Revenue Recognition Update – Step 1: Identify the Contract with the Customer)

Revenue recognition is getting a lot of attention since ASC Topic 606 “Revenue from Contracts with Customers” was first issued in 2014. Since that date, we have had several posts on our blog that focus on some of the details and changes related to the new standard. As we get closer to implementation, it is time to take a closer look.

The revenue recognition process under ASC 606 follows 5 principles or “steps.” Let’s get started with step 1 – “Identify the Contract with the Customer”.

FASB and its counterpart, the International Accounting Standards Board, determined that the best place to start was with the understanding with the customer, commonly referred to as a contract. ASC 606 defines the contract as an “agreement between two or more parties that creates enforceable rights and obligations.”

The principal of ASC 606 is “to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” That principal is a lot to process so let’s try to narrow it down a bit.

The definition of a contract includes the following criteria:

– It has the approval and commitment of both parties: ASC 606 makes it clear that a contract can be written or oral.
– The rights of the parties regarding the goods or services to be transferred are identified: This includes both implicit and explicit rights.
– Payment terms are identified: Interestingly, the transaction price does not need to be fixed or stated to have a valid contract.
– The contract has commercial substance: The performance of the contract is going to impact the company’s cash flow.
– Collectability of substantially all of the consideration is probable: This assessment needs to consider both the customer’s ability and willingness to pay.

This part is simple – If the contract does not meet these criteria, no revenue is recognized until all obligations are met and cash is collected. Management needs to develop an accounting policy that addresses these criteria in their specific company environment. This policy should take into consideration that legal requirements for contracts vary between jurisdictions and industries. The standard also does not allow for the recognition of revenue if a contract can be canceled by either party without penalty, which is a key factor for management to address as they review their existing contracts and establish their policies.

Before we wrap up Step 1, a couple additional issues need to be considered when identifying the contract with the customer:

1. Combining contracts – contracts should be combined when the actual substance is a single arrangement. The following characteristics indicate that multiple contracts should be treated as one:
– They are negotiated as a package with a single commercial obligation.
– The fee for one contract depends on the price or performance of the other contract.
– The goods or services promised in the contract are for a single performance obligation (this will be further explained in Step 2).

2. Contract modifications – should contract modifications be considered separate contracts or just catch up the accounting to meet the new terms of the contract? Under existing GAAP, there was little consistency between industries on how to handle these modifications. Under ASC 606, the following contract modifications meet the definition of a separate contract if:
– The additional promised goods or services are distinct.
– The price increase reflects the stand-alone selling price of the additional goods or services.

Although the basics of Step 1 may seem straightforward, there are nuances to customer contracts that should be evaluated from the perspective of ASC 606. As you review the criteria for your company, now is the time to dig a little deeper if some of the criteria raise questions with your current customer contracts. For tips on tackling revenue recognition implementation from a user’s first-hand experience, read more here.

Stay tuned for Step 2 – “Identifying Performance Obligations in the Contract”