license would be recognized over 36 months and the
PCS would be recognized over 12 months, both
ratably ($139 per month for 36 months7 and $83 per month for 12 months).
Example 4-9
Perpetual Software License With Pro Rata
Refund on PCS Only Upon Termination
A vendor sells a perpetual license with one year
of PCS for $6,200. The vendor’s customer has the
right to terminate the PCS at its convenience at
the end of each month. The contractual prices of
the license and the PCS are $5,000 and $1,200,
respectively. Upon termination, the customer will
be entitled to a pro rata refund for the PCS and
no refund for the license. Upon exercising the
termination right, the customer retains the right
to the perpetual license. The vendor concludes
that it has two distinct performance obligations:
(1) the license and (2) the PCS. If there was no
termination provision, the vendor would have
allocated $5,200 to the license and $1,000 to the
PCS on the basis of their stand-alone selling
prices. Further, it would have recognized the
license fee ($5,200) up front and the PCS ratably
over time ($83 per month).
The vendor should account for the PCS as 12
individual monthly contracts and for the license
as part of the initial monthly contract. As a
result, the license would be recognized upon
delivery ($5,020) and the PCS would be recognized
monthly ($80 in the first month and $100 per month
thereafter).8 The total revenue recognized in the first
month would be limited to an amount less than what
would have been recognized on the basis of
relative stand-alone selling price if the contract
were to be accounted for as a one-year contract.
Note that there is no material right for
“renewals” of PCS since the renewals are priced at
$100, which is greater than the stand-alone
selling price of $83.
Example 4-10
Perpetual Software License With a Negotiated
Refund Upon Termination and Separate Stock-Keeping
Units (SKUs)
A vendor sells a perpetual license with one year
of PCS for $6,000. The vendor’s customer has the
right to terminate the arrangement at its
convenience at the end of each month. The
contractual prices of the license and the PCS
(which have separate SKUs) are $5,000 and $1,000,
respectively. The contract specifies that upon
termination, the vendor and the customer will
negotiate, in good faith, the amount of refund, if
any, to which the customer would be entitled. The
vendor concludes that it has two distinct
performance obligations: (1) the license and (2)
the PCS.
Generally, if the amount that would be refunded
is not stated (i.e., unknown) because it is
subject to negotiation and not legally
enforceable, the arrangement would be accounted
for as a one-year contract if a substantive
termination penalty is legally enforceable.
Example 4-11
Term-Based Software License With an Uncertain
Refund Upon Termination and a Combined SKU
A vendor sells a one-year term license with
coterminous PCS for $6,000. The customer has the
right to terminate at its convenience the PCS at
the end of each month. The contractual prices of
the license and PCS are not separately stated
(i.e., the license and PCS do not have separate
SKUs). Accordingly, the amount that would be
refunded upon termination is not known. The vendor
concludes that it has two distinct performance
obligations: (1) the license and (2) the PCS.
Generally, if the amount that would be refunded
is not stated (i.e., unknown) because it is
subject to negotiation and not legally
enforceable, the arrangement would be accounted
for as a one-year contract if a substantive
termination penalty is legally enforceable.
4.4.1.1.2 License Keys and Termination Provisions
The example below illustrates how termination provisions in a software
licensing contract requiring the delivery of a license key for the
customer to use the software affect the contract term and the
recognition of revenue.
Example 4-12
Company LEH enters into an arrangement to license
its software (a right-to-use license for which
revenue is recognized at a point in time) to
Customer MJR for one year with coterminous PCS.
The annual fee for the license and PCS is $5,000
(paid quarterly). Company LEH determines that the
stand-alone selling price of the license is $4,000
and the stand-alone selling price of the PCS is
$1,000. Company LEH delivers a license key to MJR
at the beginning of each quarter; the license key
is required for MJR to use the software. Company
LEH determines that the license and PCS are
distinct performance obligations.
