What is ASC 606?
ASC 606, codified in Topic 606 of the Financial Accounting Standards Board (FASB) Accounting Standards Codification, is the single source of revenue recognition guidance for all entities, regardless of the industry or nature of activities. Formerly, U.S. GAAP had multiple sources of revenue guidance. In 2001, the FASB and International Accounting Standards Board (IASB) decided to work together on a comprehensive revenue recognition standard. A successor to Statement of Financial Accounting Standards No. 53 (FAS 53), The Financial Accounting Standards Board (FASB), was also worked on as part of that joint effort. While the joint Boards reached agreement on a converged standard in 2014, after significant outreach, both the FASB and IASB received negative feedback based on the complexity of the revenue standard’s principles and requirements. In an effort to address various concerns, the FASB removed troublesome concepts, including those related to realizing revenue and continue working on the project . Subsequently, in 2014, the FASB finalized ASU 2014-09, Revenue from Contracts with Customers – Topic 606, which authorized entities to use the new revenue standard prospectively from Dec 15, 2017 (calendar-year public entities) or Dec 15, 2018 (non-public entities). The goal of the new revenue standard is to provide guidance among U.S. GAAP with regard to contracts and provide better comparability between US GAAP and International Financial Reporting Standards (IFRS). Many entities are transitioning at the end of 2017 (calendar year-end public companies).
So, what is ASC 606? ASC 606 presents an organization with a framework for recognizing revenue. More specifically, it requires an organization to recognize revenue in accordance with the transfer of control of goods or services to customers at the then-earned amount of consideration. ASC 606 applies to contracts with customers in all industries, including insurance companies, financial entities, not-for-profits, government entities, etc. Accordingly, ASC 606 supersedes the existing revenue literature in U.S. GAAP. The core principles of ASC 606 are: ASC 606 requires an entity to recognize the transfer of control of a good or service upon delivery, rather than the transfer of risks and rewards.
Contract Assets Defined
The second feature of contract assets is that they are differentiated from contract liabilities, which represent a promise to transfer a good or service in the future for which the obligation for that good or service has already been satisfied. Contract liabilities should not be confused with contract assets; they are the opposite side of the accounting coin.
Contract assets are the result of accounting for obligations to transfer goods or services when the performance obligation has been satisfied but the resulting receivable does not yet qualify for presentation as a receivable. In other words, contract assets are recognized where the amount due has not yet been received from the customer but that there is the right to invoice the customer for the work. For example, if a company has delivered a product to a customer but it has not yet invoiced the customer because the appropriate conditions for invoicing have not yet occurred, the right to invoice represents a contract asset until the invoice is issued. Contract assets do not include unconditional rights to receive consideration from the customer. During the likely timeframe between the performance obligation being satisfied and the receipt of the invoice, the company would record a contract asset on its balance sheet. Recognition of revenue is not contingent on the statement of account or invoice being issued to the customer. The company would record the assets and liabilities created by specific contracts in accordance with the guidance in ASC 606: Revenue from Contracts with Customers and refer to the contract with the customer to determine the appropriate timing and amounts to recognize.
Contract Assets Under ASC 606
The nature of contract assets falls under the general requirements set out in ASC 606 to recognize contract assets when an entity’s right to consideration is conditional on something other than the passage of time. A contract asset is defined as follows: Contract asset—A rights to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditional on something other than the passage of time (for example, the entity’s future performance). A contract asset is the unconditional right to consideration from a customer with an unconditional promise to transfer the goods or services to the customer. If the promise to transfer goods or services to a customer is unconditional, the entity has a receivable.
At first glance, contract assets appear quite similar to receivables. However, if the receivable is unconditional, the entity must recognize an unconditional right to consideration and derecognize the contract asset, recognizing a receivable in its place. A contract asset does not need to be recognized as a receivable if an entity has an unconditional right to consideration for an amount that is contingent on the passage of time (e.g., bill-and-hold arrangements), but such an asset will become receivable once the consideration has become unconditional (e.g., when an invoice is issued). In contrast, if the right to consideration is conditional on the transfer of other promised goods or services, or additional goods or services, the entity cannot derecognize the contract asset until the promised goods or services have been transferred.
For example, contractual billing arrangements under a long-term construction contract indicate that an entity recognizes a contract asset for unbilled amounts of contract revenue. In this case, the contract provides for progress billings, under which an entity bills a customer for costs incurred and a fair profit margin at designated points in time. As work progresses, an entity records contract revenue against a contract asset that it recognizes for the excess of contract revenue recognized over billings. Such situations commonly occur under completed contract accounting.
Recognition Requirements for Contract Assets
Under ASC 606, there are specific criteria to determine when a contract asset should be presented on the balance sheet. A company will recognize a contract asset when it satisfies a performance obligation by transferring goods or services to a customer (in accordance with the definition of transferred in the standard), and in doing so, the company will be entitled to consideration in exchange for those goods or services that is contingent on the satisfaction of one or more performance obligations. In other words, a contract asset is recorded when the company has satisfied its delivery obligation (regardless of payment terms) and is dependent on the future satisfactory performance of another obligation as a condition precedent to payment. Future performance is inherently uncertain and could take months or years to perform. An example of a contract asset includes unbilled receivables, which are billings made after the close of the accounting period that will be collected within one year or within the normal operating cycle of a business’s operations, whichever is longer. Unbilled receivables would be presented as a current asset on the balance sheet under ASC 606.
A contract asset is always dependent upon the satisfaction of a different performance obligation, and in contrast to the treatment of a receivable, the promise for payment may extend over a long term period before payment becomes realizable. The company cannot request payment from the customer until it has satisfied all of its obligations. As a result, contract assets are accounted for under the guidance in ASC 340, Other Assets and Deferred Costs.
