The "Handshake Deal" under ASC 606

It is a scenario that plays out in sales departments everywhere: the quarter is closing, a top rep moves a major deal to "Closed Won" based on a verbal agreement or an email confirmation, and the implementation team is immediately given the green light to begin work. Meanwhile, the Master Services Agreement (MSA) remains unsigned, or the client is a cash-strapped startup with a highly questionable credit history.

Historically, companies might have simply recognized the cash upon receipt or booked the revenue as the work was performed. Under ASC 606, however, the "handshake deal" presents a significant compliance risk. If a transaction fails to meet the strict thresholds of contract inception, a company cannot recognize revenue—even if cash has already changed hands.

Here is a breakdown of ASC 606 Step 1, the risks of premature implementation, and how to handle high-credit-risk clients.

The ASC 606 Step 1 Reality Check

Under ASC 606, a contract does not exist for accounting purposes simply because an agreement was discussed or an invoice was generated. To establish a contract, a transaction must pass a rigid, five-part test at inception.

If an arrangement fails even one of these criteria, it is not a contract, and revenue recognition cannot begin:

1. Approval and Commitment: The parties to the contract have approved the contract and are committed to perform their respective obligations.
2. Rights Identified: The entity can identify each party’s rights regarding the goods or services to be transferred.
3. Payment Terms Identified: The entity can identify the payment terms for the goods or services to be transferred.
4. Commercial Substance: The contract has commercial substance (i.e., the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).
5. Collectibility is Probable: It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.

For growth-stage SaaS and service companies, criteria #1 and #5 are the most common points of failure.

Trap #1: Working Before the Ink is Dry (Approval and Commitment)

ASC 606 allows that contracts can be written, oral, or implied by an entity's customary business practices. This flexibility, however, is often misinterpreted.

The operative phrase is *customary business practices*. If a company historically requires a signed MSA and an executed Order Form to formalize an agreement, an oral commitment or an informal email does not meet the threshold for approval and commitment.

If an onboarding team begins a 30-day implementation process before the contract is fully executed according to customary practices, a problem arises. Work performed during this informal phase cannot trigger revenue recognition until the exact moment the contract is officially approved. In the eyes of auditors, the company is providing free services until the required documentation is completed.

Trap #2: The High-Credit-Risk Client (The Collectibility Threshold)

Sales teams frequently close deals with early-stage startups or distressed companies that lack a strong credit history.

Step 1 of ASC 606 explicitly states that a contract only exists if collectibility is probable. In U.S. GAAP, "probable" represents a high threshold (generally interpreted as a 75-80% likelihood or higher). The assessment is not based on whether the client wants to pay, but whether they have the financial capacity and intention to pay when the obligation comes due.

If a finance team evaluates a client and determines that collecting the consideration is not probable, the contract does not exist for accounting purposes.

The Consequence: The Deposit Liability

The accounting complications compound if a high-risk client submits an upfront cash payment for a contract that fails the collectibility test. Even with cash in hand, revenue cannot be recognized.

Because the arrangement failed the collectibility test at inception, the cash received must be recorded on the balance sheet as a deposit liability.

This liability cannot be converted into recognized revenue until one of two specific events occurs:

1. The contract has been terminated, and the consideration received from the customer is nonrefundable.
2. The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.

Until one of these conditions is met, the cash remains a liability, isolated from top-line revenue metrics.

The Controller’s Action Plan

To prevent informal agreements and high-risk clients from creating compliance failures, finance teams should implement strict operational controls: