ASC 606: Assessing the Collectibility Threshold

The Financial Accounting Standards Board’s (FASB) guidance, ASC 606, “Revenue from Contracts with Customers,” provides a framework for how companies recognize revenue. A key part of applying this standard is determining if an enforceable contract exists with a customer. This judgment hinges on the assessment of collectibility, which confirms the customer is likely to pay for the promised goods or services.

Defining the Collectibility Threshold

The collectibility assessment is a gateway test in Step 1 of the revenue recognition model, “Identify the contract with a customer.” For a contract to be valid under ASC 606, an entity must conclude it is “probable” it will collect substantially all of the consideration. Under U.S. Generally Accepted Accounting Principles (GAAP), “probable” means “likely to occur,” which is often interpreted as a 75% or higher likelihood. This threshold must be met at the contract’s inception.

This initial evaluation of collectibility is distinct from the ongoing accounting for credit losses. The ASC 606 assessment is a forward-looking evaluation to determine if a valid contract exists for revenue recognition purposes. In contrast, the accounting for bad debt, governed by ASC 326, “Financial Instruments—Credit Losses,” addresses the impairment of receivables that have already been recognized. In short, the ASC 606 test determines if revenue can be recognized in the first place, while the ASC 326 analysis accounts for losses on revenue already recorded.

Factors for Assessing Collectibility

At a contract’s inception, a company must assess the customer’s ability and intent to pay. This evaluation requires judgment based on all relevant facts and circumstances. The analysis should focus on the amount the entity expects to be entitled to, which may be less than the contract’s price if price concessions are anticipated.

Factors in this assessment include:

• Customer creditworthiness: This involves a review of the customer’s financial health, which could include analyzing their financial statements, obtaining credit reports from third-party agencies, or reviewing public credit ratings. For a new customer, this might involve looking at their financing commitments.
• Past payment history with the entity: A consistent record of timely payments on previous contracts provides direct evidence to support a conclusion that collection is probable, while a history of defaults would raise doubts.
• The economic environment: A customer in a declining industry or a volatile geographic region may present a higher credit risk, even if their individual financial history is clean. These macroeconomic factors can impact a customer’s ability to meet their obligations.
• The contract’s payment terms: Unusually long payment terms or a structure inconsistent with the entity’s normal business practices might signal an increased risk, especially if designed to accommodate a customer with known financial difficulties.

Accounting When Collectibility Is Not Probable

If an entity determines at the start of an arrangement that collection is not probable, the criteria for a valid contract under ASC 606 are not met. In this situation, the company cannot apply the five-step revenue recognition model, and any cash received from the customer cannot be recognized as revenue.

Instead, the cash received must be recorded on the balance sheet as a liability, often under “Unearned Revenue.” This represents the entity’s obligation to either transfer goods or services or refund the consideration. No revenue is recorded, and a receivable is not recognized if goods or services are transferred, because an accounting contract does not exist.

Revenue can be recognized from these arrangements only under two specific conditions outlined in ASC 606. The first condition is met when the entity has no remaining obligations to transfer goods or services, and substantially all of the promised consideration has been received and is nonrefundable.

The second condition allows for revenue recognition if the contract has been formally terminated and the consideration received is nonrefundable. Until one of these events occurs, the cash remains a liability.

Subsequent Reassessment of Collectibility

The collectibility assessment is not a one-time event. An entity must reassess the criteria if there is a significant change in facts and circumstances, which can alter how a contract is accounted for.

For a contract that initially failed the collectibility test, the customer’s financial situation may improve. If the entity later concludes that collection has become probable, a valid contract is considered to exist from that point forward. The entity would then begin applying the five-step revenue recognition model, and any cash previously recorded as a liability would be recognized as revenue as performance obligations are satisfied.

Alternatively, a contract may pass the initial assessment, but the customer’s ability to pay later deteriorates. This development does not trigger a reversal of revenue that has already been properly recognized, as the initial assessment was valid at the time. Instead, this change in credit risk triggers an impairment analysis of the related receivables under ASC 326. The entity would then record an impairment loss, which is presented separately from revenue.