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The revenue standard defines a contract as follows.

Definition from ASC 606-10-20

Contract: An agreement between two or more parties that creates enforceable rights and obligations.

Identifying the contract is an important step in applying the revenue standard. A contract can be written, oral, or implied by a reporting entity's customary business practices. A contract can be as simple as providing a single off-the-shelf product, or as complex as an agreement to build a specialized refinery. Generally, any agreement that creates legally enforceable rights and obligations meets the definition of a contract.
Legal enforceability depends on the interpretation of the law and could vary across legal jurisdictions. Evaluating legal enforceability of rights and obligations might be particularly challenging when contracts are entered into across multiple jurisdictions where the rights of the parties are not enforced across those jurisdictions in a similar way. A thorough examination of the facts specific to the contract and the jurisdiction is necessary in such cases.
Sometimes the parties will enter into amendments or “side agreements” to a contract that either change the terms of, or add to, the rights and obligations of that contract. These can be verbal or written changes to a contract. Side agreements could include cancellation, termination, or other provisions. They could also provide customers with options or discounts, or change the substance of the arrangement. All of these items have implications for revenue recognition; therefore, understanding the entire contract, including any amendments, is critical to the accounting conclusion.

2.6.1 Contracts with customers—required criteria

All of the following criteria must be met before a reporting entity accounts for a contract with a customer under the revenue standard.

Excerpt from ASC 606-10-25-1

An entity shall account for a contract with a customer … only when all of the following criteria are met:
a. The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
b. The entity can identify each party's rights regarding the goods or services to be transferred.
c. The entity can identify the payment terms for the goods or services to be transferred.
d. The contract has commercial substance (that is, the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract).
e. It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

These criteria are discussed further in RR 2.6.1.1 through RR 2.6.1.5.

2.6.1.1 Contract has been approved and parties are committed

A contract must be approved by the parties involved in the transaction for it to be accounted for under the revenue standard. Approval might be in writing, but it can also be oral or implied based on a reporting entity's established practice or the understanding between the parties. Without the approval of both parties, it is not clear whether a contract creates rights and obligations that are enforceable against the parties.
It is important to consider all facts and circumstances to determine if a contract has been approved. This includes understanding the rationale behind deviating from customary business practices (for example, having a verbal side agreement where normally all agreements are in writing).
The parties must also be committed to perform their respective obligations under the contract. Termination clauses are a key consideration in determining whether a contract exists. A contract does not exist if neither party has performed and either party can unilaterally terminate the wholly unperformed contract without compensating the other party. A wholly unperformed contract is one in which the reporting entity has neither transferred the promised goods or services to the customer, nor received, or become entitled to receive, any consideration. Refer to RR 2.7 for further discussion on evaluating the contract term.
Generally, it is not appropriate to delay revenue recognition in the absence of a written contract if there is sufficient evidence that the agreement has been approved and that the parties to the contract are committed to perform (or have already performed) their respective obligations.
Example RR 2-3, Example RR 2-4, Example RR 2-5, and Example RR 2-6 illustrate the considerations in determining whether a contract has been approved and the parties are committed.
EXAMPLE RR 2-3

Identifying the contract – product delivered without a written contract
Seller's practice is to obtain written and customer-signed sales agreements. Seller delivers a product to a customer without a signed agreement based on a request by the customer to fill an urgent need.
Can an enforceable contract exist if Seller has not obtained a signed agreement consistent with its customary business practice?
Analysis
It depends. Seller needs to determine if a legally enforceable contract exists without a signed agreement. The fact that it normally obtains written agreements does not necessarily mean an oral agreement is not a contract; however, Seller must determine whether the oral arrangement meets all of the criteria to be a contract.
EXAMPLE RR 2-4

Identifying the contract – contract extensions
ServiceProvider has a 12-month agreement to provide Customer with services for which Customer pays $1,000 per month. The agreement does not include any provisions for automatic extensions, and it expires on November 30, 20X1. The two parties sign a new agreement on February 28, 20X2 that requires Customer to pay $1,250 per month in fees, retroactive to December 1, 20X1.
Customer continued to pay $1,000 per month during December, January, and February, and ServiceProvider continued to provide services during that period. There are no performance issues being disputed between the parties in the expired period, only negotiation of rates under the new contract.
Does a contract exist in December, January, and February (prior to the new agreement being signed)?
Analysis
A contract appears to exist in this situation because ServiceProvider continued to provide services and Customer continued to pay $1,000 per month.
However, since the original arrangement expired and did not include any provision for automatic extension, determining whether a contract exists during the intervening period from December to February requires an understanding of the legal enforceability of the arrangement in the relevant jurisdiction in the absence of a written contract. If both parties have enforceable rights and obligations during the renegotiation period, a contract exists and revenue should not be deferred merely because the formal written contract has not been signed.
If management concludes a contract exists during the renegotiation period, the guidance on variable consideration applies to the estimate of the transaction price, including whether any amounts should be constrained (refer to RR 4.3).
EXAMPLE RR 2-5
Identifying the contract – free trial period
ServiceProvider offers to provide three months of free service on a trial basis to all potential customers to encourage them to sign up for a paid subscription. At the end of the three-month trial period, a customer signs up for a noncancellable paid subscription to continue the service for an additional twelve months.
Should ServiceProvider record revenue related to the three-month free trial period?
Analysis
No. A contract does not exist until the customer commits to purchase the twelve months of service. The rights and obligations of the contract only include the future twelve months of paid subscription services, not the free trial period. Therefore, ServiceProvider should not record revenue related to the three-month free trial period (that is, none of the transaction price should be allocated to the three months already delivered). The transaction price should be recognized as revenue on a prospective basis as the twelve months of services are transferred.
EXAMPLE RR 2-6
Identifying the contract – free trial period with early acceptance
ServiceProvider offers to provide three months of free service on a trial basis to all potential customers to encourage them to sign up for a paid subscription. One month before the free trial period is completed (during month two of the three-month trial period), a customer signs up for a twelve-month service arrangement.
Should ServiceProvider record revenue for the remaining portion of the free trial period?
Analysis
It depends. Since the contract was signed before the free trial period was completed, judgment will be required to determine if the remaining free trial period is part of the contract with the customer. Management needs to assess if the rights and obligations in the contract include the one month remaining in the free trial period or only the future twelve months of paid subscription service. If management concludes that the remaining free trial period is part of the contract with the customer, revenue should be recognized on a prospective basis over 13 months, as services are transferred over the remaining trial period and the twelve-month subscription period.

2.6.1.2 The reporting entity can identify each party's rights

A reporting entity must be able to identify each party's rights regarding the goods and services promised in the contract to assess its obligations under the contract. Revenue cannot be recognized related to a contract (written or oral) where the rights of each party cannot be identified, because the reporting entity would not be able to assess when it has transferred control of the goods or services.
For example, a reporting entity enters into a contract with a customer and agrees to provide professional services in exchange for cash, but the rights and obligations of the parties are not yet known. The reporting entities have not contracted with each other in the past and are negotiating the terms of the agreement. No revenue should be recognized if the reporting entity provides services to the customer prior to understanding its rights to receive consideration.

2.6.1.3 The reporting entity can identify the payment terms

The payment terms for goods or services must be known before a contract can exist, because without that understanding, a reporting entity cannot determine the transaction price. This does not necessarily require that the transaction price be fixed or explicitly stated in the contract. Refer to RR 4 for discussion of determining the transaction price, including variable consideration.

2.6.1.4 The contract has commercial substance

A contract has commercial substance if the risk, timing, or amount of the reporting entity's future cash flows will change as a result of the contract. If there is no change, it is unlikely the contract has commercial substance. A change in future cash flows does not only apply to cash consideration. Future cash flows can also be affected when the reporting entity receives noncash consideration as the noncash consideration might result in reduced cash outflows in the future. There should also be a valid business reason for the transaction to occur. Determining whether a contract has commercial substance can require judgment, particularly in complex arrangements where vendors and customers have several arrangements in place between them.

