Implementing The New Accounting For Revenue Recognition: Understanding the Collectibility Threshold

Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, (ASU 2014-09) establishes a new uniform revenue recognition model for substantially all industries. It is well known that its impact will vary across industry lines.

Since ASU 2014-09 is a principles-based standard, it requires judgment and interpretation in its application. As we gradually absorb its principles, common questions pertinent to many industries are emerging in certain areas. One concerns how ASU 2014-09’s guidance on collectibility will change the accounting for bad debts, revenue from multi-year contracts and non-refundable customer payments.

Collectibility

Under our existing framework, we evaluate collectibility in order to determine whether or not to recognize revenue. Collectibility must be reasonably assured in order to recognize revenue.

This generally carries over to ASU 2014-09, but with a twist. In ASU 2014-09, collectibility is only considered during application of the first step of the five step revenue model. It is used to identify whether a contract with a customer exists, and to filter out unacceptable contracts and arrangements. If a valid contract exists, one progresses to step two. Revenue is not recognized until step five. How do you assess collectibility in step one? ASU 2014-09 directs that “….an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due” (Accounting Standards Codification 606-10-25-1).

This esoteric principle is referred to as the collectibility threshold. It has generated related questions concerning the accounting for bad debts, revenue from multi-year contracts and non-refundable customer payments.

Consideration of Bad Debts

A common ASU 2014-09 implementation question concerns whether to record revenues net of bad debts expense. One view claims that revenues should be recorded net of probable bad debts expense. Another view holds that bad debts expense should be recorded later, consistent with current practice, when the conditions for impairment of the receivable are met. Which is correct?

The following example abstracted from a recent FASB staff paper illustrates the question:

An entity has a large volume of homogenous revenue for which billings are done in arrears on a monthly basis. Before accepting a customer, the entity performs procedures designed to ensure that it is probable that the customer will pay the amounts owed. While the entity collects the entire amount due from the vast majority of its customers, on average, the entity’s historical evidence (which is representative of its expectations for the future) indicates that the entity will only collect 98% of the amounts billed. If the entity bills $100 to its customers in a particular month, and there are no other issues that would preclude recognition of revenue for that amount, how much revenue should the entity recognize given that historical evidence indicates that it will collect only 98% of amounts billed?

The two possible solutions are:

1. Record revenues of $100 (when the underlying performance obligations are satisfied), and record bad debts expense of $2 later, when the conditions for recognition of an impairment loss have been met.
2. Record revenues of $98 when the underlying performance obligations are satisfied.

Both solutions incorporate important concepts in ASU 2014-09:

• Revenue should be recognized for the amount of consideration to which an entity will be entitled.
• In determining collectibility, an entity shall consider the customer’s ability and intention to pay that amount of consideration when it is due.
• Revenues should be recognized at the amount that is probable of collection.

The correct answer is number one. ASU 2014-09’s scope does not alter the current accounting for receivables. Further, as it is probable that the customers will pay the amounts owed in full at the time that the revenue is recognized, sufficient basis to record the revenues net does not exist. Remember that the collectibility threshold is only applied in step one of ASU 2014-09’s five step revenue recognition process. It is one of the criteria evaluated in order to determine whether an appropriate arrangement, or contract, exists. The collectibility threshold was not intended as shorthand for the determination of any uncollectible amounts. Therefore, number two is not correct.

Multi-year Contracts

Now let’s apply ASU 2014-09’s collectibility threshold to multi-year contracts, where revenue is recognized over the years as the performance obligations are satisfied.

For example, assume that a customer’s ability to pay is probable in periods one and two of a contract. Accordingly, the entity recognizes revenue in full in those periods. But what if the customer’s ability to pay significantly deteriorated in the third period of the contract? How does the collectibility threshold impact revenue recognition in period three? ASU 2014-09 requires that an entity shall consider the customer’s ability and intention to pay the consideration when it is due. If the entity concludes that collection is no longer probable from this customer in the third period, this is a significant change which indicates that the contract is no longer enforceable. Accordingly, revenue should not be recognized. This may reduce the amount of revenue recognized compared to current practices.

Non-refundable Customer Payments

Certain arrangements require a customer to deposit non-refundable cash with a vendor in advance of the delivery of the promised good or service. Examples include deposits, up-front fees for joining a club, retainers, or set-up fees. Questions have arisen concerning the accounting for a non-refundable payment.

For example, assume that an arrangement with a non-refundable customer payment initially passes step one of ASU 2014-09’s revenue model, and a valid contract exists for accounting purposes. Subsequently, management concludes that it is not probable that the company will collect the remaining amounts due under the contract. Should the non-refundable consideration be recognized immediately as revenue when that determination is made? Interpretations are varied. Some maintain that since the collectibility threshold ultimately failed, a contract no longer exists, and the arrangement is scoped out of ASU 2014-09. Therefore, the forfeited deposit should be recognized as revenue immediately. Others claim that consideration should be given to any remaining performance obligations, and recognize revenue from the forfeited deposit only when or as they are satisfied. This approach fully incorporates ASU 2014-09’s five steps of revenue recognition. When should the non-refundable customer payment be recognized as revenue under ASU 2014-09?

ASU 2014-09 establishes that one of the following must be met before the deposit can be recognized as revenue. These are:

1. There are no remaining performance obligations, and substantially all of the consideration received is non-refundable, or
2. The contract has been terminated, and the consideration received from the customer is nonrefundable.

In our example, it will depend on an analysis of additional facts and circumstances. If the arrangement is formally terminated, then revenue may be recognized for the forfeited payment at the time of termination. If remaining performance obligations exist, and the contract was not formally terminated, the non-refundable deposit should be recognized as a liability until the related performance obligations are satisfied. Although the underlying theory has changed, this should not result in a significant change in practice.

Additional Resources

Look for our practical insights into ASU 2014-09, and other accounting guidance, on our Assurance and Accounting Service page. We would be pleased to discuss with you how ASU 2014-09 and other current developments would affect your business and financial reporting. Contact us with your questions.

A broad discussion of ASU 2014-09 can be found at the link below:

• AICPA Financial Reporting Brief:Roadmap to Understanding the New Revenue Recognition Standards: A resource for understanding and implementing the new revenue recognition guidance:
• AICPA Website Resource on Revenue from Contracts with Customers
• The text of the new standard may be accessed as follows: www.fasb.org>>Standards>>Accounting Standards Updates Issued>>Update No. 2014