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Revenue toolkit: Step one—Identify the contract · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC.
• 0:07
  SPEAKER_02: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_02: I'm Heather Horn.
• 0:11
  SPEAKER_02: Today we're launching a brand new series, our 2022 Toolkit Series.
• 0:17
  SPEAKER_02: Each month for the remainder of 2022, my guests and I will do an in-depth examination of a single accounting and reporting topic.
• 0:26
  SPEAKER_02: Think tax or crypto or business combinations or this month revenue.
• 0:32
  SPEAKER_02: We'll recap the basics but focus more on the aspects where we get the most questions or the most judgments required.
• 0:40
  SPEAKER_02: We'll also hit on some of the sleeper issues that companies should be aware of.
• 0:44
  SPEAKER_02: So, as I said, for the month of March, our focus is on revenue.
• 0:48
  SPEAKER_02: Five Tuesdays in March for each of the five steps in the revenue model.
• 0:53
  SPEAKER_02: This week's step one, identifying the contract.
• 0:57
  SPEAKER_03: So I would say that's something to make sure you understand up front is are there cancellation or termination rights in this contract?
• 1:05
  SPEAKER_03: How do they work?
• 1:06
  SPEAKER_03: Are there any related penalties?
• 1:08
  SPEAKER_03: And work through that up front.
• 1:11
  SPEAKER_01: Revenue is really about measuring an entity's performance.
• 1:15
  SPEAKER_01: So what you really want to focus on is what is the obligation of the company to perform?
• 1:21
  SPEAKER_01: What are they doing?
• 1:22
  SPEAKER_02: Angela Ferguson, a PWC National Office partner, will be our tour guide for the month of March, and each week she'll bring along a topic specialist to help with our examination.
• 1:33
  SPEAKER_02: Today she's joined by Pat Durbin, a deputy chief accountant in PWC's national office.
• 1:38
  SPEAKER_02: I'm excited to have them both here with me today to kick off this series.
• 1:43
  SPEAKER_02: And with that, let's get started.
• 1:49
  SPEAKER_02: Today's first day of our new podcast series, and I'm very excited to announce that each month through the rest of 2022, we're going to be covering a different topic.
• 1:58
  SPEAKER_02: And so we thought for our first month, we'd pick everyone's favorite topic, which would be revenue.
• 2:04
  SPEAKER_02: And so for that conversation, I'm very happy to have Pat and Angela with me.
• 2:07
  SPEAKER_02: So thank you for joining me.
• 2:08
  SPEAKER_02: And Angela, just to kick things off, uh maybe give a preview to our listeners of this episode, but even more so why they should keep tuning in for the whole month.
• 2:18
  SPEAKER_03: Sure, Heather.
• 2:19
  SPEAKER_03: And I don't know if it's everyone's favorite topic, but it's definitely my favorite topic, revenue.
• 2:24
  SPEAKER_01: It's going to be quite a letdown for those poor people listening in April, right?
• 2:27
  SPEAKER_01: It's not going to be their favorite topic.
• 2:28
  SPEAKER_02: No, no, I promise we have another good topic plan for April.
• 2:31
  SPEAKER_03: So when we talked about doing a series of podcasts on revenue, and it turned out it would be five podcasts, we thought it was only natural to use the opportunity to cover the five steps in the revenue model.
• 2:45
  SPEAKER_03: So what we are planning is to take each episode and cover one step in the five-step model.
• 2:54
  SPEAKER_03: And we'll, of course, recap the basics, but then talk a bit about where is the most judgment uh required, where do we tend to get the most questions, and also try to highlight a few sleeper issues that companies should be thinking about when they're in this step of the model.
• 3:11
  SPEAKER_03: To quickly run through the five steps, um, today we're gonna start off with step one, which is identify the contract.
• 3:20
  SPEAKER_03: In the second episode, we will cover step two, which is identify the performance obligations.
• 3:26
  SPEAKER_03: This includes assessing the promises in the contract and when goods or services are distinct.
• 3:33
  SPEAKER_03: The third step in the third episode will be determining the transaction price, including things such as variable consideration and payments to customers.
• 3:44
  SPEAKER_03: The fourth step is allocating the transaction price, including standalone selling price and specific guidance on allocating discounts and variable consideration.
• 3:56
  SPEAKER_03: And then the last episode will be step five, which is when we finally get to recognizing revenue.
• 4:03
  SPEAKER_03: So I will plan to join you, Heather, for each of these podcasts, but to mix it up a bit, I will bring a guest along to go into more of the details on each step.
• 4:15
  SPEAKER_03: And I'm definitely looking forward to talking about revenue.
• 4:19
  SPEAKER_03: Uh, but I will say that it's also five opportunities for you to stump the guests.