Consider the following cases:
-
Case A: contract may be terminated at the end of each quarter during the one-year license term — In Case A, MJR may choose not to make the next quarterly payment, thereby alleviating LEH’s obligation to deliver the quarterly license key and provide further PCS. Customer MJR’s election not to pay the quarterly fee is not deemed to be a breach of the contract, and LEH has no recourse against MJR if payment is not received (other than to discontinue providing the license and PCS). In effect, the contract is cancelable each quarter. Upon cancellation, MJR’s rights to use the license and receive PCS for the remainder of the one-year license term are also revoked.
-
Case B: contract may not be terminated during the one-year license term — In Case B, LEH is required to deliver or make available the license key to MJR at the beginning of each quarter (such obligation is not contingent on MJR’s making quarterly payments). If LEH does not deliver or make available the license key at the beginning of each quarter, LEH will be in breach of its contractual obligations. Similarly, MJR will be in breach of its contractual obligations if it does not make the quarterly payments. Company LEH has agreed to deliver license keys on a quarterly basis as protection against a breach of contract by MJR. For example, if MJR fails to make payment on time at the start of the second quarter, LEH would still deliver the license key for that quarter. But if MJR has still not paid by the end of the second quarter and is therefore clearly in breach of its contractual commitments, LEH could consider whether to withhold the license key for the third quarter in response to MJR’s breach of contract. The contract may not be terminated by either LEH or MJR during the one-year license term, and LEH has a history of enforcing the contract term.
In Case A, because the contract may be canceled
at the end of each quarter, LEH does not have an
unconditional obligation to deliver the license
key to MJR after the first quarter, nor does MJR
have the unconditional obligation to continue
making quarterly payments to LEH. Because the
contract is cancelable by MJR each quarter, the
contract term is limited to one quarter unless MJR
renews the contract (by making the quarterly
payment). At contract inception (i.e., when the
first license key is transferred to MJR), MJR
obtains a right to use a license for only a term
of one quarter. If MJR elects not to cancel the
contract and LEH transfers an additional key to
MJR, MJR obtains the rights to use and benefit
from the software and receive PCS for an
additional quarter.
In this case, LEH transfers control of a license
for one quarter and is required to provide one
quarter of PCS each time MJR elects not to
terminate the contract. Therefore, LEH should
recognize revenue of $1,000 allocated to the
license at the beginning of each quarter and $250
allocated to PCS over the quarterly PCS
period.
In Case B, LEH should account for the arrangement
as a promise to transfer a one-year term license
and one year of PCS. Although a new license key is
required to be delivered or made available at the
beginning of each quarter, LEH and MJR have
entered into a noncancelable contract that gives
MJR the right to use the software for one year.
Control of a license can be transferred even if
the product key is not transferred to the customer
as long as the key is made available to the
customer (and accessing the key is within the
customer’s control). In Case B, MJR has an
enforceable right to demand the license key, and
LEH is obligated to transfer or otherwise make
available to MJR the key each quarter (regardless
of whether MJR makes timely payments).
Accordingly, once LEH initially transfers the
license (and key) to MJR, MJR obtains control of
the one-year term license. Because LEH does not
have the ability to terminate the contract in the
absence of a breach of contract by MJR or to
prevent MJR from accessing the license key each
quarter, LEH transfers all of the rights to use
and benefit from the software for the entire
one-year license term at contract inception.
Similarly, MJR does not have the right to
terminate the contract and cease making quarterly
payments since the contract is noncancelable and
LEH has a history of enforcing the contract
term.
Accordingly, LEH should recognize revenue of
$4,000 allocated to the license at contract
inception (when the initial key is delivered) and
$1,000 allocated to PCS over the PCS term (i.e.,
one year).
Footnotes
6
Revenue associated with the license would be
recognized at the beginning of each month, which
is similar to ratable recognition given the short
term (i.e., monthly).
7
See footnote 6.
8
Total noncancelable
consideration of $5,100 for the initial month is
allocated on a relative stand-alone selling price
basis — that is, approximately 98 percent to the
license and 2 percent to one month of PCS.
