The ASC 606 transition: Identifying the contract

The first step in applying Accounting Standards Codification (ASC) 606 is to identify the contract(s) with the customer. To do so, the entity evaluates indicators of the existence of the contract. We will discuss these and other matters related to contracts, including combinations of contracts and contract modifications.

Certain conditions must be present for there to be a contract with a customer. They are:

1. 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.
2. The entity can identify each party’s rights regarding the goods or services to be transferred.
3. The entity can identify the payment terms for the goods or services to be transferred.
4. 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).
5. It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. 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.1

The contract must have commercial substance and thus create enforceable rights and obligations. This is a matter of law and jurisdictional variations could occur when applying the guidance. As a practical matter however, most entities will be well familiar with the terms under which they conduct business with their customers and will not have difficulty in identifying contracts.

There may be situations, however, relating to when the contract takes effect. If either party has the right to terminate a contract without consideration if the contract is wholly unperformed, the contract would not be considered for accounting purposes until the condition changes.

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:

1. 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
2. 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:

1. The contracts were negotiated with a single commercial objective in mind;
2. The consideration to be paid for one contract is dependent upon another contract(s); and
3. 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:

Other contract modifications could result in cumulative catchup adjustments to revenue previously recognized, as noted in this example.

Assumptions: A contractor agrees to construct a building for $1,000,000 under the terms of a contract that provides for a $200,000 bonus for early completion. At inception the entity cannot conclude that it is probable that there will not be a significant reversal of revenue and does not include the bonus in its estimate of contract consideration. The entity estimates that the cost to complete the construction will be $700,000, for gross profit of $300,000 (30%). The revenue will be recognized over time based on a progress toward completion calculation.

At the end of the first year, the entity has completed 60% of the construction and after reassessing the probability of collecting the bonus (not yet likely) recognizes $600,000 in revenue against the costs to date of $420,000 for a gross profit of $180,000.

In year two, the customer requests a floor plan change resulting in additional revenue of $150,000 with additional costs of $120,000. The total fixed consideration is now $1,150,000 with the potential bonus of $200,000. In connection with the revision, the customer agrees to an additional six months on the completion date. As a result the entity now believes that it will earn the bonus of $200,000 and now determines to include the bonus in the contract price. It determines that the additional services are not distinct from the other promised services.

Thus, the entity accounts for the modification as if it were part of the original contract. The entity now updates its measure of progress to completion, to 51.2% (costs to date $420,000/ expected costs $820,000). Applying this to total expected revenue of $1,350,000 yields $691,200 of revenue to be recognized. Since it has only recognized $600,000 at the end of the previous period, it makes a cumulative catch-up adjustment of $91,200 as part of recognizing the contract modification.8

Reviewing these case studies points out how complex assessing accounting for contract changes is likely to be. Entities will need to put processes in place, not only to operationalize the new terms of the contract, but to consider the accounting implications and how future revenue recognition for a particular contract could change. This will require additional considerations in the design of internal controls over financial reporting related to such modifications.

For more information on revenue recognition, or learn how Baker Tilly’s specialists can help, contact our team.

1ASC 606-10-25-12

2Exposure Draft:  Revenue from Contracts with Customers (Topic 606), Narrow-Scope Improvements and Practical Expedients

3Derived from ASC 606-10-55-(95-98)

4 Variable consideration will be discussed in a future article.

5ASC 606-10-25-12

6ASC 606-10-25-13

7Derived from ASC 606-10-55-(111-116)

8ASC 606-10-55-(129-133)

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