Accounting Standards Codification (ASC) 606 allows for an entity to account for multiple contracts as a portfolio (commonly known as the portfolio method), instead of accounting for them on a contract by contract basis (commonly known as the contract method).
It should be noted that entities are not required to use the portfolio method. The portfolio method is a practical expedient that the Financial Accounting Standards Board (FASB) authorized to prevent companies from spending an unreasonable amount of time and money applying ASC 606 to their contracts (or performance obligations). Entities should analyze the cost and benefits of applying the portfolio method. If the costs of applying the portfolio method exceed the benefits, then the entity may want to invest in a system that would account for customer contracts on an individual basis (and vice versa).
Criteria to Use the Portfolio Method
Firms may elect to account for multiple contracts as a portfolio if certain criteria are met. ASC 606-10-10-4 states that the following criteria must be met in order to use the portfolio method:
- Contracts or performance obligations must have similar characteristics
- The entity reasonably expects that the effects on the financial statements from applying the portfolio method are not materially different than applying ASC 606 to the individual contracts
- The entity must use estimates and assumptions that reflect the size and composition of the portfolio
The new guidance does not explicitly outline to what extent contracts or performance obligations should be similar in order to meet the first criterion above. Entities should focus primarily on those characteristics that have the largest impact on the amount of revenue recognized and the timing of revenue recognition under ASC 606. For instance, entities could evaluate the similarity of contracts based on contract deliverables, contract duration, terms and conditions, amount and form of consideration, characteristics of the customers, and timing of transfer of goods or services (i.e. over time or at a point in time). These objective criteria applied to the facts and circumstances of each case will help entities determine whether contracts are sufficiently “similar” to warrant use of the portfolio approach.
The FASB has expressed that the entity need not quantitatively evaluate whether using the portfolio approach will produce an outcome that is materially different from that of applying the guidance on an individual contract basis. The entity should, however, demonstrate in a reasonable manner why it expects the two approaches will not differ materially. The entity can perform data analytics using information related to the portfolio, sensitivity analysis to determine a range of potential differences between the two approaches, or a qualitative assessment of disaggregating and aggregating the portfolio. The entity typically should use some form of objective and identifiable information to show that the financial statements will not differ materially using the portfolio approach.
The FASB has stated that the contract method should be used to determine if a financing component exists in a customer contract. This specification is to reduce the burden for entities, enabling them to assess the financing component on one contract and apply that component to the portfolio. If the entity finds that the financing component is significant, the transaction price should be adjusted for the financing component. See Significant Financing Component for more information.
ASC 606 allows an entity to account for contracts and performance obligations as a portfolio. The portfolio method is a practical expedient that can be used to recognize revenue when contracts have similar characteristics and when the entity reasonably expects that using the portfolio method will not be materially different than using the contract method. The entity must also use estimates and assumptions that reflect the size and composition of the portfolio. Professional judgment must be used to determine which contracts are sufficiently similar to be accounted for as a portfolio in accordance with the new standard.
- ASC 606-10-10-4, 55-203 to 55-207
- ASU 2014-09: “Revenue from Contracts with Customers.” BC69-BC70.
- Deloitte, “A Roadmap to Applying the New Revenue Recognition Standard.” November 2021. Section 184.108.40.206.
- EY, Financial Reporting Developments: “Revenue from contracts with customers.” September 2022. Section 3.3.
- KPMG, Handbook: “Revenue Recognition.”December 2021. Section 2.5.
- PWC, “Revenue from Contracts with Customers.” February 2022. Section 1.3.3.