Contract with a customer

What Is a Contract with a Customer?

A contract with a customer is a legally enforceable agreement between an entity and a customer that establishes the rights and obligations of both parties regarding the transfer of goods or services. In the realm of financial accounting, specifically under global revenue recognition standards, identifying and analyzing these contracts is the foundational step for how and when a business recognizes income from its primary activities. Such contracts form the basis for recognizing revenue when an entity satisfies its promise to transfer goods or services that the customer obtains control of in exchange for consideration.

History and Origin

Prior to the mid-2010s, accounting for revenue from contracts with customers varied significantly across industries and geographical regions, leading to inconsistencies and a lack of comparability in financial reporting. To address these issues, the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) undertook a joint project aimed at developing a converged, principles-based revenue standard. This collaborative effort, which began in 2002, culminated in May 2014 with the issuance of Accounting Standards Codification (ASC) Topic 606, "Revenue from Contracts with Customers," by the FASB, and International Financial Reporting Standard (IFRS) 15, "Revenue from Contracts with Customers," by the IASB.,¹⁴,¹³,¹²

These new standards superseded previous, often rules-based, guidance under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), respectively, such as IAS 18 and IAS 11. The objective was to provide a single, comprehensive framework for recognizing revenue from all types of customer contracts, enhancing comparability and usefulness of financial information globally. IFRS 15 became effective for annual reporting periods beginning on or after January 1, 2018, with ASC 606 having a similar effective date for public entities in the U.S.¹¹,¹⁰,⁹

Key Takeaways

• A contract with a customer is a prerequisite for revenue recognition under current accounting standards.
• It defines the rights and obligations of both the entity providing goods/services and the customer.
• The core principle is to recognize revenue when control of goods or services is transferred to the customer.
• Accounting standards provide a five-step model for analyzing and recognizing revenue from such contracts.
• These standards aim to improve comparability and transparency in financial reporting across industries and geographies.

Formula and Calculation

While there isn't a single formula for a "contract with a customer" itself, the revenue recognized from such a contract is determined through a five-step model prescribed by ASC 606 and IFRS 15. This model involves calculations and allocations at various stages to arrive at the revenue amount.

The five steps are:

1. Identify the contract(s) with a customer: A contract exists if it meets specific criteria, including approval by both parties, identifiable rights regarding goods or services, identifiable payment terms, commercial substance, and probable collection of consideration.
2. Identify the performance obligations in the contract: These are promises to transfer distinct goods or services to the customer.
3. Determine the transaction price: This is the amount of consideration the entity expects to be entitled to in exchange for transferring the promised goods or services.
4. Allocate the transaction price to the performance obligations in the contract: If a contract has multiple performance obligations, the transaction price is allocated to each based on its relative standalone selling price.
5. Recognize revenue when (or as) the entity satisfies a performance obligation: Revenue is recognized when control of the promised good or service is transferred to the customer.

The calculation of the transaction price can involve:

Where:

• Fixed Consideration: The set amount agreed upon in the contract.
• Variable Consideration: Amounts that depend on future events (e.g., discounts, rebates, performance bonuses), which are estimated using either the expected value method or the most likely amount method.
• Consideration Payable to Customer: Amounts paid or expected to be paid to the customer (e.g., coupons, rebates).

Interpreting the Contract with a Customer

Interpreting a contract with a customer goes beyond merely reading its terms; it involves applying professional judgment to determine the appropriate accounting treatment under revenue recognition standards. This interpretation is crucial for accurately reflecting a company's financial performance on its financial statements.

Key aspects of interpretation include:

• Existence of a Contract: Assessing whether an agreement, written, oral, or implied, meets the criteria to be considered an accounting contract, especially regarding collectibility and commercial substance.
• Identifying Distinct Performance Obligations: Determining if promises within a contract represent separate promises to transfer goods or services that are distinct. This influences how the transaction price is allocated and when revenue is recognized. For example, a software license might be a distinct performance obligation from related support services.
• Timing of Revenue Recognition: Deciding whether revenue should be recognized at a specific point in time (e.g., upon delivery of a product) or over a period (e.g., for ongoing services). This hinges on when control of the goods or services transfers to the customer.
• Estimating Variable Consideration: Contracts often contain elements of variable consideration, such as bonuses, penalties, or sales-based royalties. Entities must estimate these amounts and constrain their recognition, only including amounts for which it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

Accurate interpretation ensures that revenue is recognized in a manner that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled, aligning with the principles of accrual accounting.

Hypothetical Example

Imagine "TechSolutions Inc." signs a contract with a customer, "InnovateCorp," to provide custom software development and ongoing maintenance services for one year. The total contract value is $120,000.

Here’s how TechSolutions Inc. might apply the revenue recognition steps:

1. Identify the contract: A formal agreement exists between TechSolutions and InnovateCorp, detailing the scope of work, payment terms, and duration.
2. Identify performance obligations: TechSolutions determines there are two distinct performance obligations:
   • Development of custom software.
   • One year of ongoing maintenance services.
3. Determine the transaction price: The total transaction price is $120,000.
4. Allocate the transaction price: TechSolutions assesses the standalone selling prices:
   • Custom software development: $90,000
   • One year of maintenance services: $30,000
     The transaction price of $120,000 is allocated proportionally:
   • Software: (\frac{$90,000}{$90,000 + $30,000} \times $120,000 = $90,000)
   • Maintenance: (\frac{$30,000}{$90,000 + $30,000} \times $120,000 = $30,000)
5. Recognize revenue:
   • Software Development: TechSolutions recognizes the $90,000 revenue when the software development is completed and control is transferred to InnovateCorp (e.g., upon successful installation and acceptance, which happens three months into the contract). At this point, TechSolutions would record an increase in accounts receivable and revenue.
   • Maintenance Services: The $30,000 for maintenance is recognized ratably over the 12-month service period. Each month, TechSolutions would recognize $2,500 ($30,000 / 12 months) of revenue. If InnovateCorp paid for the full year upfront, the initial payment for maintenance would be recorded as deferred revenue and then recognized incrementally over the service period.

