Contract assets are a core component of revenue recognition under Accounting Standards Codification (ASC) 606, the accounting standard that governs how companies recognize revenue from customer contracts. A contract asset represents a company’s right to consideration (e.g., payment) in exchange for goods or services that it has already transferred to a customer. This right is conditional: it’s contingent on the company fulfilling its remaining performance obligations or the customer meeting certain criteria, such as passing a credit check or reaching a sales target. Unlike accounts receivable, where payment is unconditionally due, collection on a contract asset hinges on future events.

Contract assets are typically used in industries with complex or long-term contracts, such as software subscriptions, construction projects, or telecommunications services. They provide insights into a company’s future cash flows and the underlying health of its customer relationships. Below, we’ll cover the key information businesses need to have when dealing with contract assets under ASC 606.

What’s in this article?

• Why contract assets are so important in revenue recognition
  
• Contract assets vs. receivables
  
• How to recognize contract assets under ASC 606
  
• How contract assets are reported on financial statements
  
• How contract assets are treated in the five-step model of revenue recognition
  
• Examples of contract assets in different industries
  
• Common issues in accounting for contract assets
  
• Best practices for compliance and audit preparedness
  

Why contract assets are so important in revenue recognition

In revenue recognition, contract assets make sure that a company’s financial reporting is accurate and a true reflection of its business activities. Here’s a closer look at why they’re so important.

• Linking revenue to work done: Contract assets ensure that the money a company reports as earned is tied directly to the work it has actually performed, not just when the cash is received. This shows a company’s performance over time, especially when projects span multiple financial periods.

• Ensuring accurate financials: Using contract assets allows companies to report their earnings more accurately and create more dependable financial statements. This is particularly important for businesses involved in long-term projects such as construction jobs or major engineering works.

• Complying with regulations: Certain regulatory bodies, such as the US Securities and Exchange Commission, legally require companies to comply with ASC 606, among other accounting rules.

• Gaining better cash flow insight: Recognizing revenue through contract assets means a company can recognize earnings before actually getting the cash. This can help businesses conduct better financial planning by anticipating income based on the work they’ve completed.

• Building trust with stakeholders: When companies show accurate and reliable financial reports, it builds confidence among investors, banks, and other important players. This credibility can help secure new investments or funding.

Contract assets vs. receivables

While both contract assets and receivables represent a company’s right to collect payment from customers, the key difference between them is in the conditionality of that right.

Contract assets represent a conditional right to consideration. The company has performed its obligations, but payment is contingent on some future event or performance obligation. This future event could be anything from the customer achieving a specific sales target to the completion of a project phase. This conditionality introduces an element of uncertainty into the collection process.

Receivables represent an unconditional right to payment. The company has delivered its goods or services and the customer is obligated to pay. The only condition for payment is the passage of time. There are no further performance obligations or contingencies attached to collection.

Receivables represent a more concrete and certain asset compared to contract assets. Contract assets carry a higher degree of risk and might require additional disclosures or considerations for impairment. Receivables are generally considered more straightforward and less prone to collection issues.

How to recognize contract assets under ASC 606

Recognizing contract assets in line with ASC 606 requires multiple steps and ongoing monitoring. Here’s how it’s done.

• Identify performance obligations: Clearly define what the company has promised to deliver to the customer. Carefully analyze the contract terms and understand what the customer expects. Distinguish between distinct obligations (e.g., selling a product and providing installation services) and those that are bundled together (e.g., a software license with ongoing updates).

• Allocate transaction price: Fairly allocate the total contract price to each obligation. Consider market prices, discounts, and the specific terms of the contract to establish stand-alone prices. This ensures that revenue is recognized in proportion to the value delivered to the customer.

• Recognize revenue when obligations are satisfied: Recognize revenue when the customer obtains control of the good or service and when the performance obligation has been fulfilled. The timing of revenue recognition can vary depending on the nature of the obligation. It could be at a point in time (e.g., upon delivery of a product) or over time (e.g., upon completion of various phases in a construction project).

• Determine conditionality of payment: Once an obligation is satisfied, determine whether your company has an unconditional (receivable) or a conditional (contract asset) right to payment. Conditionality can be tied to the company’s future performance, the customer meeting certain criteria, or other factors specified in the contract. If the payment is conditional, outline the specific scenarios that trigger the recognition of a contract asset.

• Measure contract assets: You should initially measure contract assets at the amount the company expects to be entitled to for satisfying the performance obligation. Estimate variable consideration and adjust for any potential constraints on the collectability of the amount. In subsequent measurements, contract assets are carried at amortized cost. Systematically reduce their value over time as revenue is recognized. If there’s evidence that the company won’t be able to collect the full amount, recognize an impairment loss.

