What Are Contract Assets?
A contract asset represents a company's right to consideration in exchange for goods or services that the company has already transferred to a customer, where that right to payment is conditional on something other than the passage of time.48, 49, 50 This asset arises in the realm of financial accounting, specifically under the guidance of revenue recognition standards like ASC 606.46, 47 Unlike a standard accounts receivable, which signifies an unconditional right to payment, a contract asset's realization into cash depends on the satisfaction of further conditions or performance obligations within the customer contract.44, 45 Companies recognize a contract asset when the value of the work performed exceeds the payment received, often in long-term contracts where billing is tied to milestones or future events.42, 43
History and Origin
The concept of contract assets became formalized and prominent with the issuance of ASC 606, "Revenue from Contracts with Customers," by the Financial Accounting Standards Board (FASB) and International Financial Reporting Standard (IFRS) 15 by the International Accounting Standards Board (IASB) in 2014.40, 41 These standards aimed to create a single, comprehensive model for revenue recognition across various industries, replacing previous disparate and often industry-specific guidance.36, 37, 38, 39 The objective was to improve the comparability and consistency of financial reporting.34, 35 Prior to ASC 606's adoption, which became effective for public companies for annual periods beginning after December 15, 2017, and for private companies a year later, many companies simply recognized revenue when cash was received.30, 31, 32, 33 The new standard, which the U.S. Securities and Exchange Commission (SEC) conformed its staff guidance to, mandated a five-step process for revenue recognition that often gives rise to contract assets and liabilities.27, 28, 29
Key Takeaways
- Contract assets represent a company's conditional right to receive payment for goods or services already transferred to a customer.
- They differ from accounts receivable because payment is contingent on future events or the satisfaction of additional performance obligations.
- The recognition of contract assets is a direct outcome of the revenue recognition principles outlined in ASC 606/IFRS 15.
- These assets are presented on the balance sheet and are subject to impairment testing for credit risk.
- Proper accounting for contract assets ensures that revenue is recognized in alignment with the actual transfer of goods or services, enhancing the accuracy of financial statements.
Interpreting the Contract Assets
Interpreting contract assets involves understanding the stage of completion of a customer contract and the remaining conditions for payment. A growing balance of contract assets on a company's balance sheet might indicate a healthy pipeline of work performed but not yet fully billable, suggesting future cash flow once the contingent conditions are met. Conversely, it also highlights the existence of potential risks, as the company's right to payment is not yet unconditional. Analysts examine contract assets in conjunction with a company's performance obligation disclosures to assess the nature and timing of expected cash inflows. The presence and magnitude of contract assets are particularly relevant for industries with long-term projects, such as construction, aerospace, and software development, where revenue recognition often occurs over time based on progress.
Hypothetical Example
Consider "BuildWell Construction," which signs a contract to build a custom commercial facility for $10 million. The contract specifies that BuildWell will receive progress payments at 30%, 60%, and 90% completion, with the final 10% paid upon obtaining the certificate of occupancy.
After the first phase, BuildWell completes work valued at $3.5 million (35% of the total project), but the first progress payment milestone is only at 30% completion ($3 million).
In this scenario, BuildWell has performed services worth $3.5 million. It has an unconditional right to $3 million (the first progress payment), which would be recorded as an accounts receivable. The remaining $0.5 million (the value of work performed beyond the first billing milestone but before the next conditional billing event) would be recognized as a contract asset. This is because BuildWell has satisfied a portion of its performance obligation for which it does not yet have an unconditional right to consideration; payment for this portion is contingent on reaching the next milestone or fulfilling other future obligations.
Practical Applications
Contract assets play a crucial role in modern financial reporting, especially for businesses with long-term engagements and complex revenue streams. They appear in the financial reporting of companies across various sectors, including software-as-a-service (SaaS), construction, telecommunications, and manufacturing. For instance, a SaaS company might recognize a contract asset when it has provided software access and support for a period, but its right to invoice for that period is tied to the customer using certain features in a subsequent month. In the construction industry, where large projects span multiple accounting periods, contract assets arise when work is performed, and revenue is recognized, but the right to bill the customer depends on achieving specific construction milestones.26
The SEC and FASB closely monitor the application of revenue recognition standards, including the proper identification and measurement of contract assets, to ensure transparent financial reporting.24, 25 The principles outlined in ASC 606 provide detailed guidance on how to determine when a customer contract creates a contract asset.22, 23 This includes criteria for transferring control of goods or services and allocating the transaction price to different performance obligations.20, 21 Further guidance on managing contract assets under ASC 606 can be found from resources like Stripe.19
Limitations and Criticisms
While contract assets provide a more accurate depiction of a company's earned revenue under new accounting standards, their interpretation can present challenges. One limitation stems from the inherent subjectivity in estimating the "standalone selling prices" of various distinct goods or services within a bundled contract, which is necessary for allocating the transaction price.17, 18 This estimation can lead to differing judgments and potential inconsistencies across companies or even within the same company over time.
Another criticism relates to the complexity introduced by the new revenue recognition standards. Implementing ASC 606, which governs contract assets, has led to increased expenses for many companies due to the need for new systems, processes, and extensive judgments.16 While the standard aims for comparability, the increased reliance on management judgment, particularly in areas like identifying performance obligations and determining variable consideration, can sometimes make it challenging for external stakeholders to fully understand the underlying assumptions and impact on financial results.15 Furthermore, contract assets are subject to impairment requirements, which involve estimating expected credit losses, adding another layer of complexity and potential estimation risk.13, 14
Contract Assets vs. Accounts Receivable
The primary distinction between contract assets and accounts receivable lies in the unconditional nature of the right to payment.
| Feature | Contract Asset | Accounts Receivable |
|---|---|---|
| Right to Payment | Conditional; depends on future events or satisfaction of additional performance obligations.11, 12 | Unconditional; payment is due solely based on the passage of time or invoice terms.10 |
| Timing | Recognized when work is performed and revenue is earned, but not yet billable due to contractual conditions.9 | Recognized when the right to payment becomes unconditional, typically upon invoicing or service completion. |
| Billing | Not yet billable or only partially billable. | Already billed or immediately billable. |
| Balance Sheet | Presented separately from accounts receivable.8 | Current asset typically under a distinct line item. |
Both are assets representing a right to future economic benefits, but the contingent nature of payment for a contract asset is the key differentiating factor. A contract asset will typically convert into an accounts receivable once the condition for billing is met, at which point it becomes an unconditional right to consideration.
FAQs
Q: Why are contract assets important in financial reporting?
A: Contract assets are important because they provide a more accurate picture of a company's financial position under modern revenue recognition standards. They reflect revenue earned from satisfying performance obligations, even if the right to payment is not yet unconditional, ensuring that the income statement aligns with the progress of work.6, 7
Q: How do contract assets differ from unbilled revenue?
A: "Unbilled revenue" is a broader, informal term often used interchangeably with contract assets or sometimes refers to accounts receivable that haven't been invoiced yet. Under ASC 606, a contract asset specifically refers to a conditional right to consideration for transferred goods or services, distinct from an unconditional receivable.
Q: Can a contract asset become a liability?
A: No, a contract asset represents a right to receive consideration and is always an asset. However, a related concept is a contract liability, which arises when a company receives payment (or has an unconditional right to payment) before it transfers goods or services to the customer.5 Contract assets and contract liabilities are presented on a net basis on the balance sheet for a single contract.3, 4
Q: Are contract assets subject to impairment?
A: Yes, contract assets are subject to impairment testing under generally accepted accounting principles (GAAP) and IFRS. Companies must account for expected credit losses on their contract assets, similar to how they assess other financial instruments.1, 2