ASC 606 is on the horizon, and if the warnings being issued over the past year haven’t gotten you motivated to start looking at your contracts and accounting practices, here’s another warning: Public organizations need to apply the new revenue standard for annual reporting periods beginning after December 15, 2017. Nonpublic organizations should apply the new revenue standard to annual reporting periods beginning after December 15, 2018.
A Lot of Work to be Done—and It’s Not Easy
The problem, of course is that per PwC, only 13% of all companies are in the process of implementing the new revenue recognition standards—and nearly half of all private companies haven’t even started assessing their current processes and how they will need to change to be compliant.
This being said, the PwC Study asked survey respondents to rate the anticipated/determined amount of difficulty in implementing new standards and found that there are challenges ahead. Notably the top challenges expected or recognized by firms include contract reviews, the development of new accounting practices, and the documentation of the conversion process.
Background: What You Need to Know about ASC 606
We’ve covered a lot of the basics in our initial introduction to the topic, including who ASC 606 affects, a brief overview on the five steps, and a look at how ASC 606 will affect different industries, but today we would like to introduce a deeper look at each step:
- Identify Contract(s) with a Customer
- Identify Performance Obligations in the Contract
- Determine the Transaction Price
- Allocate the Transaction Price to the Performance Obligations in a Contract
- Recognize the Revenue When (or as) the Entity Satisfies a Performance Obligation
We will cover each stem and what it means over the next few months and share with you some resources on preparing. Today we would like to take a deeper dive at Step 1: Identifying Contract(s) with a Customer.
Deep Dive: Step 1: Identify Contract(s) with a Customer (FASB ASC 606-10-25-1 through 25-8)
Biggest Impact on Companies in the Following Industries: Aerospace and Defense, Healthcare, Licensors (Media, Life Sciences, Franchisors), Real Estate, according to KPMG.
In the multi-step process that is revenue recognition, each step has many sub-steps that need to be completed. The first step revolves around the creation and determination of contracts, the materiality of the contract, the collectability threshold, and other considerations on contract combinations and modifications.
What is a Contract under ASC 606?
As defined by the standard, a contract is an agreement between two or more parties that creates enforceable rights and obligations.
Four Criteria to Determine the Existence of a Contract
A contract exists and is enforceable under the new standard if it meets the following four criteria:
- …parties of the contract have approved and are committed to the fulfilment of the contract (in writing, orally, or based on customary business practices)
- …the entity can identify payment terms and each party’s rights regarding the goods and services to be transferred
- …the contract has commercial substance (risk, timing, or amount of future cash flows expected to change as a result of the contract)
- …collection of consideration is probable (based on a customer’s ability and intention to pay the amount of consideration when it is due)
KPMG shares two examples of contract existence on pages 25 and 26 of their Issues in Depth series.
Additional Notes on Contract Existence
There are additional things to note regarding the initial and continuing existence of a contract:
- Contracts can’t exist if each party can unilaterally terminate a wholly unperformed contract;
- If a contract meets the criteria at inception, the entity shouldn’t reassess the contract’s existence unless there are significant changes in facts and circumstances (606-10-25-5);
- If a contract doesn’t meet the initial criteria, an entity should continue to monitor the contract for adherence to the standard (606-10-25-6)
- If a contract doesn’t meet criteria defined by the standard, consideration received from a customer can’t be recognized as revenue and must recognize consideration received from a customer as a liability until the contract meets the criteria or one of two things happens (606-10-25-7-8):
- The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
- The contract has been terminated, and the consideration received from the customer is nonrefundable.
Combining Contracts and Contract Modifications
Two other important sections of ASC 606 dealing with the first step of the revenue recognition are the combining of two similar contracts entered at or near the same time with a customer, and the process of accounting for a modified contract.
Combination of Contracts (606-10-25-9)
If an entity was to enter two or more contracts with a customer at or near the same time, the entity should account for the contracts as they would a single contract if:
- The contracts are negotiated as a package or with a single objective
- Consideration to be paid on one contract depends on price or performance of another contract.
- Goods or Services promised are a single performance obligation (to be discussed in part 2)
Contract Modifications (606-10-25-10 through 606-10-25-13)
Contract modifications exist when there is a change in price and/or scope of a contract that is approved by the parties in a contract.
Explained in a flowchart by KPMG and an example on page 190 of their Revenue Issues-in-Depth paper, accounting for a contract modification follows a certain decision flow:
|Question 1: Is the Contract Modification Approved?|
|Yes: Proceed to Question 2||No: Do not Account for a Modification in Contract|
|Question 2: Does the contract modification add distinct goods or services that are priced commensurate with stand-alone selling prices?|
|Yes: Account for modification as a separate contract.||No: Proceed to Question 3|
|Question 3: Are remaining goods or services distinct from those already transferred?|
|Yes: Account for as termination of existing contract and creation of new contract.||No: Account for modification as part of existing contract.|
Start Looking Over Contracts Now
One of the more complicated parts of step one is accounting for any contract modification. This requires potential work with legal to peer over old contracts to make sure they follow guidelines, and to follow guidelines on accounting for new contracts.
This is just one of many processes highlighted in the 156-page standard (with associated guidance) that will have to be looked over and possibly changed by companies in many industries. This holds especially true for companies with extended contracts that have changed over the years.
Russell Hodge, GE Technical Controller, noted that their 15- and 20-year contracts will require a ton of restatement to be compliant with new standards:
“That’s going to be a huge change,” he said. “Having to go back and retrospectively restate those, thinking about all the modifications that have occurred in those contracts over the last 15 or 20 years, is overwhelming to think about.”
Stay tuned for next month’s article on identifying performance obligations in the revenue recognition process, and how it will work back to impact your contracts with customers.
Conclusion and Additional Resources
With the effective date of the standard rapidly approaching, it pays to look over contracts now. It also pays to start making changes to your practices, processes, and possibly systems in order to gain compliance with the new standards.
ASC 606 Compliance starts with having the right information. Read up on the following to prepare:
Guides and Whitepapers: ASC 606/IFRS 15
- Analyst Report: Intacct Leads the Way in ASC 606 and IFRS 15 Revenue Recognition
- Six Rules for ASC 606 Readiness
- ASC 606 and Subscription Businesses—Why Compliance Can’t Wait
On Demand Webcasts: ASC 606/IFRS 15
Intacct recently presented a three-part series on the new standards, which you can view on-demand.
- Part 1: New FASB Rev Rec Standards, Actions You Should Take Now!
- Part 2: The Impending Impacts of ASC 606 on Subscription Businesses
- Part 3: Master Your Transition to ASC 606 and IFRS 15
We welcome you to peer through the full text, the AICPA guidance, and to get in contact with us to learn more about preparing for ASC 606 with outsourced accounting services and/or a new accounting software designed with new RevRec Standards in mind.