• 4:25
  SPEAKER_03: So that's another reason, another reason for me to bring a friend along when we get to that part of the podcast.
• 4:31
  SPEAKER_02: All right.
• 4:32
  SPEAKER_02: Well, hopefully I'll be able to stump you.
• 4:34
  SPEAKER_02: But actually, what I'm most looking forward to, Angela, is I feel like we've done so many different episodes on revenue, but always kind of jumping in to sort of different part of the model.
• 4:43
  SPEAKER_02: And so I think it's a great chance to just take a step back and say, okay, let's restart at the beginning, make sure we all kind of understand sort of the keys that we should be following.
• 4:54
  SPEAKER_02: So, with all of that said, step one seems so simple on the surface, um, but clearly is not, since we're gonna have a whole episode, and that would be identifying the contract.
• 5:06
  SPEAKER_03: Yeah, so where to start with step one is actually maybe even before we get right into the contract, which is scope.
• 5:16
  SPEAKER_03: And sometimes we talk about the revenue standard or ASC606, about it being a residual standard.
• 5:25
  SPEAKER_03: And the reason that we call it that is because you first have to identify whether the arrangement or parts of the arrangement are in the scope of other accounting standards.
• 5:37
  SPEAKER_03: So if the arrangement is in the scope of another accounting standard, you apply that guidance, not the revenue standard.
• 5:46
  SPEAKER_03: If there are only parts or components of the arrangement that are in the scope of other accounting standards, then you're going to have to separate out those components before you apply the revenue standard.
• 6:00
  SPEAKER_03: If the other guidance has uh guidance to follow on separation or initial measurement, you apply the other standard to do that separation.
• 6:11
  SPEAKER_03: If the other standard does not specifically address separation or initial measurement, then you're gonna look at concepts in the revenue standard on how to do that, which is generally gonna be on a relative standalone selling price basis.
• 6:28
  SPEAKER_02: All right.
• 6:28
  SPEAKER_02: So it's interesting because revenue obviously is top line, seems so important, and yet it actually comes sort of second in terms of when you're looking at your accounting.
• 6:38
  SPEAKER_02: But Pat, where do we really see this coming into play in practice in terms of places some other guidance may imply instead?
• 6:46
  SPEAKER_01: So I'd say one of definitely one of the more common places we see it is in an arrangement that might contain a lease.
• 6:53
  SPEAKER_01: So where you're using a specific piece of equipment that's necessary to deliver a service.
• 7:00
  SPEAKER_01: You might think of the service as being sort of a classic revenue generating activity, but if you're using a specific piece of equipment, you might have an arrangement that contains a lease.
• 7:10
  SPEAKER_01: And there's some pretty specific rules about figuring out whether you have a lease.
• 7:15
  SPEAKER_01: Um, we might see this like if you have a dedicated um piece of equipment, you're providing transportation services, or maybe in the medical space, like some imaging services.
• 7:26
  SPEAKER_01: Um, so you might have a lease, in which case you would need to separate the lease from the revenue component and follow the leasing guidance in ASC 842.
• 7:36
  SPEAKER_01: One of the other examples that you might uh have to consider this at least, and we've had a number of discussions on the um kind of as-a-service economy.
• 7:45
  SPEAKER_01: So there's the hardware as a service, or some of the infrastructure as a service, you might see some of those arrangements potentially containing a lease element that needs to be accounted for.
• 7:57
  SPEAKER_01: I would say there's one uh note, there is a practical expedient in GAAP that might allow you to just go ahead and combine the lease and the revenue arrangement.
• 8:09
  SPEAKER_01: Um, but that's only if the pattern of transfer for the revenue standard is basically time-based, and we'll obviously get to that in one of the later episodes.
• 8:18
  SPEAKER_01: But just a point that not always where you have a lease are you stuck with kind of doing separate accounting.
• 8:25
  SPEAKER_01: Um if you do have a lease and a revenue arrangement, um, Angela talked about allocating between the two components or potentially more than two components, um, and following the guidance typically in the other standard for doing that allocation.
• 8:41
  SPEAKER_01: Well, as you may recall, the lease standard and the revenue standard sort of were um came out relatively contemporaneously.
• 8:48
  SPEAKER_01: And the way we separate things in the revenue standard is using this concept of relative standalone selling price.
• 8:55
  SPEAKER_01: The leasing standard actually provides that same guidance when you have a revenue and a lease arrangement.
• 9:01
  SPEAKER_01: So maybe it's a little more straightforward, although the two standards interestingly treat variable consideration differently, which we'll get into, I think that's step three.
• 9:11
  SPEAKER_01: Um, and it can get a little bit challenging then because of that difference.
