The revenue recognition model known as Accounting Standards Codification 606 (ASC 606) has been in effect for some time now. But many of our clients request an overview of the standard to be sure they’re on the right track. Let’s start with the basics.
What is ASC 606 revenue recognition?
ASC 606, also known as the revenue recognition model, is an accounting standard created jointly by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). ASC 606 dictates how businesses should recognize revenues from contracts with customers.
To put it more plainly, the revenue recognition model explains when businesses should record revenues on their financial statements — and in what amounts.
Why was the ASC 606 revenue recognition model created?
The FASB and the IASB wanted to harmonize the revenue recognition practices of businesses in all types of industries. They created a universal framework that attempts to recognize revenues in line with actual delivery of goods or services. This ensures that investors, analysts, and other stakeholders can make educated decisions using the information they find on the financial statements.
How should revenue be recognized under the ASC 606 model?
ASC 606 prescribes a five-step model to determine when businesses should recognize contract revenues.
1. Identify the contract with a customer.
A contract exists if:
- There is an agreement (explicit or implied) between you and another party;
- Both parties understand their rights and obligations and understand when the transfer of goods or services will be;
- Payment terms are agreed upon;
- There is commercial substance to the contract, meaning that an actual exchange of economic value occurs; and
- You are likely to collect payment from the customer.
2. Identify the performance obligations.
A performance obligation is the promise to provide a distinct good or service to your customer. A performance obligation exists only if you’re able to transfer those goods or services; if they cannot be transferred, they are not—on their own—considered a performance obligation. There may be a bundle of goods or services that make up a single performance obligation, and there can be one or more performance obligations in a single contract.
3. Determine the transaction price.
The transaction price is the amount you expect to receive in exchange for transferring goods or providing services to your customer. This includes all types of consideration—flat fees, variable rates, and incentives—and should be reduced by rebates, discounts, and concessions. If you don’t know the exact transaction price at the contract’s onset, you can estimate the transaction price.
4. Allocate the transaction price to the performance obligations.
Allocate the total transaction price to each separate performance obligation (if you have more than one).
5. Recognize revenues as you satisfy the performance obligations.
Once you complete a performance obligation and transfer it to your customer, you can report revenues for that portion of the contract.
Who needs to follow ASC 606?
Revenue recognition applies to all businesses that follow generally accepted accounting principles (GAAP): public companies, private businesses, and nonprofits alike. It is seen by both the FASB and the IASB as the current standard for US-based companies to follow when they record revenue on their financial statements.
When did ASC 606 become effective?
ASC 606 was first introduced in May of 2014. Initially, it was set to go into effect in 2016, but the effective date got pushed back more than once. Below is a table that summarizes the effective dates of ASC 606 for each type of entity.
What are some of the biggest compliance challenges of implementing ASC 606?
Adopting the new revenue recognition model likely wasn’t easy. Even if you have a system in place, there may be some compliance challenges you find along the way. Here are a few common ones.
Identifying performance obligations
It can be difficult to determine when a promise to transfer goods or services stands alone as its own performance obligation within a larger contract. There are two main criteria to consider:
- First, you need to determine if your customer can benefit from what you deliver even if the other goods or services in the contract don’t follow.
- If the first is true, you then need to be able to distinguish this promise from others in the contract.
If both are true, you’ve likely identified a single performance obligation.
Allocating the transaction price
Typically, the transaction price should be allocated among the different performance obligations based on each one’s standalone selling price (SSP). The SSP is the amount a customer would pay for that good or service on its own. If the SSP isn’t known, the company can estimate the SSP as long as they disclose their judgements and estimates in the footnotes.
How to handle contract modifications
Contract modifications exist when there has been a change in project scope or price. As an example, let’s assume you agree to provide monthly maintenance services to a customer for two years. One year in, the client wishes to add an additional two years to the contract. You need to determine if this is considered a change to the existing contract, or if this should be accounted for as a new contract altogether.
Contract modifications have been a hot-button topic since the accounting standard was introduced because it can be difficult to determine when a true modification has occurred. A qualified advisor can walk you through the nuances of this topic, but a few things you’ll need to ask yourself are:
- Have both you and your customer agreed that there has been a change in scope?
- Does the modification affect the transaction price?
- Are goods or services being added or removed from the original agreement?
The answers to these questions can help you determine if you need to (1) modify the existing contract, (2) terminate the existing contract and create a new one, (3) create a new contract for just the modification.
Drafting the right disclosures
ASC 606 requires you to disclose both quantitative and qualitative information about your revenue recognition practices. One such disclosure requirement is a disaggregation of revenues. Instead of reporting only one line of revenue, you should break that revenue up into categories so that users of the financial statements can better understand cash flow. A few other disclosure requirements are:
- Contract balances (receivables, contract liabilities, and contract assets)
- Which performance obligations remain unsatisfied
- Payment terms
- Significant judgements you made
- How you estimated contract prices
- How you allocated the transaction price to each performance obligation
- Method used to recognize revenue for performance obligations that are satisfied over time
What other questions do you have about revenue recognition?
The revenue recognition model might be a significant shift for your business. But complying with ASC 606 can help you in more ways than one. From an external standpoint, it can show your clients, business partners, investors, and lenders that you are up to date on industry standards. From an internal standpoint, it will be a great way to think about your contracts a bit differently.
If you have further questions about ASC 606, contact us today.
