One requirement for recognizing revenue is that collectibility is probable. Current practice requires this assessment at the point of revenue recognition. In contrast, the new standard requires collectibility be determined for assessing whether a contract exists. Further, the vendor must determine the consideration amount that it is entitled to (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, the new standard could alter how companies can recognize revenue when a portion of the consideration is received but collectibility for the entire contract is less than probable.
The new standard requires that collection of the transaction price for providing services or goods to a customer must be probable. “Probable” means that the future event is likely to occur. The seller must first determine the transaction price before assessing collectibility. The transaction price should include any price concessions. A price concession need not to be explicit. An implicit concession may be supported by the vendor’s history of providing a discount to the customer.
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 (ASC 606-10-55-3C).
Collectibility is reassessed if significant changes in facts and circumstances arise. For example, the customer declares bankruptcy during the contract or the customer reports negative cash flow subsequent to the contract inception. If the reassessment indicates that collectibility is less than probable, then the vendor stops recognizing revenue but does not need to 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 of 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 entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable. (Event 3)
On January 1, 20X5, Company A signs a contract to provide monthly computer support for three years to a customer for a stated price of $300,000, but Company A typically pursues 90 percent of the stated price from that customer. Also, the customer has made a nonrefundable prepayment of $200,000. Company A initially determined that it is probable to collect all of the consideration. However, on January 1, 20X6, Company A learns that the customer is experiencing significant cash flow problems, and it concludes that it may not be able to collect the rest of the consideration. Nevertheless, Company A decides to continue to provide service to that customer. Collectibility remains less than probable during 20X6 and 20X7. The customer pays the remaining $70,000 on December 31, 20X7. When can Company A recognize revenue from this contract?
There are three points to consider from the example above. First, since the vendor implicitly provides 10 percent discount to that customer, the transaction price is $270,000. Second, the vendor does not have to reverse revenue recognized prior to discovering that the customer has cash flow issues. Third, the vendor cannot recognize more revenue until the entire amount of consideration has been received and no more obligation exists. The following table demonstrates when Company A recognizes revenue:
Diversity in Thought
The Transition Resource Group (TRG) identified the four 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 recognize revenue when a contract is subsequently reevaluated as not probable of collection?
- How should an entity assess whether a contract contains a price concession?
How should an entity assess the collectibility for a portfolio of contracts? The first issue is about applying the collectibility assessment to contracts that are similar in nature and in amount. There are two distinctive views on how to account for such a portfolio of contracts. The example below demonstrates how the two views are different.
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 of its performance obligations.)
View A. 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. View A is appropriate when the vendor expects to collect the full amount stated in the contracts despite the fact that the customers may not be able to pay the full amount.
View B. The manufacturer should recognize 95 percent revenue from the portfolio of contracts and recognize zero bad debt expense. This view is valid when the vendor provides price concessions to a customer or a group of customers. In that case, the amount that the vendor is entitled to would include the price concession.
Analysis. The Boards support View A. Since a vendor generally would not enter into a contract unless it believes that it will collect the amount to which it will be entitled to (Basis for Conclusions, BC43), the manufacturer should recognize revenue for 100 percent of the consideration. This is supported by the credit checks performed, which are used to ensure collectibility is probable.
When should an entity reassess collectibility? The TRG 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.
How should an entity recognize revenue when a contract is subsequently reevaluated as not probable of collection? This issue becomes more complex when the vendor has received some nonrefundable consideration from the customer and has decided (or is legally required) to continue to provide service to this customer.
This standard may delay revenue recognition indefinitely in certain situations, such as when the vendor provides goods or services continually and the customer pays the consideration month by month. The vendor would be required to defer revenue from the payments received for services already rendered. Some TRG members expressed that this standard is very punitive because it delays revenue recognition far beyond the completion of performance obligations and the receipt of nonrefundable payments. In essence, the new standard has eliminated the current model of cash-based accounting. One of the three events in ASC 606-10-25-7 must occur in order for the vendor to recognize revenue from this type of contract. This issue is still under discussion by the Boards.
