Accounting: The Language of Business - Vol. 2 (Intermediate: Part 116)

“What helps people, helps business.”
— Leo Burnett

Revenue Recognition (Part C) 

by

Charles Lamson

Failure to Meet Contract Criteria

Recall from Exhibit 8.1 from Part 114 and reintroduced below, that there are five steps in revenue recognition.

Also recall from Part 115, that the first step in the revenue recognition process is to identify the contract, or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations (FASB ASC 606-10-20 - Revenue from Contracts with Customers - Overall - Glossary), which led us to contract criteria (also from part 115).

Contract Criteria

If the seller meets the following five criteria related to the contract, then it continues through the remaining four steps to determine the timing and measurement of revenue recognition.

1. All parties to the contract have agreed to the contract and are committed to performing under the contract. The approval by the parties can be in writing, provided orally, or implied by an entity's customary business practices.

2. Each party's rights with respect to the goods or services that are being transferred are identifiable.

3. The payment terms for the goods or services that are being transferred are identifiable.

4. The contract has commercial substance, meaning that the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract.

5. It is probable that the seller will collect the consideration to which it is entitled in exchange for the goods or services. To assess the probability of collection, the seller considers the customer's ability and intention to pay this specific amount of consideration when it is due.

If a seller does not satisfy all of the five Step 1 criteria, then it should recognize revenue when it has received the consideration and when one or more of the following have occurred:

1. The seller has no remaining obligations to transfer goods or services and substantially all (or all) of the consideration has been received by the seller and is nonrefundable, or

2. The contract has been terminated and any consideration already received from the customer is nonrefundable, or

3. The seller has transferred control of the goods or services, is no longer transferring the goods or services, has no obligation to transfer additional goods or services, and the consideration received is nonrefundable.

If the seller receives cash before the appropriate time to recognize revenue, it should report the consideration as a liability. In addition, the seller should not remove the inventory from its balance sheet. Example 8.3 provides an illustration of the accounting treatment for a transaction in which the five criteria are not met.

Multiple Contracts

It is not uncommon for vendors to enter into multiple contracts with the same customer. Under certain circumstances, the seller should combine these contracts and account for them as a single contract. Specifically, if one of the following criteria is met, the seller should continue multiple individual contracts into a single contract for purposes of determining the timing and measurement of revenue:

1. The contracts are negotiated as a package and have a single commercial objective.

2. The amount of consideration to be received by the seller related to one contract depends on the price or performance of another contract.

3. The goods or services promised in the separate contracts are all part of one performance obligation. (We discuss performance obligation in our presentation of Step 2).

Identify the Contract(s) with Customers: International Financial Reporting Standards (IFRS)

When identifying a contract with a customer, IFRS differs from U.S. Generally Accepted Accounting Principles (U.S. GAAP) in two ways. First, IFRS defines probable as “ more likely than not” whereas U.S. GAAP defines probable as “ likely to occur” in the fifth criterion that assesses collectability. “More likely than not” implies a probability of more than 50%. “Likely to occur” implies a probability threshold significantly higher than 50%. Although U.S. GAAP does not precisely define “ likely to occur,” it is often interpreted to be somewhere around 70 or 75%. Thus, U.S. GAAP sets a higher threshold for the assessment of collectability than IFRS. For example, Turro Company makes a sale to Milano Corporation, and Turro determines the probability of collection is 55%. Under IFRS, the 55% probability suggests that it is “more likely than not” that Turro will collect from Milano. Under U.S. GAAP, a probability of 55% does not meet the “ likely to occur” threshold. Therefore, the collectability criterion will be met under IFRS but not U.S. GAAP.

If the revenue recognition standard is converged, why is there a different interpretation of probable? The difference is because the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) decided to set the threshold at a level consistent with their previous revenue recognition standards and based on the interpretations of “probable” under each set of standards.

The second difference is in determining when to recognize revenue when the five criteria for a contract are not met. IFRS does not explicitly include the third condition that the seller has transferred control of the goods or services, is no longer transferring the goods or services, has no obligation to transfer additional goods or services, and the consideration received is non-refundable. The FASB added this condition to clarify when to recognize revenue. The IASB did not believe this clarification was needed because the first two conditions should cover these cases. The IASB noted that contracts often specify that a company has the right to terminate a contract if a customer is not paying. However, for any goods or services already transferred, the company has a right to collect payment. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 377-379*

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