• 9:16
  SPEAKER_01: One of the other things that we're maybe seeing a little bit more frequently now, especially as we see more of these platform operations, um, you know, sort of bringing people together, but not actually being responsible for fulfilling the service, you know, those platform operators will sometimes sort of guarantee the transaction.
• 9:40
  SPEAKER_01: And you think of a normal seller of goods, if you have a guarantee, well, that's a warranty, um, warranties or something that's scoped out of the guarantee standard.
• 9:51
  SPEAKER_01: But in a situation where, by definition, you're not really responsible for the underlying good or service and you're providing this guarantee, that then is a guarantee that's subject to the guarantee guidance in ASC 460 and has to be recognized separately at fair value at the inception of the arrangement.
• 10:13
  SPEAKER_01: Um, so just important to understand it's not anytime there's something called a guarantee, it's sort of the situation where you're guaranteeing somebody else's performance.
• 10:23
  SPEAKER_01: Well, that's that's a guarantee under ASC 460.
• 10:27
  SPEAKER_01: And then what's left over the residual in that case is actually what's dealt with in the revenue standard.
• 10:34
  SPEAKER_01: So there's different allocation models depending on what the thing that's not in the revenue contract is.
• 10:40
  SPEAKER_01: It's not a relative fair value, it's an explicit fair value of the guarantee.
• 10:45
  SPEAKER_01: And the residual then is accounted for as consideration under the revenue contract.
• 10:51
  SPEAKER_03: So before we move on, just to jump in here, I do want to point out that although we've talked about this specific fact pattern with the platform company, that's not necessarily the only time you could have a guarantee in an arrangement.
• 11:06
  SPEAKER_03: We've seen it in other industries such as healthcare.
• 11:10
  SPEAKER_03: Um, and there could be other situations where a guarantee exists.
• 11:15
  SPEAKER_03: So don't think that's just limited to the platform company fact pattern.
• 11:20
  SPEAKER_02: All right, Angela, I think that's a good reminder.
• 11:23
  SPEAKER_02: And uh definitely, I think sort of the key message here is you really need to understand your contract and make sure you understand the various components of your contract before you just jump straight into the 606 guidance.
• 11:36
  SPEAKER_02: With that said, Pat, any other reminders on scoping that you can share before we go on?
• 11:42
  SPEAKER_01: There are some specific scope exceptions in the revenue standard.
• 11:46
  SPEAKER_01: Um, insurance contracts is one, specifically insurance companies that are actually underwriting insurance contracts.
• 11:54
  SPEAKER_01: And anytime you're sort of selling a financial instrument or getting into a lending transaction, those are not part of the 606 revenue.
• 12:03
  SPEAKER_01: There's another area we see that um sometimes sort of has a relationship to a revenue arrangement, and those are collaborative arrangements.
• 12:12
  SPEAKER_01: Now, those aren't necessarily in or out of 606.
• 12:16
  SPEAKER_01: You really have to get inside the collaboration to figure out what's what's happening.
• 12:20
  SPEAKER_01: But importantly, if the the trade, if you will, is not really the output of another party's ongoing major central operations, then it wouldn't technically be in ASC 606, because that's sort of the the gateway, if you will, into 606.
• 12:38
  SPEAKER_01: And I guess just you know, bottom line, before you jump into the revenue guide, just because somebody's paying you to do something, you have to first consider whether any other accounting standards apply.
• 12:49
  SPEAKER_01: And I would say importantly, really focus on what the entity is doing, not what the cash that they're receiving or the consideration they're receiving is.
• 13:02
  SPEAKER_01: That's a key concept in the revenue standard is what's performance, what performance is happening.
• 13:08
  SPEAKER_02: All right.
• 13:08
  SPEAKER_02: So, Angela, I'm gonna go back to you and let's assume we've kind of gone through this sort of, I'll call it pre-step one, uh, maybe step zero, figuring out if we're actually in the scope of the revenue standard.
• 13:21
  SPEAKER_02: And but we've concluded that the arrangement itself, or maybe a portion of the arrangement, is in the scope of 606.
• 13:28
  SPEAKER_02: What do you do next?
• 13:29
  SPEAKER_03: So now we're really at identify the contract.
• 13:33
  SPEAKER_03: And ASC 606 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations.
• 13:43
  SPEAKER_03: So that's going to be important, that concept of enforceable rights and obligations.
• 13:48
  SPEAKER_03: A contract can be written, it can be oral, it could even potentially be implied by a company's business practices.
• 13:56
  SPEAKER_03: That piece of it is really generally a legal determination.
• 14:01
  SPEAKER_03: You also may need to think about combining contracts in certain situations if they're entered into at or near the same time with the same customer.
