are some important considerations when assessing whether a contract exists with a customer:
A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party or parties.
When evaluating whether collectability of an amount of consideration is probable, an entity needs to consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession. Some entities find the collectability criteria difficult to assess because of certain variables, such as contract modifications or non-cash considerations, that could that potentially impact the criteria.
In order to meet the definition of a contract with a customer that is within the scope of FASB ASC 606, the contract does not have to be in writing. A contract can be written, oral, or implied (as a customary business practice).
The definition of a contract creates enforceable rights and obligations. It is important to realize that an entity’s ability to enforce these rights and obligations may vary. Certain practices and processes for establishing contracts with customers can vary across legal jurisdictions (foreign and domestic), industries, and entities. In some places, consumer-friendly laws may invalidate a company’s contracts with its customers if challenged in a court of law. Therefore, careful consideration will be needed for contracts that have been approved and committed to by the entity and its customers that may not be enforceable in a court of law in a specific jurisdiction. This evaluation may be more complex in situations in which contracts are entered into across multiple jurisdictions.
Collectability
An entity is required to assess whether it is probable that they will collect substantially all of the consideration they will be entitled to in exchange for the goods or services that will be transferred to the customer. Keep in mind that part of identifying whether a contract with a customer exists is based on the entity’s assessment of whether the customer has the ability and the intention to pay the consideration in exchange for the goods or services being transferred. The objective of this assessment is to evaluate whether there is a substantive transaction between the entity and the customer, which is a necessary condition of step 1.
The collectability assessment is partly a forward-looking assessment. This means that an entity should consider all of the facts and circumstances, including customary business practices and the entity’s knowledge of their customer, when determining whether it is probable that they will collect substantially all of the consideration to which they are entitled. Keep in mind that the assessment is not necessarily based on the customer’s ability and intention to pay the entire amount of promised consideration for the entire duration of the contract. When making this assessment, 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:
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.
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 collectability 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.
When seller financing is provided, an entity will need to consider a variety of factors when evaluating collectability of substantially all the considerations in which it will be entitled. Some of those factors might include the following:
An analysis of commercially available lending terms for similar transactions
The sufficiency of the down payment
The borrower creditworthiness
Historical experience of the seller in similar transactions with similar customers
An entity should not consider whether it can repossess an asset it transferred to a customer when assessing collectability
To further explain when credit risk can be mitigated, consider the following:
Facts:
Service provider ABC entity enters into a three-year service contract with new customer XYZ at the beginning of a calendar month.
XYZ has a very low credit quality.
The transaction price of the contract is $720, and $20 is due at the end of each month.
The standalone selling price of the monthly service is $20.
Both parties are subject to termination penalties if the contract is cancelled.
The ABC entity’s history with this class of customer indicates that while they cannot conclude it is probable that XYZ will pay the transaction price of $720, XYZ is expected to make the payments required under the contract for at least nine months. If, during the contract term, XYZ stops making the required payments, ABC entity’s customary business practice is to limit their credit risk by not transferring further services to XYZ and to pursue collection for the unpaid services.
Given the facts above, ABC entity needs to assess whether it is probable that they will collect substantially all of the consideration they will be entitled to in exchange for the services they transferred to XYZ. This would include their assessing their history with this class of customer as well as their business practice of stopping service in response to a customer’s nonpayment.
Assessment
Based upon the above fact pattern:
It would not be probable that ABC entity will collect the entire transaction price ($720) because of XYZ’s low credit rating.
ABC’s exposure to credit risk is mitigated because they have the ability and intention (as evidenced by its customary business practice) to stop providing services when a customer does not pay the promised consideration for services provided when it is due.