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Identifying the contract – The first step in recognizing revenue · PwC's accounting podcast

0:00
SPEAKER_00: Thought leadership from PWC's National Office.
0:06
SPEAKER_01: Welcome to PWC's Accounting Podcast.
0:10
SPEAKER_01: I'm Heather Horn.
0:11
SPEAKER_01: Today we're back to continue our revenue series covering the first step of applying the revenue standard, which is to identify the contract.
0:20
SPEAKER_01: Now, that may sound simple enough, but as you'll learn in today's episode, it's not always as straightforward as it may seem.
0:28
SPEAKER_01: And this is an area where we get a lot of questions.
0:32
SPEAKER_02: It's step one, technically, of the model, but it does inform a bunch of the other steps.
0:37
SPEAKER_02: So it's not like this linear process, right?
0:40
SPEAKER_02: You're often, when you're getting to those other steps of like, what's the transaction price?
0:44
SPEAKER_02: I'm cycling back to what's the contract.
0:46
SPEAKER_02: What are my performance obligations?
0:47
SPEAKER_02: I'm cycling back to, you know, what's what did I identify as the contract.
0:53
SPEAKER_02: Even when I get to disclosures, right?
0:55
SPEAKER_02: When I think about the unsatisfied performance obligations, I've got to cycle back to sort of the contract.
1:01
SPEAKER_02: So yeah, it's maybe sometimes initially straightforward, but it does inform a lot of the downstream decisions you have to make.
1:13
SPEAKER_01: That was Pat Durbin, a deputy chief accountant in PWC's national office, who's joined by Mike Coleman, a partner in the national office.
1:21
SPEAKER_01: They both specialize in accounting for revenue transactions and will walk us through the accounting, helping to break it all down.
1:28
SPEAKER_01: Let's get the conversation started.
1:30
SPEAKER_01: So, Pat Mike, welcome back to the podcast.
1:33
SPEAKER_01: So nice to be kicking off our month of revenue uh episodes.
1:38
SPEAKER_01: And specifically today, we're going to start in a good place, which is at the beginning, identifying the contract.
1:43
SPEAKER_01: So, Pat, before we jump in, why this topic?
1:47
SPEAKER_02: Well, I think you teed it up great, Heather.
1:49
SPEAKER_02: It really is kind of the place we need to start because it set sort of sets the foundation for applying the rest of the model.
1:56
SPEAKER_02: Really, if you don't properly identify the contract, identify when and what rights and obligations the parties have, you're not going to get the rest of the model right.
2:08
SPEAKER_02: So on the one hand, what's the contract?
2:11
SPEAKER_02: We talk a lot about reading the final contract.
2:13
SPEAKER_02: Sounds like it's pretty easy, this one thing, I'll just find the contract and we'll be all set.
2:18
SPEAKER_02: Um, it's not uh, as you might expect, that that simple.
2:21
SPEAKER_02: Um so we'll focus on some of those key concepts, like when do the parties really have enforceable rights and obligations?
2:28
SPEAKER_02: And there can be things where they're actually legal contracts, but they're not really yet sort of in their fully enforceable phase.
2:37
SPEAKER_02: You know, they're sort of a framework agreement.
2:40
SPEAKER_02: You have to assess whether you actually believe you're going to be paid the consideration that the contract says you're entitled to.
2:46
SPEAKER_02: That's a key criterion for accounting purposes in the identification of the contract.
2:52
SPEAKER_02: And then the other thing is identifying the contract term, which again, for accounting purposes, may be different than just the literal term specified in the contract, depending on cancellation, termination provisions, or renewal rights or options.
3:08
SPEAKER_02: So if you don't really get the contract right, you're going to be lost getting through the rest of the model.
3:13
SPEAKER_01: All right.
3:13
SPEAKER_01: And I'll just also give a little bit of context here for our listeners, and you should know this, but this is our year of the guides.
3:19
SPEAKER_01: And so revenue is no surprise, one of our most popular guides.
3:23
SPEAKER_01: And so we're diving in this month to some revenue topics.
3:26
SPEAKER_01: So thanks for that background and completely agree.
3:29
SPEAKER_01: I feel like a lot of the topics we've been hitting, starting with the contract, I think is always good advice.
3:34
SPEAKER_01: So, or understanding the contractual arrangements.
3:37
SPEAKER_01: But Mike, with that said, where should companies really sort of enter their 606 accounting?
3:45
SPEAKER_03: Sure.
3:45
SPEAKER_03: So let me set the stage.
3:46
SPEAKER_03: I'll I'll quickly cover the requirements to have a contract to be accounted for in the scope of 606.
3:54
SPEAKER_03: Now, the reason I use those particular words to be accounted for is because this isn't a debate solely about whether a legally enforceable arrangement exists.
4:04
SPEAKER_03: It's whether one exists and it has the right elements to begin the revenue accounting.
4:10
SPEAKER_01: All right.
4:10
SPEAKER_01: And so given that we are accountants and we're not lawyers, I know that we need to focus in on sort of certain elements of the contract and not just sort of legal existence, which I think is important.
4:21
SPEAKER_01: But what are those elements that we should focus on then?
4:24
SPEAKER_03: Aaron Powell Sure.
4:24
SPEAKER_03: So having said that, so the definition of a contract is an agreement between two or more parties that creates enforceable rights and obligations.
4:33
SPEAKER_03: The enforceable rights and obligations is a legal concept, and we are focused on what's legally enforceable.
4:40
SPEAKER_03: So we aren't avoiding the legalities, we're just focusing on what those rights and obligations are and whether they contain the elements needed to start the revenue accounting.
