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.
Whitestone REIT is a publicly traded real estate investment trust entity headquartered in Houston, Texas. Whitestone decided to rid itself of all non-core properties at the end of 2016 in order to focus solely on being a Community Centered Retail REIT. To accomplish this, Whitestone entered into an agreement with Pillarstone Capital REIT; the transaction included the following notable factors:
- Whitestone provided a $15.5 million loan to Pillarstone.
- Whitestone was awarded 18.1 million “Class A” shares with the option to redeem for cash.
- In return, Pillarstone assumed $50.4 million of Whitestone’s liabilities.
In accordance with ASC 610, Other Income, Whitestone was required to determine whether derecognizing financial assets was appropriate. ASC 610 requires entities to first use the criteria found in ASC 606 and evaluate whether a contract exists. Whitestone performed the collectibility test in ASC 606 to complete this analysis. Thus, even though the analysis is not directly related to the recognition of revenue, this example shows Whitestone’s collectibility test under ASC 606.
Whitestone’s evaluation of whether a contract exists under ASC 606 focused primarily on the collectibility of the consideration it was owed. In its correspondence with the SEC, Whitestone explained that it would receive consideration in three parts (October 2018 Letter):
- Repayment of the $15.5 million loan
- Cash resulting from the conversion of the shares at any time
- Relief from $50.4 million of liabilities
Whitestone argued that the consideration should not be considered collectible using the following rationale:
Pillarstone’s cash flows for the remainder of the year and cash on hand will be insufficient to generate cash to repay the entire $15.5 million loan made by the Company to Pillarstone OP by December 8, 2018 and/or to make the payment required should the Company exercise its put option on its Pillarstone OP Units.
Whitestone also considered the following factors:
- Pillarstone’s Debt/Value ratio is greater than 70%.
- Pillarstone’s tenants are primarily on short-term leases.
- Pillarstone has most of its operations in a limited geographic area, leading to concentration risk.
- Pillarstone is not likely able to secure additional borrowings on its own. The lenders of Whitestone’s liabilities (that were assumed by Pillarstone in the agreement) were unwilling to transfer the liabilities to Pillarstone without Whitestone also guaranteeing the debt.
Whitestone concluded that its transaction with Pillarstone did not constitute a contract because the consideration Whitestone was owed was not collectible, based on Pillarstone’s financial capacity. However, Whitestone was still able to accomplish its goal of divesting non-core assets to improve operations. Entities seeking to recognize revenue from contracts with customers should follow similar methods in determining whether consideration is collectible or not.
Other Considerations for Collectibility
Collectibility is reassessed if significant changes in facts and circumstances arise. For example, the customer declares bankruptcy or reports negative cash flow subsequent to the contract inception. If the reassessment indicates that collectibility is less than probable, the vendor stops recognizing revenue but does 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)
Example: Evaluating Collectibility Under ASC 606
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. Company A typically pursues only 90 percent of the stated price from that customer. The customer has also made a nonrefundable prepayment of $200,000. Company A initially determined that it is probable to collect all the consideration under the collectibility assessment in ASC 606.
On January 1, 20X6, Company A learns that the customer is experiencing significant cash flow problems and concludes that it may not be able to collect the rest of the consideration. Nevertheless, Company A decides to continue providing services 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, because the vendor implicitly provides a 10% 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:
|January 1, 20X5||December 31, 20X5||December 31, 20X6||December 31, 20X7|
Because collectibility was not considered probable as of January 1, 20X6, the company does not recognize any revenue until (1) it has completely fulfilled its obligations and (2) the entire amount of consideration has been received. For this reason, no revenue should be recognized during 20X6, but the entire remainder should be recognized on December 31, 20X7.
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.