4.5 Reassessing the Criteria for Identifying a Contract
An entity is required to evaluate the criteria in ASC 606-10-25-1 at contract
inception to determine whether a valid and genuine transaction exists for accounting
purposes. Once an entity concludes that the criteria are met (i.e., that a valid
contract exists), it is not required to reassess the criteria unless there has been
a significant change in facts and circumstances (i.e., changes that might call into
question the existence of a contract rather than minor changes that might reasonably
be expected over the contract term, particularly for long-term contracts). A
reassessment may be required, for example, if an entity determines that its
remaining contractual rights and obligations are no longer enforceable or if other
changes suggest that a valid and genuine transaction no longer exists.
If an entity is required to reassess its contract because of a
significant change in facts and circumstances, the criteria in ASC 606-10-25-1 would
only be evaluated in the context of the remaining goods or services that have yet to
be provided. The reassessment would not affect any assets or revenue that has been
recognized from satisfied performance obligations. However, assets would need to be
evaluated for impairment under other applicable guidance, such as ASC 310 (or ASC
326, once adopted9).
ASC 606-10
25-5 If a contract with a
customer meets the criteria in paragraph 606-10-25-1 at
contract inception, an entity shall not reassess those
criteria unless there is an indication of a significant
change in facts and circumstances. For example, if a
customer’s ability to pay the consideration deteriorates
significantly, an entity would reassess whether it is
probable that the entity will collect the consideration to
which the entity will be entitled in exchange for the
remaining goods or services that will be transferred to the
customer (see paragraphs 606-10- 55-3A through 55-3C).
25-6 If a contract with a customer does not meet the criteria in paragraph 606-10-25-1, an entity shall continue
to assess the contract to determine whether the criteria in paragraph 606-10-25-1 are subsequently met.
There may be situations in which an entity concludes at contract inception that the
criterion in ASC 606-10-25-1(e) is met but subsequent changes in circumstances lead
the entity to question whether it will collect consideration from the customer. In
general, once an entity makes a determination that a contract exists in accordance
with ASC 606-10-25-1, the determination is not reevaluated. However, in accordance
with ASC 606-10-25-5, an entity should reassess the criteria in ASC 606-10-25-1 when
“there is an indication of a significant change in facts and circumstances.” As a
result, when concerns arise regarding the collectibility of consideration, an entity
will need to use judgment to determine whether those concerns arise from a
significant change in facts and circumstances in the context of ASC 606-10-25-5.
Example 4 in ASC 606-10-55-106 through 55-109, which is reproduced below, illustrates
when a change in the customer’s financial condition is so significant that a
reassessment of the criteria in ASC 606-10-25-1 is required. As a result of the
reassessment, the entity in the example determines that the collectibility criterion
is not met and that the contract therefore fails step 1. Accordingly, the entity is
precluded from recognizing additional revenue under the contract until the criteria
in ASC 606-10-25-7 are met or collectibility becomes probable. The entity also
assesses any related contract assets or accounts receivable for impairment.
ASC 606-10
Example 4 — Reassessing the Criteria for
Identifying a Contract
55-106 An entity licenses a patent
to a customer in exchange for a usage-based royalty. At
contract inception, the contract meets all the criteria in
paragraph 606-10-25-1, and the entity accounts for the
contract with the customer in accordance with the guidance
in this Topic. The entity recognizes revenue when the
customer’s subsequent usage occurs in accordance with
paragraph 606-10-55-65.
55-107 Throughout the first year of
the contract, the customer provides quarterly reports of
usage and pays within the agreed-upon period.
55-108 During the second year of
the contract, the customer continues to use the entity’s
patent, but the customer’s financial condition declines. The
customer’s current access to credit and available cash on
hand are limited. The entity continues to recognize revenue
on the basis of the customer’s usage throughout the second
year. The customer pays the first quarter’s royalties but
makes nominal payments for the usage of the patent in
quarters 2–4. The entity accounts for any impairment of the
existing receivable in accordance with Topic 310 on
receivables.
