COVID-19, the disease caused by the novel coronavirus, has impacted society and the economy in numerous ways. This article highlights several ways COVID-19 has affected or is expected to affect the timing of Accounting Standards Codification (ASC) 606 implementation and several steps of the revenue recognition model.
Optional ASC 606 Implementation Deferral for Non-public Franchisors
On June 3, 2020, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU 2020-05). The purpose of this update is to delay the implementation of ASC 606 by one year for “All other entities that have not yet issued financial statements or made financial statements available for issuance as of June 3, 2020” (ASC 606-10-65-1). This ASU gives these entities the option to defer adoption of ASC 606 to annual reporting periods beginning after December 15, 2019 and interim reporting periods within annual reporting periods beginning after December 15, 2020. Entities can still elect to adopt ASC 606 for annual reporting periods beginning after December 15, 2018 and interim reporting periods within annual reporting periods beginning after December 15, 2019. The adoption date deferral was initially proposed because stakeholders had unresolved questions regarding how to account for initial franchise fees under ASC 606.
For entities that have already adopted ASC 606, COVID-19 may impact steps one, three, four, and five of the revenue recognition model. The rest of this article is organized by these steps. Read The Five-Step Method for more information about these steps.
Step 1: Identify the Contract with a Customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations (ASC 606-10-25-1). ASC 606 applies only to the period of time in which parties to a contract have enforceable rights and obligations (ASC 606-10-25-3). Companies should consider whether this right to payment continues to be enforceable under current COVID-19-impacted conditions. For example, if courts cease to uphold rights to payment, or a force majeure (also known as an “act of God”) clause or similar contract provision is invoked, then some entities may no longer have enforceable rights and obligations. Without enforceable rights and obligations, a contract does not exist under ASC 606. For more information, see the RevenueHub article Identify the Contract.
Assessing collectibility is a critical part of determining whether a contract exists under ASC 606. At contract inception, an entity must determine whether it is probable that the entity will collect substantially all of the contract’s transaction price. Entities will need to first determine the transaction price, including any price concessions or other variable consideration, before making the collectibility assessment. See Price Concessions and Variable Consideration and the Constraint for more information.
If collectibility is probable at contract inception, the entity should move forward in the revenue recognition model and reassess collectibility only if there is a significant change in facts and circumstances. If entities determine that COVID-19 represents a significant change in the facts and circumstances of their existing contracts, they should reassess collectibility. If collectibility is no longer probable, revenue is adjusted prospectively. Although past revenue is not typically reversed, a change in the collectibility assessment for a customer may indicate that existing receivables or contract assets related to that customer are impaired (see the section below on impairment). Revenue could potentially be reversed if the change in facts and circumstances occurs in the current reporting period. However, previous financial statements should not be restated to reverse revenue. For an example, read comment three of Mattel's comment letter from 2018.
If collectibility is not probable at contract inception, no revenue can be recognized under ASC 606 because a contract does not exist. However, the entity should regularly reassess collectibility and may change the initial assessment if collectibility later becomes probable. When collectibility is not probable, no revenue can be recognized from the contract even if cash is received from the customer unless the payment is nonrefundable and one of the criteria in ASC 606-10-25-7 is also met.
Due to the unique nature of COVID-19, the collectibility assessment may change multiple times within even one quarter. Because revenue is adjusted only prospectively, contemporaneous documentation is critical to all collectibility assessments. Furthermore, entities should first consider COVID-19-related changes to the transaction price before determining whether collectibility is probable, because collectibility applies to the transaction price, which may vary from the amount stated in the contract if the contract contains price concessions or other variable consideration. Finally, entities should evaluate whether established processes for evaluating collectibility are sufficient given the uncertainty caused by COVID-19. For example, credit quality or payment history may not reflect recent changes to the operating environment of customers that are more indicative of the customer’s ability and intent to pay current contracts. For more information, see the RevenueHub article Collectibility of Consideration.
Contract Modifications and Combinations
Given the fluctuating economic conditions caused by COVID-19, the scope or price of contracts may be altered to meet the needs of customers. Contract modifications do not have to be formalized in writing, but can result from verbal or implied agreements. Entities should follow the three steps outlined in Contract Modifications to determine whether contract modifications should be accounted for as a modification to the original contract or as a separate contract. Already, we can see modifications to government contracts. The Pentagon alone will modify hundreds of contracts to purchase ventilators and other supplies (Nextgov).
