What Is a Contract Asset in Financial Reporting?

The introduction of Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, altered how companies report revenue. This standard established a framework that affects nearly every industry, changing the timing and presentation of revenue in financial statements. A key concept of this guidance is the contract asset, which arises from the five-step model of revenue recognition. This term accounts for performance that has been delivered to a customer before an unconditional right to payment exists.

Defining a Contract Asset

A contract asset represents a company’s right to payment for goods or services that it has already transferred to a customer. This right, however, is conditional on something other than the mere passage of time. The condition could be the completion of another distinct service, the delivery of a final product, or meeting a specific project milestone outlined in the customer contract. A contract asset is recorded when a company has recognized revenue for satisfying a performance obligation, but it does not yet have an unconditional right to invoice the customer.

This situation frequently occurs in long-term projects. For instance, consider a technology firm contracted to deliver a customized software system in two phases. The first phase is developing the core platform, and the second is implementing a specialized analytics module. The contract stipulates that the total fee is due only after both phases are complete.

After the firm successfully develops and transfers the core platform, it has satisfied a performance obligation and can recognize the revenue associated with that phase. Since payment is conditional on the future delivery of the analytics module, the company records a contract asset. This asset signifies that the company has earned a portion of the contract’s value and has a right to that payment once the remaining conditions are met.

The Distinction from Accounts Receivable

In contrast to a contract asset’s conditional nature, an accounts receivable represents an unconditional right to consideration. An unconditional right means that only the passage of time is needed before the payment becomes due. When a company issues an invoice with terms such as “net 30 days,” the only remaining condition is for those 30 days to pass, creating an accounts receivable.

To illustrate the transition, let’s return to the technology firm example. The firm has a contract asset on its books after delivering the core software platform. Once the firm completes the second phase by implementing the analytics module, the final condition of the contract has been met. At this moment, the right to payment becomes unconditional.

The company can now invoice the customer for the full contract amount. The firm would then reclassify the amount previously held as a contract asset into an accounts receivable. This accounting entry reflects that the nature of the asset has changed from a conditional right to an unconditional one.

Recognition and Measurement

A contract asset is initially recognized when a company satisfies a performance obligation before the customer pays or before payment is due. Its initial measurement is based on the transaction price allocated to the completed performance obligation. The amount recognized as a contract asset reflects the revenue earned for the work performed to date.

After initial recognition, a contract asset is subject to impairment testing. The guidance for assessing credit losses for both contract assets and accounts receivable is governed by ASC Topic 326. This standard requires companies to estimate and account for expected credit losses over the life of the asset, using the Current Expected Credit Losses (CECL) model. If a company determines that it is not probable it will collect the consideration it is entitled to, it must record an impairment loss.

Financial Statement Presentation

On the balance sheet, contract assets must be presented separately from accounts receivable. This presentation provides users with a clearer understanding of the nature of a company’s rights to consideration. The classification of a contract asset as either current or non-current depends on when the company expects the right to payment to become unconditional. If the remaining conditions are expected to be met within one year or the company’s normal operating cycle, the asset is classified as current; otherwise, it is non-current.

The notes to the financial statements must provide additional qualitative and quantitative information about contract assets. The accounting guidance requires companies to disclose the opening and closing balances of their contract assets for the reporting period. Companies must also provide an explanation of the significant changes in the contract asset balance, detailing how it was affected by performance, impairments, or reclassifications to receivables.

These disclosures help investors understand the judgments made by management. The notes should clarify the nature of the performance obligations that give rise to contract assets and the expected timing of when these assets will be converted into receivables.