Companies can use either the full retrospective method or the modified retrospective method when applying Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers. The full retrospective approach requires companies to apply ASC 606 to contracts in all comparative periods on the financial statements. In contrast, the modified retrospective method requires companies to apply ASC 606 to incomplete contracts in the current period. However, difficulties arise when identifying which contracts are considered completed and how to account for completed contracts after adopting the standard.
ASC 606-10-65-1(d) provides two options for companies to adopt the standard: (1) the full retrospective method and (2) the modified retrospective method.
Full Retrospective Method
The full retrospective method requires companies to apply ASC 606 to all contracts in all periods presented on the comparative financial statements. Therefore, all contracts in each comparative period and the current period should be accounted for as if ASC 606 had been in effect from the inception of the contracts. To ease the burden of the filers, companies may elect any of the three practical expedients below (606-10-65-1(f)):
- For completed contracts, a company does not need to restate contracts that start and end within the same annual reporting period
- For completed contracts that have variable consideration, a company may use the transaction price on the date the contract is completed rather than estimating variable consideration in the comparative reporting periods
- For reporting periods prior to the date of initial application, a company does not need to disclose the transaction price allocated to remaining performance obligations in an incomplete contract; also, the company does not need to explain when it expects to recognize the revenue from these performance obligations
Companies may utilize all or none of the practical expedients. However, companies must apply the elected expedients consistently to all comparative periods and provide additional qualitative disclosures. The disclosures should include information on which practical expedients are applied and the likely effects from the application.
Modified Retrospective Method
The modified retrospective method requires companies to apply ASC 606 only to contracts that are not completed as of the initial adoption date. Under this method, companies would recognize the cumulative effect of initially adopting ASC 606 through adjusting the beginning retained earning balance of the current period. The modified retrospective method does not offer as much comparability as the full retrospective method because it does not require companies to restate prior periods in comparative financial statements. To compensate for this drawback, entities are required to include the following disclosures:
- The amount in each financial statement line item in the current reporting period that is different because of adopting ASC 606 (i.e., applying both ASC 605 and ASC 606 to contracts in that period and finding the difference in each affected line item)
- Explanation of the reasons behind any significant changes identified above
These disclosures are needed only for the period that a company initially adopts ASC 606. To comply with the disclosure requirement, companies may need to keep two sets of accounting records to present the difference due to transitioning to ASC 606.
Diversity in Thought
According to ASC 606-10-65-1(c)(2), a contract is a completed contract if the entity has transferred all goods and services identified under ASC 605. The Transition Resource Group (TRG) recognized two issues regarding applying this definition:
- When is a contract considered completed for the purpose of transition?
- How should completed contracts be accounted for after adopting ASC 606 if not all related revenues have been recognized?
When is a contract considered completed for the purpose of applying the modified retrospective method? Stakeholders struggle to apply the definition of a completed contract consistently to existing contracts because this definition requires entities to use a concept in ASC 606 (transferred all goods and services) in the context of the legacy standard (goods and services identified under ASC 605). The three examples below demonstrate this issue and the accounting implications of these differing views follows the presentation of the issues. Assume January 1, 2018 is the initial adoption date for all examples in this article.
Example – 1
Techno Co. provides a license to a customer to use its design software for two years. The customer receives the license on January 1, 2017. In accordance with ASC 605-985, revenue is recognized ratably over the two-year licensing period. As of January 1, 2018, half of the revenue has been recognized and the other half is recorded as deferred revenue. During the transition, the company determines that this contract is a right-to-use license. The license was transferred on January 1, 2017.
View A: This licensing contract is a completed contract because Techno Co. does not transfer any additional goods or services to the customer. According to ASC 606, revenue from a right-to-use license should be recognized when the license is transferred to the customer (i.e., no additional goods or services provided to the customer). Due to the lack of specific guidance on licensing of IP in ASC 605, entities are allowed to recognize revenue ratably by drawing analogy to lease accounting. Therefore, the existence of deferred revenue does not indicate that additional goods or services exist in the contract.
View B: The contract is not completed because revenue is recognized ratably. Because revenue is recognized ratably over the life of the contract, Techno Co. must have concluded, under ASC 605, that not all goods or services have been fully transferred. The assessment of whether a contract is completed should be based on ASC 605, not ASC 606.
Example – 2
Secure Co. licenses security software to a bank on January 1, 2017. The contract does not contain other explicit goods or services. The bank pays Secure Co. in four annual installment payments. Since fees are considered not fixed or determinable if a significant portion of the fees are due after one year or later (long payment terms indicate that an entity is likely to provide price concessions or extra products to the customer), and Secure Co. does not have a history of providing prolonged financing, Secure Co. can only recognize revenue as each installment payment is received (ASC 985-605-25-33 to 35). As of January 1, 2018, Secure Co. has recognized revenue that equals to the first annual payment.
View A: The contract is a completed contract because Secure Co. does not have to transfer additional goods or services to the customer.
View B: The contract is not completed because Secure Co. is likely to provide a price concession or additional products to its customer due to the length of the payment term. The potential price concession or products indicate that Secure Co. has not transferred all of the goods and services.
Example – 3
Northstorm Co. sells high-end clothing to customers. The company has a points-rewards program that offers discounts to customers for future purchases. Customers can obtain discount points by purchasing goods at Northstorm stores.