Due to changing demands, entities may also enter many new contracts during this time. If two or more contracts are entered into at around the same time and with the same customer (or with a related party of the customer), then the entity may need to consider Combining Contracts. Combination of contracts is required when a) the contracts are negotiated as a single bundle or package with a single business objective, b) consideration in one contract is tied to the price or performance of the other contract(s), or c) promised goods or services in the contracts represent a single performance obligation (ASC 606-10-25-9).
Step 3: Determine the Transaction Price
Price Concessions and Other Variable Consideration
Due to the sharp downturn in economic activity caused by COVID-19 fears and precautions, entities may be more likely to grant price concessions to customers. These price concessions may be explicitly stated or implied through an entity’s conduct or usual business practice. Consequently, if a customer is granted or expects to be granted a price concession, the vendor may need to adjust the transaction price accordingly prior to the collectibility assessment (see the section above on collectibility). This adjustment to the transaction price is critical because it may impact whether a contract exists (i.e., whether the contract meets the collectibility threshold) and how much revenue is recognized for satisfying each performance obligation. For more information, see Price Concessions and Case Study: Price Concessions.
In addition to price concessions, COVID-19 may impact the estimated amount of other forms of variable consideration, such as expected volume discounts, returns, rebates, refunds, incentives, performance bonuses, penalties, royalties, etc. Entities must update their assessment of variable consideration each reporting period. If the transaction price of a contract is adjusted, the change should be accounted for prospectively in most cases. See the section above for collectibility. However, in evaluating variable consideration, entities may find that trade receivables, capitalized contract costs, or contract assets are unlikely to be recovered, which may lead to impairment losses (see the section below on impairment). For more information, see the RevenueHub article Variable Consideration and the Constraint.
COVID-19 may also change entities’ customary process for evaluating whether variable consideration is constrained. Variable consideration is constrained (and therefore not included in the transaction price) whenever a significant reversal in revenue is probable. Although the constraint principle leads to conservative estimates for variable consideration and typically prevents significant revenue reversals, entities may be forced to make significant downward adjustments to transaction prices because of COVID-19. Changes to the transaction price are typically accounted for prospectively, with the change allocated in the same way as at contract inception. However, if entities disregard key economic information that is reasonably available when making estimates for variable consideration, significant changes to the transaction price may need to be accounted for in accordance with ASC 250 (Accounting Changes and Error Correction). For more information on the constraint, see the RevenueHub article Variable Consideration and the Constraint.
Extended Payment Terms
In addition to offering price concessions, entities may also be more likely to extend payment terms as a goodwill gesture. Extended payment terms may qualify as a significant financing component if the gap between payment and delivery is greater than one year. Several factors should be considered in this analysis, such as the difference between the promised consideration and the cash selling price of the promised goods or services, and the combined effect of both the prevailing market interest rates and the length of time between when the entity delivers the promised goods or services and when the customer pays. If an entity determines that the extension of payment terms constitutes a significant financing component, a portion of the consideration will be recognized as interest income instead of sales revenue. For further explanation, read Significant Financing Component.
Step 4: Allocate the Transaction Price
Changes to Standalone Selling Prices
Estimating the standalone selling price (SSP) of goods and services is a critical part of Step 4 of the revenue recognition model. Entities allocate consideration to the performance obligations in a contract on a relative SSP basis. To estimate SSPs, entities typically look to observable prices for the most reliable evidence (ASC 606-10-32-32). However, during the COVID-19 pandemic, entities may notice significant fluctuations in observable prices, which are likely to impact internal SSP estimates. Although entities should not adjust the SSP of goods and services in existing contracts, consideration in new contracts should be allocated according to SSPs that reflect the most current information available. Consequently, entities will find contemporaneous documentation critical in justifying SSP estimates in the current environment. For more information, see the RevenueHub articles Standalone Selling Prices and Case Study: Transaction Price Allocation.
Step 5: Recognize Revenue When or As Performance Obligations Are Satisfied
Revenue Recognized over Time
For contracts in which revenue is recognized over time, COVID-19 may change the timing of revenue recognition. Entities must use the input or output method to measure their progress toward completion, which determines the amount of revenue they may recognize. For more information, see Input vs. Output Methods.