4:49
SPEAKER_03: So there are five general things that we look for.
4:53
SPEAKER_03: First is the parties to the contract have approved the contract and are committed to perform their respective obligations.
5:01
SPEAKER_03: Now the approval doesn't have to be signed.
5:03
SPEAKER_03: It can be written or oral, it could be customary business practices, but you want to have approval by the parties and their commitment to perform their obligations.
5:13
SPEAKER_01: So, Mike, before we go on, maybe my auditor's hat is rearing its head a little here, but orally seems very difficult then, even from an enforceability perspective, much less an audit perspective.
5:25
SPEAKER_01: So just curious, I mean, I I know that's in there, but is that typically I assume we would look to something to be in writing?
5:31
SPEAKER_03: Aaron Powell Yeah, tip typically we would, right?
5:34
SPEAKER_03: But we have to recognize that laws allow oral arrangements and we enter into them all the time.
5:41
SPEAKER_03: So when I go and buy my cup of coffee and get a latte, I've entered into orally.
5:45
SPEAKER_03: I've told them here's what I want.
5:47
SPEAKER_03: I've committed to buy it, they've ready to perform their obligations, and they hand it to me.
5:52
SPEAKER_01: Okay, in five minutes normally, though.
5:57
SPEAKER_01: It's pretty easy for you to go back to the barista and say, Where's my latte?
6:02
SPEAKER_03: Yeah.
6:03
SPEAKER_03: So we just recognize that there are certain circumstances where there isn't a written contract.
6:08
SPEAKER_03: There are oral arrangements that happen.
6:10
SPEAKER_03: There's evidence afterwards, i.e., there's some receipt or payment slip and stub to be able to account for.
6:16
SPEAKER_03: So we don't want to the the accounting model isn't designed to say you have to have a written arrangement before something happens to to in order to do the accounting, because that's not the case in all cases.
6:27
SPEAKER_01: Yeah, so you're saying that's not necessarily realistic, but then maybe there'll be other evidence that you're looking at.
6:32
SPEAKER_03: And there are other cases where you'll have companies that can take a verbal order via phone.
6:37
SPEAKER_03: You call them up and they make a verbal order.
6:39
SPEAKER_03: You go book a your flight arrangements and you do it online or you call it.
6:45
SPEAKER_03: Okay, so you have a lot of examples.
6:46
SPEAKER_03: Right.
6:46
SPEAKER_03: So we have examples of them, so there you you do have it, but eventually there is some contract that's there.
6:53
SPEAKER_03: Most of the times it's in writing and signed.
6:55
SPEAKER_01: Okay.
6:56
SPEAKER_01: So that's you said five criteria, and I interrupted you.
6:58
SPEAKER_01: That's okay.
6:59
SPEAKER_03: That's that's the first one.
7:00
SPEAKER_03: Um so then uh the the second one would be does that arrangement identify the party's rights, each party's rights and obligations related to the goods and services being transferred?
7:12
SPEAKER_03: The next one is can the entity identify the payment terms for the goods and services?
7:17
SPEAKER_01: So again, both of these easier if it's in writing, rather than the other.
7:20
SPEAKER_01: Yes, absolutely.
7:22
SPEAKER_03: Absolutely.
7:22
SPEAKER_03: Uh the contract has commercial substance.
7:25
SPEAKER_03: Um that is the risk, the timing or amount of the future cash flows is gonna change as a result of the transaction.
7:34
SPEAKER_03: And that's getting to you know, making sure we're not having round-trip transactions or we're not entering into some arrangement which really doesn't do anything, but we want to record revenue for it, right?
7:45
SPEAKER_03: So the idea of having commercial substance is important.
7:49
SPEAKER_03: And then the last one is it's probable the entity is gonna collect substantially all the consideration uh for which it'll be entitled to for the exchange of goods and services that'll be transferred to the customer.
8:01
SPEAKER_03: So is it probable I'm gonna get all the money?
8:03
SPEAKER_01: And that issue I have dealt with with Pat on a few items, so I know that it's not as straightforward as it may seem up front.
8:09
SPEAKER_01: And I always think that point is interesting.
8:11
SPEAKER_01: I know we'll get to it that people think of that as being like a bad debt issue, but actually the fact it can impact revenue recognition is I really do think an important point to focus on.
8:21
SPEAKER_01: Yes.
8:22
SPEAKER_01: Yes.
8:22
SPEAKER_01: All right.
8:22
SPEAKER_01: So with all that said then, I think it's you know, we were very clear there that you can have a contract, but you have to have these points in order to, you know, fall into this definition for accounting purposes.
8:34
SPEAKER_01: And so, Pat, then what if you do have a contract, but you don't meet all those criteria?
8:39
SPEAKER_02: Yeah, and I think it's probably worth just reinforcing again, like we're talking about a contract, which sounds like a legal term.
8:48
SPEAKER_02: Accountants are not lawyers, right?
8:50
SPEAKER_02: We're not asking accountants to practice law.
8:53
SPEAKER_02: Sometimes you will need the help of lawyers, you know, inside the company to really understand what the contract is, but we're it's also important that we're talking about what is the contract for accounting purposes.
9:06
SPEAKER_02: So there are these other considerations, which may not be critical elements of for all of the legal purposes, but they are critical elements for accounting purpose.
9:17
SPEAKER_02: So it's just sort of that tension of like, hey, wait a minute, do I does all this have to all this stuff have to be kind of part of the legal contract, or what about things that are in the legal contract?
9:26
SPEAKER_02: Are they part of the accounting contract?
9:28
SPEAKER_02: There is a little bit of, you know, it's not a complete one-to-one relationship.
