ASC 606 is the revenue recognition standard within the Accounting Standards Codification, and it sets out how companies in every industry should recognize revenue. Its purpose was to stop two businesses from booking the same kind of transaction two different ways.
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) developed it jointly, and it took effect in the fiscal year following December 15, 2017. Every organization with customer contracts or sales agreements has to follow it, for-profit and non-profit alike. If your business sells goods or services, ASC 606 applies to you.
What follows covers what changed between ASC 605 and ASC 606, where the standard sits inside the codification, and how revenue recognition works under it.
TL;DR
- ASC 606 replaces industry-specific revenue recognition rules with one set of guidelines.
- It requires more detailed disclosure, both qualitative and quantitative.
- A five-step model governs how and when revenue gets recognized.
- Software takes most of the manual work, and most of the errors, out of applying it.
What changed with ASC 606
Four changes matter most. The first is unified guidance: industry-specific rules gave way to one framework that applies everywhere, which is what makes financial reports comparable from one company to the next.
The second is disclosure. ASC 606 asks for more detail, including separate revenue streams and the connection between contract liabilities and revenue, and quantitative information alone doesn’t satisfy it; qualitative detail is required as well.
Third, sales commissions get capitalized. Under ASC 606 a business treats a commission as a long-term cost of obtaining the contract rather than counting it as an immediate expense.
Fourth, software revenue gets divided into parts, which allows more flexibility than the earlier standards did. Taken together, the four push toward a more detailed treatment of revenue and toward reports that line up with international standards.
The Accounting Standards Codification
The FASB created the Accounting Standards Codification in 2009 to organize and clarify Generally Accepted Accounting Principles (GAAP) in the U.S. The codification runs from the 100 series (general principles) through the 900 series (industry-specific guidance), and the 600 series covers revenue recognition. ASC 606 is the current standard there, replacing older ones such as ASC 605 and ASC 604.
FASB released the ASC 606 guidance in May 2014 and it took effect in the fiscal year after December 15, 2017. Legacy GAAP hasn’t disappeared, though: it still gets used for historical comparisons between the old revenue recognition standards and the current one.
Revenue recognition under ASC 606
Revenue recognition is how revenue gets identified and recorded in a company’s financial statements. GAAP requires revenue to be recognized when it is earned and realized, following the accrual principle, which means it belongs to the period in which it was earned even if the customer hasn’t paid yet.
What ASC 606 is after is consistency and comparability: one clear system covering the many different situations in which revenue arises, fewer inconsistencies in how it gets recognized, and more transparency for whoever reads the statements afterward.
The five steps
ASC 606 works through a five-step model, and each step carries criteria that have to be met before revenue can be recognized. The example running through the steps below is a software company selling a one-year subscription.
Step 1. Identify the contract with the customer
There has to be a legally enforceable agreement with specific terms and conditions, it has to have commercial substance, and collection of the consideration has to be reasonably expected. In the example, a software company contracts with a customer for a one-year subscription to its software services.
Step 2. Identify the performance obligations
Performance obligations are the distinct promises in the contract to transfer goods or services to the customer. The subscription contract carries three: access to the software, customer support, and delivery of updates.
Step 3. Determine the transaction price
The transaction price is what the business expects to receive for what it promised. It covers fixed amounts, variable consideration such as discounts and rebates, costs incurred, and any consideration payable back to the customer. You can’t leave the variable amounts out; they have to be estimated and included. The software company determines that the transaction price for the one-year subscription is $1,200.
Step 4. Allocate the transaction price
When a contract carries multiple performance obligations, the price is divided among them according to their individual selling prices, so that the revenue recognized reflects the relative value of each. The software company prices platform access at $900, customer support at $200, and software updates at $100, and allocates the transaction price on that basis.
Step 5. Recognize revenue as obligations are satisfied
Revenue is recognized when control of the goods or services transfers to the customer, which is the point at which the customer can use them and take the benefit. The software company earns its subscription revenue across the year, recognizing revenue for platform access, support, and updates as each obligation is satisfied.
The details matter at every step, and a contract that’s been read loosely produces revenue figures nobody can defend later. Contract terms and performance obligations have to be assessed accurately, and transaction prices and deferred revenue evaluated against what ASC 606 actually requires. Working the model this way is how businesses accurately track revenue and recognize it in a way that holds up in the financial statements.
Methods for revenue recognition
ASC 606 allows several recognition methods, and which one fits depends on the business’s revenue model.
- Sales-basis method: revenue is recognized at the point of sale, when the goods or services are delivered. It is the simplest option and it fits any situation where delivery marks the point of revenue recognition.
- Completed-contract method: revenue is recognized when the contract is finished, meaning all tasks are done and all costs and transactions have been recorded. It is common on projects and contracts that run a long time.
- Percentage of completion method: revenue is recognized in proportion to how much of the project is complete. It suits long contracts where income accrues gradually, and it depends on estimating completion carefully.
- Cost-recoverability method: revenue is recognized once all costs to complete the project or transaction have been recovered. It is used when the likelihood of collecting payment can’t reasonably be estimated up front.
- Installment method: revenue is recognized as each payment comes in. It is common on expensive items such as machinery or property, where the buyer’s payments may not be certain.
Other methods apply in narrower cases: accrual, appreciation, brokerage agreement, deposit, proportional performance, and bill-and-hold transactions. Choosing among them means weighing project duration, payment terms, collectability, and what is standard in the industry, then picking the one that represents the transaction honestly and still meets what ASC 606 requires.
For revenue operations, ASC 606 comes down to discipline. Get the contract, the obligations, and the price right and the recognition follows from them. Software helps manage the parts that don’t scale by hand, particularly contracts with many performance obligations or heavy variable consideration.
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