Revenue Recognition Issue 3 – Identify the Contract

Contracts can take many forms. Some contracts are formal, some are written agreements, some are in the form of purchase orders, and some may be just oral understandings. At the time of revenue recognition, you would need to assess that collection is at least probable, and there needs to be some identification as to each party’s rights and clear payment terms under the contract. The nature of the contracts that you have with your customers can have significant implications as to how you recognize the revenue under those contracts within your financial statements. But if the agreement with your customer is not enforceable, it will create difficulties for you in how you recognize revenue, as further discussed below.

You need to consider not only your basic contract, but also any amendments to the contract, change orders received, or variations as permitted within the existing contract. Determining how revenue will be recognized under the contract cannot be done without consideration of these contract amendments.

A worst-case accounting scenario exists in that, if a contract with a customer is, for some reason, deemed to be legally unenforceable, then the new accounting standard would provide that revenue cannot be recognized on that contract until either:

1. the terms have been substantially completed and substantially all consideration has been received and is non-refundable, or
2. the contract is terminated and the consideration is non-refundable, or
3. you have transferred goods/services to which consideration received relates, you have stopped providing goods/services to the customer and no further obligation exists to provide goods/services and all consideration received is non-refundable.

For example, if you have a purchase order from a customer saying they will pay you $12 per widget for each widget they have received and inspected/approved and provide for a reduced payment in certain circumstances, you might not actually have an enforceable contract until the widget has been received and inspected/approved by the customer as well as having collected substantially all of the payment for this widget.

This could put this unenforceable contract on the cash basis of accounting. As you can imagine, there may indeed be some circumstances where you will need to consult with your attorney to determine whether a contract is enforceable, as these interpretations can be exceptionally complex.

Stay tuned for additional alerts in our Revenue Recognition Readiness Check Series. In the coming issues, we will dig deeper into the basic tenants of each of these five provisions. Next in our series, we will explore the second step: Identify Separate Performance Obligations.

Please contact your BMF Advisor for additional information regarding the new standards.