2.6.1.5 Collection of the consideration is probable

The objective of the collectibility assessment is to determine whether there is a substantive transaction (that is, a valid contract) between the reporting entity and a customer. A reporting entity only applies the revenue guidance to contracts when it is “probable” that the reporting entity will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer. “Probable” is defined as “the future event or events are likely to occur,” which is generally considered a 75% threshold.
The assessment of whether an amount is probable of being collected is made after considering any price concessions expected to be provided to the customer. Management should first determine whether it expects the reporting entity to accept a lower amount of consideration than that which the customer is contractually obligated to pay (refer to “Impact of price concessions” section below). A reporting entity that expects to provide a price concession should assess the probability of collection for the amount it expects to enforce (that is, the transaction price adjusted for estimated concessions).
The reporting entity’s assessment of this probability must reflect both the customer’s ability and intent to pay as amounts become due. An assessment of the customer’s intent to pay requires management to consider all relevant facts and circumstances, including items such as the reporting entity’s past practices with its customers as well as, for example, any collateral obtained from the customer.
Additional implementation guidance is included in the revenue standard to clarify how management should assess collectibility.

Excerpt from ASC 606-10-55-3C

When assessing whether a contract meets the [collectibility] criterion…an entity should determine whether the contractual terms and its customary business practices indicate that the entity’s exposure to credit risk is less than the entire consideration promised in the contract because the entity has the ability to mitigate its credit risk. Examples of contractual terms or customary business practices that might mitigate the entity’s credit risk include the following:
a. Payment terms— In some contracts, payment terms limit an entity’s exposure to credit risk. For example, a customer may be required to pay a portion of the consideration promised in the contract before the entity transfers promised goods or services to the customer. In those cases, any consideration that will be received before the entity transfers promised goods or services to the customer would not be subject to credit risk.
b. The ability to stop transferring promised goods or services — An entity may limit its exposure to credit risk if it has the right to stop transferring additional goods or services to a customer in the event that the customer fails to pay consideration when it is due. In those cases, an entity should assess only the collectibility of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer on the basis of the entity’s rights and customary business practices. Therefore, if the customer fails to perform as promised and, consequently, the entity would respond to the customer’s failure to perform by not transferring additional goods or services to the customer, the entity would not consider the likelihood of payment for the promised goods or services that will not be transferred under the contract.
An entity’s ability to repossess an asset transferred to a customer should not be considered for the purpose of assessing the entity’s ability to mitigate its exposure to credit risk.

This additional guidance explains that management should consider the reporting entity’s ability to mitigate its exposure to credit risk as part of the collectibility assessment (for example, by requiring advance payments or ceasing to provide goods or services in the event of nonpayment). A reporting entity typically will not enter into a contract with a customer if there is significant credit risk without also having protection to ensure it can collect the consideration to which it is entitled. The guidance clarifies that the collectibility assessment is not based on collecting all of the consideration promised in the contract, but on collecting the amount to which the reporting entity will be entitled in exchange for the goods or services it will transfer to the customer. These concepts are illustrated in Example 1 of ASC 606 (ASC 606-10-55-95 through ASC 606-10-55-98L).
Impact of price concessions
Distinguishing between an anticipated price concession and the reporting entity’s exposure to the customer’s credit risk may require judgment. The distinction is important because a price concession is variable consideration (which affects the transaction price) rather than a factor to consider in assessing collectibility (when assessing whether the contract is valid). Refer to RR 4.3 for further discussion on variable consideration.
Factors to consider in assessing whether a price concession exists include a reporting entity’s customary business practices, published policies, and specific statements regarding the amount of consideration the reporting entity will accept. The assessment should not be limited to past business practices. For example, a reporting entity might enter into a contract with a new customer expecting to provide a price concession to develop the relationship. Refer to Revenue TRG Memo No. 13 and the related meeting minutes in Revenue TRG Memo No. 25 for further discussion of this topic. These concepts are illustrated in Examples 2 and 3 of the revenue standard (ASC 606-10-55-99 through ASC 606-10-55-105).
Question RR 2-1 addresses the accounting implications of extended payment terms.
Question RR 2-1
A reporting entity provides payment terms that are extended beyond normal terms in a contract with a new customer. Should management conclude that the amounts subject to the extended payment terms are not probable of collection?
PwC response
It depends. Extended payment terms should be considered when assessing the customer's ability and intent to pay the consideration when it is due; however, the mere existence of extended payment terms is not determinative in the collectibility assessment. Management's conclusion about whether collection is probable will depend on the relevant facts and circumstances. Management should also consider in this fact pattern whether the reporting entity expects to provide a concession to the customer and whether the payment terms indicate that the arrangement includes a significant financing component (refer to RR 4.4).

