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:
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.
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:
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:
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:
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:
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:
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:
To reflect the credit related to the defective units
To record the delivery of the remaining 60 units under the original contract
To reflect the delivery of the final 30 units under the modified terms7
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.
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.
7Derived from ASC 606-10-55-(111-116)