9:32
SPEAKER_02: So I think it's just important to kind of you know remind people of that.
9:35
SPEAKER_02: You've got to really think about what are the key elements for accounting and how they drive the accounting, which may not be exactly the same as if you asked a lawyer, hey, what's the legal contract, right?
9:45
SPEAKER_02: So, you know, when we talk about what could be a legal contract then that wouldn't actually give rise to a contract for accounting purposes or a contract that would yet have an accounting consequence, the one classic example we see is what we would call like a master services agreement or kind of a blanket purchase order MSAs, sometimes you hear them referred to as those will set out sort of some framework, terms, and conditions, might set out pricing, but there's oftentimes not actually a commitment yet from the buyer to actually purchase the goods or services.
10:24
SPEAKER_02: You know, this sort of sets out a framework agreement, but until an actual purchase order is issued by the customer for a specific purchase, you don't have a revenue contract.
10:34
SPEAKER_02: You see this oftentimes in some sort of a long-term supply agreement, and then there'll just be separate purchase orders for each of the individual purchases.
10:43
SPEAKER_02: So until you have one of those individual purchase orders, you don't have a contract to account for.
10:48
SPEAKER_02: That gets back to this concept of really having enforceable rights and obligations.
10:54
SPEAKER_02: So we've set on an agreement here, but until I commit to purchasing a good, I as the seller don't really have an ability to enforce those on the buyer, right?
11:02
SPEAKER_02: I can't say you must buy these things.
11:04
SPEAKER_02: Now, sometimes we might have minimum commitments and we could talk a little bit about that, but in just sort of a basic here's a you know period of time and some pricing until somebody says I want to buy X number of things, I don't have an enforceable contract.
11:18
SPEAKER_01: Yeah, although it's interesting, there's a fine line here, or maybe not too fine, but between this and then like a derivative put or call contract, because I'm just thinking of commodities.
11:29
SPEAKER_01: If you said, if you and I agree, oh, we have this master agreement, but there is a price in there, and I can buy either a minimum or up to a certain amount, then you can bump into derivative counting.
11:39
SPEAKER_01: I know this is a good thing.
11:40
SPEAKER_02: Don't go to the dark side on how to.
11:42
SPEAKER_01: Sorry, sorry.
11:43
SPEAKER_01: As soon as you started talking about that, that was the first thing to came to mind.
11:46
SPEAKER_02: We live in the comfortable space of the normal purchase, normal sale, etc.
11:50
SPEAKER_01: All right, all right, fair enough.
11:51
SPEAKER_01: But just for our listeners' benefit, you could run into derivative accounting, just keep that in mind.
11:56
SPEAKER_01: But with that said, maybe we should, assuming it's not a derivative, and that will be the case for this entire podcast.
12:02
SPEAKER_01: Pat, what does happen then when you have these minimums in these MSAs?
12:07
SPEAKER_02: So if you have these minimum commitments, then you potentially are in a situation where you do have some accounting to think about.
12:14
SPEAKER_02: Now the challenge might be, well, okay, I have a minimum commitment, but I still don't know how many.
12:19
SPEAKER_02: So now I have to think about, okay, well, what is that total consideration I'd be entitled to for that quote unquote minimum commitment, then I need to make an estimate of how many items do I think they're going to buy.
12:31
SPEAKER_02: But ultimately, unless I've been paid in advance, which many times there won't be, it'd be sort of more of a catch-up payment.
12:38
SPEAKER_02: I still don't have any accounting to do.
12:40
SPEAKER_02: Because remember, under the revenue standard, we only account for revenue when we perform.
12:45
SPEAKER_02: So until again, they order a good or service from me, I don't have revenue to recognize.
12:51
SPEAKER_02: So even if I have to estimate the total purchases because of this minimum commitment, until I deliver one item, I don't have any accounting to do.
13:01
SPEAKER_01: All right.
13:01
SPEAKER_01: I think that's helpful.
13:02
SPEAKER_01: How about, though, if you have other types of contract clauses in there?
13:08
SPEAKER_01: So termination penalties or otherwise.
13:10
SPEAKER_01: Like how do you think about some of those things?
13:12
SPEAKER_02: Aaron Powell So those are all potentially elements of variable consideration or could affect my estimate of how many goods I'm going to deliver, how much consideration am I ultimately going to be entitled to.
13:25
SPEAKER_02: So I do need to think about those things.
13:27
SPEAKER_02: And so I think it's important to maybe separate what those things are called from really what the accounting implications are, because a minimum commitment versus a termination penalty versus some sort of penalty for ordering too few.
13:42
SPEAKER_02: Like all those things can kind of have the same implication.
13:45
SPEAKER_02: They just may be framed or described differently in the contract.
13:49
SPEAKER_01: Well, and I think, Pat, that actually goes back to a question I had jotted down when you were talking about sort of the difference between like an accounting interpretation and legal interpretation.
13:58
SPEAKER_01: Obviously, we do need to focus on accounting, but I know from experience that the legal often does get involved as we're looking at these various clauses.
14:07
SPEAKER_01: So how do you sort of navigate from your experience between dealing with attorneys who are saying this is how you should interpret it, and then what you're looking for from an accounting perspective?
14:20
SPEAKER_02: So I think the legal perspective will be relevant in identifying what truly are the rights and obligations of the parties, right?
14:29
SPEAKER_02: It's just that sometimes, again, sort of in the fully executory model of these framework agreements, like we haven't hit the trigger for doing accounting yet, even though we have the legal contract.
14:41
SPEAKER_02: Or we might say there are some contractual terms that we need to account for that aren't specifically specified or laid out in the contract.
