Collectibility requirement
One area that may present certain challenges is with respect to item (e), the collectibility requirement. An entity must consider whether, at inception, a customer has the ability and intent to pay. The standard requires the entity to apply the probability concept to this decision. Probable in the context of ASC 606, is that future events are likely to occur. Generally in US GAAP, this has come to mean that there is a 75-80%+ chance of the event to occur.
The Transition Resource Group has received inquiries related to applying the collectibility criteria and the Financial Accounting Standards Board (FASB) deliberated these matters and issued Accounting Standards Update 2016-12, Revenue from Contracts with Customers (Topic 606), Narrow-Scope Improvements and Practical Expedients. Among other items addressed were some clarifications related to the collectibility requirement.
Briefly, these include the following:
- The objective of this assessment is to determine whether the contract is valid and represents a genuine transaction on the basis of whether a customer has the ability and intention to pay the promised consideration in exchange for the goods or services that will be transferred to the customer.2
- The amendment also adds a new concept to address situations where if the condition above has not been met, when revenue could be recognized. In such situations revenue could be recognized if the entity has transferred control of goods or services to the customer and received some payment. If the entity stops the further transfer of goods or services and the amount received is not refundable, revenue may be recognized to the extent of cash received.
Generally speaking, most entities currently go through a process wherein they address the credit risk of customers before granting credit so significant process changes may not be necessary. But for certain industries, collectibility is likely to be an issue and the timing of recognizing a contract may change. Here are a couple of examples:
- An entity sells a commercial building for $1,000,000. The customer makes a down payment of $50,000 and the entity extends a loan for the balance. The customer intends to open a restaurant and has no prior experience in the business. The customer has not pledged any additional collateral for the loan; the intent is to repay the loan from the profits of the restaurant. In this situation, the entity may conclude that there are too many risk factors impacting the probability of the collection of the remaining proceeds and determine that collectibility is not probable and as such does not recognize a contract. The entity would not derecognize the building and would record all payments made on the loan as a contract liability until such time as it determines that collectibility becomes probable.3
- Healthcare organizations that provide emergency services may face an issue as to collectibility as they may not have the ability to determine whether the patient has the intent or the ability to pay for such services, prior to the actual provision of the services in the emergency room. Hospitals will need to assess whether and when revenue could be recognized after the provision of services and what amount of revenue would meet the collectibility criteria. Until a contract can be identified meeting the criteria, any cash collected must be recorded as a contract liability. Entities will need to assess their policies, procedures, and the level of risk associated with meeting contract criteria and appropriately update internal control over financial reporting.
Combining contracts
ASC 606 requires entities to combine contracts with the same customer, prior to further assessment of the five elements, when certain conditions have been met. These are:
- The contracts were negotiated with a single commercial objective in mind;
- The consideration to be paid for one contract is dependent upon another contract(s); and
- Goods and services promised in the contracts are single performance obligations (as defined in the standards).
Contract modifications
In many industries, contract modifications are a common occurrence. Under current GAAP, generally speaking, most of the contract modifications are accounted for on a prospective basis. ASC 606 may change how modifications are handled in the future.
The standard defines a contract modification as a change in scope or price that is agreed to by both parties. The change can be written, oral, or in accordance with customary business practices, but it must create enforceable rights. It is possible that both parties approve a change in scope, but have not agreed to a change in the consideration. In such cases the entity shall estimate the consideration in accordance with ASC 606 guidance on variable consideration4 and apply the constraint to such estimates.
Contract modifications are accounted for in two ways, either as a separate contract or as a modification to the original contract, depending on the following guidance:
- Separate contract:
- Modification (the changes are not accounted for as a separate contract):
- The scope of the contract increases because of the addition of promised goods or services that are distinct
- The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.5
- An entity shall account for the contract modification as if it were a termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligations (or to the remaining distinct goods or services in a single performance obligation identified in accordance with paragraph 606-10- 25-14(b)) is the sum of:
- An entity shall account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. The effect that the contract modification has on the transaction price, and on the entity’s measure of progress toward complete satisfaction of the performance obligation, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) at the date of the contract modification (that is, the adjustment to revenue is made on a cumulative catch-up basis).
- If the remaining goods or services are a combination of items (a) and (b), then the entity shall account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations in the modified contract in a manner that is consistent with the objectives of this paragraph.6
- The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognized as revenue and
- The consideration promised as part of the contract modification.
In practice, applying this guidance may prove to be complex for businesses that see frequent contract modifications. The ASC provides examples which are extracted below:
Assumptions
An entity agrees to sell 120 items to a customer for $12,000 ($100 per item), over a six month period. After 60 items have been delivered, the contract is modified to deliver an additional 30 items (150 items in total).
Scenario 1: The entity agrees to sell the additional 30 items at $95 per item, which is the current standalone selling price of the item.
In accordance with the guidance, the entity determines that the agreement to sell 30 additional items is a separate contract. It therefore delivers the balance of 60 items recognizing revenue at $100 per item, followed by the next 30 items recognizing revenue at $95 per item.
Scenario 2: The customer negotiates a price of $80 per item for the additional 30 items. It also notifies the entity that there were minor defects in the 60 delivered already. The entity agrees to provide a credit of $15 per item or $900 and apply the credit to the delivery of the remaining, now, 90 items. The entity immediately recognizes the $900 credit as a reduction to revenue recognized to date.
The new price does not reflect current standalone value and, as such, the entity accounts for the additional items as a termination of the original contract and entry into a new contract to deliver 90 items. Revenue will be recognized based on a blended price of $6,000 for 60 and $2,400 for 30, or $93.33 per unit.
The entries to reflect this modification are as follows:
