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.
Conclusion
ABC entity concludes that the contract meets the collectability criteria because it is probable that XYZ will pay substantially all of the consideration to which ABC entity is entitled for the services transfer to the XYZ (that is, for the services ABC entity will provide as long as XYZ continues to pay for the services provided).
ABC entity would then apply the remaining guidance in FASB ASC 606 to recognize revenue and only reassess the criteria if there is an indication of a significant change in facts or circumstances such as XYZ not making their required payments.
An entity’s ability to repossess an asset transferred to a customer should not be considered when assessing the entity’s ability to mitigate its exposure to credit risk.
The following example illustrates collectability of consideration as described in step 1:
Carl Construction, a real estate developer, enters into a contract for the sale of a building for $1 million. The customer, Neilson Enterprises, intends to open a restaurant in the building. The building is located in an area where new restaurants face high levels of competition and Neilson Enterprises has little experience in the restaurant industry. Neilson Enterprises pays a nonrefundable deposit of $50,000 at the inception of the contract and enters into a long-term financing agreement with Carl Construction for the remaining 95% of the promised consideration.
The financing agreement is provided on a nonrecourse basis, which means if Neilson Enterprises defaults, Carl Construction can repossess the building but cannot seek further compensation from Neilson Enterprises, even if the collateral does not cover the full value of the amount owed.
Does Carl Construction have a contract with Neilson Enterprises in accordance with FASB ASC 606? (As a reminder, in this example, Neilson Enterprises entered into the financing arrangement with Carl Construction with the intent of repaying the loan from the cash flow of the restaurant and has no other income or assets with which to repay the loan.)
A1 Fitness, a health club, enters into a one-year membership with a Susan Jones, a customer with low credit quality. The transaction price of the contract is $120, and $10 is due at the beginning of each month. The standalone selling price of the monthly service is $10.
On the basis of Susan Jones’ credit history and in accordance with the customary business practice of A1 Fitness, Susan Jones is required to pay each month before AI Fitness provides her with access to their health club. In response to non-payment, A1 Fitness’ customary business practice is to stop providing service to the Susan Jones upon non-payment.
Has A1 Fitness met the criteria that collectability is probable?
Big Pharma Inc. sells 1,000 units of a prescription drug to customer Jenco Corporation for promised consideration of $1 million. This is the first sale Big Pharma Inc. has made to customer Jenco Corporation, who is located in a new region, which is experiencing significant economic difficulty. Thus, Big Pharma Inc. does not expect to be able to collect the full amount of the promised consideration from Jenco Corporation. Despite the possibility of not collecting the full amount, Big Pharma Inc. expects the region’s economy to recover over the next two to three years and determines that a relationship with Jenco Corporation could help it forge relationships with other potential customers in the region.
Based on the assessment of the facts and circumstances, Big Pharma Inc. determines that it expects to provide a price concession and accept a lower amount of consideration from Jenco Corporation. Accordingly, Big Pharma Inc. concludes that the transaction price is not $1 million and, therefore, the promised consideration is variable. Big Pharma Inc. estimates the variable consideration and determines that it expects to be entitled to $400,000.
Is consideration probable because the implicit price concession is not the stated price consideration Big Pharma Inc. expects to receive from Jenco Corporation?
Portfolio approach
FASB ASC 606 permits, as a practical expedient, the application of a portfolio approach for contracts with customers having similar characteristics, provided that the effects on the entity’s financial statements would not differ materially had FASB ASC 606 been applied to each individual contract within that portfolio.
How should an entity assess whether the results of a portfolio approach would differ materially from the application of FASB ASC 606 on a contract-by-contract basis? FASB indicates in the Basis of Conclusions (BC) paragraph, paragraph 69, of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), that it did not intend for an entity to quantitatively evaluate each outcome and, instead, the entity should be able to take a reasonable approach to determine the portfolios that would be appropriate for its types of contracts.
When determining whether to apply step one to each individual contract with a customer or to elect the portfolio approach practical expedient, an entity will need to assess the cost versus benefits. Some entities may determine that the portfolio approach is best applied in step one, and perhaps even step 3 in the application of FASB ASC 606, but this is based on varying facts and circumstances.
Although not all inclusive, the following are some entities that may benefit from the application of the portfolio approach:
A health care entity might want to consider the application of the portfolio approach. For example, it may evaluate whether to establish separate portfolios for uninsured self-pay patients, insured patients with co-payments, insured patients with deductibles, emergency room uninsured self-pay, elective surgery that is not medically necessary or covered by insurance, and so on.
An educational institution may consider applying the portfolio approach when assessing collectibility of tuition and housing.
Knowledge check
1 A contract with a customer exists only when:Each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party or parties.The contract lacks commercial substance, so the risk, timing, and the amount of the entity’s future cash flows are expected to change as a result of the contract.It is probable that the entity will collect some of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customerThe parties to the contract have approved the contract (in writing, orally,