• 14:11
  SPEAKER_03: But then you also need to meet five specific criteria in the revenue standard to have a contract for accounting purposes.
• 14:21
  SPEAKER_03: So I'll walk through quickly these five criteria.
• 14:25
  SPEAKER_03: And they are number one, all parties have approved the contract and are committed to perform.
• 14:32
  SPEAKER_03: Secondly, the company can identify each party's rights regarding the goods or services to be transferred.
• 14:39
  SPEAKER_03: Third, the company can identify the payment terms.
• 14:43
  SPEAKER_03: Fourth, the contract has commercial substance.
• 14:46
  SPEAKER_03: And lastly, it is probable that the company will collect substantially all the consideration.
• 14:53
  SPEAKER_02: All right.
• 14:53
  SPEAKER_02: So, Angela, those five criteria make sense to me.
• 14:56
  SPEAKER_02: But one question on this.
• 14:58
  SPEAKER_02: So do you have cases where you would see that you actually have a legal contract between these two parties, but it wouldn't actually meet these criteria to have a contract for accounting purposes?
• 15:08
  SPEAKER_03: Yeah, one situation that comes up pretty often is when a vendor and a customer sign a master agreement, like a master services agreement, or often called an MSA, that lays out certain terms and conditions of the relationship.
• 15:27
  SPEAKER_03: However, the customer doesn't commit to make any purchases until they subsequently issue a purchase order.
• 15:35
  SPEAKER_03: So in this case, the there is a legal contract, there's an MSA, but there is no contract for accounting purposes under the revenue standard until a purchase order is issued, which actually commits the customer to make a purchase.
• 15:52
  SPEAKER_03: So this gets back to having enforceable rights and obligations.
• 15:57
  SPEAKER_03: It's important to remember that the customer has to be committed in order to have a contract.
• 16:03
  SPEAKER_03: And even if it's highly probable that the customer is going to make a purchase, you do need to wait until it's actually legally enforceable to start accounting for that contract.
• 16:15
  SPEAKER_02: All right.
• 16:16
  SPEAKER_02: So it seems they often would be straightforward to identify the contract.
• 16:20
  SPEAKER_02: But Pat, have we seen, or what are some of the examples we've seen where that actually might require more judgment?
• 16:27
  SPEAKER_01: Angela mentioned the oral contract.
• 16:30
  SPEAKER_01: I mean, I suppose there could be some circumstances there where it could get a bit more judgmental.
• 16:35
  SPEAKER_01: Um, the you know, customary business practices, you're going to need some help there.
• 16:39
  SPEAKER_01: Honestly, I don't think we see that all that often, right?
• 16:41
  SPEAKER_01: In most commercial contexts, there are written contracts.
• 16:44
  SPEAKER_01: So the thing that we spend more time thinking about or where there's more judgment involved potentially is when you assess collectability under the revenue standard.
• 16:55
  SPEAKER_01: And the the concept here is not necessarily the um just pure like company's ability to pay um in a like a bad debt context.
• 17:04
  SPEAKER_01: What you're really assessing is you know, do I expect to be compensated for the stated price of the goods or services when I enter into the contract?
• 17:14
  SPEAKER_01: So the customer situation could be relevant.
• 17:16
  SPEAKER_01: I mean, there could be situations where you basically have no expectation of the customer being able to pay, and you would assess then that collectability is not probable.
• 17:25
  SPEAKER_01: Um, where it gets a little bit more um interesting is when you start to contrast, well, um I might offer price concessions rather than collecting all the consideration.
• 17:37
  SPEAKER_01: Is that because I really don't think I have a contract?
• 17:40
  SPEAKER_01: I really don't think probability of collection is probable, or I'm just willing to take a lesser amount and I think that that is probable.
• 17:47
  SPEAKER_01: I guess maybe just focusing on this concept of probable, um, many accountants will know that probable usually has a special meaning in GAP.
• 17:56
  SPEAKER_01: Um, it's formally defined as the future event or events are likely to occur.
• 18:01
  SPEAKER_01: Um, that's sort of a dictionary definition.
• 18:04
  SPEAKER_01: Accountants, we usually think of it as something in the neighborhood of a 75% likelihood.
• 18:10
  SPEAKER_01: Now, that's not written down anywhere, it's not codified anywhere, but it's something that's, I'll say, more likely than just more likely than not.
• 18:17
  SPEAKER_01: You know, there's a pretty good chance that it's going to happen.
• 18:21
  SPEAKER_01: Um, but it is a judgmental assessment.
• 18:23
  SPEAKER_01: So you need to be thinking about whether it's probable that the customer has both the intent and the ability to pay.