14:53
SPEAKER_02: So we might need some help in the combination of either the oral agreements, the totality of the arrangement with the customer, the relationship, the understanding, you know, maybe by virtue of our past practice, we've created an implied contractual obligation.
15:10
SPEAKER_02: So all of those things kind of come into play.
15:13
SPEAKER_02: So it's I would say there's no like specific algorithm that says, okay, go do these five things and you'll know the contract.
15:21
SPEAKER_02: So there's a little bit of you have to navigate both sides of it, sort of the what's important for the accounting as well as what legally do we think is formally there, and just sort of try to find the the right combination of those factors to get you to what the accounting contract is.
15:37
SPEAKER_01: Yeah, so our message is not saying, oh, this is not a legal question at all.
15:41
SPEAKER_01: It's just saying you could have a legal contract, you don't have accounting yet, and that maybe we are looking for different things from an accounting perspective than what an attorney may be focused on.
15:51
SPEAKER_01: Is that a fair summary?
15:53
SPEAKER_01: Okay, and I do think your point on back to Mike's oral agreements, that's where the attorneys definitely could be helpful in in what has or has not been committed.
16:02
SPEAKER_01: So then with that said, then I want to come back to something that I weighed in on before, which is this question of collectability and specifically then the judgment involved in assessing whether um collecting the consideration is probable.
16:17
SPEAKER_01: So, Mike, what are your perspectives on that?
16:20
SPEAKER_03: So most accountants know of you know probable having that special meaning and gap of you know being defined as future events or events are likely to occur.
16:32
SPEAKER_03: Um in practice, that's considered everybody focuses on the likelihood.
16:36
SPEAKER_03: How much likelihood do you need to have?
16:38
SPEAKER_03: And in general, it's considered around 75 percent.
16:41
SPEAKER_03: But let's be clear, it's not codified anywhere, and this podcast is not a codification either.
16:48
SPEAKER_03: But so it's ultimately in a a judgment, but practice around probable is about 75 percent likelihood.
16:54
SPEAKER_01: Aaron Powell Yes, although I will point out that in my time at the national office, this has gone from 75 to 80 percent.
17:00
SPEAKER_01: So I feel like now we say 75 percent because I guess people looked at that.
17:04
SPEAKER_01: I don't know.
17:05
SPEAKER_01: Pat, you and I have talked about this before.
17:07
SPEAKER_02: So I I think depending on who you talk to, some might say it's somewhere between 70 and 80, but at the end of the day, like it's not something you can actually really quantify anyway.
17:16
SPEAKER_02: Fair enough.
17:17
SPEAKER_02: At least I I can't.
17:18
SPEAKER_02: Maybe there's some uh fancy computer game theory out there that could do it, but I I can't do it.
17:23
SPEAKER_01: Yeah, so 75 is reasonable.
17:26
SPEAKER_01: It's it's more than likely, but not a hundred percent.
17:30
SPEAKER_01: So all right, so keep going, Mike.
17:32
SPEAKER_03: Right.
17:32
SPEAKER_03: So then when we're assessing from a revenue perspective, whether it's probable we're gonna collect the consideration, we're really focused on whether the customer has both the intent and ability to pay the agreed upon contractual consideration.
17:47
SPEAKER_03: Okay.
17:48
SPEAKER_03: Without the intent and ability, there is no valid revenue contract for accounting purposes, and then no revenue would be recognized or we wouldn't do the accounting.
17:57
SPEAKER_03: Okay, so that intent and ability sort of has two pieces to it.
18:03
SPEAKER_03: Um the ability side is generally whether they have the wherewithal to pay, and oftentimes companies will try to figure that out with either a credit check or some type of financial review or even past practice will give us some indication.
18:22
SPEAKER_03: Um the intent to pay gets a little more tricky because often companies will have the intent to pay.
18:28
SPEAKER_03: It's always hard to figure out what their intent is.
18:31
SPEAKER_03: And then it's even harder if they wind up not paying.
18:36
SPEAKER_03: And we'll get into that a little in in a bit.
18:39
SPEAKER_03: Um, but also what winds up happening is we'll look to see if there's sort of any mitigation that the company has to be able to withhold the goods before they get paid or things like that to help with the ability and intent.
18:54
SPEAKER_03: Um, although we recognize certain industries, you just can't do that.
18:58
SPEAKER_01: Aaron Powell Yeah.
18:58
SPEAKER_01: And I think that you know the issue that I've previously dealt with Pat, I think a few times on, unfortunately, is then when you have a customer that, for example, goes into bankruptcy.
19:08
SPEAKER_01: And so I think that's where people can tend to get tripped up, right?
19:12
SPEAKER_01: Because they had this customer that was paying, but now the customer circumstance have changed.
19:17
SPEAKER_03: Aaron Powell Right.
19:18
SPEAKER_03: And when doing the evaluation of the revenue contract, you're doing this at the outset.
19:23
SPEAKER_03: Do they have the ability and intent at that point in time?
19:27
SPEAKER_03: If there is a change in circumstance later about bankruptcy, that doesn't impact whether you had a good contract at the time.
19:35
SPEAKER_01: Right.
19:35
SPEAKER_01: But then going forward, maybe if it's a continual delivery, et cetera.
19:39
SPEAKER_01: And we have a whole separate episode, so we don't need to go into this.
19:42
SPEAKER_01: But I do think it's an important point because I think sometimes people think, oh, well, I had a good contract.
19:48
SPEAKER_01: So even though three years later they went into bankruptcy and I have three more years of deliveries, you know, there could be questions, right?
