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All businesses that enter into contracts with customers must recognize revenue in accordance with Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers.
This standard was created by the Financial Accounting Standards Board (FASB), and for most public businesses, the effective start date was January 1, 2018, while non-public companies had an additional two years to comply.
What Is ASC 606?
Simply put, ASC 606 establishes the principles for when and how revenue should be reported by organizations. This standard builds off of traditional GAAP guidance by providing a more robust framework to follow when accounting for contract revenue.
The new revenue recognition standard applies to all types of organizations that sell products and services, including public companies, private companies, and not-for-profit (NFP) entities. It also applies to all types of contracts, including sales of goods, services, land, and intellectual property.
ASC 606 requires businesses to acknowledge revenue when the products or services are provided to the buyer. The amount of revenue should reflect the total value that a company expects in return for its goods or services.
- Accounting Standards Codification 606 – ASC 606 is an abbreviation for Accounting Standards Codification 606, which is the full name of the FASB accounting standard.
- ASC Topic 606 – Revenue from Contracts with Customers: This is the official name of the standard as assigned by the FASB.
- IFRS 15 – International Financial Reporting Standards 15 is the equivalent standard issued by the International Accounting Standards Board.
Accounting for Revenue from Contracts under ASC 606
The core principles of ASC 606 Revenue from Contracts are:
- Revenue should be recognized when the products or services are provided to the buyer.
- The amount of revenue should reflect the total value that a company expects in return for its goods or services.
- Revenue recognition should be based on observable facts and evidence.
It started back in 2014 when the FASB and IASB released their convergence project on revenue recognition. The project’s goal was to create one revenue standard that would replace all current revenue recognition guidance.
After years of waiting and receiving feedback from businesses and other interested parties, the Board finally issued Update 2014-09 on May 28, 2014. The update went into effect for annual reporting periods beginning after December 15, 2016. By December 15, 2018, all other entities were required to comply with the new revenue standard.
Shortly after the first update, the Board issued Accounting Standards Update No. 2015-14 to delay Revenue from Contracts with Customers (Topic 606) by one year for all entities, although early adoption was also permitted.
Companies that rely on subscription services or license fees as their primary source of income were most affected by this rule change, and many had to make significant adjustments to their accounting processes and financial reporting.
Prior to ASC 606, if a company sold a 12-month software product license, it could only record six months of revenue. The other six months would go unrecorded until the following year. However, under the new law, all revenue can be counted immediately.
ASC 606 not only changed accounting and finance, but it also impacted IT systems, HR policies, and more. The unknown ramifications made it tough for many companies to adjust.
The 5 Steps to Recognizing Revenue Using ASC 606
To comply with ASC 606, businesses must follow a five-step process when accounting for revenue from contracts with customers. The steps are:
1. Identify the contract(s) with a customer
The first step is to identify whether a contract exists. This may seem simple, but it can be tricky in some situations.
A physical contract isn’t required in all cases, but some criteria should be met.
- Each party has approved the contract, and they both understand their rights and obligations.
- The contract has commercial substance. This means that it involves the exchange of goods or services that have value to the customer.
- The terms of the contract are enforceable by both parties.
- Each party’s rights can be identified, measured, and understood.
- The customer is likely to pay for the goods or services.
2. Identify the performance obligations in the contract
Examples of performance obligations include:
- Product: A company sells a widget to a customer. The performance obligation is to deliver the widget.
- Service: A company provides landscaping services to a customer. The performance obligation is to mow the lawn and trim the hedges.
- Warranty: A company sells a car to a customer and includes a warranty. The performance obligation is to repair or replace parts that break during the warranty period.
An obligation could also be to transfer a good or service to the customer at a specific time in the future.
3. Determine the transaction price
The transaction price is the amount of money that the company expects to receive in return for its goods or services. This amount can be a fixed price, variable price, or a mix of both. It can also be adjusted based on certain conditions, such as whether the customer pays on time (e.g., 2/10 net 30) or receives a discount for early payment.
The transaction price also comprises non-cash considerations, such as the value of loyalty points or frequent flyer miles.
4. Allocate the transaction price to the performance obligations in the contract
Businesses must allocate the transaction price to each performance obligation based on how much each one is worth. The standalone selling price is the amount that would be charged if the goods or services were sold separately.
5. Recognize revenue when (or as) the company satisfies a performance obligation
Revenue is only earned (or recognized) once the company has delivered a good or service to the customer—mo earlier or later.
In some cases, this will be at the time of delivery. For example, if a company sells a widget to a customer, the revenue will be recognized when the widget is delivered.
In other cases, revenue may be recognized over time. This is often the case with service contracts, where the company provides a service on an ongoing basis.
How ASC 606 Connects Sales and Accounting
Revenue recognition under ASC 606 is based on the transfer of control of goods or services to the customer. This is different from the previous method, which was based on when the revenue was earned.
The new method requires companies to have a better understanding of their sales processes and how they relate to the accounting system.
Subsequently, more changes to performance obligations will result from alterations in a quote or contract. To avoid this issue, sales management—which is responsible for creating the terms of customer contracts—needs to collaborate with the departments that are generating revenue from those contracts.
When ASC 606 is effectively implemented, there are several benefits:
- Accounting is less of a guessing game because there are more objective measures to determine when revenue should be recognized.
- Contracts can be written in a way that is more advantageous to the company since there is a better understanding of how those contracts will impact the financial statements.
- There is more transparency for investors, since they can see when revenue is actually being generated.
How CPQ Helps Companies Comply With ASC 606
CPQ software can help companies comply with ASC 606 in several ways.
By automating the creation of quotes and contracts, CPQ ensures that the terms of those documents are consistent with the company’s sales processes.
CPQ helps companies track the progress of their performance obligations and improve revenue intelligence initiatives. This is important because ASC 606 requires companies to have a clear understanding of their sales processes in order to correctly allocate the transaction price.
It also allows companies to track changes to performance obligations by providing a complete history of all the changes that have been made to a contract. This information can be used to allocate the transaction price and recognize revenue in accordance with ASC 606.
A few other ways CPQ helps companies with ASC 606 compliance include:
- Unifying different departments that are involved in the revenue management process, including sales, finance, and accounting
- Generating real-time reports on the status of performance obligations
- Helping companies identify areas where they may need to make changes to their sales processes in order to comply with ASC 606.
- Integrating contracting with invoicing and billing processes
People Also Ask
Who does ASC 606 apply to?
Initially, ASC 606 only applied to public companies and certain other organizations. Now, ASC 606 applies to all companies that report under GAAP. This includes public companies, private companies, and not-for-profit organizations.
When did revenue recognition rules change?
Companies both public and private were required to begin utilizing the new revenue recognition rules defined by Accounting Standards Codification Topic 606 (“ASC 606”), Revenue from Contracts with Customers, starting January 1, 2018 for public companies, and January 1, 2019 for private companies.
How is ASC 606 different from the previous revenue recognition standard?
ASC 606 is different from the previous revenue recognition standard in a few key ways. The most significant difference is that ASC 606 requires companies to recognize revenue based on the transfer of control of goods or services to the customer, rather than when the revenue is earned.
This change requires companies to have a better understanding of their sales processes and how they relate to the accounting system.
What is the difference between ASC 606 and IFRS 15?
The main difference between ASC 606 and IFRS 15 is that ASC 606 also applies to nonfinancial assets, such as real estate, while IFRS 15 does not as much.
IFRS 15 is principles-based, while ASC 606 is more rules-based. This means that there is more guidance available for companies when complying with ASC 606.