On December 31, 2017, the company sells products to a customer and receives full payment on the same day. Northstorm uses an incremental cost accrual model to accrue the expected costs to satisfy the rewards program while recognizing full revenue at the point of sale. On the transition date, Northstorm concludes that its points-rewards program is a material right, the company would need to allocate part of the transaction price to the rewards program for contracts entered on and after January 1, 2018.
View A: The contract is not completed because Northstorm concludes that its rewards program is a material right. A material right under ASC 606 indicates that goods and services would be transferred in the future. Even though no revenue is deferred to account for the rewards program under the current standard, the company has not transferred the goods or services related to its rewards program.
View B: The contract is completed because the rewards program is not identified as a deliverable under ASC 605. All goods and services were transferred to the customer at the point of sale.
In each of the above cases, View A requires a company to identify goods and services in a contract and use ASC 606 to assess whether they have been transferred to the customer. Under this view, a contract is completed if all identified goods and services are transferred to the customer under ASC 606. This is the case even when not all of the revenue from that contract has been recognized at the date of transition.
In each of the above cases, View B allows a company to determine whether a contract is completed based on whether revenue from that contract has been recognized under ASC 605 before the date of transition. The rationale behind View B is that if revenue is not recognized under ASC 605, then not all goods or services have been transferred. Choosing between adopting Views A and B would affect the number of contracts that a company must review at transition.
How should an entity account for completed contracts after adopting ASC 606? This issue arises when a completed contract does not have all of its related accounting complete at the transition date (e.g., when collectibility is less than probable after all deliverables are delivered). Because no guidance exists, stakeholders are unsure of how to account for these contracts once the transactions are complete (e.g., when cash is received). The example below, which is based on the TRG discussion, illustrates this issue.
Example – 4
BigTruck Co. sells a fleet of custom-built trucks to a large client. The fee for the trucks is fixed and the trucks are delivered on November 1, 2017. On April 1, 2018, the client lost a significant portion of its cash reserve due to unforeseen economic downturns. Under ASC 605, BigTruck Co. concludes that since collectibility for this contract is less than reasonable, revenue may only be recognized once cash is received. However, as of January 1, 2018, the contract is considered completed because all goods and services are delivered. Therefore, this contract is not subject to ASC 606. On June 1, 2018, BigTruck Co. receives the cash payment from the client.
View A: Since the contract is considered completed, BigTruck Co. should not recognize revenue from this contract even when cash is received. Instead, the cash received would bypass the income statement and appear as an adjustment to retained earnings. According to View A, no revenue should be recognized from a completed contract after the transition to ASC 606. The income statement would not include any unrecognized revenue from completed contracts. This view may misrepresent that company’s actual financial performance and reduce comparability of the financial statement.
View B: BigTruck Co. should recognize revenue from the cash received on June 1, 2018. Because the accounting for the contract was not complete at the transition date, BigTruck Co. should continue to use ASC 605 to account for this contract. View B allows companies to continue using the legacy standard for completed contracts even after it ceases to exist in the Codification. This view resolves the problems identified with View A, but it represents prospective transition approach to ASC 606, which is not the Financial Accounting Standards Board’s (FASB) intention for the transition.
The FASB has proposed a tentative amendment to clarify the definition of a completed contract for transitional purposes. The tentative amendment defines a completed contract as one for which all (or substantially all) of the revenue has been recognized under the legacy standard. This solution would resolve both issues discussed above, but the FASB must formally amend ASC 606.
Companies may adopt ASC 606 by using two transitional methods—the full retrospective method and the modified retrospective method. When using the modified retrospective method, companies need to determine whether existing contracts are completed contracts at the transition date. A completed contract is currently defined as one for which all identified goods and services have been transferred to the customer. This definition is difficult to apply because it uses a concept from ASC 606 (i.e., transferring goods and services) in the context of ASC 605. The TRG identified two major issues regarding completed contracts:
- When a contract is considered completed for the purpose of transition (Issue 1)
- How to account for revenue from a completed contract after the transition (Issue 2)
Two alternatives exist for issue 1. One alternative is to determine whether goods and services have been transferred using the principles in ASC 606. If all goods and services in a contract are transferred before the transition date (regardless whether all accounting has been done for the contract), then the contract is a completed contract. The other alternative is to define a completed contract as one for which all of its revenue is recognized by the transition date.
Two views also exist for issue 2. One view is that no revenue should be recognized from a completed contract after the transition. Any revenue that would have been recognized under the legacy standard after the transition date is an adjustment to retained earnings. The other view is to continue to recognize revenue from a completed contract using the legacy standard.
The FASB has not reached a conclusion regarding the two issues, but the Board is considering one tentative amendment to ASC 606. The tentative amendment defines a completed contract as one for which all (or substantially all) of its revenue has been recognized under ASC 605. This amendment, if finalized, would resolve all of the issues discussed above.
- ASC 606-10-65-1ASC, ASC 985-605-25-33 to 35.
- Deloitte, “A Roadmap to Applying the New Revenue Recognition Standard.” Nov 2018. Section 15.2 “Transition.”
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised October 2018. Section 1.3.1 “Full retrospective adoption” and Section 1.3.2 “Modified retrospective application.”
- FASB & IASB, TRG Memo 42: “Completed Contracts at Transition.” 13 July 2015.
- PWC, “Revenue from contracts with customers.” September 2018. Section 13.3 “Transition guidance.”