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, Example RR 2-6, and Example RR 2-7 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?
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)?
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?
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?
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.
EXAMPLE RR 2-7
Identifying the contract – master services agreement
ServiceProvider enters into a master services agreement (MSA) with a customer that includes general terms and pricing for Product A. The customer is not committed to make any purchases of Product A until the customer subsequently submits a noncancellable purchase order for a specified number of units of Product A.
Does the MSA meet the criteria to be accounted for as a contract under ASC 606
No. In this fact pattern, the MSA, on its own, does not create enforceable rights and obligations because the customer is not committed to make any purchases. A contract does not exist until the customer subsequently submits a noncancellable purchase order.