Step-by-Step: Step 1 of the ASC 606 Revenue Model
Are you ready for the new revenue recognition standard (ASC 606 / IFRS 15 Revenue from Contracts with Customers)? The core principle of the new revenue recognition standard is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This post focuses on step 1 of the ASC 606 revenue model.
Introducing the 5-step model within ASC 606
ASC 606 prescribes a new five-step model entities should follow in order to recognize revenue in accordance with the core principle. These five steps are:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfied the performance obligations.
In this post, we will focus on step 1: Identify the contract(s) with a customer, specifically the changes, if any, to existing guidance. In this series’ subsequent posts, we will cover the other steps in the new revenue recognition model.
What is a contract under ASC 606?
According to ASC 606, a contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral or implied by an entity’s customary business practices.
An entity should account for a contract with a customer that is within the scope of ASC 606 only when all of the following criteria are met:
- The parties to the contract have approved the contract and are committed to perform their respective obligations.
- The entity can identify each party’s rights regarding the goods or services to be transferred.
- The entity can identify the payment terms for the goods or services to be transferred.
- The contract has commercial substance.
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Does this differ from current guidance? Perhaps. Let’s take a look at an example.
Example: Step 1 of ASC 606
Metro Man, Inc. produces and sells custom leather man bags. Metro Man receives a large order on December 15 from Paulie’s Purses, an existing customer in good standing. Metro Man’s normal and customary business practice for such transactions is to receive a written sales agreement from the customer that requires the signatures of authorized company representatives and approval from their sales committee. Authorized representatives from both Metro Man and Paulie’s Purses have signed the agreement. However, the sales committee for Paulie’s Purses is currently on a “mancation” and will not be able to formally approve the order and sign the agreement until January. They did verbally approve the contract on a phone call. Due to the size of the order and their existing relationship with Paulie’s Purses, Metro Man decides to ship the man bags the last week in December. The man bags arrive at Paulie’s Purses prior to December 31.
Can Metro Man recognize revenue at December 31, as it is highly unlikely that Paulie’s Purses sales committee will not approve the order?
Answer: Old guidance (ASC 605 / SAB 104)
No. The arrangement does not follow Metro Man’s normal and customary business practices.
SAB 104 requires persuasive evidence of an arrangement to exist in order to recognize revenue. According to the SEC, persuasive evidence of a sale represents the “agreement of the sale.” Without it, delivery means nothing in terms of transferring the risks and rewards of the sold item. If a written contract is considered evidence of normal business practice, all criteria are not met until signed by both parties!
Whatever is determined to be “persuasive evidence” should be applied consistently for all transactions of the same kind within a company. Oral agreements typically are not acceptable and delivery cannot be used as a substitute. The agreement either exists in its final form or it does not.
Answer: New guidance (ASC 606)
It depends on whether the contract was deemed “legally enforceable” on December 31 and the other contract criteria had been met.
With ASC 606, the definition of a contract emphasizes that a contract exists when an agreement between two or more parties creates enforceable rights and obligations between those parties. Note that the agreement does not need to be in writing to be a contract. Whether the agreed-upon terms are written, oral or evidenced otherwise (for example, by electronic assent), a contract exists if the agreement creates rights and obligations that are enforceable against the parties.
Determining whether a contractual right or obligation is enforceable is a question to be considered within the context of the relevant legal framework that exists to ensure that the parties’ rights and obligations are upheld. The factors that determine enforceability might differ between jurisdictions.
Final thoughts
Based on current guidance within SAB 104, instances have been noted where improper revenue recognition has occurred when an entity’s policy for recognizing revenue was not followed. However, the focus of the new standard is on legal enforceability. Therefore, a contract will exist once legal enforceability exists, even if it differs from an entity’s normal and customary business practice.
We don’t expect a major impact to companies as result of applying step 1 of the new revenue recognition model. But when transitioning from ASC 605 / SAB 104 to ASC 606, companies need to undergo a review of their sales contracts to ensure that they are legally enforceable. Need additional help? Check out our Revenue Recognition Topic Page or our Step-by-Step Guide to Revenue Recognition. Or, if you want to earn CPE while learning more, our ASC 606: Revenue from Contracts with Customers eLearning course collection!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
