One requirement for recognizing revenue is that collectibility is probable. ASC 606 requires that entities determine collectibility as part of step 1 in the revenue recognition process when assessing whether a contract exists. Further, the vendor must determine the amount of consideration to which it is entitled (i.e., transaction price), which may not necessarily be the stated amount on the contract. This assessment may be difficult when a vendor must distinguish a price concession from an uncollectible amount. Also, ASC 606 requires careful analysis when a portion of the consideration is received but collectibility for the entire contract is less than probable.
Determining the Collectibility of a Revenue Contract
To recognize revenue for providing goods or services to a customer, the collectibility of the transaction price must be probable. “Probable” means that “the future event or events are likely to occur” (ASC 606 Glossary). To make this analysis, the seller must first determine the transaction price, which should include any price concessions, before assessing collectibility. A price concession does not need to be explicit; an implicit concession may be supported by the vendor’s history of providing a discount to the customer.
When assessing collectibility, a vendor should determine whether the customer has both the financial capacity and the intent to pay the consideration owed (ASC 606-10-25-1(e)). In assessing the customer’s financial capacity, a vendor may consider a customer’s credit risk and credit history. A vendor may assess a customer’s intention to pay by evaluating the vendor’s past experience with that customer or that class of customer. A vendor should consider all relevant facts and circumstances, such as the current economic conditions of the customer’s industry or the customer’s income, in assessing collectibility.
Other Considerations for Collectibility
Collectibility is reassessed if significant changes in facts and circumstances arise. If, for example, the customer declares bankruptcy or reports negative cash flow subsequent to the contract inception and the reassessment indicates that collectibility is less than probable, the vendor should stop recognizing future revenue and not reverse previously recognized revenue. If a vendor receives some cash from the customer, but collectibility for the entire contract is less than probable, then one of three events must occur for the vendor to treat the payment as revenue (ASC 606-10-25-7):
- The vendor has no remaining obligations to the customer, and all the payment promised by the customer has been received and is nonrefundable. (Event 1)
- The contract has been terminated and the payment is nonrefundable. (Event 2)
- The vendor has transferred control of the goods and services and has stopped (and has no obligation to continue) transferring more goods and services to the customer. (Event 3)
Financial Accounting Standards Board (FASB) Commentary on Common Issues
In January 2020, the FASB issued its Revenue Recognition Implementation Q&As. The FASB discussed the three following issues regarding collectibility:
- How should an entity assess the collectibility for a portfolio of contracts?
- When should an entity reassess collectibility?
- How should an entity assess whether a contract contains a price concession?
Issue 1: How should an entity assess the collectibility for a portfolio of contracts?
The first issue is about applying the collectibility assessment to multiple contracts that are similar in both nature and amount. Consider this example:
Suppose a vendor has a large volume of homogenous contracts with customers. Based on the company’s history with this type of customers, about 95 percent of the customers will pay. In addition to this past experience, the company performs a credit check on every customer before signing a contract. This process is to ensure that collectibility is probable for these contracts. Given the historical collection of 95 percent of the payments from this portfolio of contracts, how much revenue should the company recognize? (Assume that the manufacturer has satisfied all its performance obligations.)
In the example, the FASB concluded that it is probable the customer will pay what is owed, so the contract is considered collectible. The vendor should recognize revenue at 100 percent. The 5 percent is treated as a bad debt expense when conditions for impairment loss are met. This conclusion is appropriate when the vendor expects to collect the full amount stated in the contracts even though the customers may not be able to pay the full amount.
Issue 2: When should an entity reassess collectibility?
The FASB reaffirmed the standard—once collectibility of a contract has been established, a vendor does not have to reassess collectibility unless the customer’s ability to pay the payments deteriorates significantly. An in-depth case study of how one company reassessed collectibility can be found in this article: Mattel, Inc. and Toys R Us – Evaluating Collectibility when a Customer Experiences Financial Distress: Case Study
Issue 3: How should an entity assess whether a contract contains a price concession?
Difficulties with this issue come from distinguishing an implicit price concession from customer credit risk. A price concession may be based on the vendor’s history of providing price concession and the vendor’s intention when entering into the contract with the customer (i.e., the vendor expects to collect an amount including the concession). In contrast, customer credit risk suggests that although the vendor expects to collect the amount of consideration stated in the contract, it is unlikely that the vendor is able to collect all of the payment due to the customer’s inability or lack of intention to pay.
ASC 606 requires entities to determine collectibility during step one of the revenue recognition model. Collectibility can be assessed based on the customer’s financial capacity and intent to pay. Entities may need to reassess collectibility during the life of the contract if there is a significant change in facts or circumstances. In addition, entities must distinguish between price concessions and bad debt expense when establishing the amount of consideration to which they are entitled.
- ASC 606-10-25-1; 25-7; 25-8.
- FASB, Update N. 2014-09—Revenue from Contracts with Customers (Topic 606) Section C—Background Information and Basis for Conclusions, BC44-BC45.
- KPMG, Revenue Recognition Handbook, December 2019, Section 3.2.10.
- EY, “Technical Line: A closer look at the new revenue recognition standard,” 16 January 2020, Section 3.1.5.
- PWC, “Revenue from contracts with customers,” March 2020, Section 2.6.
- FASB Revenue Recognition Q&A January 2020.