asc 606 generally accepted accounting principles

ASC 606 Revenue Recognition: A Practical Guide for Private Companies

by Hillel Zafir

Published: March 15, 2024,  

Updated: December 30, 2024

Revenue recognition is important for financial reporting. The new Accounting Standards Codification (ASC) Topic 606 requires private companies to follow updated standards more closely than before.

ASC 606 is a five-step guide for companies to recognize revenue accurately, promoting clear and consistent financial reporting. This blog shows private companies how to follow ASC 606 and outlines the key steps for recognizing revenue correctly.

It's important for all businesses, whether large or small, to understand the revenue rules of ASC 606. This knowledge helps them follow regulations and ensures they report their finances correctly. Let's explore the world of revenue recognition under ASC 606 and how it impacts private companies.

ASC 606 Revenue Recognition Requirements

What is Revenue Recognition?

Revenue recognition is a key accounting procedure that documents expected payments for goods and services a company offers. This process accurately records sales transactions and is crucial for assessing an organization's financial health.

Changes in Revenue Recognition under ASC 606

In 2019, FASB created ASC 606, which is a new rule for how companies recognize revenue in their accounting. This standard replaces previous rules that let revenue be recorded based on estimates, ignoring the actual cash received. Under ASC 606, businesses need to review customer contracts carefully. They should consider the services offered, how long they last, and the payment terms.

Parameters Defined by ASC 606 in Customer Contracts

ASC 606 sets specific parameters to ensure clear and transparent revenue recognition practices. It focuses on the following aspects of customer contracts:

  1. Type of Services Provided: Identifying the type of services or products provided to customers is crucial for determining the contract's performance obligations.
  2. Timing of Services: The timing of services indicates the period over which a company will recognize revenue, whether on a monthly, quarterly, or annual basis.
  3. Amount: The financial statements should accurately reflect the price of all performance obligations specified in the customer contract.

Following these rules ensures that accounting and revenue timing align with when goods or services are delivered. This provides a clear view of a company's financial performance. Now that we know the requirements, let's look at the steps private companies need to follow to implement ASC 606.

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Implementing ASC 606 for Private Companies

ASC 606 improves revenue reporting but can be difficult for small businesses to implement. Let's delve into some hurdles and considerations they must address during the implementation process.

Challenges Faced by Small Businesses

1. Simplicity to Complexity: Small businesses with simple revenue cycles may find tracking contracts, prices, and performance obligations relatively more straightforward. As they grow, however, ASC 606 becomes clearer, and they need to adapt to a more complex accounting system.

2. Expertise Requirement: Implementing ASC 606 demands internal expertise in handling complex standards and interpreting contractual arrangements. Small companies struggle to hire or train staff due to the complex revenue recognition rules of ASC 606.

Need for Internal Expertise and Repeatable Processes

1. Contract Reviews: ASC 606 requires careful evaluation of contracts to identify performance obligations and allocate transaction prices. Cross-functional communication between accounting, legal, and sales teams is essential. Implementing repeatable processes for contract reviews ensures consistency and accuracy in recognizing revenue.

2. System Improvements: Businesses must upgrade their systems to accommodate the requirements of ASC 606. These systems must collect detailed information on past transactions, discounts, disputes, and customer fees.

Tracking Transactions Across Multiple Periods

1. Integration of Data: Companies often encounter challenges integrating data from multiple operational tools. For accurate revenue recognition, finance teams need a centralized platform to segment and analyze transaction data effectively.

2. Price Determination: The transaction price requires detailed information about historical transactions and pricing adjustments. Finance teams need to set up systems to collect and organize information. This is important for accurate pricing and to comply with ASC 606 rules.

Private companies can increase their income and gain better financial insights. They can address challenges and invest in systems that comply with ASC 606 rules.

The Five Steps of ASC 606 Revenue Recognition

To ensure compliance with ASC 606, private companies must follow a structured five-step process for revenue recognition. Let's explore each step in detail:

1. Identify the Contract(s) with a Customer

Contracts play a fundamental role in revenue recognition under ASC 606. Companies must identify contracts with customers, whether written or oral, that have enforceable rights and obligations. Several criteria come into play during contract identification:

  • Commitment and Rights: The agreement between the parties should demonstrate a commitment to perform and rights to receive consideration.
  • Payment Terms: Companies must determine the agreed-upon payment terms and conditions.
  • Collectability: There should be a reasonable expectation of collectability for consideration.
  • Commercial Substance: The transaction should have commercial substance, expected to impact the entity's future cash flows.

A business should clearly explain how often customers will receive their subscriptions, which could be monthly or yearly. They should also specify when customers will be billed for subscriptions and setup fees. The business must also detail the customer's commitment to pay, specifying both the payment amount and schedule. Some fees are recorded right away. However, unearned revenue is recognized later. It is only recorded when the business completes its service obligations.

2. Identify the Performance Obligations in the Contract

Performance obligations are specific commitments in a contract to provide goods or services to a customer. These obligations can be distinct from one another and serve as separate entities for accounting purposes.

A company offers a yearly software subscription, a one-time setup fee, and a charge for custom integration. These charges are treated as three separate performance obligations and are monitored independently.

Finding these obligations often requires teamwork among departments such as accounting, legal, and sales. This collaboration helps ensure everyone understands the services or products and clarifies their prices and delivery times. A central financial data platform helps manage transactions and track revenue. It keeps all information in one place, making it easier to access and use.

3. Determine the Transaction Price

The transaction price is the total expected payment from the customer for the goods or services. Calculating this price can be complicated. It requires information about past transactions, discounts, disputes, and fees. This information varies for different customers.

Frequently, this data is scattered across several operational systems, lacking efficient integration. A single system for all transaction data helps finance teams analyze information better and set accurate transaction prices.