How contract assets are reported on financial statements

Contract assets are typically reported on a company’s balance sheet as a separate line item within current assets. This segregation from other receivables reflects their conditional nature and potential collection risks. Here’s more detail about how to handle these assets in your financial statements.

Balance sheet

Contract assets are reported on the balance sheet as a separate line item under current assets, distinct from accounts receivable. They are classified as current assets if the company expects to invoice and collect the amount within its normal operating cycle or one year, whichever is longer. They might be classified as noncurrent assets if the settlement of a contract asset is expected to take longer than this period.

Income statement

Contract assets affect income statements through revenue recognition. When a company recognizes a contract asset, it also recognizes revenue in the same amount, reflecting the completion of a performance obligation under ASC 606. The revenue is recognized on the income statement in the time period during which the performance obligation was satisfied.

Notes to financial statements

Companies must provide detailed disclosures about their contract assets in the notes to the financial statements. These disclosures typically include:

• The nature of the goods or services that have been transferred to customers but not yet billed

• Major changes in the contract assets balances during the reporting period, including a reconciliation from the beginning to the end of the period

• Information about the timing of satisfying performance obligations and the expected timing of the conversion of contract assets into receivables

Example

Suppose a construction company engages in a project where payment is structured around specific milestones. After completing the first phase, the company has earned $100,000 based on the contract terms. But this amount can only be billed after the second phase is completed, which is expected in the next financial period. At the end of the current period, the $100,000 is reported as a contract asset under current assets on the balance sheet. The income statement for the period will reflect $100,000 in revenue associated with this phase of the project. The notes to the financial statements would detail the nature of the project, the reasons for the recognition of the contract asset, and expected future cash inflows from this asset.

How contract assets are treated in the five-step model of revenue recognition

Contract assets are a direct outcome of the fifth step in the revenue recognition model. They represent the company’s right to receive payment for performance obligations that have been satisfied but where collection is contingent on future events or conditions. Here’s how contract assets fit into each of the five steps.

• Identify the contract with the customer: The company identifies a contract that is enforceable and has commercial substance. A contract must clearly specify the rights of the parties and the payment terms. Contract assets are not recognized at this stage, but the terms set here influence their recognition in later steps.

• Identify the performance obligations: The company identifies distinct performance obligations. A performance obligation could be a promise to deliver a product, provide a service, or a combination of both. Contract assets typically arise from performance obligations that require continuous management or progression of a project before billing can occur.

• Determine the transaction price: The company determines the amount of consideration it expects to receive for fulfilling its performance obligations. This price might include fixed amounts, variable consideration, or both. While contract assets are not directly influenced by the transaction price, the nature of the payment terms (such as bonuses or penalties that affect the price) can dictate when and how performance obligations are met and thus when contract assets are recognized.

• Allocate the transaction price: The company allocates a transaction price to each performance obligation based on their relative stand-alone selling prices. This allocation determines how contract assets are recognized as these obligations are fulfilled.

• Recognize revenue when (or as) the performance obligation is satisfied: The company recognizes revenue either at a point in time or over time. If a performance obligation is satisfied over time, revenue is recognized based on the progress toward completion. A contract asset is recorded when the work performed (or value transferred) exceeds the payment received. This often occurs in long-term contracts where billing occurs upon reaching certain milestones or at the end of the contract. Once a specific performance obligation is completely satisfied and is billable under the contract terms, any associated contract asset is converted into a receivable. This conversion reflects a change in the nature of the company’s right to payment from conditional to unconditional.

Example

Imagine a software development company contracted to create a custom software solution for a client. The contract stipulates milestone payments, with a significant final payment upon completion. The company recognizes revenue as it satisfies performance obligations over time (defined here as various phases of the software development lifecycle). If the company completes a milestone but the terms of the contract prevent immediate billing until the next milestone is also completed, the revenue recognized for completing the first milestone is recorded as a contract asset. This asset represents the company’s right to payment that is contingent on further performance.

Examples of contract assets in different industries

Various industries use contract assets when recognizing revenue. Here are some examples of how different types of businesses use these assets in their accounting.

Software

• A software company delivers a cloud-based application to a customer. The contract stipulates annual billing. The portion of the annual fee that represents the months of service already provided but not yet billed are a contract asset.

• A software vendor completes the installation and configuration of software for a client, but final payment is contingent upon the successful completion of user acceptance testing. The amount representing the completed work but awaiting final acceptance is a contract asset.

Construction

• A construction company completes a phase of a project and uses progress billing to invoice the client. Until the client approves and pays the bill, the outstanding amount represents a contract asset.

