Summary: ASC 606 lays out recognition rules. Rather than recognizing revenue when the risk of loss has been passed on to the customer, revenue must be reported when the goods are transferred. Click through for an introduction to the complex world of revenue recognition through the lens of ASC 606.
The Financial Accounting Standards Board created ASC 606, which is essentially a standard that clarifies how businesses must go about recognizing their revenue. The ASC 606 revenue recognition standard provides a consistent, principles-based framework for all businesses, no matter the industry.
The standard is designed to create a path that businesses within all industries can utilize when it comes to recognizing revenue, and ASC 606 sets forth five steps that these businesses can implement across the board. With a standardized method for recognizing revenue, investors and other interested parties can compare a company’s results with those of other companies.
Here is one way to think about ASC 606. Basically, under legacy generally accepted accounting principles, revenue is recognized when substantially all the risks from the sale of goods or services have been passed on to the customer. Under ASC 606, revenue is recognized when the control of the goods or the services is passed along to the customer.
The five-step ASC 606 model
ASC 606 sets out a standard five-step model for its revenue recognition process:
- Identify the contract with the customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price.
- Recognize revenue when or as the entity satisfies a performance-related obligation.
These steps must be adhered to for the duration of the contract’s term. Failing to do so could result in errors or, even worse, a restatement.
Examples of the five steps in action
The five steps that make up the ASC 606 model involve technical accounting changes that include the application of new estimates and judgments.
Here are some examples of the five steps in action:
- Identifying performance obligations, such as whether the contract includes more than one good or service that can be considered distinct or whether the goods or services in the contract are either highly independent or highly interrelated.
- Determining the timing of the transfer of control of each performance-related obligation.
- Identifying incremental contract costs for capitalization.
- Listing all variable considerations in the contract, such as claims and pending change orders, unpriced change orders, incentives, penalty provisions, shared savings, price concessions, liquidating damages and unit prices.
- Determining whether one or more of the goods or services in the contract significantly modifies one or more of the other goods or services in the contract.
- Capitalizing and amortizing costs, such as sales commissions and bonuses.
- Determining the beginning retained earnings adjustment.
- Adding certain quantitative and qualitative disclosures.
More details regarding ASC 606
ASC 606 applies to both existing and future contracts. In order to be compliant, companies are required to review every contract. ASC 606 also requires them to review any and all existing policies, procedures or internal controls. Additionally, the process will involve the financial, IT and HR departments as well as various other relevant departments.
A good way to approach the implementation of ASC 606 is by naming a multidisciplinary team and charging it with the development of a checklist or decision tree that identifies the items that need to be included in every type of contract that the company enters into. Doing so will help the business successfully identify every contract clause that contains an element of revenue recognition, and from there, each one can be reported correctly, as advised by ASC 606. Also, to ensure that the resulting document remains comprehensive, it should be reviewed periodically.
At the end of the day, determining when the control of the goods or the services is passed along is a matter of judgment, which is based on criteria such as whether the customer or the company holds legal rights to titles or whether the physical possession of the goods or the services has been passed along to the customer.
The process is both complicated and detailed. Businesses should implement revenue recognition software that can help determine their contracts’ performance-related obligations and allocate the transaction price to each obligation. Among the features to look for when comparing software options are flexible data models, configurable templates, forecasting models and seamless integration with other applications.
Everything we have discussed today is merely an introduction to the topics at hand. Other guidance may also affect how you address this. When it comes to revenue recognition, it is especially important for you to work closely with an accounting professional.