Revenue Recognition – Step 1: Identify the Contracts with a Customer

In our initial installment, we identified the five steps in recognizing revenue in the upcoming changes to FASB Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, with the first step being to identify the contract(s) with the customer.

Defining a ‘Contract’
A contract, whether written or oral, is an enforceable right and obligation between two or more parties. While the enforceability is a matter of law, it is important to note that a contract as described in the new standards is an accounting definition, not a legal definition.

Criteria required for each contract:

1. Approval and commitment of the parties
2. Identification of the rights of the parties
3. Identification of the payment terms
4. The contract has commercial substance
5. It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods and services that will be transferred to the customer

Review Current Contracts
Entities should review their current contract structure and evaluate whether contract modifications are necessary to ensure each of the criteria are appropriately addressed. Oral contracts, such as retailer point of sale transactions, should also undergo a similar evaluation. Failure to demonstrate that the contract criteria is met may preclude an entity from recognizing revenue in the same manner as revenue has been recognized historically and/or as preferred by the entity. Although identification of a contract is only the initial step in the FASB’s five-step process, contract terms may have a significant impact on the timing of revenue recognition.

A Major Shift
The last criterion noted above may represent a significant change to current practice for certain entities. Under current standards, as an entity determines they have met all the necessary revenue recognition criteria, revenue is recorded, with a separate consideration of the collectability of the related receivable balance, often resulting in an allowance for doubtful accounts, which is presented as a reduction of the related receivable balance, but not a reduction of the recorded revenue. While the concept of the receivable allowance is retained in the new standard, there is a major shift in an entity evaluating the risk of nonpayment and reducing and/or not recording revenue during the initial recognition phase.

For example, an entity sells $100,000 of product to a new customer with uncertain credit worthiness. The entity evaluates the risk of collectability and determines that it is probable that they will only collect $70,000. Rather than record revenue of $100,000, with a receivable allowance and offsetting bad debt expense of $30,000 under current standards, under ASC 606, the entity will only recognize $70,000 of revenue, as that was the amount probable of collection at the time of the transaction. While there is no “bottom line” impact resulting from this change, there is a material impact on the amount of top line revenue recognized.

Our next installment will address Step 2 in the revenue recognition process—identifying performance obligations in the contract.

Have questions before then? Please contact an Eide Bailly representative today.

Catch up on this series!

Revenue Recognition – Step 1: Identify the Contracts with a Customer

Revenue Recognition – Step 2: Identify the Performance Obligation in the Contract

Revenue Recognition – Step 3: Determine the Transaction Price

Revenue Recognition – Step 4: Allocate the Transaction Price to the Performance Obligation in the Contract

Revenue Recognition – Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation