After determining that a contract is within the scope of Accounting Standards Codification (ASC) 606, the first step of the revenue recognition model is for an entity to identify the contract with a customer. This step is crucial, because payment received for agreements that do not rise to the level of a contract can only be recognized as revenue when the payment is nonrefundable and no remaining obligations exist. Identifying a contract with a customer that is within the scope of ASC 606 includes a determination of legal enforceability (which may require assistance from legal counsel) along with specific requirements in ASC 606.
ASC 606-10-05-4 defines a contract broadly as an “agreement between two or more parties that creates enforceable rights and obligations.” Whether or not a contract is enforceable is a matter of law, and may vary between types of customers, jurisdictions, and industries. However, there are several common law requirements that generally must be met for a contract to exist.
The general common law elements of a contract include agreement, consideration, capacity, and legality. Agreement, or mutual assent, may be written, verbal, or implied. Consideration includes anything of value, including forbearance from a future action. Contractual capacity is the ability to enter a binding contract. To have capacity, one must be of sound mind and have reached the age of majority (usually 18 in the US). If one party to a contract lacks contractual capacity, the contract is only enforceable by this party. Finally, contracts that are illegal or counter to public policy will not be legally enforceable.
In addition to the common law elements of a contract, statutes often modify what constitutes an enforceable contract. For example, in most jurisdictions contracts to sell real estate must be in writing. The Uniform Commercial Code (UCC) and Statute of Frauds are some of the most commonly adopted statutes, but specific statutes vary between states.
Requirements of ASC 606
In addition to being legally enforceable, a contract must meet the criteria from ASC 606-10-25-1 to be within the scope of ASC 606. These additional required elements ensure implementation of the 5-step model is possible and appropriate. These criteria are as follows:
- The parties to the contract have approved the contract and are committed to perform. For a contract to be enforceable an agreement must be reached, so contracts that are enforceable will meet the first part of this requirement. However, in addition to being approved, the parties must be committed to performing the contract. This assessment should be made at the level of the contract. A contract can still be identified if a party is substantially committed to the contract yet is not committed to a component, or performance obligation, within the contract. In determining whether the other party is committed to perform, an entity should consider all relevant factors, such as termination clauses in the contract, historical experience with similar customers, and the customer’s ability to perform. An agreement that is wholly unperformed and has no termination penalties should not be considered a contract until one party begins performance.
- The entity can identify each party’s rights regarding the goods or services to be transferred. If an entity is unable to identify its customer’s rights to goods or services, it cannot identify performance obligations within the contract. Therefore, ASC 606 cannot be applied until the parties specify their rights and obligations, regardless of whether a contract has been approved. However, performance obligations for an entity can be based on the valid expectations of a customer, even if such expectations would be unenforceable.
- The entity can identify the payment terms for the goods or services to be transferred. An entity must be able to identify the payment terms to be able to calculate the transaction price (step 3). Agreements with variable consideration can still be considered contracts because ASC 606 provides guidance for allocating variable consideration. This requirement can be met if the scope of the work has been approved and the entity expects the price to be approved. In this circumstance, change orders and/or the final determination of the price should be accounted for as contract modifications.
- The contract has commercial substance. This requirement is designed to prevent entities from exaggerating revenue by transferring goods or services back and forth to each other. A contract has commercial substance if an entity expects the likelihood, the timing, or quantity of cash received to change because of the contract. Contracts lacking commercial substance are not accounted for under ASC 606, regardless of whether they are monetary or nonmonetary exchanges.
- It is probable that the entity will collect the consideration to which it will be entitled. In US GAAP, probable is defined as “likely to occur.“ This is one area of divergence from IFRS, where the same term is defined as “more likely than not.” For more details related to this difference see Revenuehub’s comment letter to the FASB. To make this assessment, the entity should consider the financial capacity and intent of its customer. The seller must determine the transaction price, including any price concessions, before assessing collectibility. This requirement for identifying the contract is addressed in the article Collectibility.
Once a contract meets all of these requirements to be accounted for under ASC 606 it should only be reassessed if a significant change in facts and circumstances occurs (such as a significant deterioration in a customer’s ability to pay).
Contracts Not Meeting the Criteria in ASC 606
For a contract that does not meet the requirements of ASC 606-10-25-1, the entity should continue to reassess the agreement until these requirements are met. Payments received before the criteria are met should be recognized as a liability. ASC 606-10-25-7 provides the following two events that trigger revenue recognition if a contract never meets the criteria for a contract:
- The entity has no remaining obligations to transfer goods or services to the customer, and consideration has been received and is nonrefundable.
- The contract has been terminated, and the consideration received from the customer is nonrefundable.
Identifying the contract is an important step in the ASC 606 model, and may require significant subjective judgment. If a contract is not legally enforceable or does not meet the additional requirements in ASC 606-10-25-1 then revenue recognition must be delayed. Once a contract is identified, the entity will proceed with the remaining steps in ASC 606.
- ASC 606-10-25-1 through 8
- ASU 2014-09: Basis for Conclusion. BC 36, 38, 40
- EY, Financial reporting development: Revenue from contracts with customers. August 2016. Section 3 “Identify the Contract with the Customer.”
- PWC, Revenue from contracts with customers. August 2016. Section 2.6 “Identifying the Contract.”
- KPMG, Issues-In-Depth: Revenues from Contracts with Customers. May 2016. Section 5.1.1 “Criteria to Determine Whether a Contract Exists.”
- Cornell, Legal Information Institute: Contract. Accessed April 4, 2016.