• 18:29
  SPEAKER_01: And with because without that intent and ability, I mean, Angela talked about, you know, enforceable rights and obligations, you know, the customer's committed.
• 18:37
  SPEAKER_01: You don't have a valid revenue contract if you don't expect the customer to pay you, right?
• 18:42
  SPEAKER_01: I mean, if you're just willing to perform in exchange for an unlikely expectation of payment, you don't really have a basis to recognize revenue.
• 18:52
  SPEAKER_01: When you talk about like really assessing it, um, you can think about historical experience with a customer, or, you know, fairly typically there's some sort of a you know, credit check, some sort of diligence done on a new customer to assess their ability to pay.
• 19:07
  SPEAKER_01: But essentially you're getting back to this point that you know, when you sign the contract, you expect the customer to pay.
• 19:15
  SPEAKER_01: I would say where we tend to see more questions about this, or maybe in situations where the entity really has an obligation to perform when they really likely don't have a valid expectation of payment.
• 19:28
  SPEAKER_01: So you can see this in the utility space, you're required to continue to provide electricity services, for example, um, to people even if they're not able to pay, or maybe in the medical space where you're obligated to treat a patient even if you don't believe they they can pay.
• 19:44
  SPEAKER_01: So it does come up in those situations.
• 19:46
  SPEAKER_02: Pat, before we go on, can I ask a question?
• 19:48
  SPEAKER_02: Well, two things.
• 19:49
  SPEAKER_02: One, I would like to point out if you're a utility, you might have some other mechanism of collecting that money.
• 19:55
  SPEAKER_02: So it may not just be that you're not getting it paid, but that's very specific.
• 19:58
  SPEAKER_02: But you mentioned up front this is different than bad debt.
• 20:02
  SPEAKER_02: So is it fair to say that day one, you assess collectability and there's every reasonable or there's every reason that you would expect that they have the intent and build and ability.
• 20:14
  SPEAKER_02: And then maybe bad debt would be what happens after you've performed, something changed, they decide not to pay you, you know, whatever the circumstances are.
• 20:23
  SPEAKER_02: And again, I know it's very general and there's more to it, but is that a fair way of it?
• 20:27
  SPEAKER_01: No, that's the right way to make the cut.
• 20:28
  SPEAKER_01: And in fact, the the revenue standard sort of talks about once you have performed and you have a valid receivable for the revenue, sort of from that point forward, you use the credit loss standard, um, the Cecil standard, ASC326, I think it is, to assess your collectibility or your allowance for doubtful accounts, your credit losses.
• 20:52
  SPEAKER_01: That's outside of the revenue standard at that point.
• 20:55
  SPEAKER_01: And I would say, like we've talked about this idea that if you if you began to perform and you really had no reasonable expectation of payment, then you can't recognize revenue.
• 21:05
  SPEAKER_01: And even if perhaps you got some payment from the customer and you were continuing to perform, it's possible that you might need to defer that.
• 21:13
  SPEAKER_01: I would say in practice, what you end up seeing is, well, okay, I'm performing, they've paid me something, or I expect I'll get something.
• 21:24
  SPEAKER_01: We would probably think about that as an implicit price concession.
• 21:27
  SPEAKER_01: I haven't done anything to alter the contract, but I'm also not going to stop performing, and I'm likely going to accept whatever you pay me as consideration.
• 21:38
  SPEAKER_01: I've now got an implicit price concession.
• 21:40
  SPEAKER_01: I can recognize revenue for performance, but obviously only to the extent that I believe I'm going to get paid something.
• 21:47
  SPEAKER_01: Right.
• 21:48
  SPEAKER_01: It's pretty unusual that we see situations where you're performing with no expectation of consideration.
• 21:54
  SPEAKER_01: I think you'd probably agree with that, Angela.
• 21:57
  SPEAKER_03: Yeah, no, I think that's true.
• 21:58
  SPEAKER_03: But it is important to Distinguish between, especially on day one, whether there's a collectibility issue or whether you're planning or expecting to give a price concession to the customer because the accounting model is different, right?
• 22:16
  SPEAKER_03: I mean, collectibility is determining whether you have a contract.
• 22:19
  SPEAKER_03: A price concession comes into estimating what the transaction price will be and is accounted for like variable consideration.
• 22:28
  SPEAKER_02: So then maybe I'll go back to you, Pat, with this question.
• 22:31
  SPEAKER_02: How do I really tell if I have a collectability issue versus this an expected concession?
• 22:38
  SPEAKER_01: I think it's an important distinction, but it sort of can be judgmental.
• 22:43
  SPEAKER_01: I mean, you might think about your past history, um, your particular intent to pursue collection, especially in those circumstances where you know it's like unlikely or you know, almost impossible for the customer to pay.
