Home
Step 1: Contract

Identify the Contract

The first step of ASC 606 is to identify the contract with a customer. ASC 606 outlines many criteria, including legal enforceability and collectability.

Published:
Jul 15, 2020
Updated:

After determining that a contract is within the scope of Accounting Standards Codification (ASC) 606, the first step of the revenue recognition model requires 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.

Legal Enforceability

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 customer, 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 can be 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 the other 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

Arena Group Holdings (2022 SEC Correspondence)
add

In a comment letter to the SEC, Arena Group Holdings, a technology platform and media company, explained how its subscription model with its customers meet all necessary criteria to be identified as a contract. The SEC questioned why Arena’s subscription contracts with their customers were able to be identified as a contract with a customer with enforceable rights and obligations, even though a customer can cancel anytime without penalty. The response by Arena Group Holdings references the following as support for identifying their subscriber contracts as contracts with customers: 1) They are required to deliver the magazine for the contract period on an issue-by-issue basis that was agreed to in the contract. Therefore, there are enforceable rights and obligations. 2) Even though the customer can cancel anytime without penalty, a contract still exists because the customer receives consideration in advance and an agreement is executed. 3) The customer’s ability to cancel the contract without penalty impacts the duration of the contract for purposes of establishing the amortization period for accounting purposes, which is consistent with the amortization period. 4) The five criteria under Step 1 of the revenue recognition model, are met (ASC 606-10-25-1).

Requirements of ASC 606

In addition to being legally enforceable, a contract must meet the criteria from ASC 606-10-25-1 to satisfy the first step of ASC 606. These additional criteria ensure implementation of the 5-step model is possible and appropriate. These criteria are as follows:

  1. The parties to the contract have approved the contract and are committed to perform. After both parties have reached an agreement, they must also be committed to performing their obligations in 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.
  2. 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.

In question 11 of the its 2020 Q&A Document, the FASB clarifies what it means to identify each party’s rights. “The staff would like to clarify that there is no requirement in Topic 606 that states that companies are required to consult with legal counsel for all revenue transactions.” 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). However, agreements with variable consideration can still be considered contracts and ASC 606 provides guidance for allocating variable consideration. This requirement can also 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.

Ford Motor Company (2017 SEC Correspondence): Not Meeting Criteria Of A Contract
add

In a letter to the SEC, Ford Motor company articulated its reasons for not being able to identify a contract under ASC 606.

ASC 606 emphasizes the importance of identifying the customer and the contract with specific criteria for determining when there is a sales contract. The two criteria in paragraph 606-10-25-1 that were most relevant in our analysis of the Consorcio arrangement are: i) whether the parties to the contract have approved the contract and are committed to perform their respective obligations, and ii) whether we can identify each party’s rights regarding the goods to be transferred. Because we are not obligated to manufacture a vehicle and we do not have a right to keep the cash received, until the individual member has ordered a vehicle, we do not have a contract with a customer under ASC 606. Consequently, we have a financial liability until the customer orders a vehicle (i.e., when we have a contract), at which point we reclassify the financial liability to deferred revenue.

Financial liabilities that bear interest are reported as debt on our Consolidated Balance Sheet. The terms of the Consorcio arrangement require that we pay interest when we return cash to an individual member who chooses not to order a vehicle. Therefore, we now report such amounts collected prior to vehicle orders as debt. (September 2017 Letter)

  1. 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). However, agreements with variable consideration can still be considered contracts and ASC 606 provides guidance for allocating variable consideration. This requirement can also 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.
  2. 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 risk, the timing, or amount of the entity’s future cash flows 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.
The RealReal, Inc. (2019 SEC Correspondence): Consigned Goods
add

In a comment letter to the SEC, The RealReal, Inc., a luxury consignment marketplace, explained how its agreement with the consignors lacks commercial substance until a customer purchases a consigned good.

“The Company determined that a contract with the consignor does not exist until a buyer has been identified for the consigned good which occurs upon purchase of the consigned good via the Company’s marketplace. This is because the consignor can terminate the consignment arrangement at any point prior to purchase of the consigned good by a buyer resulting in no consideration received by the Company and accordingly, there is no commercial substance to the contract (ASC 606-10-25-1d) until the purchase of the consigned good by the buyer.” (June 2019 Letter)

  1. It is probable that the entity will collect substantially all of 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.” 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 collectability.
Square (Form 8-K, 2021): Square and Bitcoin
add

In a letter to the SEC, Whitestone REIT, a real estate investment company, concluded that a contract with Pillarstone had not been identified because “it is not probable that the entity will collect substantially all of the consideration to which it will be entitled.” (September 2018 Letter)

The SEC responded, asking for more clarification on Whitestone’s “consideration of the cash flows, loan-to-value ratios, and other pertinent information for Pillarstone to support [their] conclusion.”

In its reply to the SEC, Whitestone explained all factors it considered, including “net cash provided by operating activities of Pillarstone REIT and its subsidiaries, … net cash used in investing activities of Pillarstone, … net cash used in financing activities of Pillarstone, … [and] cash on hand of Pillarstone.” After considering these factors, Whitestone came to the following conclusion:

As a result of the foregoing, the Company believes Pillarstone’s cash flows for the remainder of the year and cash on hand will be insufficient to generate cash to repay the entire $15.5 million loan made by the Company to Pillarstone OP by December 8, 2018 and/or to make the payment required should the Company exercise its put option on its Pillarstone OP Units. As noted in previous communications to the Staff, the $15.5 million loan from the Company to Pillarstone OP was not evidenced by a written agreement and there is no expressed recourse to Pillarstone OP for non-payment. The Company does not intend to pursue collection of the $15.5 million loan or exercise the put option on its Pillarstone OP Units until Pillarstone has available funds.” (October 2018 Letter)

In question 9 of its Q&A document, the FASB provided an example of a hypothetical company that concludes collectability is probable for each customer, but historically only collects 98% of revenue. Even though there are still some customers that might not pay, since each individual customer is probable to pay, ASC 606-10-25-1(e) is met and the company would recognize 100% of the revenue when appropriate.

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. The company does not have to wait until payment is received to recognize revenue, but rather should continually assess all the requirements mentioned above until they are met. Payments received before the criteria are met should be recognized as a liability. ASC 606-10-25-7 provides the following three events, any one of which can trigger revenue recognition even 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 all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
  • 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.
  • The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.

Once a contract meets all of the 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 (ASC 606-10-25-5).

Hovnanian Enterprises, Inc. (2021 SEC Correspondence): Forfeited Customer Deposits
add

In a comment letter to the SEC, Hovnanian Enterprises, a real estate company, explains that their forfeited customer deposits must be recognized as revenue because they are considered contract terminations, which meet the criteria described in ASC 606-25-7(b).

“Forfeited Customer Deposits: ASC 606-10-25-7(b) requires that nonrefundable consideration received from a customer due to contract termination be recognized as revenue when such contract does not meet the criteria in 606-10-25-1. The Company already included forfeited customer deposits with “Other Income” in the “Revenues” section of the statement of operations.” (March 2021 Letter)

Conclusion

Identifying the contract is an important step in the ASC 606 model and may require significant 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.

Resources Consulted:

Footnotes