Pending Content (Transition Guidance: ASC
326-10-65-1)
55-108 During the second year of the
contract, the customer continues to use the
entity’s patent, but the customer’s financial
condition declines. The customer’s current access
to credit and available cash on hand are limited.
The entity continues to recognize revenue on the
basis of the customer’s usage throughout the
second year. The customer pays the first quarter’s
royalties but makes nominal payments for the usage
of the patent in quarters 2–4. The entity accounts
for any credit losses on the existing receivable
in accordance with Subtopic 326-20 on financial
instruments measured at amortized cost.
55-109 During the third year of the
contract, the customer continues to use the entity’s patent.
However, the entity learns that the customer has lost access
to credit and its major customers and thus the customer’s
ability to pay significantly deteriorates. The entity
therefore concludes that it is unlikely that the customer
will be able to make any further royalty payments for
ongoing usage of the entity’s patent. As a result of this
significant change in facts and circumstances, in accordance
with paragraph 606-10-25-5, the entity reassesses the
criteria in paragraph 606-10-25-1 and determines that they
are not met because it is no longer probable that the entity
will collect the consideration to which it will be entitled.
Accordingly, the entity does not recognize any further
revenue associated with the customer’s future usage of its
patent. The entity accounts for any impairment of the
existing receivable in accordance with Topic 310 on
receivables.
Pending Content (Transition Guidance: ASC
326-10-65-1)
55-109 During the third year of the
contract, the customer continues to use the
entity’s patent. However, the entity learns that
the customer has lost access to credit and its
major customers and thus the customer’s ability to
pay significantly deteriorates. The entity
therefore concludes that it is unlikely that the
customer will be able to make any further royalty
payments for ongoing usage of the entity’s patent.
As a result of this significant change in facts
and circumstances, in accordance with paragraph
606-10-25-5, the entity reassesses the criteria in
paragraph 606-10-25-1 and determines that they are
not met because it is no longer probable that the
entity will collect the consideration to which it
will be entitled. Accordingly, the entity does not
recognize any further revenue associated with the
customer’s future usage of its patent. The entity
accounts for additional credit losses on the
existing receivable in accordance with Subtopic
326-20.
Connecting the Dots
Stakeholders have questioned how to evaluate the reassessment criteria in ASC
606-10-25-5 to determine when to reassess whether a contract continues to
meet the collectibility threshold. The assessment of whether a significant
change in facts and circumstances occurred will be situation-specific (e.g.,
a significant change due to a bankruptcy) and will often be a matter of
judgment.
The above issue is addressed in Implementation Q&A 10 (compiled from previously
issued TRG Agenda Papers 13 and 25). For additional information and Deloitte’s summary
of issues discussed in the Implementation Q&As, see Appendix C.
Footnotes
9
See footnote 5.
4.6 Consideration Received When the Criteria for Identifying a Contract Are Not Met
If a contract does not meet the criteria in ASC 606-10-25-1 at contract
inception, no revenue can be recognized until either the contract existence criteria
are met or other conditions are satisfied. That is, any consideration received from
a customer, including nonrefundable consideration, is precluded from being
recognized as revenue until certain events have occurred.
ASC 606-10
25-7 When a contract with a customer does not meet the criteria in paragraph 606-10-25-1 and an entity
receives consideration from the customer, the entity shall recognize the consideration received as revenue only
when one or more of the following events 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.
25-8 An entity shall recognize the consideration received from a customer as a liability until one of the events
in paragraph 606-10-25-7 occurs or until the criteria in paragraph 606-10-25-1 are subsequently met (see
paragraph 606-10-25-6). Depending on the facts and circumstances relating to the contract, the liability
recognized represents the entity’s obligation to either transfer goods or services in the future or refund the
consideration received. In either case, the liability shall be measured at the amount of consideration received
from the customer.
Connecting the Dots
The contract existence criteria provide a framework for determining when a contract with a
customer includes all of the elements required to apply the rest of the revenue recognition
model. The model relies on a complete analysis of the rights and obligations under the contract.
