Assessing collectibility under ASC 606: 5 things you need to know

Determining when to recognize revenue under the new revenue standard for customers in financial distress or bankruptcy requires judgment. Don't assume the answer is the same as it used to be. In this episode, PwC partners Heather Horn and Pat Durbin discuss five things you need to know about assessing collectibility under the new revenue standard, with a specific focus on recognizing revenue when customers are in financial distress or bankruptcy. We discuss the collectibility model: credit risk v price concession, the implications of the new credit risk model, judgment points in the model/when to reassess, factors to consider and document in the assessment, and other considerations.

• 0:52 – The collectibility model: credit risk v price concession
• 3:30 – The implications of the new credit risk model
• 6:53 – Judgment points in the model/when to reassess
• 9:30 – Factors to consider and document in the assessment
• 12:02 – Other considerations

Transcripts available upon request for individuals who may need a disability-related accommodation. Please send requests to us_podcast@pwc.com.

Transcript

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SPEAKER_02 0:03

Hello, and welcome to another episode of PwC's Accounting and Reporting Podcast Series. Our mission is to inform and educate accountants and other stakeholders on today's hottest accounting topics. I'm Heather Horn, a partner in our national office, and I'll be your host today. Today's guest, Pat Durvin, is the leader of the Revenue Group in our national office. Pat's going to focus on five things you need to know about assessing collectibility under the new revenue standard with a specific focus on considerations for customers in financial distress, including customers in bankruptcy. He'll talk about a key shift in the guidance between ASC 605 and ASC 606, which may change how you're recognizing revenue. Pat, thanks for joining us and let's jump straight into our discussion. I know we have

The collectibility model: credit risk v price concession

SPEAKER_02 0:52

a new revenue model that most public companies have now adopted. And one of the aspects of the model that I wanted to talk to you about is how do you think about a contract when your counterparty is in financial distress? Let's say they're in bankruptcy. How do you make your assessment of whether or not collection of that receivable is probable? What are the considerations under 606 and what are the implications?

SPEAKER_01 1:16

Yeah, well, it's a very relevant topic, Heather, especially because the collectability assessment actually needs to be made even before you have a receivable. It's sort of the part of the whether you have a contract question and kind of a ticket into the revenue game under ASC 606, because you need to assess whether you think it's probable that you're going to get paid in order to establish you actually have a contract to account for. That's different than under the old model where we typically did focus on collectibility more at the point of when we were recognizing revenue and just whether or not we were going to get paid. So if you get to a conclusion under 606 where you don't think collection is probable at the outset of the contract, then you actually don't have a contract for accounting purposes, which is kind of an interesting outcome when you may in fact actually have a legal contract that you're performing under and your customer is paying under. That is a possibility, maybe a bit of a more extreme outcome, but if there is uncertainty as the amount or whether you're going to collect the full amount of consideration to which you're entitled, you need to consider a few other things first. For example, are you likely to make a price concession, in which case it becomes more like a variable consideration? But in that case, you'll just have a contract, but at a lower price than maybe the stated price.

SPEAKER_02 2:44

So then how would you know if it's really that you're providing a price concession or you're just taking on risk that at some point in the future your customer is going to stop paying?

SPEAKER_01 2:54

So certainly that's something that's going to require judgment, especially if you have limited experience with these types of circumstances, which may be the common case, right? You don't expect your customers to be in bankruptcy. Yeah, like sometimes it might be an emerging business, so kind of new types of arrangements, something they don't have a history with. If you do happen to have a history, then that's going to be sort of the first place you would look to figure out if there's sort of an expectation that you're likely to provide price concessions. But if this is your first time through it, you know, definitely not going to be clear and going to require judgment.

SPEAKER_02 3:28

Okay, so then Pat, let's move on

The implications of the new credit risk model

SPEAKER_02 3:30

to this what you said more extreme scenario. So you've just decided collection's not probable. So you don't have a contract, but you've performed and you've got some cash from a customer. What are you supposed to do? Can you record revenue?

SPEAKER_01 3:43

This is where it definitely gets interesting, Heather. One might assume that if you performed and you've been paid that you should have revenue. Well, under the 606 framework, if you don't believe that you're going to collect the promised consideration in the contract in full, as we stated before, you don't have a contract and you can't recognize revenue if you don't have a contract. Essentially, this means that any cash you received would be deferred until you got to some point where you thought now you had a contract at some later date. So before you get there, though, you really need to think about what are the alternatives. So as we established before, one of them, you could have no contract, so you defer any cash received. You could, as we talked before about price concessions, conclude you have a contract, but just with variable consideration, i.e., you have an effective price concession that you're going to estimate. The third outcome, which is also a possibility, is that in substance your contract has, in effect, been terminated. You've performed, you've received cash, and you don't intend to perform anymore, and the cash is non-refundable, then at that point you could recognize revenue to the extent that you performed and been paid for the services.