This example illustrates how a single contract with a customer can lead to revenue recognition at different points in time based on the satisfaction of distinct performance obligations.

Practical Applications

The concept of a contract with a customer and its associated revenue recognition principles are fundamental across various business sectors and financial practices:

• Software and Technology: Companies in this sector often deal with complex contracts involving software licenses, implementation services, and ongoing support. Applying the principles ensures proper timing of revenue recognition for each distinct component.
• Construction and Engineering: Long-term contracts for large projects require careful determination of performance obligation satisfaction over time, often using a "percentage-of-completion" method where revenue is recognized as work progresses, based on costs incurred or milestones achieved.
• Telecommunications: Providers manage contracts for mobile plans, internet services, and hardware. They must analyze whether the handset and the service plan are distinct performance obligations and how to allocate the transaction price.
• Retail and Consumer Goods: While often straightforward (revenue recognized at the point of sale), more complex contracts can arise with loyalty programs, extended warranties, or bundle deals that require careful unbundling of performance obligations.
• Audit and Compliance: Public companies and their auditors must meticulously apply ASC 606 or IFRS 15. The U.S. Securities and Exchange Commission (SEC) actively monitors compliance, issuing comments on revenue recognition disclosures to ensure companies provide adequate transparency on judgments made in applying the standards. A⁸uditors review a company's contracts and processes to ensure revenue is recognized in accordance with the five-step model, impacting financial reporting integrity.

The comprehensive framework provided by these standards aims to improve the consistency and comparability of financial reporting, enabling investors and other stakeholders to better understand a company's financial performance.

Limitations and Criticisms

While the unified revenue recognition standards (ASC 606 and IFRS 15) aimed to improve financial reporting, they introduced new complexities and areas of judgment, leading to certain limitations and criticisms:

• Increased Complexity and Judgment: The principles-based nature of the standards requires significant judgment from preparers, particularly in identifying distinct performance obligations, estimating variable consideration, and determining the timing of transfer of control. This can lead to subjective interpretations and potential inconsistencies in application, despite the goal of convergence.,
  ⁷⁶ Implementation Challenges: Companies, especially private entities, faced substantial challenges in implementing the new standards, requiring significant investments in new systems, processes, and training. This transition was noted for its depth and breadth of impact on financial statements.,
  ⁵⁴ Disclosure Overload: The enhanced disclosure requirements under the new standards, while intended to provide more useful information, can sometimes result in an overwhelming amount of data that is difficult for users to navigate and interpret effectively.
  *³ Potential for Manipulation: Despite the intent to reduce opportunities for earnings management, the increased reliance on management judgment, particularly in areas like variable consideration estimates or identifying performance obligations, could still open avenues for manipulation if not properly governed and audited. The risk of improper revenue recognition leading to fraud remains a concern.,
  ^{2
  1}Despite these criticisms, the standards represent a significant step towards global harmonization of revenue recognition practices, forcing companies to adopt a more rigorous and principles-based approach to accounting for their contracts with customers.

Contract with a Customer vs. Sales Order

While closely related, a contract with a customer and a sales order are distinct concepts in business operations and financial accounting.

In essence, a sales order is often a component or a specific fulfillment instruction that falls under the umbrella of a broader contract with a customer. The contract dictates the overall terms and conditions of the business relationship, while the sales order specifies the details of each particular sale within that relationship.

FAQs

What are the five steps of revenue recognition for a contract with a customer?

The five steps are: (1) Identify the contract(s) with a customer, (2) Identify the performance obligations in the contract, (3) Determine the transaction price, (4) Allocate the transaction price to the performance obligations, and (5) Recognize revenue when (or as) the entity satisfies a performance obligation. These steps provide a structured approach for applying the principles of the revenue recognition standards.

How does a contract with a customer differ from a general agreement?

A contract with a customer, for accounting purposes, must meet specific criteria outlined in accounting standards. These include having commercial substance, the ability to identify the rights of each party, identifiable payment terms, and the probability of collecting the consideration. A general agreement may lack some of these specific elements or might not involve the transfer of goods or services from the entity to a customer in exchange for consideration.

Why is identifying performance obligations so important?

Identifying performance obligations is crucial because it determines how the total transaction price of a contract is allocated and when revenue is recognized. Each distinct performance obligation represents a promise to transfer a good or service to the customer, and revenue is recognized as each of these promises is satisfied. This ensures that revenue accurately reflects the transfer of control of goods or services to the customer.

What are the challenges in accounting for contracts with customers?

Key challenges include applying significant judgment, especially in identifying distinct performance obligations and estimating variable consideration. The complexity of certain contracts, like those with multiple deliverables or long-term service agreements, can make it difficult to determine the appropriate timing and amount of revenue recognition. Auditors also face challenges in verifying these judgments.

Can a contract with a customer be verbal?

Yes, a contract with a customer does not necessarily have to be in writing. According to the accounting standards, a contract can be written, oral, or implied by an entity's customary business practices. However, for a contract to be accounted for, it must meet specific criteria, including being legally enforceable and having commercial substance. Written contracts are generally preferred for clarity and evidentiary purposes.