For an entity to recognize revenue in an amount that depicts the consideration to which it
expects to be entitled in exchange for promised goods or services, the entity needs to be able
to adequately determine both the promised goods or services and the consideration to which it
expects to be entitled (along with meeting the other criteria). When any of the contract existence
criteria are not met (including the collectibility threshold), the entity is unable to determine how
to allocate consideration to promised goods or services under the contract because either
the promised consideration or the promised goods or services are inadequately defined.
Consequently, even if nonrefundable consideration is received from a customer and the entity
has transferred some of the goods or services promised under the contract, if the contract
existence criteria are not met and none of the events in ASC 606-10-25-7 have occurred, the
entity is unable to conclude that the consideration received is related entirely to satisfied (or
partially satisfied) performance obligations. Therefore, any such consideration received needs
to be recorded as a liability until the entity determines that either the contract existence criteria
are met or one of the events in ASC 606-10-25-7 has occurred.
4.6.1 Whether a Contract Can Be Deemed Terminated if Pursuit of Collection Continues
ASU 2014-09 did not include the criterion in ASC 606-10-25-7(c).
In some cases, questions arose about whether the criterion in ASC 606-10-25-7(b)
was met — specifically, whether a contract can be deemed to be terminated if
goods or services were transferred to a customer and some nonrefundable
consideration was received, but the customer paid less than the full transaction
price and the entity continued to pursue collection of outstanding balances to
which it was entitled. ASU 2016-12 added a third criterion, ASC
606-10-25-7(c),10 to enable an entity to recognize consideration received from a customer as
revenue when the contract does not meet the criteria in ASC 606-10-25-1 if (1)
the “entity has transferred control of the goods or services to which the
consideration that has been received relates,” (2) “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 (3)
“the consideration received from the customer is nonrefundable.”
When the events described in ASC 606-10-25-7(c) occur, it will be evident that
nonrefundable consideration received from a customer is entirely related to
satisfied performance obligations (or satisfied portions of a performance
obligation that is satisfied over time). That is, the customer will no longer
have rights to obtain additional goods or services from the entity, and the
entity has no further obligation (or intention) to transfer goods or services to
the customer. In these circumstances, the contract can be accounted for as if it
were terminated (i.e., revenue can be recognized for the nonrefundable
consideration received) even if the entity continues to pursue collection of
outstanding balances from the customer.
4.6.2 Whether a Receivable Can Be Recorded When a Contract Fails Step 1 Because Collectibility Is Not Probable
If an entity decides to transfer its promised goods or services
before collecting consideration from its customer and the collection of such
consideration is not probable, a question arises about whether the entity can
recognize a receivable for the amount of consideration to which it is legally
entitled.
ASC 606-10-45-4 states, in part, the following (pending content
effective later than the effective date of ASC 606 {in braces}):
A receivable is an entity’s right to consideration that is
unconditional. A right to consideration is unconditional if only the passage
of time is required before payment of that consideration is due. . . . An
entity shall account for a receivable in accordance with Topic 310 {and
Subtopic 326-20}.
In general, an entity cannot record a receivable if it transfers a good or
service to its customer but the accounting contract fails step 1 because
collectibility of the expected consideration is not probable. While an entity
may have a legal contract, if it cannot conclude that a contract exists from an
accounting perspective, it cannot recognize revenue and typically would not
recognize a receivable.
