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Revenue Recognition Serial - Part 2: Step 1: Identifying the Contract(s) with a Customer

September 23, 2014

In the last edition of this Serial we discussed an overview of the 5-step process for revenue recognition, including the basic concepts of Step 1. In this issue we will further explore the intricacies of Step 1: Identifying the contract(s) with a customer. Normally, a business knows who its customers are and can identify its contracts, however, the specific requirements of Topic 606 contain some challenges that will require judgment and documentation around these conclusions.

The application of Topic 606 and each step requires the use of judgment and provides opportunities for multiple approaches. The following discussion is broken down into a systematic framework for applying the guidance that we believe to be helpful whenever Step 1 is applied. This framework consists of three parts:

  1. Determine if a contract exists
  2. Determine if the contract is with a customer
  3. Evaluate the five criteria in Step 1 to determine if the contract is a contract with a customer in the scope of Topic 606 (a "revenue contract").

1. Determine if a contract exists

Any agreement between two or more parties that creates enforceable rights and obligations is a contract and therefore, potentially falls within the scope of Topic 606. A contract can be written, oral, or implied based on customary business practices. However, enforceable rights and obligations means that the contract must be legally enforceable, the conditions of which may vary by jurisdiction. Careful consideration of the form of an agreement may be necessary when operating in a foreign jurisdiction. In jurisdictions that require a written contract for a particular transaction in order for the terms to be legally enforceable, an oral contract to which both parties agreed would not be sufficient.

When it is determined that a contract exists it is important to also evaluate if the contract falls within the scope of any other U.S. GAAP. This is because the application of Topic 606 to a contract occurs after applying any other applicable U.S. GAAP to a part or the entirety of a contract. Examples of other U.S. GAAP that may be applied to a contract before Topic 606 include leasing, certain non-monetary exchanges, certain guarantees, insurance and financial instruments. Any remaining parts of a contract are then subject to evaluation under Topic 606. It is also important to note that if the other applicable U.S. GAAP does not include separation or measurement guidance, then the separation or measurement guidance in Topic 606 is applied.

Things to Consider

  • Goods and services can include the sale of intangible assets, such as patents, trademarks and customer lists.
  • A contract must be legally enforceable. When operating in different jurisdictions, in particular foreign countries, it will be important to understand under what circumstances a contract, written or unwritten, becomes enforceable.
  • In industries where existing practice is to have all parties to a contract sign an agreement before revenue can be recognized the new guidance may result in earlier revenue recognition if the contract is legally enforceable prior to all parties signing the agreement.
  • Contracts with customers are evaluated at their inception and the arrangement is only re-evaluated when a significant change occurs.
  • Contracts with customers that are not expected to be able to pay the full contract price may be determined to be contracts that include a price concession under the new guidance. When the consideration expected to be received can be estimated by the entity it may result in recognition of a portion of the contract price as revenue earlier than in existing guidance.
  • In some instances evaluation and disclosure of wholly unperformed contracts may be required in order to comply with the new guidance. The additional evaluation may require the involvement of accounting expertise earlier in the sales process than has been done under the existing guidance.

Illustrative example:

An entity enters into an agreement to provide a piece of manufacturing equipment and supplies to a customer for a five year period with required minimum monthly payments plus the cost of supplies in excess of predetermined amounts. At the end of the five year period the equipment is returned to the entity.

In this instance the right to use the equipment over five years would be accounted for under the leasing guidance, while the sale of supplies to the customer would not. Therefore the sale of the supplies would be evaluated to determine if Topic 606 applies. In addition, since existing leasing guidance does not address how to allocate the transaction price between the leasing component and the revenue component of the transaction, the guidance in Topic 606 would be applied.

2. Determining if a contract is with a customer

Topic 606 only applies to contracts that are entered into with customers. A customer is defined by the FASB as "a party that has contracted with an entity to obtain goods or services that are an output of the entity's ordinary activities in exchange for consideration."

