Farewell to the Contingent Cap

One of the most significant changes to revenue recognition on the new standard may be the elimination of the contingent, or cash, cap requirement. There are those that did not like the contingent cap requirements because they linked revenue recognition to cash payments and that did not seem to follow the spirit of accrual accounting. That view, however, seems based on believing the contingent cap requirement is in place due to a collectability issue with recognizing revenue before the cash is due from the customer. While that view may be applicable in some cases, the primary driver of the contingent cap rules is that you should not recognize revenue until delivery is complete. If the vendor is still required to provide a significant service in order to be entitled to a payment, you cannot recognize revenue under current GAAP.

In practical terms, if I need to provide wireless service in order to be entitled to a payment, I cannot and should not recognize any portion of that revenue even if today’s multi-element rules say a portion of that service charge should be allocated to a deliverable that is already completed (providing the subsidized handset), because if I don’t provide that second deliverable (the wireless service) I will never be entitled to the revenue. I acknowledge that the future service is almost always delivered and there is very little question about the ability to continue to deliver that service in the future. In fact, the business model of subsidizing wireless handsets is built upon delivering that service in the future, otherwise a business would go bankrupt very quickly selling smartphones to hundreds of dollars below cost.

The FASB has decided that if you have a contract, or even an implied contract, then the revenue from performance obligations (the new term for deliverables) is not contingent at all on the future performance because they start with the assumption that both parties will fully deliver on all elements of the contract (the vendor will provide all performance obligations and the customer will make all required payments). Given that is the way it works a significant majority of the time that assumption is not unreasonable even though it is less conservative than the previous assumption.

The result of this position is that revenue will get recorded earlier under the new standard compared to existing GAAP. It also brings into question other “conservative” elements in existing GAAP. For example, the general practice is that no matter how likely a gain contingency is under ASC 450, you simply do not record it until it is legally owed because to do so “might be to recognize revenue before its realization” (ASC 450-30-25-1). On the other hand, you recognize losses as soon as they are probable and estimable. The asymmetrical answer under ASC 450 would seem to be the opposite of the answer the FASB has come up with under the new revenue standard and I wonder if and when the Board will decide to address that difference.

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