19:54
SPEAKER_01: So what are some of the other things you look at that, Mike?
19:58
SPEAKER_03: Yeah.
19:58
SPEAKER_03: So one of one of the real particular issues that we deal with is whether uh the customer has a collectability issue, a wherewithal to pay issue, or whether they're just not paying or the entity has given a concession.
20:13
SPEAKER_03: So oftentimes we'll see entities say, well, I didn't get paid and assume it was a collectability issue and not focus on whether it's a concession issue.
20:25
SPEAKER_03: So let me let me explain that.
20:28
SPEAKER_03: Um oftentimes companies will look at a contract they're entering into with a customer, let's say it's an existing customer, and to determine whether collection is probable, they'll look at past history.
20:39
SPEAKER_03: And let's say that past history says, oh, I only get 50% of the contract value from this customer, does that mean collection is not probable?
20:50
SPEAKER_03: The question is, well, why aren't I getting the whole amount?
20:54
SPEAKER_03: Why am I getting 50%?
20:56
SPEAKER_03: And if it's a notion where at some point the company decides not to exercise all its legal remedies to try and collect, suing, collection agencies, all of those unfriendly, awkward, uncomfortable uh situations to be in with your with your customer.
21:17
SPEAKER_03: Sometimes companies will make the decision, all right, I'm not going to pursue the legal route to get the full amount.
21:24
SPEAKER_03: I'm just gonna, you know, leave it be, let them off the hook, so to speak, and not force them to pay their AR.
21:32
SPEAKER_03: That action is essentially the customer or the company granting the customer a concession, right?
21:38
SPEAKER_03: The concession aspect is done when we're measuring the arrangement consideration.
21:43
SPEAKER_03: So for this customer, it would be more of a circumstance to say you've got the transaction price.
21:49
SPEAKER_03: Is it likely you're going to grant a concession?
21:52
SPEAKER_03: That would reduce the transaction price.
21:54
SPEAKER_03: And then once I've factored into what likely concessions I may give, then I assess.
22:00
SPEAKER_03: Is it probable I'm going to collect after I've given the concessions?
22:04
SPEAKER_02: So to come back to your example in that case, if I really only expect I'm ever going to force them to pay the 50%, I'm doing that assessment of am I going to get 50%?
22:13
SPEAKER_02: Not, hey, I'm not going to get 100%, so collection is not probable.
22:17
SPEAKER_02: Correct.
22:17
SPEAKER_02: Correct.
22:18
SPEAKER_01: Trevor Burrus And is that concession analysis then based just on your history with that customer or similar types of customers, or how broad do you need to look when you're thinking about that?
22:29
SPEAKER_03: Yes, yes, and yes.
22:30
SPEAKER_03: It's all it's all the going to be what the circumstance is.
22:34
SPEAKER_03: So often it's that customer's is a powerful tool to look, because a lot of times you're going to behave differently with one customer than another, especially depending upon the class customer, the size of business you do with that customer.
22:50
SPEAKER_03: You can have circumstances where it's a new customer and a new geography, so you'll be more willing to let them go on certain things.
22:58
SPEAKER_03: You can be in certain industries that'll have a propensity to renegotiate a rate, but then later there's some adjudication review process where the rate goes lower and you know that's going to happen.
23:11
SPEAKER_03: So it all depends upon the facts and circumstances of where you're going.
23:15
SPEAKER_03: You want to consider all of that in making your assessment.
23:18
SPEAKER_01: Aaron Powell All right.
23:19
SPEAKER_01: So then the key here, though, is that this is a crucial step that companies should be taking.
23:23
SPEAKER_01: It's not just an after the fact.
23:25
SPEAKER_03: That's right.
23:26
SPEAKER_01: And then what are the implications then, Pat, if you conclude it's not probable?
23:30
SPEAKER_01: So it's not this concession case.
23:32
SPEAKER_01: It's actually not probable.
23:33
SPEAKER_02: Aaron Powell, so as we set up at the beginning, it is one of the criteria for having a contract for accounting purposes.
23:39
SPEAKER_02: So if your conclusion is it's not probable that I'm going to collect everything that I believe I'm entitled to for delivering the good or service, I don't have a contract for accounting purposes.
23:49
SPEAKER_02: That's kind of interesting because sometimes I might actually start doing some things, I might actually get some payment, you know, just some maybe progress payment, maybe it's a deposit because the customer in question has a pretty sketchy credit rating.
24:05
SPEAKER_02: But if I haven't gotten to that point where I think collection is probable, I don't have a revenue contract to account for.
24:10
SPEAKER_02: Now I would continue to reassess that each period, but until the point at which I have a revenue contract, I can't recognize the revenue even if I'm receiving the cash.
24:20
SPEAKER_02: And when I'm performing, you know, I guess I'm sort of building up some potential right to payment, but I can't recognize the revenue, right?
24:30
SPEAKER_02: So that's I think the tension in this model.
24:34
SPEAKER_02: Now, to be fair, how often does that happen?
24:36
SPEAKER_02: Mike talked about some of the mitigating circumstances.
24:39
SPEAKER_02: Like, look, if I don't think I'm gonna get paid, why am I performing?
24:42
SPEAKER_02: But there are some arrangements where you you have to do that, right?
24:46
SPEAKER_02: So like utilities, I know you come from that world, like you might have to continue to deliver even if you don't believe a customer can pay.
24:52
SPEAKER_02: Happens in the healthcare space too.
24:54
SPEAKER_02: Now, healthcare is a little bit more interesting because you get into this whole price concession model where you know there are probably a lot of different people that are involved that are going to pay something less than the stated amount.
