Step 1: contract criteria, combination and contract modifications

• Apply the five contract criteria, including the collectibility test as amended by ASU 2016-12
• Account for consideration received before a contract meets the criteria
• Determine when contracts entered into at or near the same time must be combined
• Classify a modification as a separate contract, a prospective change or a cumulative catch-up

The five criteria

Under 606-10-25-1, an entity accounts for a contract with a customer only when all of these are met:

• The parties have approved the contract (in writing, orally or by customary business practice) and are committed to perform.
• The entity can identify each party's rights regarding the goods or services.
• The entity can identify the payment terms.
• The contract has commercial substance: the risk, timing or amount of future cash flows is expected to change as a result of it.
• It is probable that the entity will collect substantially all of the consideration to which it will be entitled for the goods or services that will be transferred.

The collectibility test looks only at the customer's ability and intention to pay when amounts are due. ASU 2016-12 added implementation guidance that the assessment considers the entity's ability to mitigate credit risk, for example by stopping service when the customer does not pay. So a monthly service to a weak customer can pass collectibility if the entity will cut off service after one missed payment: the entity is not exposed to credit risk for services it will never provide.

Collectibility is also separate from price concessions. If the entity expects to accept less than the stated price, the difference is variable consideration (a price concession) in step 3, not a collectibility failure.

When the criteria are not met

If the criteria are not met, the entity keeps reassessing (606-10-25-6). Cash received in the meantime is a liability. As amended by ASU 2016-12, 606-10-25-7 permits revenue for that cash only when one of these occurs:

• the entity has no remaining obligations and has received substantially all of the consideration, which is nonrefundable;
• the contract has been terminated and the consideration received is nonrefundable; or
• the entity has transferred control of the goods or services the cash relates to, has stopped transferring goods or services, has no obligation to transfer more, and the cash is nonrefundable.

Contract term

Topic 606 applies to the period in which the parties have present enforceable rights and obligations. A month-to-month arrangement that either party can cancel without penalty is a one-month contract, renewed each month. Read termination clauses before you count a three-year deal as three years of transaction price.

Combining contracts

Under 606-10-25-9, two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) are combined if any one of these is met:

• they were negotiated as a package with a single commercial objective;
• the consideration in one contract depends on the price or performance of the other; or
• the goods or services in the contracts are a single performance obligation.

Splitting a deal into a cheap "product" contract and an expensive "services" contract signed the same week is the classic pattern this rule catches.

Contract modifications

A modification is a change in scope or price (or both) approved by the parties (606-10-25-10). It can be approved orally or by business practice, and it can exist while price is still being disputed. If scope changed but price has not been agreed, estimate the price change as variable consideration.

The accounting follows a decision path:

1. Separate contract (606-10-25-12). Both conditions: the scope increases by distinct goods or services, and the price increases by an amount that reflects their standalone selling prices (with appropriate adjustments). Account for the add-on as a new contract and leave the original alone.
2. Termination and new contract, prospective (606-10-25-13(a)). If not a separate contract and the remaining goods or services are distinct from those already transferred, treat the original as terminated. Allocate to the remaining performance obligations the sum of consideration not yet recognized plus the consideration added by the modification.
3. Cumulative catch-up (606-10-25-13(b)). If the remaining goods or services are not distinct and form part of a single, partially satisfied performance obligation, update the transaction price and measure of progress and book the adjustment to revenue on the modification date.

Mixed modifications use both treatments. The modification memo template walks this path, and the worked entries guide shows the journal entries.

A mid-term software services modification