5 steps to recognizing revenue under ASC 606
Today, different industries approach revenue recognition differently, making for a convoluted and inconsistent process. That changed in December 2017 -- businesses across the U.S. and Europe must follow the industry-neutral Revenue from Contracts with Customers guidelines.
US GAAP requires public entities to apply the revenue standard for annual reporting periods (including interim periods therein) beginning after December 15, 2017, while nonpublic entities reporting under US GAAP are required to apply the revenue standard for annual periods beginning after December 15, 2018.
The new guidelines impact companies’ finance and IT departments in particular, as old, rigid accounting solutions are in no way capable of supporting ASC 606 compliance. But all business units, including tax compliance, contracts, and legal, will feel the impact as contract revenue reporting gets turned on its head.
The new revenue recognition model
The Revenue from Contracts with Customers guidelines (dubbed ASC 606 by the Financial Accounting Standards Board and IFRS 15 by the International Accounting Standards Board) establish a five-step process to govern contract revenue reporting. Broadly speaking, they are:
- Identify the contract(s) with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when or as you satisfy a performance obligation (rather than on final delivery, as in the past)
Let’s look at each of these steps in turn.
Identify the contract(s) with a customer
A defined contract is relatively straightforward. It’s essentially an agreement reached between two parties or more creating obligations and rights that can be enforced when necessary. ASC 606 guidelines apply to a contract with a customer which meets certain criteria within the guidelines. ASC 606 also gives specified requirements for accounting of changes made to the contract.
Identify the performance obligations in the contract
In this case, contracts feature an agreement to give a specified good or service to the customer named in the contract. If the good or service is different enough from each other, promises featured in the contract are handled separately. ASC 606 details what makes a good or service distinct enough from the other.
Determine the transaction price
This step is pretty straightforward in that it defines the price that will be paid to an entity after that entity delivers the good or service promised within the contract. The price can be a set amount as noted in the contract, but it can also include other variables or come in a different form. The price will also be changed based on effects if the time value of money. This is usually the case where a notable financial investment is required.
Allocate the transaction price to the performance obligations in the contract
The entity gives the agreed upon transaction price once an obligation is met. That price can be based on standalone selling prices as determined by the service or good which is defined within the contract. If that selling price is not apparent, the entity will need to estimate what it is. Transaction prices don’t always have to match the standalone selling price. Sometimes the contract will dictate that a discount is offered along with any other chosen variables. Requirements in ASC 606 detail when the entity can allot these variables to obligations.
Recognize revenue when (or as) the entity satisfies a performance obligation
Once a performance obligation has been met, the entity recognizes that revenue and transfers the good or service defined in the contract to the customer. That customer thus retains has control over that good or service. The total amount of that revenue is the already defined amount as agreed upon to the performance obligation once met. Satisfying a performance obligation can happen in a number of ways, either at a specific moment or over a period of time. Transferring goods usually happens in the former manner while transferring a service typically happens in the latter manner. In cases where an obligation is satisfied over a period of time, the entity will choose an appropriate way to measure progress relating to when the obligation will be completed.
There’s more to ASC 606 than the above, of course. The guidelines also include instructions on how to disclose revenue with a list of the requirements. The idea is to help the business give comprehensive details about revenue and cash flows that come from the contracts it has with customers. This would include information about the timing, nature, uncertainty, and amount of the revenue. All in all, ASC 606 sets a standard for what organizations must disclose regarding revenue. This includes:
- Revenue recognized from contracts with customers, including the disaggregation of revenue into appropriate categories
- Contract balances, including the opening and close balances of receivables, contract assets, and contract liabilities
- Performance obligations, including when the entity typically satisfies its performance obligations and the transaction price that is allocated to the remaining performance obligations in a contract
- Significant judgments, and changes in judgments, made in applying the requirements to those contracts
In a sense, this is an attempt to bring all companies around the world into agreement by setting a mutually agreed upon standard that everyone can follow. No longer will companies have their own sets of qualifications for how they report contract revenue. One of the goals is to eliminate confusion and lack of clarity. Of course, as with any new rule or regulation, it will take some time to get used to how best to follow the new standards. Even a simplified process has its own unique intricacies as companies become more experienced with it. That’s why having a full understanding what the guidelines are is so important.
Delving deeper into the guidelines brings the complexities to light. For example, there are new considerations for bonuses, refunds, and penalties, and ASC 606 may impact how companies handle sales and use tax compliance on contracts, particularly recurring ones.
Sales and use tax is typically a tricky area for businesses, as regulations, rules, and rates vary widely by U.S. jurisdiction — there are more than 12,000. In some industries, such as manufacturing, distribution, and software, tax rules are especially complex and can change frequently. Businesses in any industry can find relief in automated solutions that seamlessly apply the right tax to customer invoices generated from contracts.
The new guidelines will have a significant impact on industries all over the world. In the financial industry, for example, workers will likely see many of their daily tasks affected. The more standardized and general regulations means having an intricate knowledge of the financial rules of a specific industry will not be necessary anymore. Instead, those in finance will need to get to know the revenue recognition ASC 606 standards, but once that knowledge is gained, they’ll be able to apply it in a variety of industries. Legal and sales industries will also be affected, though in different ways. Legal teams already deal with contracts, so the new regulations will obviously have an impact, especially when it comes to the value of the deal in regards to performance obligations. In the case of sales, organizations will have to take into account how the ASC 606 standards affect sales incentives. Many salespeople rely on commissions and bonuses, so figuring out how they should handle the changes will become a top priority.
Relief in terms of adopting ASC 606 guidelines will come from planning ahead, allowing time to think through all the implications of the wide-ranging changes and adjust accordingly — not to mention plan for the transition. Yet, according to a Connor Group study, nearly 90 percent of public U.S. companies are behind on understanding how the new standards will impact their financial operations.
However, given that the future holds more complexity for essentially every business in every industry — even those for which revenue recognition has been neat and tidy in the past — the time for procrastination has clearly passed.
To learn more about ASC 606 and the implications, click here.
Avalara helps businesses of all sizes achieve compliance with transactional taxes, including sales and use, VAT, excise, communications, and other tax types. The company delivers comprehensive, automated, cloud-based solutions that are designed to be fast, accurate, and easy to use. Avalara’s Compliance Cloud™ platform helps customers manage complicated and burdensome tax compliance obligations imposed by state, local, and other taxing authorities throughout the world.