• A portion of each progress invoice is held back until the entire project is completed and meets certain quality standards. This is referred to as retention, and the amount held back from each payment is a contract asset.

Telecommunications

• A telecom provider installs equipment and activates service for a new customer. The installation fee is billed on the first monthly invoice. Until that invoice is generated and paid at the end of the first month’s service, the installation fee is a contract asset.

• A telecom company offers a bonus to customers who sign up for a multiyear contract. The bonus is paid out in installments over the contract term. The portion of the bonus earned but not yet paid is a contract asset.

Other examples

• An agency completes a marketing campaign for a client but payment is contingent upon achieving certain performance metrics (e.g., website traffic, sales leads). The agency’s fee for the completed work, pending performance verification, is a contract asset.

• A consulting firm delivers a project report to a client. Final payment is contingent on the client reviewing and approving the report. The consulting fee for the completed work, pending approval, is a contract asset.

Common issues in accounting for contract assets

Accounting for contract assets involves navigating several complex areas of revenue recognition. Here are some common issues businesses might face in managing contract assets.

• Determining performance obligations: Businesses must accurately identify and separate the performance obligations within a contract. Each obligation must be distinct and reasonably accounted for, which can be complicated in contracts that involve multiple deliverables or bundled services. Misidentifying these obligations can lead to incorrectly timing revenue recognition and misclassifying assets.

• Setting transaction price and consideration: Businesses might struggle to determine the transaction price, especially when it involves variable consideration (such as bonuses, penalties, or discounts). Businesses must also estimate the amount of consideration to which they will be entitled, taking into account the likelihood and magnitude of potential revenue reversals. This estimation and any subsequent adjustments can greatly impact the valuation of contract assets.

• Recognizing revenue over time vs. at a point in time: Businesses must decide whether revenue should be recognized over time or at a point in time. Errors in judgment here can lead to premature or delayed revenue recognition, which affects financial records and compliance with financial reporting standards.

• Measuring and reassessing progress: For contracts where revenue is recognized over time, businesses might struggle to measure their progress toward completely satisfying a performance obligation. Methods such as cost-to-cost, input, or output require judgment and consistent application; measuring incorrectly or failing to reassess progress can lead to incorrect recognition of contract assets.

• Changing contract terms: Businesses might need to reassess the contract asset and reallocate the transaction price among performance obligations if any modifications are made to the contract terms (e.g., changes in the scope of services, pricing adjustments). These changes can cause difficulties in maintaining accurate and current accounting records.

• Distinguishing between a contract asset and a receivable: Businesses might struggle to distinguish between contract assets and receivables. This distinction must be clear in financial statements, as errors can lead to misstatements in reported assets.

• Assessing impairment of contract assets: Contract assets are subject to impairment testing. Businesses must work to determine if and when a contract asset is impaired (e.g., if the collectibility of the consideration becomes uncertain), as this can affect financial reporting.

• Providing disclosures: Under ASC 606, businesses must provide extensive disclosure regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from customer contracts. Maintaining these disclosures can be a substantial administrative burden.

Best practices for compliance and audit preparedness

Businesses need to prioritize compliance with ASC 606 and prepare for audits year-round. Here are some of the best practices that businesses can employ.

Contract review and analysis

• Establish a formal process for reviewing and analyzing contracts. Involve cross-functional teams from finance, legal, and sales.

• Clearly identify performance obligations, payment terms, and any contingencies or conditions affecting revenue recognition.

• Document the contract review process and its conclusions to provide evidence of compliance.

Policies and procedures

• Develop comprehensive policies and procedures for accounting of contract assets and addressing recognition, measurement, impairment, and disclosure requirements.

• Communicate these policies and procedures to relevant personnel and provide ongoing training.

• Regularly review and update policies to reflect changes in accounting standards or business practices.

Internal controls

• Implement strong internal controls over contract asset accounting, including segregation of duties, authorization processes, and regular reconciliations.

• Use technology to automate data collection and analysis.

• Conduct periodic internal audits to check compliance with policies and procedures, and identify areas for improvement.

Documentation

• Maintain detailed records of contracts including the original agreements, amendments, and any relevant correspondence.

• Document key assumptions and judgments made in recognizing and measuring contract assets.

• Prepare comprehensive schedules and supporting documentation to facilitate audit preparedness.

Auditor communication

• Establish open and transparent communication with auditors early in the process.

• Share relevant policies, procedures, and documentation up front to help auditors understand the company’s contract asset accounting.

• Be prepared to address any questions or concerns from the auditors and to provide additional information as needed.