Contract Asset Examples
One practical example is when a government contractor is invoicing for a task order on a time-and-material basis. The contractor would record a contract asset for the amount of materials utilized that day but not paid. There’s no assurance whatsoever of payment for those materials, since they are technically unable to bill until the project has been completed, and there is always a chance that the agency or a prime contractor could reject a subsequent invoice containing these materials. ASC 606 would require the contractor to adjust the contract asset for any change in the likelihood of future collection.
Another practical example would involve an agency retailing mail and packages for tenants in a government building. A contract asset could be recorded based on the incurred costs of its small warehouse for a certain month, or for inventory not yet shipped to a tenant. Unless the authority has a contractual right to bill the tenant for these costs, an asset would be recorded .
One more example involves a government contractor who assembles several different components into one kit, known as a bill of material (BOM), and then sells the BOM to a government customer. The government customer can then use any or all of the components within the BOM while paying a fixed price for the whole project. Accounting under ASC 606 would require this contractor to ascribe one total price to the entire BOM no matter how many items of each individual type that were included in the BOM. It would be recorded that way as one complete item. Then, the sub-components would be treated as a series of distinct products to be delivered by the contractor.
The SEC Staff also noted in the Article that contract assets will affect an acquirer’s analysis of the target’s intangible assets. The Staff recommends entities consider the effects of ASC 606 on the fair value of acquired contract assets. Acquiring entities may have to perform additional incurred cost tests as a result.
Issues and Misconceptions
The recognition of a contract asset under ASC 606 can present various challenges for companies. One area of difficulty can be determining when the transfer of a product or service is complete and when payment is due for that product or service. The identification of this point in time is crucial in determining whether you as a company will be recording an asset or a receivable on your financial statements.
Put simply, you as a company should be recording a contract asset when you have delivered a product or service to your customer but are awaiting the right to receive payment in return. This delay is typically due to a requirement in the contract that the customer must first pay another party before they owe you the related fee. In contrast, you will be recording a receivable when the company has delivered the product or service to the customer and are awaiting payment, however payment from the customer is not contingent upon a payment from a subsequent party.
One way ASC 606 approaches this issue is by initially determining whether you as a company are satisfied with the performance obligation required or whether you need to deliver another good or service to complete the package. Then, it is important to consider whether receipt of payment by you is dependent on the customer first paying a third party. It is here that the confusion and difficulties surrounding contract assets and receivables can begin. The following diagram is a helpful way to visually represent the differences between the two items, and can also serve as a reference point when you want to evaluate your own goods or services.
As stated previously, the confusion often resides in the contract itself and the differences in wording that form the basis of each relationship. Contracts can be dated, implying that payment is not contingent on any other party, or they can be open ended in which case payment will be considered contingent on the customer making their own payments first.
After reviewing various contracts, it has become evident that companies are making a few similar mistakes in recognizing contract assets and receivables. First, many companies require several conditions to be met in order for an item to become a receivable when it should really be a contract asset. This occurs because these companies do not recognize the implications of a contract stating a payment is due only if the customer first pays a third party. Another common error is underestimating the cash flow delays that are present due to the contract language. Companies should then consider the time it will take a customer to make a payment. Pay attention to clauses such as if the company expects the customer to keep all payments made to the third party in addition to making a second payment to the company. Finally, ensure that you are documenting the goods and services that are being received by the customer. Because this has a direct impact on whether you are satisfied with your performed performance obligations, it is important that you are keeping track of what is being provided.
Overall, it is clear that understanding the language in which a contract is written is crucial to understanding whether you as a company should be recording a contract asset or a receivable on your books.
Accounting for Contract Assets – Best Practices
Contract Assets (or Unbilled Receivables)
A best practice is to maintain a schedule, updated on a monthly basis, of contract assets amounts. This will allow the controller or CFO to have visibility as to the companies unbilled receivables prior to their being submitted to the customers. Also, monthly review of the contract asset balance by the executive team of the company to determine if any invoices need to be accelerated due to potential payment problems or the need to submit invoices to reach a revenue recognition milestone.
Types of Intercompany Recharges
Companies often charge other legal entities for the provision of services such as, legal or accounting functions. This can create a contract asset or receivable under ASC 606. Best practice is that these charges should be accrued for at the end of each quarter and set up as a journal entry in all impacted legal entities. The intercompany charge should be balanced against the services provided account to ensure adequate documentation is in place to support the charged amount. It is also important to determine which legal entity the service department will bill and invoice which legal entity.
ASC 606 takes effect annually for public and certain other large private companies on or after January 1, 2018; and next year for smaller private companies (December 31, 2019). Lawyers are often reluctant toward new regulations, but this one looks and feels like something that is going to be a major improvement over the previous method of implementation, so take advantage of it!
Looking Ahead
The most immediate implication of ASC 606 continued monitoring of accounting policies and their correspondence to the standards as the new revenue accounting standards continue to evolve. The Financial Accounting Standards Board ("FASB") first published the ASC 606 revenue recognition standard on May 28, 2014. Since then, amendments have been made on April 5, 2016, November 22, 2016, December 13, 2016, October 3, 2017, August 24 2018, March 19, 2019, and last week on January 15 , 2020. Although there have not been amendments yet specifically addressing contract assets (at least, that are easy to find), it is possible that the FASB could issue future updates addressing contract assets including eliminating the speciation of contract assets from receivables for the purposes of disclosure. As noted above, currently, companies must present contract assets separately from receivables and we have seen this create a burden on companies to appropriately record and present the information in their financial statements.