Many projects are likely to be delayed by COVID-19, which naturally delays the progress of revenue recognition under the input or output methods. In addition, COVID-19 has affected many supply lines, which may increase the cost of procuring certain materials. A change in materials prices could impact the timing of revenue under the input method because the costs incurred would deviate from expected costs. Entities may need to adjust the total expected costs of the contract to calculate the percentage of costs already incurred relative to total costs. All changes to these types of estimates should be accounted for prospectively. For more details, read Revenue Recognition Over Time.
Impairment of Receivables and Contract Assets
Due to COVID-19, many entities may be unable to collect receivables or contract assets (such as unbilled receivables) from their customers. ASC 606 states that entities should evaluate receivables or contract assets for impairment under ASC 310 (or ASC 326 for SEC filers that have already adopted this update) rather than reversing previously recognized revenue (ASC 606-10-45-3). See the above section on collectibility for an exception. Under ASC 310, impairment is required when 1) it is probable that the asset has been impaired at the date of the financial statements based on information available before the financial statements are issued and 2) the amount of the loss can be reasonably estimated (ASC 310-10-35-8). Under ASC 310, entities may not recognize losses before it is probable that they have been incurred (ASC 310-10-35-4). It would not be appropriate to forecast future losses due to COVID-19 and recognize those losses in the current period.
For entities already following the guidance in ASC 326 (Financial Instruments—Credit Losses), the probable threshold for initial recognition of the losses has been eliminated, and impairment losses are now based on “past events, current conditions, and on reasonable and supportable forecasts” (ASC 326-30-35-8). Because of the forward-looking nature of ASC 326, entities may find that future expected losses differ significantly from impairment losses under ASC 310. Entities should ensure that all estimates reflect the rapid change in economic conditions brought on by COVID-19.
Some of the costs to fulfill or to obtain a contract can be capitalized and amortized if they are expected to be recovered. In light of COVID-19, recoverability of capitalized costs may be in question as, for example, customers may be more likely to default on contracts. At the end of each reporting period, entities should check for impairment. If the asset’s carrying value is greater than the expected transaction price, the capitalized cost should be written off in an impairment loss.
In addition, the amortization period may need to be adjusted prospectively. The amortization period is typically consistent with the pattern of transfer of the good or service to which the asset relates. If COVID-19 has affected this pattern of transfer, the amortization period should be adjusted accordingly. To learn more about these topics, read Costs to Fulfill a Contract and Incremental Costs of Obtaining a Contract.
The objective of the disclosure requirements related to ASC 606 is to “disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers” (ASC 606-10-50-1). With this goal in mind, entities will need to disclose significant judgments used to apply ASC 606. COVID-19 may influence or change these judgments. In addition, any impairment losses related to receivables or contract assets will also need to be either disclosed or presented separately on the statement of comprehensive income (ASC 606-10-50-4). To read more about disclosure requirements, read Disclosures in ASC 606. To see an example of revenue disclosures under ASC 606, read the section COVID-19 in Microsoft’s 10-Q for the quarter ended March 31, 2020 (page 32). Microsoft reports that COVID-19 had “minimal net impact on [its] revenue” because many customers shifted to working and learning from home and increased their usage of Microsoft’s cloud products.
Many steps of the revenue recognition model may be affected by COVID-19. The FASB has delayed implementation for non-public franchisers to help ease the burden for these entities, but those that have already implemented ASC 606 may need to review the terms of their contracts and adjust as necessary.
- ASC 250, Accounting Changes and Error Corrections
- ASC 310, Receivables
- ASC 326, Financial Instruments—Credit Losses
- ASC 606, Revenue from Contracts with Customers
- FASB, “Proposed Accounting Standards Update—Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities.” April 2020.
- ASU 2020-05: “Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842)—Effective Dates for Certain Entities.” BC5-BC11.
- PwC, “FAQ on accounting for COVID-19 and market volatility.” March 2020.
- KPMG, “Are revenue-cycle assets recoverable?” March 2020.
- Nextgov, “Pentagon to Modify Hundreds of Contracts for COVID-19 Response.” March 2020.