Assessing collectibility for a portfolio of contracts
It is not uncommon for a reporting entity’s historical experience to indicate that it will not collect all of the consideration related to a portfolio of contracts. In this scenario, management could conclude that collection is probable for each contract within the portfolio (that is, all of the contracts are valid) even though it anticipates some (unidentified) customers will not pay all of the amounts due. The reporting entity should apply the revenue model to determine transaction price (including an assessment of any expected price concessions) and recognize revenue assuming collection of the entire transaction price. Management should separately evaluate the contract asset or receivable for impairment under  ASC 310 (or for credit losses under ASC 326, Financial instruments – credit losses, once adopted). Refer to Revenue TRG Memo No. 13 and the related meeting minutes in Revenue TRG Memo No. 25 for further discussion of this topic. Example RR 2-7 illustrates this accounting.
EXAMPLE RR 2-7
Identifying the contract – assessing collectibility for a portfolio of contracts
Wholesaler sells sunglasses to a large volume of customers under similar contracts. Before accepting a new customer, Wholesaler performs customer acceptance and credit check procedures designed to ensure that it is probable the customer will pay the amounts owed. Wholesaler will not accept a new customer that does not meet its customer acceptance criteria.
In January 20X1, Wholesaler delivers sunglasses to multiple customers in exchange for consideration totaling $100,000. Wholesaler concludes that control of the sunglasses has transferred to the customers and there are no remaining performance obligations.
Wholesaler’s concludes, based on its procedures, that collection is probable for each customer; however, historical experience indicates that, on average, Wholesaler will collect only 95% of the amounts billed. Wholesaler believes its historical experience reflects its expectations about the future. Wholesaler intends to pursue full payment from customers and does not expect to provide any price concessions.
How much revenue should Wholesaler recognize?
Analysis
Because collection is probable for each customer, Wholesaler should recognize revenue of $100,000 when it transfers control of the sunglasses. Wholesaler’s historical collection experience does not impact the transaction price in this fact pattern because it concluded that the collectibility threshold was met (that is, the contracts were valid) and it did not expect to provide any price concessions. Wholesaler should evaluate the related receivable for impairment based on the relevant financial instruments standard.

2.6.2 Arrangements where criteria are not met

An arrangement is not accounted for using the five-step model until all of the criteria in RR 2.6.1 are met. Management will need to reassess the arrangement at each reporting period to determine if the criteria are met.
Consideration received prior to concluding a contract exists (that is, prior to meeting the criteria in RR 2.6.1) is recorded as a liability and represents the reporting entity’s obligation to either transfer goods or services in the future or refund the consideration received. The reporting entity should not recognize revenue from consideration received from the customer until one of the following criteria is met.

Excerpt from ASC 606-10-25-7

When a contract with a customer does not meet the criteria … and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenue only when one or more of the following events have occurred:
a. The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
b. The contract has been terminated, and the consideration received from the customer is nonrefundable.
c. The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.   

