This criterion is met if a reporting entity is entitled to payment for performance completed to date, at all times during the contract term, if the customer terminates the contract for reasons other than the reporting entity's nonperformance. The assessment of whether a right to payment exists may not be straight forward and depends on the contract terms and relevant laws and regulations. Management will generally have to assess the right to payment on a contract-by-contract basis; therefore, variances in contract terms could result in recognizing revenue at a point in time for some contracts and over time for others, even when the products promised in the contracts are similar. Refer to US Revenue TRG Memo No. 56
and the related meeting minutes in Revenue TRG Memo No. 60
for further discussion of this topic.
A reporting entity’s right to payment for performance completed to date does not have to be a present unconditional right; that is, the contract does not have to contain explicit contractual terms that entitle the reporting entity to invoice at any point throughout the contract period. Many arrangements include terms that stipulate that progress or milestone payments are required only at specified intervals, or only upon completion of the contract. Regardless of the stated payment terms or payment schedule, management needs to determine whether the reporting entity would have an enforceable right to demand payment if the customer cancelled the contract for other than a breach or nonperformance. A right to payment would also exist if the contract (or other laws) entitles the reporting entity to continue fulfilling the contract and demand payment from the customer under the terms of the contract in the event the customer attempts to terminate the contract.
Assessing whether a right to payment is enforceable
A reporting entity’s enforceable right to payment for performance completed to date will generally be evidenced by the contractual terms agreed to by the parties. However, the revenue standard provides that legislation or legal precedent in the relevant jurisdiction might supplement or override the contractual terms. A reporting entity asserting that it has an enforceable right to payment despite the lack of a contractual right should have sufficient legal evidence to support this conclusion. The fact that the reporting entity would have a basis for making a claim against the counterparty in a court of law is not sufficient to support that there is an enforceable right to payment.
If the contractual terms do not provide for a right to payment, we do not believe management is required to do an exhaustive search for legal evidence that might support an enforceable right to payment; however, it would be inappropriate for a reporting entity to ignore evidence that clearly provides for such a right. Similarly, if the contractual terms do provide for a right to payment, it would be inappropriate to ignore evidence that clearly indicates such rights have no binding legal effect.
Even if a reporting entity has a customary business practice of not enforcing right to payment clauses in its contracts, this generally does not mean there is no longer an enforceable right to payment. Such a business practice would only impact the assessment if it renders the right unenforceable in a particular legal environment.
Question RR 6-1 addresses how an acceptance provision affects the assessment of whether a right to payment is enforceable.
Question RR 6-1
Can a reporting entity conclude it has an enforceable right to payment for performance if the contract includes an acceptance provision?
It depends. If the nature of the acceptance provision is to confirm that the reporting entity has performed in accordance with the contract, we believe the provision would not impact the assessment of whether the reporting entity has an enforceable right to payment. However, if the acceptance provision relates primarily to subjective specifications and allows a customer to avoid paying for performance to date for reasons other than a breach or nonperformance, an enforceable right to payment would likely not exist. Refer to RR 6.5.5
for further discussion of acceptance provisions.
Assessing whether the payment compensates for performance to date
The amount of the payment that the reporting entity can enforce must at least compensate the reporting entity for performance to date at any point during the contract. The amount should reflect the selling price of the goods or services provided to date. For example, a reporting entity would have an enforceable right to payment if it is entitled to receive an amount that covers its cost plus a reasonable profit margin for work completed. A reporting entity that is entitled only to recover costs incurred does not have a right to payment for the work to date if the selling price of the finished goods or completed services includes a profit margin.
The revenue standard describes a reasonable profit margin as follows.
Excerpt from ASC 606-10-55-11
Compensation for a reasonable profit margin need not equal the profit margin expected if the contract was fulfilled as promised, but an entity should be entitled to compensation for either of the following amounts:
a. 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 by the customer (or another party)
b. A reasonable return on the entity's cost of capital for similar contracts (or the entity's typical operating margin for similar contracts) if the contract-specific margin is higher than the return the entity usually generates from similar contracts.
A specified payment schedule does not necessarily indicate that the reporting entity has a right to payment for performance. This could be the case in situations where milestone payments are not based on performance. Management should assess whether the payments at least compensate the reporting entity for performance to date. The payments should also be nonrefundable in the event of a contract cancellation (for reasons other than nonperformance).
Customer deposits and other upfront payments should also be assessed to determine if they compensate the reporting entity for performance completed to date. A significant nonrefundable upfront payment could meet the requirement if the reporting entity has the right to retain that payment in the event the customer terminates the contract, and the payment would at least compensate the reporting entity for work performed to date throughout the contract. The requirement would also be met even if a portion of the customer deposit is refundable as long as the amount retained by the reporting entity provides compensation for work performed to date throughout the contract.
In assessing whether the reporting entity has a right to payment for performance completed to date, management should only consider payments it has a right to receive from the customer. That is, management should not include payments it might receive from other parties (for example, payments it might receive upon resale of the good).
Question RR 6-2 addresses the assessment of whether a reporting entity has a right to payment when the contract is priced at cost or at a loss.
Question RR 6-2
Can a right to payment for performance completed to date exist when the contract is priced at cost or at a loss, and thus the right to payment does not include a profit margin?
Yes. The principle for assessing whether a reporting entity has a right to payment for performance is based on whether the reporting entity has a right to be compensated at an amount that approximates the selling price of the goods or services transferred to date. While the selling price for a contract will often be based on estimated costs plus a profit margin, selling price will not include a margin if the contract is priced at cost or at a loss. For example, a reporting entity might be willing to incur a loss on a sale if it has a strong expectation of obtaining a profit on future orders from the customer, even though such orders are not contractually guaranteed. We believe the analysis of right to payment should be focused on whether the reporting entity has a right to a proportionate amount of the selling price (reflecting performance to date) rather than solely based on whether such amount is equal to costs incurred plus a profit margin.