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Question 56: How and when should an entity determine whether it has an enforceable right to payment in accordance with paragraph 606-10-25-27(c)?
Publication date: 31 Jan 2020
us FASB Staff Q&A Revenue 56
Reference(s): Sections 606-10-25 and 606-10-55
In accordance with paragraph 606-10-25-27(c), if an entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date, the entity satisfies its performance obligation, and recognizes revenue, over time. An entity must meet both of the criteria in paragraph 606-10-25-27(c) in order to recognize revenue over time.
Paragraph 606-10-25-29 provides further guidance on the right to payment criterion.
The assessment of whether the entity has an enforceable right to payment is dependent on whether the termination payment includes a reasonable profit margin on its performance completed to date at all times throughout the duration of the contract if the contract is terminated by the customer for reasons other than the entity’s failure to perform as promised, as provided in paragraph 606-10-25-29. That is, if a termination provision only compensates the entity for costs or a portion of costs, the enforceable right to payment criteria would not be met. The payment schedule specified in the contract does not necessarily indicate whether an entity has an enforceable right to payment for performance completed to date.
The term right to payment is intended to refer to a payment that serves as compensation for an entity’s performance completed to date. The criterion in paragraph 606-10-25-27(c) was written with the intention to reinforce the notion of control because an entity would only agree to transfer control of a good or service to a customer if the entity is compensated for the costs associated with fulfilling the contract and it receives a reasonable profit margin that includes a return on those costs. If an entity concludes that it has entered into a contract with a customer to create an asset that has no alternative use, the entity would recognize revenue over time if there is an enforceable right to payment (including a reasonable profit margin) for performance completed to date.
Paragraphs 606-10-55-11 through 55-15 include considerations that an entity should use to assess whether there is an enforceable right to payment for performance completed to date, including whether there is a reasonable profit margin. Paragraph 606-10-55-11 states that an entity does not need to be entitled to the profit margin expected if the contract was fulfilled as promised, but an entity should at least be entitled to either a proportion of the expected profit margin in the contract that reasonably reflects the extent of the entity’s performance under the contract before termination or a reasonable return on the entity’s cost of capital. Paragraph BC144 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), clarifies this guidance by stating that an entity should focus on the amount that it would be entitled upon termination rather than the amount that the entity may ultimately be willing to settle for in a negotiation.
In some contracts, a customer may have a right to terminate the contract only at specified times during the life of the contract or the customer might not have any right to terminate the contract. Paragraph 606-10-55-13 provides guidance that if a customer terminates a contract without having the right to terminate the contract at that time, the contract (or laws) gives the entity a right to continue to perform its obligations in accordance with the contract, which would require the customer to perform its obligation of paying the promised consideration and create an enforceable right to payment.
An entity should consider the terms of the contract, as well as any legislation or legal precedent that could supplement or override those contractual terms, when assessing the existence and enforceability of a right to payment for performance completed to date. Paragraph 606-10-55-14 explains that an entity needs to consider legislation, administrative practice, or legal precedent that confers upon the entity a right to payment for performance to date even though that right is not specified in the contract with the customer, relevant legal precedent that indicates that similar rights to payment for performance completed to date in similar contracts has no binding legal effect, and an entity’s customary business practice of choosing not to enforce a right to payment that has resulted in the right being rendered unenforceable in that legal environment.
Paragraph BC145 of Update 2014-09 points out that the contractual payment terms in the contract might not always align with the entity’s enforceable rights to payment for performance completed to date. The right to payment does not need to be a present unconditional right to payment, but rather an entity should consider whether it would have an enforceable right to demand or retain payment for performance completed to date if the contract were to be terminated before completion for reasons other than the entity’s failure to perform as promised. An entity must consider both the terms of the contract and any laws or regulations that could have an effect on the existence and enforceability of right to payment on the contract.
The Board clarified in paragraph BC146 of Update 2014-09 that a nonrefundable upfront payment that represents the full transaction price would at least compensate the entity for work completed to date throughout the contract and would provide the entity a right to payment as long as the entity’s right to retain the payment is enforceable if the customer terminates the contract in accordance with paragraph 606-10-25-29.
As summarized above, Topic 606 provides a framework for evaluating whether an entity has a right to payment. However, application of the guidance sometimes will require judgment. For example, paragraph 606-10-55-11 states that a right to payment should include a reasonable profit margin. This will be a matter of judgment applied to the specific facts and circumstances of the arrangement. Also, application of the guidance on right to payment will be a matter of law. Sometimes an entity’s right to payment for performance completed to date might not be explicit in a contract or it might be vague in the contract. In applying the guidance in paragraph 606-10-25-29, an entity should consider contractual provisions as well as any legislation or legal precedent that could supplement or override those contractual terms.
Consider the following example:
For each of the last five years, an entity has received an order from a customer for 300 custom ice cream machines. The specifications of the ice cream machines are unique to the customer. In anticipation of the customer’s order this year, the entity starts production of the custom ice cream machines before there is a contract between the parties in the current year. The entity is willing to take the risk of beginning to manufacture custom units before there is a contract because (a) the customer has predictable purchasing behavior and (b) the entity has knowledge of the customer’s performance in the current year and plans for growth from the customer’s public disclosures. The entity and the customer later enter into a contract (that meets all of the criteria in Step 1 of Topic 606) for 300 units. The entity has a practical limitation on its ability to direct the equipment in its completed state because it could not do so without incurring a significant economic loss. The entity has an enforceable right to payment beginning when the contract is executed. Assume that each of the machines is distinct. At the inception of the contract, the entity has completed 50 units (that is, 50 units are in inventory awaiting shipment to the customer), has 10 units in production (that is, 10 units are in various stages of the manufacturing process), and has not begun manufacturing 240 units.
In this example, the entity begins production before the existence of a contract under Topic 606. Therefore, the entity cannot recognize revenue (whether at a point in time or over time) until a contract exists (that is, meets all of the criteria for a contract in Step 1 of Topic 606).
In the staff’s view, at contract inception the entity would assess the nature of its promise(s) to the customer and identify the performance obligation(s). Each of the machines is distinct; however, the entity considers whether the arrangement is a series of distinct goods or services in accordance with paragraphs 606-10-25-14(b) through 25-15. One of the two criteria to be a series is that the performance obligation is satisfied over time. There is no alternative use for the machines because of the practical limitation noted in the fact pattern. In addition, there is an enforceable right to payment at the inception of the contract. Therefore, the entity concludes that it will recognize revenue over time in accordance with paragraph 606-10-25-27(c). The second criterion to be a series is that the same method would be used to measure progress toward complete satisfaction to transfer each distinct good or service to the customer. In this fact pattern, the 300 units in the contract are identical so the entity concludes that it would use the same measure of progress for each of the 300 distinct units. Because both of the criteria for a series are met, the entity concludes that the arrangement for 300 machines should be accounted for as a series of goods and services.
At contract inception, the entity would record a cumulative catch up adjustment for progress made as of contract inception toward complete satisfaction of the performance obligation (that is, the series comprised of 300 units), considering both the 50 completed units and the 10 in process units. The entity would continue to recognize revenue over time as progress is made on finishing the 10 units and manufacturing the 240 units.
Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.
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