Revenue Recognition: Contract Enforceability Provisions

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which was incorporated into the existing codification under ASC 606.   The current guidance on revenue recognition is contained in ASC 605.  However, when the transition occurs, ASC 606 will replace all current guidance. Much attention has been made to certain industries which may see significant changes under the new guidance, such as construction contractors, entities with multiple deliverables and big box retailers, however, one of the more significant cross-industry impacts in ASC 606 relates to contract enforceability.

Under the guidance in ASC 605, when an entity is able to demonstrate through past arrangements that the revenue is either realized or realizable and earned, an entity can recognize revenue even without the presence of a legally signed contract. This guidance is much more lenient that the provisions under ASC 606, which requires that an arrangement meet the definition of a contract in order for recognition to occur. A contract is defined as “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.” Such considerations could vary by jurisdiction, or industry and entity practice.

For illustrative purposes, consider the following facts and circumstances:

• Entity A provides core IT services to a customer subject to an agreed-upon fee of $100,000.  The services to be provided by Entity A are defined in a signed agreement with the customer.
• Entity A frequently performed other services outside of the scope of the signed agreement.  Such services were billed based upon an hourly rate of $100 per hour.   Entity A has had other similar arrangements with the customer and the customer has historically paid the amounts of such services.

Analysis:  Under ASC 605, Entity A would be able to recognize the $100,000 fee as the work is earned. Entity A would also be able to recognize the additional services as the entity has performed such services in the past and has established a pattern to determine that such fees are realizable.

Under ASC 606, it is apparent that the $100,000 fee should be recognized as the work is performed as the agreement satisfies the definition of a contract.  However, upon legal consultation, if the entity determines that the additional services are not “enforceable,” such revenue would not be recognized until all the rights to the fees under the arrangement become enforceable (i.e. most likely when the cash is collected).

Action Plan: Stay Tuned!!!

On January 17, 2018, the ACIPA’s Private Company Practice Section (PCPS) committee sent a letter to the FASB, requesting that private companies be allowed to employ less restrictive interpretations to certain aspects of ASC 606.  One of the issues raised by the PCPS, related to concerns of the contract enforceability provisions contained in the guidance.  Until the FASB responds to the concerns raised by the PCPS, it is difficult to determine an appropriate action plan for private entities.  However, if no further modifications to ASC 606 are made by the FASB, entities should plan on modifying their business practice for any arrangements which may not be “enforceable.” This could result in more consultations with legal counsel and/or deferral of additional revenues. Private companies were required to adopt the new standard effective December 15, 2018, while public companies must adopt the standard in the first quarter of 2018.

Questions on revenue recognition? Please contact your Keiter representative or Email | Phone: 804.747.0000. We are here to help.

Additional Resources: 

• Revenue Recognition: Accounting for Franchisor Revenues
• “Revenue Recognition for Private Social Clubs”
• “Construction Contractors Should Be Aware of These Special Rules for Long-Term Contracts”
• “High Level Look at Disclosures Required for Revenue Recognition”
• “New Revenue Recognition Standard: Manufacturing, Distribution, and Retail Industry Changes”