• 22:57
  SPEAKER_01: If you're really interested in sort of more details on this particular aspect, we we did do a podcast back in uh 2020 on this topic, um, kind of thinking about you know COVID and some of those implications, but the the concepts are still still relevant today.
• 23:14
  SPEAKER_02: So we talked about the fact that we have these criteria, and if you don't meet all of the criteria, then you don't have a contract.
• 23:21
  SPEAKER_02: And so, Angela, going back to you, what do you do?
• 23:25
  SPEAKER_02: Let's say that you collection is not probable, then how do you account for it?
• 23:31
  SPEAKER_03: The first thing to keep in mind is if you don't meet the criteria initially, that is something you continue to risk reassess.
• 23:38
  SPEAKER_03: So you would continue to assess the criteria and whether you meet them in a subsequent period.
• 23:45
  SPEAKER_03: However, in the meantime, if you really don't meet those criteria, then you cannot recognize revenue.
• 23:53
  SPEAKER_03: And Pat sort of touched on this, but even if you receive cash, if you don't have a contract, um, you would have to defer that.
• 24:02
  SPEAKER_03: You can't recognize revenue until all of those contract criteria are met, or if you meet certain other requirements, and this basically boils down to either the contract's been completely terminated, or you have no further obligations under the contract and the cash that you received was non-refundable.
• 24:24
  SPEAKER_03: But I think the important takeaway there is that you can't just default to cash basis accounting and assume that because I received cash, I can recognize revenue.
• 24:36
  SPEAKER_03: You do have to go through and you assess whether you've met the requirements to recognize revenue.
• 24:42
  SPEAKER_02: Right.
• 24:43
  SPEAKER_02: I do think that idea I got money, but I can't recognize revenue is a difficult one, but people can go listen to our other podcast for more on that.
• 24:51
  SPEAKER_02: So, Angela, sticking with you, what are some of the other key considerations you think about in step one?
• 24:59
  SPEAKER_03: Another important part of this step is determining the contract term.
• 25:04
  SPEAKER_03: And contract term is the period during which the parties have present and enforceable rights and obligations.
• 25:11
  SPEAKER_03: So we come back to enforceable rights and obligations again.
• 25:14
  SPEAKER_03: And I think it's easiest to explain this by going through a quick example.
• 25:20
  SPEAKER_03: So assume a company signs a three-year contract to provide services to a customer.
• 25:26
  SPEAKER_03: So the stated term is three years.
• 25:30
  SPEAKER_03: However, the customer has the right to cancel at the end of each month without paying any kind of penalty.
• 25:38
  SPEAKER_03: They can basically walk away at the end of each month.
• 25:41
  SPEAKER_03: So even though the contract might have a stated term of three years, because you have that cancellation right, the contract term for accounting purposes is only one month because that's the period of enforceable rights and obligations, or the period that the customer is committed.
• 26:02
  SPEAKER_03: Another way to think about it is that this is essentially a one-month contract with the right to renew at the end of the month.
• 26:11
  SPEAKER_03: On the other hand, if we took the same example, but the customer couldn't just walk away, they have to pay a penalty to cancel the contract.
• 26:21
  SPEAKER_03: If that penalty, termination penalty, is substantive, then the contract term is likely three years because of the penalty that the customer would have to pay to cancel the contract.
• 26:34
  SPEAKER_02: And then, Angela, can you just clarify why this contract term, other than the obvious, is you need to know how long you're going to be serving this customer.
• 26:44
  SPEAKER_02: But how does it impact the actual accounting for the contract?
• 26:48
  SPEAKER_03: Yeah, determining the contract term for accounting purposes is important because it can impact other steps of the model that we'll we'll get to later.
• 26:58
  SPEAKER_03: But for example, transaction price only includes fees related to the contract term.
• 27:05
  SPEAKER_03: So going back to my example, if the term is only one month, transaction price is only one month worth of fees, versus if it's a three-year contract, your transaction price would include fees for the entire three years.
• 27:20
  SPEAKER_03: And that can have an impact, especially if there are multiple performance obligations that you're allocating to.
• 27:27
  SPEAKER_03: You have to know how much to include in the transaction price.
• 27:31
  SPEAKER_03: Another important implication is that one of the key disclosures for the revenue standard is to disclose the amount of transaction price that's related to remaining performance obligations in the future.
• 27:47
  SPEAKER_03: Sometimes this is called the RPO disclosure.
• 27:51
  SPEAKER_03: And that disclosure only includes what's in the contract term.
• 27:56
  SPEAKER_03: So there could be a big difference between what's left in a 30-day contract versus a three-year contract.
• 28:03
  SPEAKER_03: So it has a big impact on that disclosure.
