This guide provides a framework for reading large corporate contracts for revenue recognition purposes. Ultimately contract review can be more complex than this guide lays out but experience has shown this guide to be extremely effective at creating a much more rapid review of contracts. ASC 606 has 700 pages of guidance and an accountant can go around in circles reading it and the contract the corporation has drawn up. This guide gives the Revenue Accountant a clear mission as to what they are reading the contract and ASC 606 for. Once you know what you are doing your reading and analysis will go much more quickly.
Our first objective is to determine if we have a clear contract for the sale of products and services. The ASC 606 codification provides us with a five-step process that begins with “identify the contract”. However, the five-step process is a very inefficient and confusing way to work as a Revenue Accountant. The most efficient way to work is to use the two-step process of revenue recognition which is the following.
This model above is much easier to work with to manage a book of business and its revenue recognition. Now that we are oriented correctly with the two steps of a clear contract and performance and delivery of the products and services under the contract, we can setup a structure for how to read a large corporate contract.
The goal of our reading a contract is to determine if we have a clear contract for the products and services we think are being sold. Sometimes the contract is perfectly clear and it is the finding of performance and delivery evidence that is the difficult part. Sometimes the contract maybe be clear but we are not sure how to turn it into the allocation of revenue for revenue purposes. This guide will focus on how to read the contract to be sure it is a clear contract so that you can easily comply with all the steps within the five-step process of ASC 606 codification. This guide comes as a result of reading thousands of contracts over a 35 year career and seeing what are the key things to look for and what can be ignored so the contract review can be done quickly.
Almost all contracts for large corporations will have a good “recitals” section of the contract. It usually looks something like the following.
Above we see the two parties to the contract and we see the main purpose which is to document the contract of the sale of services to the “Client”.
Below is another example of a preamble to the contract and its recitals.
Above we have a slightly different structure but it is doing the same things. It is identifying the parties involved in the contract and it is explaining the purpose of the contract, which is to document what products and services are being sold. This portion of the contract we can call the preamble or the recitals. This recitals section can also provide a history and context of the contract which we need to know for revenue recognition purposes. We need to know the full context for any contract so we can determine the correct revenue recognition. The main thing we are looking for in terms of context is if the contract we are reading is modifying some other contract and therefore we would need to combine the two contracts into one for revenue recognition purposes.
The recitals section will ground us in three key points that are foundational to revenue recognition and they are the following:
- What parties are involved. Many times, just two but if three or more parties are involved, we will have to sort that out.
- What is the purpose of the contract which will often include a big picture summary of what is being sold and sometimes a history of the business relationship.
- Is there a prior contract we are amending or a master contract this contract is related to.
Once these foundational concepts are known we can dig into the three key elements of a contract which are Product, Price, and Payment.
Products and Services
Many of the contracts you may encounter will have many pages and you find the page(s) with the products and services mentioned at least around paying for them on a payment schedule. This might be called the payment schedule or Exhibit A that contains each product or service in a listing and the price for each product. I have seen the payment schedule also called the order form or other similar names but the key is that it is stating the products and services being purchased or potentially purchased depending on circumstances. For revenue recognition purposes we need to be sure we have all the products and services clearly identified within the contract. If you are just getting used to the contracts you are working with you can use a yellow highlighter and post it notes on a printed copy to clearly identify where the products and services are clearly defined.
If your contract contains wording around potential products purchases and discounts then you will have to consider the full context of the business relationship with the customer and how they behave over time. This is a complex topic which cannot be fully addressed in this guide. However, we can provide a guideline that discounting a potential purchase is one aspect of how a contract written on paper may not be enough to know what the full contract is. In other words, if there is a business practice that shows the seller needs to reallocate in Step 4 of the ASC 606 process, we would have to incorporate that here as part of identifying what that products and services the contract is selling.
Price for Products and Services
The payment schedule mentioned above can often have the price for the products and this can often be clearly laid out in a table. However, the price of the product can also be placed in the contract where it is not 100% clear and you may have to deal with this lack of clarity. In many cases in many companies something goes wrong in the quoting and contracting process where a subset of products or services are not clearly priced in the contract. Therefore, you may have to make some assumptions to calculate revenue. If there is any lack of clarity around pricing then the billing team will have the same problem as a revenue accountant and therefore you can make sure you use the same price used in billing as you will use in revenue recognition.
Payment for Products and Services
With our work on Products and Services and pricing mentioned above done we can move on to payment terms. It is important to mention that the order of your review of the contract is critical. There is logic to starting with the Recitals and then going to Product, Price, and Payment Terms in that order. The reason is that you cannot price what you are not sure you are selling and you cannot determine timing of a payment if you do not have the price determined.
What You Can Ignore
Now you have the big picture in mind. You know you have to read for the Recitals, Products, Price, and Payment terms. One of the ways you can develop your contract reading skills into a high-level skill is to also know what you can safely ignore because it will not impact revenue recognition. Much of this guide comes from reading contracts for software and services firms which contain many elements of the contract that can safely be ignored for revenue recognition purposes. One example of specific software and services firm is one selling electronic healthcare record software. With each contract selling the software there was also an agreement to comply with the Health Insurance Portability and Accountability Act (HIPAA). This is just another set of terms and conditions that surround the purchase of a software product that does not address the key elements of recitals, product, price, or payment.
You can read the contract headers to get an indication of what a particular paragraph is addressing and if the header indicates it is not referring to any of the key issues like Product, Price, or Payment then you most likely can ignore the entire paragraph. You will have to use your judgement around headers but as a guideline often attorneys who make the contracts consistently create headers that are reliable for revenue recognition purpose.
With the above caveat about headers here are some main headers and topics which often can be skipped because they contain nothing relevant for revenue recognition purposes.
- Limitations of Liability
- General
- Arbitration
- Governing Law
- Software License Terms
- Nondisclosure
- Confidentiality
- Data Security
- Laws and Governmental Regulation
If you have a standard contract template it is advisable to read at least one of the contracts in its entirety to be sure about what clauses of the contract are not relevant to revenue recognition for a particular company and or its particular product line or division. Once you are confident you know the template you can confidently make your list of what to ignore and focus on what does have impact for your revenue recognition analysis.
Disclaimer: The information provided in this booklet is for general informational purposes only and is not intended to be, and should not be, construed as legal, tax, or investment advice. You should consult with your own legal, tax, and investment advisors before making any decisions based on this information.