SPEAKER_02 5:01

Let me go back then to something that you said under these different scenarios that you could have. So one of the scenarios you talked about was that you could say the contract, you've substantively terminated the contract. So what do we mean when we say that?

SPEAKER_01 5:13

It's a concept that's described in the standard, and you might get into some debate with somebody from a legal perspective, but the standard sort of contemplates this notion of that if you've performed everything that you're planning to perform, you've stopped performing, and you don't have an obligation, like that you can't be compelled to continue to perform, then you could conclude the contract's been effectively terminated, and you could then recognize revenue to the extent that you'd received cash, as long as it's obviously non-refundable, meaning there's legally no obligation for you to continue to perform and no right for the customer to reclaim the cash that they've paid.

SPEAKER_02 5:51

Well, so it is much different because previously, you know, maybe you deferred your revenue, but you got the check in the door, you say, okay, I'm paid, I'm done. And what you're saying now is, okay, you have to wait. Do you think the whole amount's probable? And then if it's not, you may not recognize that until this point of substantive termination.

SPEAKER_01 6:10

Right. It really comes back to this question of before I can even think about revenue, I've got to establish that I have a contract. And if I I don't think I'm going to collect all the amount that I'm entitled to, I wouldn't have a contract. So then it's a full deferral model. It's only if then something else happens that leads me to conclude either I have a contract now, I've agreed a price concession, something else has changed, or I get to this point where okay, you're not able to pay me anymore, I'm gonna stop performing, you can't compel me to perform as my customer, and whatever cash I've received, I don't have to refund to you. Then you can recognize it.

SPEAKER_02 6:49

Okay. So then let's move on to our next section,

Judgment points in the model/when to reassess

SPEAKER_02 6:53

which is talking about the judgment in this model. Obviously, a lot of different points of judgment. And how would we think about terms like probable in this assessment?

SPEAKER_01 7:04

So, in the context, in this particular context of 606, the word probable is used in sort of what I'll call the traditional accounting sense, kind of like it's used in the accounting for contingencies. It's not quantified specifically anywhere in gap. Practice generally views it to be somewhere in the 75% range.

SPEAKER_02 7:24

Okay. So then, Pat, we've talked a lot about assessing if it's probable. What about from a timing perspective? So once I've decided, let's say, let's start with the scenario that it is probable, would I continue to reassess the probability of collection each period?

SPEAKER_01 7:41

Aaron Powell It's interesting. I might actually turn the question around and say if I've determined that it's not probable, then I absolutely do need to continue to assess whether I am getting to a point where it's probable. On the flip side, I guess coming back to your original question, if I had initially assessed that it's probable, then I would only need to reassess if there have been some significant change in facts and circumstances. For example, the customer declares bankruptcy. Importantly, we talked a lot about this idea if it's not probable from the outset, I get into this deferral model. If I've already started performing, I thought collectability was probable, I'd been recognizing revenue along the way, and then I get one of these trigger events where I come to a conclusion that it's now not probable that I'll collect what's remaining on the contract. That's only a prospective assessment. I'm not going to go back and reverse the revenue that I had previously recognized I thought was good revenue. Now there's obviously a little bit of a timing play there in terms of the receivables, when the negative event occurred, and whether that calls into question whether my probability assessment was right. But clearly there's a scenario that you had legitimate good revenue and then you had a negative event, and then it's only a prospective issue with respect to your revenue.

SPEAKER_02 8:58

Yeah, and I think Pat, it's a good point, right? That sometimes there'll be one event, but other times you'll have, and that's why we said customers in financial distress. Maybe a company's been struggling for some time and they've been paying you late, and you can see information or you know information that they are experiencing financial difficulty, at that point you should be doing your assessment, even maybe there's not one clear item that you can point to. Exactly right. Okay. So then we have to, since we're talking about accounting, talk about controls as well. And so

Factors to consider and document in the assessment

SPEAKER_02 9:30

let's move on to our next topic. And clearly, a lot of judgments here, a lot of different things to consider. And as you're an entity and you're assessing collectability, what types of processes should you make sure that you have in place and what would be the key judgments that you should document?

