Final answer:
A company recognizes contract assets or liabilities based on the performance obligations being satisfied. Contract assets are recorded when the right to payment is conditional, while contract liabilities occur when payment is received in advance or an unconditional right to payment exists prior to delivering a good or service.
Step-by-step explanation:
A company does not recognize contract assets or liabilities until the performance obligations in the contract are satisfied either partially or in full. In accounting, this is known as the revenue recognition principle, which is a cornerstone of accrual accounting and is detailed in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 606 for revenue from contracts with customers.
According to ASC Topic 606, a company recognizes revenue when it satisfies a performance obligation by transferring a promised good or service to a customer. A contract asset is recognized if the company's right to consideration is conditional not only on the passage of time but also on the fulfillment of other performance obligations. Conversely, a contract liability, such as customer deposits or deferred revenue, is recognized when a customer pays consideration, or the company has an unconditional right to payment before the goods or services are transferred to the customer.
Examples of Contract Assets and Liabilities
• A contract asset may be recognized when a company has performed part of a service but has not yet billed the customer because the billing occurs at a specified milestone in the contract.
• A contract liability would be an instance where the customer pays in advance for services or goods that are to be delivered in the future.
By adhering to these principles, companies ensure that their financial statements accurately reflect the transfer of goods and services and align with the economic events that drive those transfers.