Definition of a Customer

Because Accounting Standards Codification (ASC) 606 applies only to transactions that an entity enacts with customers, it is important to understand how “customer” is defined under ASC 606. Transactions that an entity enacts with parties other than customers are outside the scope of ASC 606. Consequently, it is important to understand how ASC 606 defines a customer before endeavoring to apply the new guidance.

Key Points in the Definition of a Customer

ASC 606 defines customers as “parties that contract with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.” Key points of this definition include: (1) the goods or services must be an output of the entity’s ordinary activities and (2) the transaction must be an exchange. If the counterparty to a transaction does not meet this definition of a customer, the transaction will not be accounted for under ASC 606.

Goods or Services Must be Outputs of Ordinary Activities

ASC 606 is silent on what constitutes the ordinary activities of an entity, but the Financial Accounting Standards Board's (FASB) Financial Accounting Concepts No. 6 (Con 6) elaborates that all revenues must come from activities that are ongoing and central to the operations of an entity. Increases in equity may come from sources that are not ongoing or central to the operations of an entity, and are therefore not revenue. Two examples of this are a) investment contributions by owners and b) foreign currency (or other) gains. Investment contributions by owners involve a transfer of assets (or assumption of liabilities) by an owner acting as an owner in exchange for an ownership stake. These transactions involving owners are generally outside the scope of ASC 606 and are instead accounted for under ASC 505 and 815-40.

The only accounting difference between a non-recurring exchange transaction and an ordinary exchange transaction will be its classification (gain/loss vs. revenue). Gains are increases in equity from non-recurring transactions, rather than from the ongoing and central operations of an entity. These gains will generally be subject to ASC 610 - Other Income, rather than ASC 606. Identical transactions that result in revenues for some entities may result in gains for others, depending on what constitutes a given entity’s ordinary activities. Consequently, ASC 610 directly incorporates ASC 606 guidance to account for the incidental sale of intangibles or PP&E.

Aridis Pharmaceuticals, Inc. SEC Correspondence

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Aridis Pharmaceuticals, Inc. (Aridis) is a biopharmaceutical company that focuses on the discovery and development of targeted immunotherapy. In January 2019, Aridis entered into an agreement with the Cystic Fibrosis Foundation (CFF) to engage in research and development activities in exchange for funding.

In correspondence to the SEC dated February 12, 2021, Aridis explains how CFF meets the definition of a customer by referencing ASC 606-10-15-3 and stating the following:

“A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”

Aridis explains how the company devoted all of its resources to its research and development efforts. As a result, Aridis considers such efforts to be “ordinary activities” as mentioned in ASC 606-10-15-3.

Companies must carefully consider whether revenues come from activities that are truly central to its operations in order to meet the definition of a customer in ASC 606.

Transaction Must be an Exchange

Exchange transactions are reciprocal transfers where each party sacrifices and receives consideration that they deem to be of equal value (ASC 845-10-20). This is in contrast to other transactions that are not at arms-length, such as transactions with owners and contributions. To the extent that nonreciprocal transfers constitute the ordinary activities of an entity, these transfers may still be considered revenue (e.g. contribution revenue or tax revenue).

However, ASC 606 only applies to a subset of revenue transactions, specifically revenues from contracts with customers. Consequently, although ASC 606 eliminates the majority of industry specific revenue recognition guidance, contribution revenue will continue to be accounted for according to industry specific not-for-profit guidance found in ASC 958-605. It should be noted that not-for-profit entities still enter into transactions that are exchanges (either entirely or partially), including contributions such as membership dues or for naming rights. To the extent that such a transaction is an exchange, ASC 606 should be applied, with the residual treated as a contribution.

In addition to considering what constitutes an entity’s ordinary activities and whether a transaction is an exchange, it may be useful to consider whether the 5-step model could reasonably be applied. If an entity cannot identify promised goods or services (step 2) or cannot determine when control of promised goods or services transfers (step 5) this may be an indicator that a transaction is not an exchange transaction with a customer.

Example A: Non-Recurring Sale Not Ordinary Activity

Amy’s Ambulance Co. (AAC) sells cutting-edge ambulances to police stations and other emergency response providers. These ambulances contain sophisticated digital equipment to treat patients while traveling to the hospital. To stay at the top of the ambulance business, AAC invests heavily in R&D. This includes purchasing new computers for the research team on a regular basis (every two years) and selling the old computers. Is the regular sale of Computers by AAC subject to ASC 606?

Analysis: No, this is not a transaction with a customer because AAC’s central operations relate to the manufacture of ambulances, not the sale of computers. The sale of computers is an incidental activity that will lead to gains or losses, not revenues.

Example B: Donation In Exchange For Naming Rights

Bob Davis decided to donate $10 million dollars to the Atlanta hospital to fund development of a new neonatal children’s center. Bob’s generosity prompted the hospital to offer him the opportunity to name the hospital, and he determined that the new children’s center would be known as “Bob’s Babies.” Should Bob’s donation be accounted for under ASC 606?

Analysis: If Bob had donated the money without receiving naming rights, this would be a pure contribution transaction because there would be no exchange component. However, because Bob effectively paid for the right to name the children’s center, this transaction is part exchange and part contribution. To the extent this transaction is an exchange ASC 606 will apply. First the exchange portion subject to ASC 606 must be determined, perhaps by using an adjusted market approach and considering naming rights prices for other similar venues (perhaps performing arts centers and sporting arenas). Any residual amount would be a contribution and would have no performance obligations attached.

Conclusion

ASC 606 defines a customer as an entity that contracts to obtain goods (or services) that are an output of an entity’s ordinary activities in exchange for consideration. Goods sold that are not ordinary outputs are gains or losses, with similar measurement and recognition under the newly issued ASC 610. Non-exchange transactions may be considered revenue (e.g. contribution revenue), but are not considered contracts with customers subject to ASC 606. It is important to determine if a contract is with a customer before endeavoring to apply the ASC 606 standard.

Resources Consulted

ASC 606-10-15-3, 55-36 to 55-37
ASU 2014-09: "Revenue from Contracts with Customers." BC28, BC53, BC55.
Concept Statement 6, "Elements of the Financial Statements." para. 78-79.
Deloitte, "A Roadmap to Applying the New Revenue Recognition Standard." February 2015. Section 3.2.
FASB TRG Memo 26: "Contributions." 30 March 2015.
PWC, "Revenue from contracts with customers." August 2016. Section 2.4.