SPEAKER_01 9:46

Sure, and I I think it actually dovetails with that last point you were making around sort of looking at the timeline of sort of how things are developing at your customers. Certainly, you need a process just to apply the revenue model to assess collectability when entering into new contracts, but you also need to think about what's my process to monitor for significant developments, positive or negative, in my customers' businesses so I can properly adjust my revenue if I need to. I also need to have a process to think about whether I'm in this price concession model or not. Um, what are my past business practices? What's the nature of the specific arrangement in question? Meaning how likely is it that the entity would not perform? So, can I get to this substantive termination? Am I compelled to perform either to mitigate some other risk or maintain the relationship with a long-term customer? Maybe there's some regulatory considerations. So I need to have some process to do that monitoring. And again, it's a little bit judgmental, right? Depending on the nature of your business, these may be more or less routine activities. And then importantly, once I identify a change in facts and circumstances, it's important that I have a process in place then to respond. How do I evaluate the timeline of events, especially sort of in the period maybe leading up to a bankruptcy? And then really thinking through how contracts might be treated in bankruptcy. Maybe it differs depending on the nature of the activity in the contract, the nature of the vendor-customer relationship, regulatory considerations again, etc.

SPEAKER_02 11:26

So, Pat, maybe taking a step back, you referenced your overall revenue controls. So I think it's almost you have your initial date, do you even have a contract to begin with? And that's for a new contract. Then once you started recognizing revenue, I think the point you're making is that you should be monitoring your counterparties, especially individually significant ones. And at the point in time then that you would conclude it's not probable you would stop recognizing, you'd be in these new models, but you'd want to make sure you had documentation along the way that showed what process you had undertaken. Absolutely. Okay, very good. So, Pat, let's

Other considerations

SPEAKER_02 12:02

move on then to our last item. Um, we've obviously talked about considerations under 606 and you know how you would kind of work through revenue recognition if you have a counterparty that's in financial distress or in bankruptcy. But beyond revenue, what are some of the other areas our listeners should be thinking about when they have a counterparty in that situation?

SPEAKER_01 12:22

It's definitely a good topic because revenue is not the only consideration. And importantly, as we talked a little bit earlier, when you get to sort of the negative event, it's really more of a prospective assessment. Like, is there revenue I may not be able to recognize in the future? Many of the other considerations actually require you to deal with assets that are recognized on the balance sheet today. And the first one that really comes to mind would be long-lived assets, so you know, PPE intangibles that need to be assessed for impairment under ASC 360. In particular, you'd be thinking about whether there's an asset group that's dedicated to servicing a particular contract with that uh bankrupt or financially distressed customer. Do I have an impairment of that asset group? Would I think about other customers or avenues that might be able to take the production capacity from that asset group? How dependent is that asset group on that customer? And this is where we come back to this importance of assessing the facts and the timeline underlying that assessment to make sure that we're, I would say, appropriately considering all the information at the appropriate point in time, and that we're aligning those facts and judgments with perhaps what we did in the revenue model. I think it's important to recognize that the impairment model has its own set of rules and considerations, if you will, that aren't necessarily the same as the revenue one, but you need to be at least working with the same understanding of the timeline and events. For example, when we talk about this probability threshold, that's very much an entity-specific expectation of whether I think I will collect the amount that I'm entitled to under the contract, which may be different than if you thought about something from sort of a more generic marketplace participant assumption without regard to maybe a very specific entity arrangement. So when you're thinking about fair value estimates and doing cash flow forecasts for the whole business, that might be different than when you're thinking about one individual contract.

SPEAKER_02 14:33

Okay, so Pat, clearly impairment is definitely a potentially big area. What other areas should companies be focused on?

SPEAKER_01 14:40

So potential restructuring liabilities? Are you going to have to close a facility, terminate employees as a result of maybe losing a significant contract? Probably we'll also need to think through supply chain. Do you have some purchase commitments to vendors for materials that were you were using to service that contract? Can those materials be redeployed for other arrangements? Do you have inventory on hand that was dedicated to that arrangement? Do you have a lower of cost or net realizable value issue with that inventory? And then another important one: derivatives and hedging. If you have a forecasted transaction that now may no longer be probable of occurring, that's going to have an impact on your hedging relationships.

SPEAKER_02 15:24

Good. Very helpful. Obviously, a lot for our listeners to think about when they're dealing with counterparties or arrangements involving a customer in financial distress or bankruptcy. And to our listeners, if you're interested in further information on this topic, I encourage you to check out our podcast page at cfodirect.com. It includes a flowchart that may help with accounting for revenue when your counterparty is in financial distress or bankruptcy. If you enjoyed this episode, please share it with a colleague. Please also subscribe, rate, or review our podcast series on iTunes, Stitcher, Spotify, or wherever you get your content. And drop me a line anytime at heather.horn at pwc.com. I'm always interested in hearing your ideas and suggestions for future episodes. For PWC, I'm Heather Horn. Thanks for tuning in.

SPEAKER_00 16:19

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