For example, in a service contract, the vendor subsequently assesses that the collectibility of consideration from this contract is less than probable yet the vendor has received partial consideration from the customer. The vendor may establish that the time between the contract inception date and the reassessment date (can be viewed as contract “termination” date) represents a contract for accounting purposes. Therefore, if the consideration received is for the service provided during this shortened contract, then the vendor may recognize that amount as revenue.
ASC 606 is an effort to capture the “substantive transaction between the entity and the customer” (ASC 606-10-55-3A). In a reassessment scenario, ASU 2016-12 instructs vendors to focus on the ability of the customer to pay “substantially all of the consideration” – not “the entire amount” (ASC 606-10-55-3B). This focus relieves some of the punitive nature that TRG members expressed earlier. In addition, ASC 606-10-55-3C reminds the vendor to look at the “contractual terms” and the “[vendor’s] ability to mitigate its credit risk”. All facts in every circumstance should be used in making reassessments.
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 contrary, 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.
Comparison to 605
Current practice requires collectibility of consideration to be reasonably assured for revenue recognition. This requirement is the same as the term “probable” in the new standard.
The difference comes from the timing of collectibility assessment. Currently, a vendor evaluates collectibility at the point of revenue recognition. A vendor may recognize revenue in situations where the customer pays consideration month-to-month as the vendor provides service without considering collectibility for the entire contract. In contrast, the new standard requires the vendor to assess collectibility to determine whether a contract exists for accounting purposes before allowing the vendor to recognize any revenue under that contract.
The new collectibility criterion affects the healthcare industry by replacing some specific rules used in current practice. A healthcare entity may provide services for a patient regardless of his/her ability to pay (e.g., emergency room). Current practice allows the healthcare entity to record a significant amount of the revenue when the service is performed. Bad debt expense is recorded to represent the amount that the entity is expecting not to collect from that customer.
Under the new standard, if a healthcare entity expects to receive a lower amount of payment than the amount billed to a customer class (i.e., those who are self-insured or uninsured), then the entity should estimate the actual amount that it expects to receive. This estimate could be obtained via historical collection experience that the entity has with that patient class. The difference between the billed amount and the expected amount is considered a price concession.
The new standard also replaces industry-specific guidance for real estate transactions. Current practice allows the recognition of full profit if the buyer provides a specified amount of initial and continuing investment and if the seller does not have any significant continuing involvement in the real estate after the sale. However, instead of assessing significant continuing involvement, the new standard requires the seller to assess collectibility (and other criteria in ASC 606-10-25-1) to determine whether a contract exists.
In some cases, the new standard may allow revenue to be recognized earlier for cash-basis customers than current practice. The new standard does not include the concept of extended payment terms; it requires that collectibility be assessed over the life of the contract.
This may result in some slow-paying customers moving revenue recognition forward if it is probable that the company will collect the transaction price.
Currently, companies assess collectibility at the point of revenue recognition; however, the new standard requires collectibility to be determined during step one of the revenue recognition model. This change in timing of assessing collectibility may delay revenue recognition in some and in other cases move revenue recognition forward. Companies also need to establish the consideration amount that they are entitled to in contracts with customers by distinguishing price concession from bad debt expense.
- ASC 606-10-25-1; 25-7; 25-8.
- ASU 2014-09: “Basis for Conclusions.” BC44-BC45.
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised August 2016. Section 3.1.5 “Collectibility.”
- FASB, Update N. 2014-09 – “Revenue from Contracts with Customers” (Topic 606) Section C—Background Information and Basis for Conclusions, BC44-BC45.
- FASB, Update N. 2016-12 – “Revenue from Contract with Customers” (Topic 606) – Narrow-Scope Improvements and Practical Expedients
- FASB & IASB, TRG Memo 13: “Collectibility.” 26 January 2015.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 5.1.1 “Criteria to determine whether a contract exists.”
- PWC, “Revenue from contracts with customers.” August 2016. Section 2.6 “Identifying the contract.”
- EY, “Technical Line: A closer look at the new revenue recognition standard,” 16 June 2014, Section 3.1.5.