242 SECTION 1 The Role of Accounting as an Information System A contract does not exist if (a) neither the seller nor the customer has performed any obligations under the contract and (b) both the seller and the customer can terminate the contract without penalty. In other words, either the seller or the customer must have done something that has commercial substance for the seller to start accounting for revenue. Illustration 5–12 provides an example. Recall from Illustration 5–7 that CompStores ordered 1,000 Tri-Box systems on December 20, 2015, at a price of $250 per unit. Assume that CompStores and TrueTech can cancel the order without penalty prior to delivery. TrueTech made delivery on January 1, 2016, and received $250,000 on January 25, 2016. When does TrueTech’s arrangement with CompStores qualify as a contract for purposes of revenue recognition? The arrangement qualifies as a contract on January 1, 2016. That’s the date TrueTech makes delivery to CompStores. Prior to delivery, neither TrueTech nor CompStores had performed an obligation under the contract, and both parties could cancel the order without penalty, so the arrangement didn’t qualify as a contract for purposes of revenue recognition. Illustration 5–12 Determining Whether a Contract Exists for Revenue Recognition Purposes Additional Consideration Contract Modifications. A customer and seller might agree to modify a contract in some way. For instance, they might change the transaction price, change the performance obligations, or add another performance obligation. The way we account for a contract modification depends on the nature of the modification: 1. Sometimes a modification is really just a separate new contract. That happens when the modification adds another distinct good or service and requires the customer to pay an additional amount equal to the stand-alone selling price of the added good or service. In that case, we view the modification as a separate contract. 2. Other times a modification adds a distinct performance obligation, but that new performance obligation isn’t priced at its stand-alone selling price. In that case, the seller needs to update the existing contract to reflect the modification. The modified contract includes whatever performance obligations remain after the modification, and its transaction price is equal to the amount that hasn’t yet been recognized under the old contract plus or minus any change in price required by the modification. We allocate the revised transaction price to all performance obligations remaining in the contract based on their stand-alone selling prices at that time. 3. Finally, sometimes we modify a contract that includes a performance obligation that is being satisfied over time. In that case, we need to update our assessment of progress toward completion and adjust revenue as appropriate to reflect progress to date, just like we treat other changes in estimates. Special Issues for Step 2: Identify the Performance Obligation(s) Previously we saw that promises to provide goods and services are treated as performance obligations when the goods and services are distinct. Now let’s consider several aspects of contracts we often encounter and whether they qualify as performance obligations. We discuss prepayments, warranties, and options. PREPAYMENTS. Some contracts require non-refundable up-front fees for particular activities (for example, Bally Total Fitness charges up-front registration fees for gym memberships). We don’t consider such prepayments to be performance obligations because they aren’t a promise to transfer a product or s ervice to a customer. Instead, the up-front fee A prepayment is not a performance obligation.
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