The third criterion is intended to clarify when revenue should be recognized in situations where it is unclear whether the contract has been terminated. Example RR 2-8 illustrates the accounting for a contract for which collection is not probable and therefore, a contract does not exist.
EXAMPLE RR 2-8
Identifying the contract — collection not probable
EquipCo sells equipment to its customer with three years of maintenance for total consideration of $1 million, due in monthly installments over the three-year term. At contract inception, EquipCo determines that the customer does not have the ability to pay as amounts become due and therefore collection of the consideration is not probable. EquipCo intends to pursue collection and does not intend to provide a price concession. EquipCo delivers the equipment at the inception of the contract. At the end of the first year of the contract, the customer makes a partial payment of $200,000. EquipCo continues to provide maintenance services, but concludes that collection of the remaining consideration is not probable.
Can EquipCo recognize revenue for the partial payment received?
Analysis
No. EquipCo cannot recognize revenue for the partial payment received because it has concluded that collection is not probable. EquipCo cannot recognize revenue for cash received from the customer until it meets one of the criteria outlined in RR 2.6.2. In this example, EquipCo has not terminated the contract and continues to provide services to the customer. EquipCo should continue to reassess collectibility each reporting period.

Question RR 2-2 addresses the accounting implications if a reporting entity continues to pursue collection for remaining amounts owed.
Question RR 2-2
Can a reporting entity recognize revenue for nonrefundable consideration received if it continues to pursue collection for remaining amounts owed under the contract (for an arrangement that does not meet all of the criteria to establish a contract with enforceable rights and obligations in RR 2.6.1)?
PwC response
It depends. Reporting entities sometimes pursue collection for a considerable period of time after they have stopped transferring promised goods or services to the customer. Management should assess whether the criteria in RR 2.6.2 are met. We believe that management could conclude that a contract has been terminated even if the reporting entity continues to pursue collection as long as the reporting entity has stopped transferring goods and services and has no obligation to transfer additional goods or services to the customer.

Question RR 2-3 addresses how a reporting entity should measure progress for a performance obligation satisfied over time if activities begin before a contract is established.
Question RR 2-3
If a reporting entity begins activities related to a performance obligation for which control will transfer over time (for example, begins manufacturing a customized good or constructing a building) before a contract meets the criteria described in RR 2.6.1, how should progress be measured once the contract subsequently meets the criteria?
PwC response
The measure of progress for a performance obligation satisfied over time should reflect the reporting entity’s performance in transferring control of goods or services. Thus, once a contract is established, a reporting entity should generally recognize revenue for any promised goods or services that have already transferred to the customer (that is, revenue is recognized on a cumulative catch-up basis). Refer to RR 6.4.6 and Revenue TRG Memo No. 33 and the related meeting minutes in Revenue TRG Memo No. 34 for further discussion of this topic.
Reporting entities generally should not recognize revenue on a cumulative catch-up basis for distinct goods or services provided for no consideration prior to contract inception (for example, as part of a "free trial"). Refer to Example RR 2-6.

2.6.3 Reassessment of criteria

Once an arrangement has met the criteria in RR 2.6.1, management does not reassess the criteria again unless there are indications of significant changes in facts and circumstances. The determination of whether there is a significant change in facts or circumstances depends on the specific situation and requires judgment.
For example, assume a reporting entity determines that a contract with a customer exists, but subsequently the customer's ability to pay deteriorates significantly in relation to goods or services to be provided in the future. Management needs to assess, in this situation, whether it is probable that the customer will pay the amount of consideration for the remaining goods or services to be transferred to the customer. The reporting entity will account for the remainder of the contract as if it had not met the criteria to be a contract if it is not probable that it will collect the consideration for future goods or services. This assessment does not affect assets and revenue recorded relating to performance obligations already satisfied. Such assets are assessed for impairment under the relevant financial instruments standard.
Example 4 in the revenue standard (ASC 606-10-55-106 through ASC 606-10-55-109) provides an illustration of a situation when the change in a customer’s financial condition is so significant that it necessitates a reassessment of the criteria discussed in RR 2.6.1. Also refer to Revenue TRG Memo No. 13 and the related meeting minutes in Revenue TRG Memo No. 25 for further discussion of this topic.
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