25:07
SPEAKER_02: So I'm probably going to get something, just not everything.
25:09
SPEAKER_02: So I think in most cases you conclude that, you know, I just have a whole bunch of implicit price concessions, but you know, there's some collection that's probable at the end of the day.
25:18
SPEAKER_02: So, you know, it I wouldn't say it comes up all the time, but I think it's important to just understand that until you get to that conclusion that you have a contract, you can't recognize the revenue.
25:28
SPEAKER_02: And importantly, just getting the cash isn't the same as saying, well, I'm just going to go to cash basis, right?
25:34
SPEAKER_02: That means I got something, but if I still didn't get everything that I expect to be entitled to, I'm not in a probable of collection mode, so I'm still not yet at a point where I can recognize the revenue.
25:45
SPEAKER_01: Aaron Powell Well, and I think, Pat, this is the point that is confusing that you have the money in hand, and then to say, I still can't recognize the revenue.
25:54
SPEAKER_01: So what do you do in that case then?
25:56
SPEAKER_02: Aaron Powell You just put it on the balance sheet as sort of a deposit.
25:59
SPEAKER_01: Aaron Powell And then at what point do you conclude, okay, I can recognize this?
26:03
SPEAKER_02: Aaron Powell Well, it's back to all these same judgments.
26:05
SPEAKER_02: I mean, if there's some change in circumstances, I mean, I guess if I got all the cash that the was the state of contract price, then that would be different, right?
26:13
SPEAKER_02: If but just having sort of a deposit and I'm still going to do a whole bunch of additional work that I don't expect to be paid for.
26:20
SPEAKER_02: Again, it's a theoretical outcome, probably more than we see it very often in practice.
26:25
SPEAKER_02: But I think it's just important to understand that the notion is you're looking at it in the context of the whole contract, and do I expect I'm going to get paid?
26:34
SPEAKER_02: Is there an implicit price concession?
26:36
SPEAKER_02: You know, so maybe that's the other angle you take.
26:39
SPEAKER_02: So I think we just try to disabuse people of the notion that it's just purely cash basis because it it technically isn't.
26:46
SPEAKER_01: And I guess the point there, and again, then we can move on, is that if you got cash, some cash, but then you still have performance obligations, you can't just recognize that cash for what you've already done and then ignore everything that's still to come, is is the point theory there.
27:02
SPEAKER_01: Okay.
27:02
SPEAKER_01: That's actually helpful to kind of give that context because otherwise it's like I have the money.
27:06
SPEAKER_00: Yep.
27:06
SPEAKER_01: Feels like I should recognize it.
27:08
SPEAKER_01: So then the next point then is contract term.
27:11
SPEAKER_01: And that's another point we talked about, and obviously important in this model, but how do we think about it and and why is this so critical?
27:20
SPEAKER_01: Sure.
27:20
SPEAKER_03: So contract term is the period for which the parties have enforceable rights and obligations, and it can have a fairly big impact on how you apply the model.
27:30
SPEAKER_03: Best to walk through an example.
27:32
SPEAKER_03: So let's say a company signs a two-year contract to provide services, but the customer can cancel at the end of each month without compensating the company, meaning that there's no penalty for terminating the contract early.
27:46
SPEAKER_03: So in that case, even though the stated term is two years, if the customer can walk at every after every month, the only enforceable rights and obligations are for that month.
27:58
SPEAKER_03: So that's the period the customer is committed.
28:02
SPEAKER_03: So this is essentially the same as a month-to-month contract, a one-month contract with the option to renew each month.
28:09
SPEAKER_03: Yeah.
28:10
SPEAKER_03: So, okay, so if you have a contract that's two years versus a contract that's one month, how does it impact the rest of the model?
28:20
SPEAKER_03: Well, you'd have to think about if the contract is renewable, is there a material right?
28:27
SPEAKER_03: Like, is there anything of uh that way?
28:30
SPEAKER_03: If you had a contract in that service contract, if let's say there was a good or service that was sold along with like a product that was also sold along with the service, whether the contract is two years or one year is going to have a big impact on measuring the arrangement consideration, because a one-month contract, you would only take one month's worth of service.
28:53
SPEAKER_03: And so that can impact the allocation between the other goods and services in the contract.
28:59
SPEAKER_03: So it it matters a lot whether we have that term or not.
29:03
SPEAKER_03: The other thing is on disclosure.
29:06
SPEAKER_03: So from a disclosure perspective, there's a disclosure requirement for the remaining performance obligations, you know, that backlog disclosure.
29:13
SPEAKER_03: So a lot of companies, oh, I have a two-year contract, I can disclose more backlog, tell my investors I have more coming.
29:19
SPEAKER_03: But if it's a month-to-month contract, you can't take credit for what the customer is not committed for.
29:26
SPEAKER_03: So you'd restrict that backlog disclosure to what the commitment period is.
29:30
SPEAKER_01: Aaron Powell, but then what if I have a point of view that, well, my customer's definitely not going to cancel because I know they need the goods, or for whatever other reason, in my mind, I'm saying no, I'm going to get the two years.
29:42
SPEAKER_03: Does that uh yeah, whether you think they're gonna cancel or not, or whether it's likely they cancel, they always renew.
29:49
SPEAKER_03: Yes.
29:50
SPEAKER_03: That doesn't really matter.
29:51
SPEAKER_03: What focuses is the rights and obligations.
29:53
SPEAKER_03: Can they cancel or not?
29:55
SPEAKER_03: Do they have a penalty?
29:56
unknown: Trevor Burrus, Jr.
29:56
SPEAKER_01: And then the example you gave, even when you were explaining, I'm like, okay, it's fairly obvious that's a one-year contract, but I think it can get tricky, right?
