What is ASC 606?
ASC 606 is the revenue recognition standard established by FASB and the IASB that governs how revenue generated by public and private companies is recorded on their financial statements.
The effective date in which compliance with ASC 606 was mandated for public companies was set to start in all fiscal years after mid-December 2017, with an extra year offered to non-public companies.
ASC 606 Revenue Recognition Compliance (Step-by-Step)
ASC stands for the “Accounting Standards Codification” and is intended to establish the best practices for reporting purposes among companies, both public and private, to ensure consistency and transparency in financial statement filings.
The ASC 606 principle was developed in conjunction between FASB and IASB to further standardize revenue recognition policies.
ASC 606 provides guidance on the recognition of revenue by companies with revenue models oriented around long-term contracts.
The relatively new accounting policy — a highly anticipated adjustment — addresses the topics of performance obligations and licensing agreements, which are two items that are increasingly prevalent in modern business models.
The ASC 606 framework offers step-by-step guidance to companies on the standards for how revenue is recognized, i.e. the treatment of “earned” revenue vs. “unearned” revenue.
FASB and IASB Guidance: ASC 606 Effective Dates
The purpose of the updated standard was to eliminate inconsistencies in the methodology by which companies would record their revenue, especially across different industries.
Before the changes were implemented, the limited standardization in financial reporting made it challenging for investors and other consumers of the financial reports filed with the SEC, resulting in comparisons among different companies to sometimes be “apples-to-oranges”.
The effective date in which ASC 606 compliance became required are as follows:
- Public Companies: Start in all fiscal years after mid-December 2017
- Private Companies (Non-Public): Start in all fiscal years after mid-December 2018
The nature of the transaction, the associated dollar amount, and the terms surrounding the timing of the delivery of the product or service must be considered by the accountant preparing (or auditing) the financials of a company.
Once ASC 606 became the new standard, it achieved the following goals:
- The inconsistencies in revenue recognition policies utilized by different companies were removed, or at the very least, substantially reduced.
- The majority of the “uncertainty” or grey areas of revenue recognition were clarified in the official document, which clearly outlines the specifics around the criteria of what constitutes revenue.
- The comparability of revenue among companies, even for those operating in different industries, improved due to the increased consistency stemming from the stricter rules.
- Companies are required to provide more details around any unclear parts of their revenue recognition, resulting in more in-depth disclosures in financial reports to supplement the core financial statements, i.e. the income statement, cash flow statement, and balance sheet.
ASC 606 5-Step Model: Revenue Recognition Framework
In order for revenue to be recognized, a financial arrangement among the parties involved must be evident (i.e. the seller delivering the good/service and the buyer receiving the benefits).
Within the transaction agreement, the specific events that denote the completion of the product or service delivery must be clearly stated, as well as the measurable pricing charged to the buyer (and the seller’s collection of the proceeds post-sale and delivery should be reasonable).
The five-step revenue recognition framework set by ASB 606 is as follows.
- Step 1 → Identify the Signed Contract between the Seller and Customer
- Step 2 → Identify the Distinct Performance Obligations within the Contract
- Step 3 → Determine the Specific Transaction Price (and Other Pricing Terms) Stated in the Contract
- Step 4 → Allocate the Transaction Price over the Contract Term (i.e. Multi-Year Obligations)
- Step 5 → Recognize the Revenue if the Performance Obligations are Satisfied
Once the four steps are met, the final step is for the seller (i.e. the company obligated to deliver the good or service to the customer) to record the revenue earned, since the performance obligation was satisfied.
In effect, ASC 606 provided a more robust structure for revenue accounting for public and non-public companies, which, most importantly, became standardized across all industries.
Types of Revenue Recognition Methods
The most common methods of revenue recognition are the following:
- Sales-Basis Method → The revenue is recorded once the purchased good or service is delivered to the customer, irrespective of whether the form of payment was cash or credit.
- Percentage of Completion Method → The revenue is recorded based on the percentage of the performance obligation completed, which is most applicable to multi-year contracts.
- Cost-Recoverability Method → The revenue is recorded once all of the costs associated with the completion of the performance obligation (and the transaction) are complete, i.e. the payment collected from a customer must exceed the cost of the services.
- Installment Method → The revenue is recorded after receipt of each installment payment from the customer, which is in compensation for the ongoing project (i.e. the delivery of the good/service).
- Completed-Contract Method → While seldom used in practice, revenue here is recognized once the entirety of the contract and performance obligations are fulfilled.
What is the Impact of ASC 606?
While the transition phase might have been inconvenient for certain companies, the objective of the new compliance standards is to make the process of revenue recognition simpler (and thus, easier for end users to interpret and understand the financial statements of companies).
The impact of ASC 606 was certainly not uniform across all industries. For example, clothing retailers most likely saw minimal disruption or inconvenience from the switch. The retail business model is characterized by purchases of products and the recognition of revenue post-delivery at a single point in time, whether the customer paid using cash or on credit.
However, companies with business models with recurring sales such as those operating in the software-as-a-service (SaaS) industry with subscriptions and licenses most likely had a vastly different experience in terms of the adjustment period.
In accordance with the revenue recognition principle, revenue is expected to be recognized in the period in which the good or service was actually delivered (i.e. “earned”), so the delivery is the determinant of when revenue is recorded on the income statement.
SaaS Business ASC 606 Example: Multi-Year Customer Contracts
Suppose a B2B SaaS business offers its clients the option to pick a specific type of pricing plan, such as quarterly, annual, or multi-year payment plans.
Notably, upfront payments are accepted for services not anticipated to be received by the customer for more than twelve months. But whichever plan the customer picks, the service is delivered on a monthly basis.
Each specific contractual obligation contained within the customer contract (and the corresponding pricing and performance obligation) determines the timing of the revenue recognition.
If we assume one corporate client signed a contract with an average order value (AOV) of $6 million upfront for four years of services, the company cannot record the entire one-time customer payment in the current period.
Instead, the revenue can only be recognized after each month over the four-year term, or 48 months.
- Average Order Value (AOV) = $6 million
- Number of Months = 48 Months
By dividing the AOV by the total number of months, the “earned” revenue each month is $125,000.
- Monthly Recognized Revenue = $6 million ÷ 48 Months = $125,000
If we multiply the monthly revenue by the number of months in a year, 12 months, the annual recognized revenue is $1,500,000.
- Annual Recognized Revenue = $125,000 × 12 Months = $1,500,000
In the final step, we can multiply the annual revenue by four years to arrive at our AOV of $6 million, confirming our calculations so far are correct.
- Total Recognized Revenue, Four-Year Term = $1,500,000 × 4 Years = $6 million
Accrual Accounting Concept: Deferred Revenue
Our example in the prior section introduces the concept of deferred revenue, which describes the event wherein the company collects cash payment from a customer before the actual delivery of the good or service.
In other words, the performance obligation of the company has not yet been met. The cash payment collected from the customer was received in advance because the company is obligated to provide a specified benefit to the customer on a future date.
With that said, the deferred revenue, often referred to as “unearned revenue”, is recorded in the liabilities section of the balance sheet, as the cash was received and all that remains is for the company to fulfill its responsibilities as part of the signed agreement.
Until the unmet obligation of the company is fulfilled, the cash received from the customer cannot be recorded as revenue.
The prepayment is captured by the deferred revenue line item on the balance sheet and will remain there until the company “earns” the revenue. The period in which the good or service was delivered determines the timing of when the revenue is formally recognized as well as the associated costs per the matching principle.