Accounting for the Coronavirus under Topic 606, Revenue from Contracts with Customers
Coronavirus disease 2019 (COVID-19) is a hot topic on the tip of everyone’s tongue.
The effects of the disease have been swift. The pandemic has transformed health, economic outlooks, and social norms around the globe. Government and health care providers are working around the clock to slow the spread of the disease.
As accountants, we have a plethora of topics to consider directly or indirectly related to this Coronavirus outbreak. First up is Topic 606, Revenue from Contracts with Customers.
Accounting for revenue under Topic 606 is a five-step process:
- Step 1 – Identify customer contracts;
- Step 2 – Identify performance obligations;
- Step 3 – Calculate the transaction price;
- Step 4 – Allocate the transaction price; and
- Step 5 – Recognize revenue.
Let’s dive into potential considerations when performing each step.
Step 1–Identify Customer Contracts
A customer is defined as a party that enters into a contract with an entity to acquire goods and services that are outputs of its ordinary activities in exchange for consideration.
The coronavirus has turned many companies’ “ordinary” activities on their head. Clothing manufacturers are repurposing their plants to produce face masks. Liquor producers are pivoting to make hand sanitizer.
This begs the question: have your “ordinary” activities changed? If so, do you have new types of contracts that are within the scope of Topic 606?
Also, by definition, a customer pays consideration for a good or service. Some companies may be donating goods or services to health care workers or others in need. If you make a donation, the recipient is not a customer and the transaction is not within the scope of Topic 606.
As a result of the coronavirus, customers may be undergoing financial distress. Customers also may be more likely to terminate a contract these days. With this in mind, make sure you’ve considered termination clauses appropriately when applying Topic 606.
Collectability is also important to determine if a contract exists. Many parties are under financial strain due to the pandemic. Thus, the evaluation of collectability takes on heightened importance. To determine if collection is probable, an entity must consider the customer’s ability and intent to pay consideration when due. The overall objective of evaluating collectability is to determine if there is a substantive transaction.
Step 2—Identify Performance Obligations
Parts of the country are undergoing partial lockdowns, such as New York, New Jersey, and Connecticut. For instance, many restaurants have been forced to close their dining rooms and move to takeout and delivery only. Retailers have been required to shutter physical stores temporarily.
Businesses are getting creative to boost sales. Some restaurants are throwing in non-food extras like toilet paper to encourage food sales. Retailers may run promotions to increase online business. Companies must consider if freebies and other marketing incentives are performance obligations under Topic 606. However, an entity does not have to account for immaterial goods or services as separate performance obligations.
Some companies may not be accustomed to providing shipping. However, they may start shipping goods while stores are temporarily closed. Topic 606 addresses whether shipping and handling is accounted for as a separate performance obligation.
When an entity identifies its performance obligations, it also must determine if it serves as a principal or an agent in the transaction. A principal presents revenue on a gross basis; an agent presents revenue on a net basis. Some companies may see themselves stepping into new or different roles as the pandemic unfolds. Therefore, don’t forget to think about if you are serving as a principal or an agent in a transaction. Topic 606 provides guidance on how to make this determination.
Step 3—Calculate the Transaction Price
To calculate the transaction price, an entity must determine the amount of consideration it expects to be entitled to for a good or service. The transaction price includes both fixed and variable consideration.
These days, it’s a good idea to look closer at your variable consideration, such as:
- Consideration based on sales: Manufacturers or other suppliers may receive additional consideration from retailers based on the amount of retail sales to consumers. Sales across industries are currently in flux. The coronavirus is generating significant demand for staples like groceries and cleaning supplies, but limiting demand for non-essential items. The dramatic shifts in demand may affect consideration based on sales.
- Refunds: The coronavirus has caused many businesses to close temporarily to limit public gatherings, encourage social distancing, and deter transmission of the virus. The virus is also increasing the usage of streaming services, which may reduce picture quality or slow speeds. Displeased customers may request refunds. Therefore, estimates of refunds may have to be revised.