Ordinary activities

To begin to determine if a contract is with a customer it is important to understand the meaning of ordinary activities. While ordinary activities is not defined explicitly by Topic 606, the term is not new. In existing literature, ordinary activities generally means the ongoing major or central operations of an entity.

Illustrative examples:

  • An entity sells manufactured components and enters into a contract to sell these components to another party.

The sale of manufactured components is the primary activity of the entity and the way in which it earns revenue, therefore it is part of the ordinary activities of the entity.

  • An entity sells manufactured components and enters into a contract to sell a piece of equipment that is used in its manufacturing process to another party.

The sale of the equipment is unlikely to be part of normal operations of the manufacturer, because it is not in the business of selling the equipment it uses in operations. However, it is important to note that the accounting update also modifies the guidance for the sale of nonfinancial assets, such as equipment, to be consistent with the guidance of Topic 606.

As outlined in the examples above, determination of whether the contract is for goods or services that are part of the ordinary activities of an entity is normally straight forward.

Contracts with multiple parties

Contracts may involve multiple parties. A common question that arises when there are multiple parties to a contract is whether the entity is acting as a principal or an agent. If an entity acts as an agent it would record revenue on a net basis.

Illustrative example:

The scenario of a distributor that drop-ships a manufacturer's product to an end user could potentially have different interpretations that need to be considered:

  • From the perspective of the distributor the customer could be the end user, in which case, the product sold would be recorded at the gross amount.
  • Alternatively, from the perspective of the distributor, the customer could be the manufacturer, because the distributor is acting in the capacity of an agent for the manufacturer. If the distributor is an agent, the service of marketing and selling the product would be recorded at the net amount it receives from the transaction.

While significant change in the determination of whether an entity is an agent or principal is not expected, it is an evaluation that can be complex; therefore we will discuss this evaluation further in a future installment of this Serial.

Collaborative arrangements

Collaborative arrangements are another type of contract that may make it difficult to determine if one of the parties to the contract is a customer. A collaborative arrangement is one where two or more parties are jointly involved in an operating activity, such that they are active participants in the activity and are exposed to significant risks and rewards to the activity. While collaborative arrangements are generally addressed by ASC Topic 808 Collaborative Arrangements (Topic 808), one of the parties to the arrangement could also be a customer for a portion of or the entire contract.

Illustrative example:

A manufacturing entity contracts with a distributor to research and develop a new product that will be brought to market. As part of its involvement, the distributor will make payments to the manufacturer in order to contribute to the development of the product. Both entities will share in the proceeds from licensing of the product.

In this instance, the contract may meet the definition of a collaborative arrangement through co-development of the product and the joint participation in the risks and rewards of the product. However, a careful evaluation of the facts and circumstances would be necessary. For instance, if the manufacturer's ordinary business was to sell research or development services, the distributor could be its customer.

In addition to this complexity, if an arrangement falls within Topic 808 the income statement classification for payments under such a contract should be appropriately analogized to other authoritative guidance where possible. Therefore, it may be appropriate, or necessary, to elect an accounting policy to treat these payments in the same manner in the income statement as contracts within the scope of Topic 606 when that is the most appropriate analogy.

Due to the unique nature of each collaborative arrangement it is not possible to provide general implementation guidance that would apply to all such arrangements, and accounting for them will require a careful evaluation of the specific facts and circumstances of each contract.

Evaluate the five criteria in Step 1

Once it is determined that a contract with a customer exists, we can proceed with Step 1. In Step 1 the FASB provided criteria that are used to evaluate whether a contract with a customer is a revenue contract within the scope of the new guidance. Evaluation of the criteria is performed at the inception of the arrangement. After inception of the arrangement, the conclusion is not reassessed unless there is a significant change in facts and circumstances. All five criteria must be met for the arrangement to be within the scope of Topic 606.

  1. A contract is approved and the parties have committed

The parties to the contract have approved the contract (in writing, orally, or in accordance with other customer business practices) and are committed to perform their respective obligations.

