a public business entity for purposes of financial statements that are filed or furnished with the SEC.”
Chapter 2 Identifying The Contract With a Customer
Learning objectives
Distinguish the difference between a gain and revenue.
Identify the criteria needed in order to determine that collectability is probable within the context of FASB ASC 606.
Identify when an entity will need to continue to reassess whether a contract with a customer exists.
Overview
The core principle of the revenue recognition standard is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In order to achieve this core principle, an entity should be able to perform the following:
Step 1: Identify the contract with a customer
Step 2: Identify the performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price
Step 5: Recognize revenue when or as the entity satisfies a performance obligation
One key concept to remember is that the five steps are achieved consecutively; meaning if an entity cannot achieve the criteria in step 1 they cannot simply move on to step 2 and so on.
Key definitions used in this chapter
Before delving into the application of step 1, it is important to understand the following definitions in the FASB Accounting Standards Codification® (ASC) master glossary:
Contract: An agreement between two or more parties that creates enforceable rights and obligations.
Customer: A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.
Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from deriving or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operation.
A gain is defined in FASB Concept Statement No. 6, Elements of Financial Statement, as:
Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.
FASB Concept Statement No. 6, further states in paragraph 84, that
Gains and losses result from entities’ peripheral or incidental transactions and from other events and circumstances stemming from the environment that may be largely beyond the control of individual entities and their managements. Thus, gains and losses are not all alike. There are several kinds, even in a single entity, and they may be described or classified in a variety of ways that are not necessarily mutually exclusive.
The difference between revenue and gains
While revenue and gains may appear to be similar, some significant differences exist. As described in the definition, revenue is the result from an entity’s ongoing major or central operations and activities, meaning revenue is derived from producing goods, rendering services, or other activities. Gains result from an entity’s peripheral or incidental transactions and from other events and circumstances stemming from an environment that may be largely beyond the control of the entity and their management. Understanding the difference between gains and revenue is important because gains from peripheral or incidental transactions are outside the scope of FASB ASC 606, Revenue from Contracts with Customers, and therefore outside any of the course’s content.
Based upon the previously mentioned definitions, which of the following are revenue and which are gains?
1 An entity sells equipment for $600. They manufacturer the equipment at a cost of $500.
2 An entity sells equipment they no longer need for $600. They bought the equipment for $1,000 five years ago, and have been depreciating it on a straight-line basis assuming a 10-year useful life.
Knowledge check
1 Which best describes the definition of revenue as defined in FASB ASC 606?Inflows of assets of an entity or settlements of its liabilities (or a combination of both) from deriving or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operation.The results of an incidental transaction from an event and circumstance stemming from an environment beyond the control of individual entity.Outflows or other enhancements of an entity or settlements of its liabilities (or a combination of both) from deriving or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operation.The results of a peripheral transaction from an event and circumstance stemming from an environment beyond the control of individual entity.
How to identify a contract(s) with a customer
FASB ASC 606 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” Paragraph 1 of FASB ASC 606-10-25 further specifies that a contract(s) with a customer exists only when all of the following criteria have been met:
The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
The entity can identify each party’s rights regarding the goods or services to be transferred.
The entity can identify the payment terms for the goods or services to be transferred.
The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).
It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer
Here are some important considerations when assessing whether a contract exists with a customer:
A