4. Allocate the Transaction Price to the Performance Obligations

When handling a contract with multiple performance obligations, a company must divide the transaction price among different tasks. The FASB provides guidance on estimating the standalone price of obligations. It also explains how to distribute discounts and manage changes in contract terms. This ensures that revenue is appropriately recognized for each distinct obligation within the contract.

5. Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

Revenue is recognized when a company finishes a task for a customer. This can happen over different accounting periods. For example, suppose a business enters into a one-year agreement with a customer. It will recognize revenue gradually over 12 months as it fulfills its contract obligations.

To apply ASC 606, businesses need to understand their transactions. They also need a system that can handle revenue accounting and recognition complexities. Private companies can use financial data platforms and automation tools. These help them meet ASC 606 requirements and provide valuable insights, improving their financial management and planning strategies.

revenue recognition principle

Real-World Examples of Revenue Recognition under ASC 606

Let's look at real-world examples to understand better how ASC 606 works in practice for recognizing revenue.

Example 1: Software as a Service (SaaS) Company

Consider a SaaS company that offers a subscription-based software product with an annual subscription fee. Under ASC 606, the company must identify its promises in the contract. This includes monthly revenue, software access, and ongoing customer support.

  1. Identify the Contract: The contract is established when the customer agrees to pay for the annual subscription, and the company agrees to provide access to the software and support.
  2. Identify the Performance Obligations: The company has two distinct performance obligations: providing access to the software and offering ongoing customer support.
  3. Determine the Transaction Price: The transaction price is the annual subscription fee agreed upon by the customer.
  4. Allocate the Transaction Price: The company must allocate the transaction price between the two performance obligations based on their standalone selling prices.
  5. Recognize Revenue: Revenue is recognized over the subscription period as the company fulfills its performance obligations, providing access to the software and offering customer support.

Example 2: Construction Company

Consider a construction firm contracted to erect a commercial building. This agreement encompasses a range of services, including design, material provision, and labor.

  1. Identify the Contract: This step occurs when both parties concur on the project's specifics.
  2. Identify the Performance Obligations: The firm must fulfill several key tasks: offering design services, supplying the necessary materials, and executing labor.
  3. Determine the Transaction Price: The total amount agreed upon for the contract.
  4. Allocate the Transaction Price: The firm must distribute the transaction price among the identified obligations, according to their individual or relative standalone selling prices.
  5. Recognize Revenue: Revenue is acknowledged as obligations are met. Revenue from design services is recorded as the work is done. Revenue from materials and labor is recorded when those parts of the project are completed. This method helps the company show its earnings correctly based on the project's progress and follow ASC 606 rules.

These examples illustrate how ASC 606 impacts revenue recognition across different industries and contract types. Implementing ASC 606 for private companies requires careful consideration of the contract terms, performance obligations, and transaction data. Automation tools and finance platforms can simplify revenue recognition, ensure compliance, and offer useful insights for finance leaders.

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ASC 606 Implications for Warranties

Warranties are important for product sales, and ASC 606 provides rules for how to recognize revenue from them. Companies must carefully evaluate the nature of their warranties and how they impact revenue recognition. Here's how ASC 606 addresses warranties:

  1. Identify Warranties as Separate Performance Obligations: Under ASC 606, warranties that provide customers with an additional assurance beyond the assurance provided by the standard products or services are considered separate performance obligations. Companies must allocate a portion of the transaction price to these warranties and recognize revenue accordingly.
  2. Determine Standalone Selling Price of Warranties: To allocate the transaction price to warranties, companies must determine the standalone selling price. This can be done using observable standalone sales of similar warranties or the expected cost plus a margin approach.
  3. Recognize Revenue Over the Warranty Period: Revenue related to warranties is recognized over the warranty period as the company fulfills its obligations under the warranty terms. If the company incurs additional costs to fulfill the warranty, such as repairs or replacements, these costs may impact the timing and amount of revenue recognition.
  4. Consider Impact on Deferred Revenue: In some cases, the warranty period may extend beyond the initial sale of the product or service. Companies must add this to their deferred revenue calculations and recognize revenue accurately as they provide warranty services.

Understanding and applying these guidelines is crucial to ensure accurate revenue recognition for warranties and compliance with ASC 606. Companies might need to change their accounting systems to handle the special requirements of warranties under the new rules.

Practical Expedients Under ASC 606

ASC 606 allows companies to apply practical expedients to simplify the implementation of the new revenue recognition standard. These practical expedients relieve specific requirements under ASC 606 and can benefit companies with limited resources or complexities. Some common practical expedients include:

  1. Portfolio Approach: Companies can apply the portfolio approach to groups of similar contracts with similar characteristics. This simplifies determining the transaction price and allocating it to performance obligations.
  2. Sales Taxes: Companies can exclude sales taxes from the transaction price if third parties collect them.
  3. Incremental Costs of Obtaining a Contract: Companies can recognize certain incremental costs of obtaining a contract as an expense when incurred rather than capitalizing them.
  4. Costs of Obtaining a Contract with a Customer: Companies can use a practical expedient when accounting for certain costs incurred to obtain a contract with a customer.

Companies should evaluate how these practical options apply to them and keep records of their decisions. This will help ensure clarity and compliance with ASC 606.

Conclusion

ASC 606 has fundamentally altered the landscape of revenue recognition for contracts, imposing substantial adjustments for companies. Private companies need to think carefully about changes, use skilled team members, and follow clear procedures. This helps them meet compliance standards and maintain accurate financial records.

Grasping new requirements, using available simplifications where fitting, and employing technological solutions can help businesses transition to ASC 606 efficiently. This method helps companies comply with rules, prioritize client value, and stay updated on the latest revenue recognition standards.

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