(Source: FASB Accounting Standards Update No. 2014-09, May 2014)

The approval of a contract by both parties is normally a necessary condition to have a legally enforceable contract and therefore it will often be clear that an agreement that has met the definition of a contract has the approval of the parties. It is important to note that approval of the parties need not necessarily be explicitly stated.

In a change from current U.S. GAAP, the contract need not be in the form that a company normally uses to document a revenue transaction. For instance, under existing U.S. GAAP, if a medical service provider customarily has a signed contract with its customer it may be required to obtain a signed contract to recognize revenue. This could result in performing a service in one period but deferring revenue until a later period when the signed contract is obtained. In contrast, application of the new guidance may result in revenue being recognized at the time the service is delivered even if no contract is signed, because the performance may have established approval of the customer. The entity should have a rationale for deviating from customary business practices and all facts and circumstances should be considered to conclude that the approval criterion is met.

To determine commitment of the parties to perform their obligations under the arrangement requires the use of judgment. While commitment requires both the entity and the customer to be committed, it does not require complete commitment. For instance a supply contract in which minimum quantities are not expected to be reached could still be considered substantially committed to and therefore meet the conditions to be considered a contract.

An important component of the evaluation of commitment is termination clauses. A termination clause held by both parties that allows the arrangement to be unilaterally terminated without compensating the other party would prevent the arrangement from meeting the criteria of Topic 606 because commitment would not exist. Once a contract is no longer wholly unperformed, i.e. once performance has been partially performed by the vendor, or the vendor has received consideration or has a right to receive consideration, the parties would be considered committed.

  1. A contract identifies the rights of the parties

The entity can identify each party's rights regarding the goods or services to be transferred.

(Source: FASB Accounting Standards Update No. 2014-09, May 2014)

The second criterion will often be easy to evaluate. As long as goods or services have been identified this criterion can be met. A more challenging situation occurs with oral or implied contracts; therefore, for these types of arrangements, it will continue to be important to have processes and controls in place to properly evaluate and document the arrangements. An arrangement in which the goods or services cannot be identified would not be able to meet the definition of a revenue contract within the scope of the new guidance.

  1. A contract has payment terms

The entity can identify the payment terms for the goods or services to be transferred.

(Source: FASB Accounting Standards Update No. 2014-09, May 2014)

The third criterion is another criterion that is normally easy to evaluate. The existence of a legal right to payment for the goods or services satisfies this criterion. Like the second criterion, if the payment terms cannot be identified the arrangement cannot meet the definition of a revenue contract within the scope of Topic 606. However, the payment terms need not be fixed. If the entity can reasonably estimate the transaction price it would meet the requirements of this criterion.

We will discuss the estimation of the consideration in the contract further in our Serial edition on Step 3 of the model Determining the Transaction Price.

  1. A contract has commercial substance

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).

(Source: FASB Accounting Standards Update No. 2014-09, May 2014)

The fourth criterion prevents the use of round-tripping to inflate revenues. Round-tripping may occur when a vendor loans or provides money to a customer in order for the customer to purchase the vendor's goods or services. In addition, transactions in which part of the transaction price contains nonmonetary transactions will require careful evaluation to ensure that the nonmonetary component of the transaction has commercial substance. The evaluation of commercial substance would be the same as that contained in the guidance for transactions to be accounted for under ASC 845 Nonmonetary Transactions (Topic 845).

  1. A contract contains a collectible price

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 (see paragraph 606-10-32-7).

(Source: FASB Accounting Standards Update No. 2014-09, May 2014)

The final criterion addresses whether the consideration due under the transaction price is collectible. Any fixed or variable consideration that has been estimated to be received under the arrangement is considered collectible when it can be determined that collection is probable. Probable in this context is used in the same manner as in ASC 480 Contingencies (Topic 480), which is an event that is likely to occur. This threshold is often thought of as an event that has a 70 to 75 percent chance of occurring.

