Question

Describe the conditions when contract assets and liabilities are recognized and presented in financial statements.  Find an example of a recent 10-K or 10-Q that has contract assets or liabilities recognized in them and share it with the class.

Answer 1

While exhibiting similarities to prior guidance relating to accounting for construction- and production-type contracts, the concepts of contract assets and contract liabilities are new. Furthermore, under ASC 606, contract assets and contract liabilities may be recognized for all types of contracts.

A contract asset is an entity’s right to payment for goods and services already transferred to a customer if that right to payment is conditional on something other than the passage of time. For example, an entity will recognize a contract asset when it has fulfilled a contract obligation but must perform other obligations before being entitled to payment. This is in contrast to a receivable, which is the right to payment that is unconditional, except for the passage of time. Therefore, a receivable is not a contract asset, and each is presented separately.

A contract liability is an entity’s obligation to transfer goods or services to a customer at the earlier of (1) when the customer prepays consideration or (2) the time that the customer’s consideration is due for goods and services the entity will yet provide.

Generally, contract assets and contract liabilities are based on past performance. The key to determining which to recognize is ascertaining which party acted first. For example, when a customer prepays, the receiving entity records a contract liability—an obligation that must be fulfilled to “earn” the prepaid consideration. Once the entity performs by transferring goods or services to the customer, the entity can then recognize revenue and adjust the liability downward (ultimately to zero). The proper accounting for a contract liability is very similar to treatment for deferred or unearned revenue.

There is a possible exception to the past performance rule: in the case of non-cancellable contracts, an entity may actually record a contract liability before payment has been received. Suppose an entity and its customer enter into a contract to deliver goods and agree on dates for payments. Assume the date for a customer’s prepayment arrives, but the customer fails to pay on time, and the entity has not yet delivered goods. The entity recognizes a receivable because non-cancellable contract payments are treated as guaranteed. In this circumstance, recognition of the receivable is based on the contract’s payment schedule.

It is not linked to the timing of revenue recognition. In conjunction with the receivable, the entity will also recognize a contract liability to deliver goods. This liability will be reversed and revenue will be recognized once the entity fulfills the performance obligation by delivering goods to the customer.

Most people would prefer to avoid reading 100-page documents whenever they can, but lengthy and technical 10-Q and 10-K filings from the Securities and Exchange Commission are a necessity for success.

A Look inside 10-Q and 10-K Filings

Investors looking at a 10-Q or 10-K filing for the first time may be a bit surprised by the size of the document, which can often be in excess of 100 pages. However, all of these filings are divided into easy-to-understand sections in order to make them easier to follow. These three sections include:

Business Overview—A description of the business, risk factors associated with the business, legal proceedings for and against the company and matters to vote, among others.

Financial Overview—A review of the company's performance over the period, management's discussion and analysis of the results, changes in accounting procedures or disclosures and supplementary data, among others.

Governance Overview—A review of executive compensation, beneficial ownership by management, relationships with directors and accounting fees, among others.

Balance Sheet—A review of the company's assets versus its liabilities; this is useful for checking liquidity ratios, cash on the books and the level of debts owed to others.

Income Statement—A review of the company's revenues and profits; this is useful for seeing how the business is performing on the top and bottom line.

Cash Flow Statement—A review of cash flows in and out of the bank; this is useful for cross-checking with the income statement to verify net income figures.