Assessing collectibility under ASC 606: When good contracts go bad

By now, many have either adopted or begun adopting ASC 606 Revenue from Contracts with Customers. You’ve learned about the new five-step model and are quite comfortable with it, but now some of the nuances of the new standard and its application to real-life scenarios might occasionally throw you for a curve. In this blog, I’m going to look at a recent issue that came up at one of my trainings involving Step 1 regarding identifying the contract with the customer. Specifically, this post discusses assessing collectibility under ASC 606 and what to do when good contracts go bad.

Reminders: Assessing collectibility in step 1

While step 1 may seem like one the most basic of the five steps, sometimes applying this guidance can pose a challenge. One aspect of identifying a contract is to ensure it is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In other words, if you can’t establish this probability, it’s not really a contract “in substance”. This is done at the inception of the contract. However, are you required to subsequently reassess collectibility? Maybe! Let’s look at an example.

Example: Assessing collectibility under ASC 606

Mufasa’s Meters entered a multi-year contract to sell smart meters and ongoing monitoring services to one of its largest customers, a public utility located in Pride Rock. Under the terms of the 5-year contract, Mufasa will recognize $10 million in revenue each year and has no issues with collectibility from the public utility at contract inception. Through the first two years, Mufasa has recognized $20 million in revenue related to this contract. However, in year 3, the public utility is found to have been the cause of massive wildfires in the region. As a result of the liability associated with these wildfires, the public utility was forced to file for bankruptcy protection. Should Mufasa continue to recognize revenue for this contract in years 3 through 5?

Discussion: When are we required to reassess collectibility?

While it seems clear that a contract exists at inception of the contract, subsequent to entering into it, but before all the goods and services were performed and consideration was collected, the risk of collectibility from the customer has changed.

During the first two years, revenue will be recognized at $10 million per year, but after these first two years, it is no longer considered probable that the company will be able to collect substantially all the consideration that they are entitled.

Should this change in collectibility be reflected through an adjustment to the allowance for doubtful accounts and bad debt expense, but not impact the revenue that is recognized over the remainder of the contract? Or does this change in circumstances impact the ability to recognize revenue going forward on this contract? The answer might surprise you.

In accordance with ASC 606-10-15-5, if a contract with a customer meets the criteria for “existence of a contract” in Step 1 at contract inception, an entity shall not reassess those criteria unless there is an indication of a significant change in facts and circumstances. How this reassessment criteria is to be applied was addressed by the Transition Resource Group in January 2015, where they noted that the assessment of whether a significant change in facts and circumstances occurred will be situation-specific and will often be a matter of judgment. 

One source to turn to is Example 4 in ASC 606-10-55-106 through 55-109. Here the FASB illustrates when a change in the customer’s financial condition is so significant that a reassessment of the step 1 is required. As a result of the reassessment, the entity determines that the collectibility criterion is not met and that a contract no longer exists. Accordingly, the entity is precluded from recognizing additional revenue under the contract until collectibility becomes probable or the contract otherwise qualifies for revenue recognition (i.e. nonrefundable fee has been received and performance has been completed, the contract is terminated, etc.). The entity also assesses any related contract assets or accounts receivable for impairment.

If an entity is required to reassess its contract because of a significant change in facts and circumstances, the criteria in step 1 would only be evaluated in the context of the remaining goods or services that have yet to be provided. The reassessment would not affect any assets or revenue that has been recognized from satisfied performance obligations. However, assets would need to be evaluated for impairment under other applicable guidance (e.g., allowance for doubtful accounts and impairment of contract assets).

Closing thoughts

In our example, the change in facts and circumstances is quite significant, with the customer going from a stable public utility to an entity going through bankruptcy, but in practice, these changes are not so obvious. How will an entity determine when there has been a significant change in the collectibility of a customer? Clearly a process needs to be in place to flag situations that may lead to a change in how revenue is recognized. And as we like to say in the training business when judgment needs to be applied… “that’s why you get paid the big bucks!”. 

Need more help with ASC 606 and revenue recognition? Check out our ASC 606: Revenue from Contracts with Customers eLearning course collection (7 courses; 5.5 CPE) or contact us today to discuss tailored training options for your organization. We’re here to help (and sometimes your questions make it a case study)!

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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.