Collectibility, the ability and intent of the customer to pay, requires an evaluation of the credit worthiness of the customer. For many entities the evaluation of collectibility will be performed in a manner similar as that which is performed to meet the collectibility threshold in existing U.S. GAAP. For instance, a control used to determine whether collectibility is probable could be to perform credit checks on customers and assign appropriate credit limits.

Other Considerations

  • Contracts entered into at or near the same time with the same customer that meet certain criteria are required to be combined.
  • If an entity expects no material effect on the financial statements from the election, it may elect to account for a portfolio of similar contracts instead of each individual contract.
  • The new guidance addresses the accounting for contract modifications, which can result in a cumulative catch-up adjustment, prospective adjustment, or new contract depending on the relevant facts and circumstances.

These issues will be discussed in a further installment of this Serial.

It is important to note a significant change from existing practice when evaluating collectibility under the new guidance. The amount evaluated for collectibility under the new guidance is the expected transaction price to be received and not the stated contractual amount. Therefore, an entity must first determine the expected transaction price before evaluating whether or not that amount is probable of being collected. Existing guidance, as interpreted under Staff Accounting Bulletin (SAB) 13, requires collectibility of the entire contract amount to be reasonably assured before any revenue is recognized. This change may result in the earlier recognition of revenue, particularly when a portion of the contracted amount is at risk as a result of expected, or past history of, price concessions.

Since most businesses normally only sell products or services when collection of at least a portion of the transaction price is probable, the impact of this change will likely be entities identifying and accounting for price concessions during the Step 1 evaluation. Under existing U.S. GAAP the existence of a price concession may have precluded revenue recognition because the price was not fixed or determinable, resulting in a recognition of revenue when cash was received. However, whether the price is fixed and determinable, as it exists in current U.S. GAAP, no longer applies under the new guidance. Therefore identification of a price concession during the Step 1 evaluation under the new guidance may permit an entity to determine that the expected amount to be received, net of the price concession, is probable. Therefore the contract, assuming all other criteria is met, would be a revenue contract accounted for under Topic 606 and revenue may be recognized earlier then under existing U.S. GAAP.

Transactions that do not meet the five criteria in Topic 606

The new guidance addresses circumstances when an arrangement with a customer is not a contract within the scope of the new guidance because it fails to meet one of the five criteria.

Such arrangements are accounted for by recording a liability equal to the amount of consideration already received from the customer until one of the following two conditions are met:

  1. 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, or
  2. The contract has been terminated, and the consideration received from the customer is nonrefundable.

(Source: FASB Accounting Standards Update No. 2014-09, May 2014)

Once one of these two criteria is met, the liability is removed and revenue can be recognized.

Final Thoughts

Update Corner

In regards to the presentation of revenues in the five-year table included in Management Discussion and Analysis (MD&A), the staff of the Securities and Exchange Commission (SEC) stated in a meeting of the Financial Accounting Standards Advisory Council that the Division of Corporation Finance will not object to an issuer that adopts Topic 606 retrospectively only retrospectively restating those years in the five-year table included in the audited financial statements. An issuer that does not restate all five years will be expected to have clear disclosure about the fact that the earlier periods were not restated.

It is critical for management to identify its population of contracts with customers and assess whether they meet the criteria in Step 1 to fall within the scope of Topic 606. Since the assessment of contracts will be ongoing as new contracts are entered into it will also be critical to establish controls, procedures and information systems to support the assessment of contracts. Remember to take a team approach and gather input from sales, legal, and information technology.

For More Information

If you have any specific questions, comments or concerns, please share them with James Comito of MHM's Professional Standards Group or your MHM service professional. You can reach James at jcomito@cbiz.com or 858.795.2029.


» Up Next

In the next edition of this Revenue Recognition Serial we will discuss the considerations and factors that go into the evaluation of Step 2: Identify the Performance Obligations in the Contract.

Previous Editions

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