The potential accounting impacts from the coronavirus have been extensive and from a financial reporting perspective, broad-ranging, affecting among others, a company’s going concern considerations, asset impairment considerations and financial statement disclosures. Yet another critical accounting area that could be affected by COVID-19 is revenue recognition, including revenue recognition internal control processes.
The revenue recognition guidance in ASC Topic 606 provides principles that permit entities to make the judgments necessary to recognize revenue in a manner that reflects the true economics of a transaction stemming from a contract with a customer. Three concepts embedded in the principles that are particularly relevant in the current economic situation are:
- Assessing the ability to collect the consideration promised in a contract,
- The requirement for entities to not recognize revenue in excess of what is probable to be reversed in future (a concept otherwise known as the constraint on variable consideration), and
- The accurate measurement of revenue that is recognized over time.
With these in mind, we will identify the revenue recognition areas that could be most susceptible to impact or change, due to the pandemic, as well as evaluate the potential repercussions from these COVID-19 effects.
Probability of Collection
Step 1 of the ASC Topic 606 revenue recognition guidance requires the reporting entity to evaluate the contract with a customer. The contract would only fall within the scope of ASC Topic 606 and qualify for revenue recognition if 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. Notably, this assessment should be made at the individual contract level.
The disruption of the COVID-19 pandemic may have many customers stretching accounts payable or relying on financing in order to alleviate short-term cash shortages. Entities with customers under these circumstances may elect to extend payment terms, which does not in and of itself affect collectibility. However, extended payment terms may indirectly affect the evaluation of the collectibility criterion and indicate potential future price concessions or the presence of a significant financing component in an arrangement, which may require additional consideration.
In more extreme cases, customers with insufficient cash reserves that are struggling to make ends meet due to sharply affected demand may not be able to obtain incremental financing to sustain their operations. This, in turn, will affect customers’ ability to pay for goods or services delivered. Entities will need to reconsider the process of assessing the probability of collection not only for new, but also existing customers.
Simply following the status quo may not be sufficient, even with respect to recurring customers that have previously exhibited a good credit history, due to the changing circumstances. Financial statement auditors will likely inquire for support that Step 1 of ASC 606 was met with respect to sales that originated post-announcement of the pandemic by the World Health Organization on March 11, 2020.
If an entity cannot establish that collection is probable, the arrangement does not meet Step 1 to qualify as a revenue contract that is analyzed under the 5-step revenue recognition method in the first place. Continuing with delivery of goods or services without adequately validating the probability of collection, could place an entity in the difficult position of applying the guidance for contracts not within the 5-step model, which is no longer as simple as applying the cash method of accounting. Accounting in this circumstance typically results in recognition of cost of goods sold, without the ability to recognize any receivable or other asset until a later period. In other words, gross margins can be significantly skewed.
Effect on Existing Contracts
COVID-19 creates a potential additional nuance, even with respect to contracts that existed prior to when the pandemic took hold. An existing contract that previously met the criteria in Step 1 for application of ASC Topic 606 is typically not reassessed for collectability unless there is a significant change in circumstances that significantly impacts the customer’s ability to pay. Entities would need to evaluate whether the COVID-19 pandemic may have affected customers under existing contracts so significantly as to require reopening the assessment of Step 1.
It is worth noting that entities may encounter customers making payments if and when possible during this time, even before meeting the collectability criterion under Step 1. If Step 1 is initially not met, for instance because of failing to meet the collectability criterion, Step 1 is continued to be assessed until it is met. However, some contracts will never meet all of the criteria of Step 1.
ASC Topic 606 prescribes what is known as the alternative accounting model to account for consideration received when Step 1 has not been met, which is pointedly not a straightforward cash basis approach. When a contract does not meet Step 1 and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenue only when one or more of the following events have occurred:
- The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
- The contract has been terminated, and the consideration received from the customer is nonrefundable.