30:04
SPEAKER_01: Well, what if there's some penalty to cancel?
30:07
SPEAKER_01: And what if it's small?
30:08
SPEAKER_01: What if it's big?
30:08
SPEAKER_01: Like, how do you, you know, what do you start doing on that spectrum?
30:11
SPEAKER_03: Aaron Ross Powell, Jr.: Yeah, so if we had that two-year contract, but you had the right to cancel, but there was a substantive penalty.
30:17
SPEAKER_03: And for the audience, I'm using air quotes and it's a substantive penalty.
30:21
SPEAKER_03: In that case, the notion is, well, if the penalty is substantive, that's an indication that the customer really doesn't have the right to cancel.
30:32
SPEAKER_03: That's how the accounting would view it.
30:34
SPEAKER_03: It's substantive, but because of this penalty, it's they're really not going to exercise that.
30:41
SPEAKER_03: It's, you know, remote, they're going to exercise it, so we're going to account for it like a two-year penalty, uh like a two-year contract.
30:48
SPEAKER_03: The question we always get is, well, what's substantive?
30:50
unknown: Exactly.
30:52
SPEAKER_03: That's the question we always get.
30:54
SPEAKER_03: And what we tell folks is, well, there's no particular bright line for guidance in it.
31:00
SPEAKER_03: Um, what I'm often telling folks is, well, from a monetary perspective, uh, I would always say if it's like 5% or less, you probably have a good argument it's not substantive.
31:13
SPEAKER_03: 20% or more, you'll probably have a really strong argument that it's substantive.
31:18
SPEAKER_03: Anywhere between those two numbers, you want to talk to see what the circumstance is.
31:24
SPEAKER_03: And even those aren't really bright lines, but that's sort of like the guidance we give.
31:28
SPEAKER_01: So, Mike, let me jump in here on um your five to twenty percent.
31:33
SPEAKER_01: Sure.
31:33
SPEAKER_01: What are those values in comparison to the whole, like in our example, the whole two years, the one month?
31:40
SPEAKER_03: Um, so in the example we were using, which is the two years with the right to cancel, it'd be in relation to the two-year period.
31:49
SPEAKER_01: That's helpful.
31:49
SPEAKER_01: And then so then, Pat, if we just take a step back and think about this substantive term more broadly, any other sort of qualitative things that you would think about or other factors you would highlight?
32:01
SPEAKER_02: Yeah, I mean, obviously, maybe the first thing is clearly the larger the penalty payment, if we're talking about a payment, um, clearly that's a more likely indication that it's it's substantive.
32:11
SPEAKER_02: But I think as we were alluding to, the penalties don't necessarily always just come in straight monetary form, um, like meaning new cash out the door.
32:21
SPEAKER_02: It might be other things, like maybe we received a discounted purchase.
32:27
SPEAKER_02: So by terminating the contract, we sort of have to give back some of that discount.
32:32
SPEAKER_02: So it's not explicitly stated as a termination payment, but it's sort of like a catch-up on the pricing.
32:38
SPEAKER_02: Importantly, we're focused on the relationship between, in this case, the vendor, probably the company we're doing the revenue accounting for, and their relationship with the customer.
32:48
SPEAKER_02: To the extent that there are other implications to the customer as a result of canceling the contract, we're not factoring those in, right?
32:56
SPEAKER_02: It sort of goes back to the conversation about like assessing the likelihood, even if it's going to be painful for the company to cancel, like that in and of itself wouldn't give rise to a view that, well, there's a significant termination penalty.
33:09
SPEAKER_02: It's really focused on the relationship that we have between those two parties.
33:13
SPEAKER_02: So I think that's that's really the key, is kind of focusing on what contractually will happen in that case.
33:22
SPEAKER_02: Now, the one other example where this can come up is like if I let's say I made an upfront payment and I obtained an asset as part of the arrangement and I have to surrender that asset.
33:33
SPEAKER_02: Sometimes this comes up in like the either in a case of a software license or some other licensed intellectual property.
33:40
SPEAKER_02: If I have to surrender the use of that asset and I don't get my money back, sometimes we would view that as, well, that's also a substantive termination penalty.
33:49
SPEAKER_01: All right, that's helpful.
33:50
SPEAKER_01: So definitely a lot of pieces to think about here.
33:53
SPEAKER_01: So then if I kind of take a big step back from all this and loop back to the very beginning, where we were talking, we're talking about having a contract for accounting purposes as sort of a starting point for revenue accounting and these five elements.
34:07
SPEAKER_01: And just maybe a question for you guys from a practical point of view is this a case where you kind of know you have a contract when you see it, and so it's sort of implied, or we would generally expect that companies are going through these five criteria each time they're starting a revenue accounting process.
34:26
SPEAKER_01: And I know, you know, it's not there's always going to be outliers, but big picture sort of rule of thumb.
34:32
SPEAKER_03: Well my expectation is companies would have a process around each of the indicators.
34:37
SPEAKER_03: So they probably have a credit process, or they probably have a process where they'll use a certain type of contracting.
34:45
SPEAKER_03: And so you can quickly get to if they use our certain type of contracting, it's going to have the product identified.
34:52
SPEAKER_03: We have standard payment terms, we do these types of transactions so we know there's commercial substance.
34:59
SPEAKER_03: It's so so I would I would think in ingrained in the company's control process is probably hitting on most of these, it'll be those nuanced arrangements where there'll be a more fine point on analyzing each of these in a newer type of arrangement.
35:16
SPEAKER_02: Yeah, and some are going to probably inherently require a little bit more thought, even for the routine, than others, right?