• 28:05
  SPEAKER_02: All right.
• 28:06
  SPEAKER_02: So one other question on this.
• 28:07
  SPEAKER_02: So when you're talking about the termination penalty, I definitely noted that you made a point of saying it needs to be substantive.
• 28:14
  SPEAKER_02: It's another word that I think can sometimes be open to interpretation.
• 28:18
  SPEAKER_02: So, Pat, in practice, how what like are there any guidelines about determining how large the penalty needs to be?
• 28:26
  SPEAKER_01: Well, I would say substantive and substantive mean the same thing.
• 28:29
  SPEAKER_01: So you say substantive, I say substantive, same thing.
• 28:32
  SPEAKER_01: Um but um there really are no bright lines.
• 28:36
  SPEAKER_01: I mean, I think the key here is you're really focused on determining when the parties have enforceable rights and obligations.
• 28:45
  SPEAKER_01: And sometimes this is going to be obvious, right?
• 28:47
  SPEAKER_01: If the customer can simply walk away with no consideration, termination for convenience, well, clearly that's not a substantive termination penalty.
• 28:56
  SPEAKER_01: But in other cases where there's a real transfer of value, customer has to make a termination penalty payment.
• 29:04
  SPEAKER_01: Um, they have to give something else up of value, um, then you need to think about, okay, is that substantive?
• 29:12
  SPEAKER_01: You really have to think of it in the context of the contract, you know, how substantive is that payment?
• 29:19
  SPEAKER_01: And really, is there a substantive decision that the customer is making about whether or not to continue the contract either by you know not or avoiding the termination penalty or or not exercising a right to terminate?
• 29:36
  SPEAKER_01: Um, so you really need to understand those terms, try to understand the underlying business reasons for those terms, put it back in the context of the contract to assess is it substantive?
• 29:48
  SPEAKER_01: So it's it's not an easy judgment.
• 29:50
  SPEAKER_01: I'd say in some in most cases, I it's fairly obvious.
• 29:53
  SPEAKER_01: It's either not or it's pretty obvious that it is, but there will definitely be times when it's uh a little more challenging.
• 29:59
  SPEAKER_02: All right.
• 30:00
  SPEAKER_02: That's definitely helpful.
• 30:01
  SPEAKER_02: And I guess my overall observation is a lot more to think about in step one uh than you know, I think it appears on the surface.
• 30:10
  SPEAKER_02: So for each of you, what would be your key takeaway for someone as they're thinking about this step in the model?
• 30:16
  SPEAKER_02: And maybe Pat, I'll start with you.
• 30:18
  SPEAKER_01: Yeah, so I think certainly don't just default to the revenue standard, right?
• 30:22
  SPEAKER_01: As we hit on, it could the arrangement could be subject to other guidance or could have parts that are subject to other guidance.
• 30:29
  SPEAKER_01: So that's important.
• 30:30
  SPEAKER_01: And then the final thing is revenue is really about measuring an entity's performance.
• 30:36
  SPEAKER_01: So what you really want to focus on is what is the obligation of the company to perform?
• 30:42
  SPEAKER_01: What are they doing?
• 30:44
  SPEAKER_01: And put your sort of try to put that lens on your analysis as opposed to just when someone else gives you cash.
• 30:52
  SPEAKER_01: Yes, that really matters ultimately economically, but when you're trying to apply the revenue standard, it's really important to focus on what you're doing as opposed to what someone else is giving you.
• 31:03
  SPEAKER_02: Yeah, I think again, that's a good reminder because I think we do tend to focus in on when's the cash coming in versus when am I performing.
• 31:11
  SPEAKER_02: So great reminder there.
• 31:13
  SPEAKER_02: And Angela, how about your from your perspective?
• 31:16
  SPEAKER_03: So the area that I see people skip over here is contract term.
• 31:22
  SPEAKER_03: I often see people get too far down the road and then they realize, oh, there was a termination right or a cancellation right that they didn't think about back in step one that actually drives how you apply the rest of the model.
• 31:36
  SPEAKER_03: So I would say that's something to make sure you understand up front is are there cancellation or termination rights in this contract?
• 31:45
  SPEAKER_03: How do they work?
• 31:46
  SPEAKER_03: Are there any related penalties and work through that up front?
• 31:50
  SPEAKER_02: All right.
• 31:50
  SPEAKER_02: And Angela, that sounds like maybe I can give an overall recommendation is that you don't want to shortcut this step.
• 31:57
  SPEAKER_02: So again, on the surface, like what's your contract?
• 32:00
  SPEAKER_02: Seems fairly easy, but there's definitely a lot of pieces to it.
• 32:03
  SPEAKER_02: And if you don't get this right, you can't get your other four steps right.
