ASC 606 is an accounting and revenue recognition procedure that came into effect in the financial year following December 15, 2017. All businesses and organizations engaging in contracts or sales agreements with customers need to follow these standards. ASC 606 calls for a five-step model for revenue recognition. It also outlines methods of measuring progress.
In the United States, ASC 606 replaces an earlier model that was referred to as ASC 605. Thus, it is an update of existing standards. The aim is to create consistency in revenue recognition.
Earlier, there were separate rules for separate industries and sectors. This sometimes led to a lack of proper comparison across them. With ASC 606, there are unified guidelines that have to be followed across all sectors.
ASC 606 also calls for more detailed and comprehensive disclosures by companies. Among other things, organizations need to:
- Disclose separate revenue streams.
- Create links between contractual liabilities at the beginning of an accounting period with revenue earned at the end of the period.
- Share details of performance obligations as well as quantitative data.
Let’s take a deep dive into the five steps of ASC 606, the codification procedures, measuring progress, and the overall impact.
What is ASC 606?
ASC 606 is an accounting process developed by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). It aims to create transparency in the way businesses recognize revenue.
The need for ASC 606 arose because enterprises followed different procedures in accounting for transactions of a similar nature. Because of this, investors and other stakeholders found it difficult to compare financial statements.
ASC 606 creates a common platform for measurement. It leads to better comparative analysis and simplifies financial statements.
Businesses have to follow a five-step model to adhere to ASC 606. This is what you need to know:
Step 1: Identify the contract with a customer
To begin with, businesses needs to follow certain standardized norms when entering into a contract with a consumer for good or services.
Under this principle, all documents of this nature are clubbed together as one agreement.
For example, if a software vendor has separate contracts with a client for sales, service, and support, it is treated as one contract.
The contract has to be approved by both parties, and payment and other terms have to be clearly specified. This makes it the single source for investigating revenue received.
Step 2: Identify the performance obligations in the contract
This step lays out how different performance obligations in the contract should be handled.
Performance obligations mean all the different promises made to a customer that is mentioned in the contract. These obligations often relate to a single purchase agreement.
Examples of performance obligations include:
- Installation services.
- Subscriptions.
- Training and other professional services provided by the vendor.
The company’s systems have to be reconfigured to capture all such performance obligations. Fees and services for each one need to be separately tracked.
Step 3: Determine the transaction price
Under this step, the transaction price refers to the total amount that the enterprise expects to receive after transferring the goods and services to the customer under the contract. The accounting department should be careful in estimating this amount.
In many cases, it also involves the revenue expected during the entire term of the contract. Any discounts, rebates, and other variables also should be taken into account.
Finally, the figures in this step need to be balanced with a risk of non-payment or any possible reduction in revenue in the future.
Step 4: Allocate the transaction price
This step deals with guidelines for distributing and allocating the transaction price across separate performance obligations that are mentioned in the contract. It should all add up to the total of what the customer agrees to pay for the goods and services.
For example, a software company can allocate separate amounts for the actual software sale, the training period, any subscriptions for different tiers, services, and so on.
Similarly, other companies can allocate the price based on product price, guarantee period, after-sales service, etc.
Step 5: Recognize revenue when or as the entity satisfies a performance obligation
Here, revenue received is linked to meeting performance obligations. This step recognizes the timely manner in which the customer receives goods and services and pays for the same.
The client has to indicate satisfaction as per contractual obligations. This step recognizes the period when the complete transfer of goods and services takes place to the customer’s satisfaction.
How to Measure Progress Using ASC 606
ASC 606 regulations specifically state that the objective of measuring progress is “to depict an entity's performance in transferring control of goods or services promised to a customer (that is, satisfaction of an entity's performance obligation).”
Under ASC 606, measuring progress refers to:
- Satisfying performance obligations over time.
- Tracking progress towards completion.
- Timing of revenue recognition
A company can employ various ways of measuring progress. It should select the method that best depicts the completion and transfer of goods or services.
Various factors can affect the measurement of progress. These are related to resource allocation and cost calculations.
For example, a certain procedure can cost the company more than expected due to reasons such as inflation or price rise because of other factors.
There could also be cases in which more resources are needed to fulfill obligations. That is why the company should regularly update measures of progress and revenue recognized.
This will accurately depict the reporting performance over time.
A. Output Methods
Output methods of measuring progress refer to revenue based on direct measurements of the value transferred to the customer.
Examples include surveys of work performed to date, units produced, and units delivered.
B. Input Methods
Input methods relate to revenue based on the company’s efforts to satisfy performance obligations.
Examples are costs incurred, labor and machine hours, and quantities of materials used.
Companies should use the methods that best reflect their operations and contracts. ASC 606 guidelines stipulate that this should be consistent with the stated objective. The method should succeed in depicting satisfaction of a performance obligation when transferring control of goods and services to the customer.
What Is the Impact of ASC 606?
For many companies, the introduction of ASC 606 has changed the way they look at sales strategies, compensation packages, product roadmaps, and sales commissions. They have had to re-evaluate when and how they account for revenue. Contracts have to be re-evaluated to determine whether sales need to be booked differently.
Yet another impact of ASC 606 is that companies have had to change systems, processes, and reporting. This changes how they communicate internally and externally and to their investors.
Moreover, it becomes more complicated in a digital world, where companies and consumers have to navigate different levels of engagement. These relate to individual offerings as well as ongoing subscriptions.
Companies also have to disclose much more information. This relates to the accounting approach, tools used, contract details, and all means of estimating revenue.
With ASC 606, companies have to design new rules for recognizing all forms of revenue and apply them to all of their offerings.
Conclusion
ASC 606 calls for a consistent manner of recording revenue across industries. The objective is to simplify financial records for purposes of assessment and comparison.
Under the rules of ASC 606, every company must follow five accounting steps. These are:
- Identify the contract with a customer.
- Identify performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price.
- Recognize revenue as the entity satisfies performance obligations.
Companies must also measure progress in order to satisfy performance obligations and revenue receipts over time. For this, they can follow input or output models. There should be a consistent approach, whatever the method employed.
ASC 606 has had a large impact on the way enterprises approach contracts and fulfill customer obligations. They have had to re-evaluate how and when revenue is recorded.