- The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable
Lastly, updating internal control processes to reflect management’s revised consideration of collectability in light of the coronavirus, is something management should consider as part of maintaining effective internal controls, and likely an item external auditors would expect to see. The absence of such a reconsideration may be indicative of a potential internal control deficiency, in addition to the potential revenue recognition issues discussed above.
Variable consideration, as part of the transaction price defined in Step 3, is another area that may be affected by the coronavirus.
Explicit variable consideration can be identified by the terms of the contract. These include terms that have historically been viewed as contingent, such as performance bonuses based on meeting certain standards of quality, timing or milestones, or rights of return.
Implicit variable consideration can arise from implied terms of the contract, such as a price concession. A price concession is an adjustment to a contractual or agreed-upon price for a good or service such as a discount, rebate, refund or credit.
A price concession causes the consideration in the contract to be variable when an entity expects to accept or receive less than the agreed-upon price for a good or service because one of these two conditions are met:
- The customer has a valid expectation that the entity will accept a price concession (this may be due to customary business practices, policies or statements made by an entity), or
- The entity intended to offer a price concession when it entered into the contract.
If either of the conditions discussed above exists, then the price concession is a form of variable consideration that is estimated and included as a component of the transaction price (Step 3). Variable consideration is also constrained to the extent that a future revenue reversal would not occur. In other words, consideration that is variable, is only recognized to the extent that it is probable that the revenue would not reverse in future.
Variable consideration and the constraint is estimated at the contract inception, and should be reassessed at subsequent reporting dates as needed. The negative impacts of the pandemic on estimates of volume discounts, returns, rebates, and refunds may require companies to update their previous estimates, including the amounts that may be constrained, to represent faithfully the circumstances present at the end of the reporting period and the changes in circumstances during the reporting period. The impact on some forms of variable consideration may reduce revenues recognized, for instance an increased likelihood of returns.
Oddly, other impacts may increase revenues recognized thus far in 2020. For instance, an entity may conclude it is now probable that a customer will not purchase a sufficient volume to achieve a volume discount and will recognize the amount of revenue that was previously deferred from purchases made earlier in 2020.
The negative impacts of the pandemic could also affect the entity’s or its customers’ ability to perform. Variable consideration and the constraint related to realization of performance bonuses, or other performance-based amounts, may also require adjustment.
Finally, in light of the circumstances, management may be more open to granting price concessions that would cause the consideration in the contract to be variable. This type of variable consideration should be considered when determining the transaction price in Step 3.
Lastly, with respect to revenue recognized over time as determined in Step 5, the pandemic may affect the period and or pattern over which to record the revenue.
The coronavirus and social distancing measures forced many companies that sell season passes, gift cards or memberships like theme parks, restaurants or gyms to close temporarily. Entities in these scenarios would need to reconsider the pattern of recognition from these types of arrangements, including breakage, now that their operations are temporarily suspended, and determine the impacts of potentially cancelling or deferring memberships and issuing refunds. For example, a health club that charges annual dues may have extended the period of time the annual dues will be applied to due to temporary closures of the facility, the result modification to contract would cause a cumulative catch-up in order to update the estimates of the amount of revenue that should be recognized through the reporting date.
The coronavirus may also hinder access to supplies and labor, which in turn could affect the timing of revenue in a scenario where inputs are utilized as a measure of progress for revenue recognition. For example, if labor and building materials are delayed or more expensive for a construction entity to obtain, it may impact the total expected costs and measurement of progress that drives revenue recognition.
How to Assess COVID-19 Impact Moving Forward
The discussion of potential revenue recognition COVID-19 effects above is not intended to be all-inclusive; rather, our assessment is intended to highlight some of the issues that may need to be addressed in a company’s consideration of the consequences of COVID-19 on the 5-step process prescribed by ASC Topic 606. Management should carefully consider all aspects of the 5-step process applicable to their specific facts and circumstances, and may find additional areas that require consideration.
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