• 32:07
  SPEAKER_03: Yep, that's a good summary.
• 32:09
  SPEAKER_02: All right.
• 32:10
  SPEAKER_02: So then, last question before we get to the fun part of the podcast.
• 32:14
  SPEAKER_02: Uh, where should our listeners go if they'd like more information?
• 32:18
  SPEAKER_03: Yes, we cover step one and chapter two of our uh revenue from contracts with customers guide.
• 32:26
  SPEAKER_02: Perfect.
• 32:26
  SPEAKER_02: All right, well, Angela, you alluded to this up front.
• 32:29
  SPEAKER_02: You seemed very excited.
• 32:30
  SPEAKER_02: So hope you brought your knowledge.
• 32:34
  SPEAKER_02: Uh, first one might require a little football knowledge here.
• 32:38
  SPEAKER_02: This one is since the subject today is contracts, we thought we'd ask about a very big one.
• 32:44
  SPEAKER_02: And this is in 2020, the Kansas City Chiefs signed the largest ever NFL contract, and it was about half a billion dollars.
• 32:53
  SPEAKER_02: Any guesses for what player?
• 32:56
  SPEAKER_02: I have a hint.
• 32:58
  SPEAKER_03: Well, is this for me only?
• 32:59
  SPEAKER_03: Or I think Pat probably knows.
• 33:02
  SPEAKER_03: You got a friend for a reason.
• 33:05
  SPEAKER_03: I definitely need the friend.
• 33:06
  SPEAKER_03: Maybe it's the quarterback.
• 33:08
  SPEAKER_02: So that is actually correct.
• 33:10
  SPEAKER_02: So then, Pat, do you know who it is?
• 33:11
  SPEAKER_01: It's Patrick Mahomes.
• 33:13
  SPEAKER_02: All right.
• 33:17
  SPEAKER_02: Fact check.
• 33:18
  SPEAKER_02: Looks like Angela picked the right guest to help her with a football question.
• 33:23
  SPEAKER_02: Their teamwork paid off with the correct QB answer of Patrick Mahomes.
• 33:31
  SPEAKER_02: All right.
• 33:31
  SPEAKER_02: So then, second one, one of the other things we spent a lot of time talking about is collectability and the fact that that's gating assessment in step one in terms of recognizing revenue.
• 33:42
  SPEAKER_02: So, in making the assessment, sometimes companies may rely on information from rating agencies.
• 33:48
  SPEAKER_02: And so, what business proprietor was the first to release publicly available bond ratings close to the turn of the early 20th century?
• 33:57
  SPEAKER_01: Um Moody's, Dunham Brad Street, Fitch.
• 34:01
  SPEAKER_01: I'm gonna maybe some guy named Don.
• 34:05
  SPEAKER_02: All right, Angela.
• 34:07
  SPEAKER_02: Anything else, or do you want to stick with Pat's guesses?
• 34:10
  SPEAKER_03: We can go with that.
• 34:10
  SPEAKER_03: That works.
• 34:11
  SPEAKER_02: All right, I think those are probably pretty reasonable guesses, Pat's, but I will sh I will share the actual answer.
• 34:20
  SPEAKER_02: Fact check.
• 34:21
  SPEAKER_02: That was a good string of guesses from Pat.
• 34:24
  SPEAKER_02: The correct answer is John Moody of Moody's Fame.
• 34:31
  SPEAKER_02: Both, always a pleasure to have you on, and thanks so much for all the insight.
• 34:36
  SPEAKER_02: That's our show for today.
• 34:38
  SPEAKER_02: I hope you enjoyed the first installment in our monthly toolkit series.
• 34:42
  SPEAKER_02: Next Tuesday, we'll continue our revenue deep dive when we look at identifying performance obligations.
• 34:48
  SPEAKER_02: Until then, if you're looking for more information on the topic of revenue, head over to our revenue recognition resource page on viewpoint.pwc.com.
• 34:59
  SPEAKER_02: And don't forget to join me this Thursday for a new episode in our Finance 2025 series.
• 35:05
  SPEAKER_02: This week's topic is AI and machine learning.
• 35:09
  SPEAKER_02: My guests and I will examine the many ways these technologies are helping organizations achieve a modern finance function.
• 35:16
  SPEAKER_02: No matter where you are and launching your own efforts, this episode shares some best practices you won't want to miss.
• 35:22
  SPEAKER_02: And I'll share from my own perspective, it's probably one of the best explanations of how this works and how it applies to finance that I've heard.
• 35:31
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• 35:39
  SPEAKER_02: From Thought Leadership at PWC, I'm Heather Horn.
• 35:42
  SPEAKER_02: Thanks for tuning in.
• 35:52
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