35:22
SPEAKER_02: So if you have a standard process for assessing credit, right, okay, that's pretty, pretty obvious.
35:27
SPEAKER_02: Contract term, that's probably one that you're gonna spend a little more time on, just because you might expect there will be some differences in the contractual arrangements.
35:35
SPEAKER_02: The more you have standard contractual terms, like Mike was saying, and it's just gonna be baked into the process, you really just focus on the outliers.
35:43
SPEAKER_02: So, you know, the commercial substance one, again, that's probably one that isn't gonna require a ton of deliberation each time, right?
35:50
SPEAKER_02: I mean, that's more of a there'd be a unique fact pattern where you'd get into that.
35:54
SPEAKER_01: And then I guess my other question is again, if we're thinking of this in the in terms of the whole revenue recognition process, if you think about places where a lot of questions come up, is this identification of whether you have a contract for accounting purposes relatively more straightforward compared to some of the other steps, or each of them have their own issues, so you don't want to pick a favorite one?
36:17
SPEAKER_01: Or uh how do you think about this part of the process?
36:20
SPEAKER_03: So I would say it's straightforward until it's not.
36:23
SPEAKER_03: And I know that sounds weird, but what I would tell companies is the best thing to do with determining whether you have a contract is also very in line with how does the entity protect itself if a contract goes wrong?
36:38
SPEAKER_03: So if the other party was going to claim I didn't have a contract, I didn't do that, what evidence did they have to protect themselves of either getting paid for the asset or service they did or being able to get the asset back or whatever that is?
36:52
SPEAKER_03: Normally it's the contract terms that are clear enough to be able to say, well, this is why I did what I did.
36:59
SPEAKER_03: So if the company protects itself for the circumstance that's odd, normally it'll have the evidence it needs to support the arrangement.
37:09
SPEAKER_03: Trevor Burrus, Jr.
37:09
SPEAKER_01: Yeah, and I guess it goes back to then where the legal can be helpful.
37:12
SPEAKER_01: I don't know.
37:13
SPEAKER_01: Any additional perspective?
37:14
SPEAKER_02: Well, I think it's kind of just it's step one technically of the model, but it does inform a bunch of the other steps.
37:22
SPEAKER_02: So like it's not like this linear process, right?
37:24
SPEAKER_02: You're often, when you're getting to those other steps of like, what's the transaction price?
37:28
SPEAKER_02: I'm cycling back to what's the contract, what are my performance obligations?
37:32
SPEAKER_02: I'm cycling back to you know, what's what did I identify as the contract.
37:38
SPEAKER_02: Even when I get to disclosures, right?
37:40
SPEAKER_02: When I think about the unsatisfied performance obligations, I've got to cycle back to sort of the contract.
37:46
SPEAKER_02: So yeah, it's maybe sometimes initially straightforward, but it does inform a lot of the downstream decisions you have to make.
37:53
SPEAKER_01: Aaron Powell Yeah, it's interesting because I just finished a mini-series on the consolidation models and talking about variable interest entities.
38:00
SPEAKER_01: And it's the exact same that if you don't do all this upfront stuff, then it's gonna make it a lot harder as you go down the road.
38:07
SPEAKER_01: So I think this is a great point.
38:09
SPEAKER_03: Yeah, and to the extent companies can use a standard contract, it makes the evaluation easier.
38:15
SPEAKER_03: That is actually if a company has a different contract for every transaction, it's gonna make it more complicated.
38:21
SPEAKER_03: So that's just a reality of you have to play that that you know ebb and flow of how easy do I want to make it internally and how easy do I want to make it for my my customer?
38:32
SPEAKER_01: Yeah, so it's like the intersection of business practice and accounting.
38:35
SPEAKER_01: All right, well I sort of already asked this with those two questions, but I'll ask anyway, because I like to always end with this.
38:41
SPEAKER_01: But just as you guys think about this step in the revenue process, then what is the key takeaway from for each of you?
38:48
SPEAKER_03: Uh well for me it's always RTFC, which for I know how much Heather likes acronyms uh in in in the podcast, it's read the final contract.
38:58
SPEAKER_03: And so I'm I'm big on that.
39:00
SPEAKER_03: It's uh there's really no sub substitute for that when you're trying to understand what the rights and obligations are.
39:06
SPEAKER_03: You need to actually read the thing that is is signed to make sure we understand that.
39:11
SPEAKER_01: And Pat, have up from your point of view.
39:13
SPEAKER_02: Well, I think I would probably say, in addition to sort of how important this step is and driving all the downstream conclusions, the other thing that um I would probably caution people against is thinking about contract terms that they might view as non-substantive, right?
39:28
SPEAKER_02: We sometimes hear that as we're evaluating the accounting, it's like, well, there's that provision, but we don't intend to enforce it, or it's just kind of in there as sort of a not inconsequential protective right.
39:40
SPEAKER_02: I guess I start from the perspective of most companies are going into business thoughtfully.
39:46
SPEAKER_02: They're getting good legal advice about what to put in writing in their contracts.
39:50
SPEAKER_02: And so I think you have to start with the presumption that if it's in the contract in writing, it's substantive and you need to respect it when you're doing the accounting evaluation.
39:59
SPEAKER_01: Excellent advice.
40:00
SPEAKER_01: All right, well, gentlemen, as always, such a pleasure to talk to you.
40:03
SPEAKER_01: Thanks so much for joining me today.
40:04
SPEAKER_03: Thanks.
40:06
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40:08
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40:28
SPEAKER_01: From Thought Leadership at PwC, I'm Heather Horn.
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40:44
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