Example 1, Case A, in ASC 606-10-55-95 through 55-98 illustrates
a situation in which an entity concludes that it does not have a contract with a
customer because one of the criteria in ASC 606-10-25-1 is not met —
specifically, collectibility of the expected consideration is not probable. In
the revenue standard as originally issued, the example11 included the following text (subsequently deleted from ASC 606-10-55-98 by
ASU 2016-12), which we still believe appropriately reflects the timing of
recognizing receivables for contracts that have not yet met the criteria in step
1:
Because the criteria in paragraph 606-10-25-1 are not
met, the entity applies paragraphs 606-10-25-7 through 25-8 to determine the
accounting for the nonrefundable deposit of $50,000. The entity observes
that none of the events described in paragraph 606-10-25-7 have occurred —
that is, the entity has not received substantially all of the consideration
and it has not terminated the contract. Consequently, in accordance with
paragraph 606-10-25-8, the entity accounts for the nonrefundable $50,000
payment as a deposit liability. The entity continues to account for the
initial deposit, as well as any future payments of principal and interest,
as a deposit liability and does not derecognize the real estate asset. Also,
the entity does not recognize a receivable until
such time that the entity concludes that the criteria in paragraph
606-10-25-1 are met (that is, the entity is able to conclude that it is
probable that the entity will collect the consideration) or one of the
events in paragraph 606-10-25-7 has occurred. [Emphasis
added]
ASU 2016-12 deleted the text above from ASC 606-10-55-98 to make the Codification
example focus only on the evaluation of the collectibility threshold. We believe
that the principle in the original example is still appropriate and that a
receivable would generally not be recognized if goods or services are
transferred to a customer but the contract fails step 1 because collectibility
is not probable.
When an entity has a right to recover products from customers, it may be
acceptable for the entity to record an asset (and corresponding adjustment to
cost of sales) for its right to recover products from customers on settling the
refund liability. For example, if the entity is unable to conclude that a
contract has met all of the step 1 criteria because collectibility of the
expected consideration is not probable, but the entity has already transferred
inventory to the customer, the entity may record an asset for the right to the
inventory if the legal contract stipulates that the entity has the right to take
back the inventory in the event that the customer does not pay.
Footnotes
10
The IASB did not amend IFRS 15 to add this third
criterion. For a summary of differences between U.S. GAAP and IFRS
Accounting Standards on revenue-related topics, see Appendix A.
11
That is, what the revenue standard, as amended by ASU
2016-12, refers to as Case A of Example 1. Before ASU 2016-12 was
issued, Example 1 had only one fact pattern.
4.7 Combining Contracts
Generally, the revenue standard is applied at the individual contract level
unless the portfolio approach has been elected (see Section 3.1.2.2). However, an entity’s contracting
practice could result in a single arrangement with a customer that is governed by
multiple legal contracts. That is, the commercial substance of a single arrangement
to provide goods or services to a customer could be addressed by multiple contracts
with the same customer. The revenue standard requires multiple contracts with a
customer to be combined and accounted for as a single contract when certain
conditions are present.
ASC 606-10
25-9 An entity shall combine two or more contracts entered into at or near the same time with the same
customer (or related parties of the customer) and account for the contracts as a single contract if one or more
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 contract depends on the price or performance of the other contract.
- The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation in accordance with paragraphs 606-10-25-14 through 25-22.
The contract combination guidance should be assessed at contract inception. An
entity will need to use judgment in determining whether multiple contracts are
“entered into at or near the same time.” As a general rule, the longer the period
between entering contracts with the same customer, the more likely those contracts
are not economically linked.
4.8 Wholly Unperformed Contracts
An entity may have entered into a legal contract with a customer under which neither party has
performed and either party can cancel the contract for no consideration.
ASC 606-10
25-4 For the purpose of applying the guidance in this Topic, 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 (or parties). 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.
As previously discussed in Section
4.3.1, the revenue standard does not apply to wholly unperformed
contracts that allow either party the unilateral ability to terminate a contract.
See Section 4.4.1 for further
discussion of termination provisions. If an entity enters into a contract with a
customer and only the entity can cancel the contract (i.e., the customer does not
have an ability to terminate the contract), the contract exists for accounting
purposes under ASC 606 because the entity has an enforceable right to consideration
if it chooses to perform (e.g., transfer goods or services to the customer).
4.9 Modifying Contracts
A contract may be modified after an entity has already accounted for some or all
of the revenue related to that contract. The impact on revenue recognition will
depend on how that contract has been modified. This is discussed in Chapter 9.