- Returns: Many stores are also amending their return policies. Some stores are extending the period to return goods. Others are prohibiting returns of certain items to limit transmission of the virus and prevent hoarding of essential items like paper products, cleaning supplies, and food. As a result, estimates of returns may change.
- Penalties or incentives: Some companies are dismissing or reducing penalties to help customers through the crisis. For instance, certain telecommunications companies are waiving overage fees for voice and data. These decisions must be factored into estimates of the transaction price. Also, some industries may find it takes longer to satisfy performance obligations for customers. For instance, construction companies may forfeit incentives or incur penalties if projects are behind schedule. Delays may affect estimates of variable consideration.
Variable consideration is subject to a constraint. Variable consideration is recognized as revenue only to the extent it is probable that there will not be a significant reversal of revenue in the future.
An entity must update the transaction price – including its estimate of variable consideration and any constraint – at the end of each reporting period. This may result in recognizing more revenue, or a reduction of revenue. For satisfied performance obligations, any additional revenue or reduction of revenue is recorded in the period the transaction price changes.
You also need to think about significant financing components in your contracts. If a contract includes a significant financing component, the transaction price must be adjusted for the time value of money. This requires consideration of credit risk and current interest rate levels. It may be harder to gauge a customer’s credit risk these days. Interest rates are also in flux, with the Federal Reserve issuing emergency rate cuts in recent weeks.
Step 4—Allocate the Transaction Price
Topic 606 requires an entity to allocate the transaction price to the performance obligations in the contract. The allocation generally is based on the standalone selling prices of the goods and services.
As a result of the coronavirus, supply and demand for goods and services is largely in flux, which is also affecting prices. Therefore, companies must be mindful of whether standalone selling prices of goods and services have changed.
Such changes would affect the allocation of the transaction price for new contracts.
An entity must not revise its allocation of the transaction price for changes in standalone selling prices of goods and services after contract inception.
Step 5—Recognize Revenue
Under Topic 606, revenue must be recognized when or as a performance obligation is satisfied. Revenue might be recognized either at a point in time or over time.
To recognize revenue over time, you need to determine:
- The period over which to record the revenue; and
- The pattern in which to record the revenue.
The coronavirus could change one or both of these.
For example, the coronavirus has forced many companies that sell season passes or annual memberships to close temporarily. Consider theme parks, gyms, and museums. Should these companies continue to recognize revenue in the same pattern now that their doors are temporarily shuttered? According to Topic 606, revenue must be recorded when or as a good or service is transferred to the customer.
The coronavirus may also impede access to supplies and labor. For instance, certain building materials are becoming more difficult for construction entities to obtain. Fewer workers also may be available due to illness, quarantine, or social distancing. These factors may delay the timing of transferring goods and services to customers. Therefore, it may be necessary to reconsider the period over which to recognize revenue.
In addition, the government is currently devoting a significant portion of its resources to combat the coronavirus. Entities that need permits, inspections, or other government clearances to provide goods and services to customers may have to wait longer. This may also affect when revenue can be recognized.
In many cases, companies may be considering modifications to their contracts with customers due to the coronavirus. If you alter agreements with your customers, make sure those changes are captured for accounting purposes. Topic 606 provides specific rules on accounting for changes to customer contracts. Depending on the situation, the change might be considered a new contract that replaces the original agreement, a modification of the original agreement, or some combination of the two. In the current pandemic environment, changes may occur quickly and broadly across large portfolios of customer contracts.
Also, don’t forget that the accounting for contract costs under Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers, is closely tied to the accounting for revenue from contracts with customers. Therefore, factors affecting your revenue may also impact your accounting for the related costs, such as the amortization and impairment of deferred contract costs.
COVID-19 is a rapidly evolving situation. In the coming weeks and months, we may witness additional accounting effects as the full impact of this disease manifests itself. We encourage you to stay informed on accounting and financial reporting developments.