A generally accepted accounting principle (GAAP), ASC 606 revenue recognition identifies the specific conditions in which revenue is recognized and determines how to account for it. If we dig deeper, the revenue recognition principle states that revenue can only be recognized once it has been earned – not necessarily when money is received.
To illustrate, we’ll use a couple of simple examples. Say your landscaping business completes the tree trimming of a housing development and sends the client an invoice for $500. Since the tree trimming is complete, you can recognize the $500 immediately – even though payment won’t be received until the following month. Using the same landscaping example, we’ll add a twist to the scenario. The client pays $1,500 in advance each quarter for monthly tree trimming – can you recognize the $1,500 as soon as it’s received? Since your services take place on a monthly basis, you can only recognize $500 each month once you’ve completed your tree trimming obligations for that month.
Knowing when to recognize revenue can be challenging for businesses across all industries. In an effort to establish best practices, eliminate confusion and standardize the recognition of revenue, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) developed a framework – Accounting Standards Codification (ASC 606) – for more consistent revenue recognition.
The Four W’s of ASC 606 Revenue Recognition
To start, let’s cover the four W’s – who, what, when, and why – of ASC 606 revenue recognition.
ASC 606 revenue recognition affects virtually all companies – public and private – that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of specific nonfinancial assets.
Focusing on the promises of the contract, its primary basis is that a company should only recognize revenue in the amount they are entitled to for the exchange of goods or services provided. To help organizations stay focused on and adhere to the principles, the standard provides a five step process for revenue recognition.
- Identify the contract(s) with a customer – This is the agreement between the company and the client, and contains obligations and rights that can be enforced by either party when necessary. The essential components of the contract are 1) all parties have approved the contract, 2) all parties are committed to fulfilling their obligations, 3) each party’s rights are identifiable, 4) payment terms are identified, 5) the contract has commercial substance, and 6) collectibility is probable.
- Identify the performance obligations in the contract(s) – This is the promise to transfer goods or services to the customer. A distinct service is identified when 1) the customer can benefit from the goods or service, and 2) the goods or service can be transferred independently of other performance obligations in the contract.
- Determine the transaction price – This step refers to the cash and non-cash a company expects to receive in exchange for the transferring of the promised goods or services. The amount can be fixed, variable, or a combination of both and may include other considerations such as upgrades, downgrades, price concessions, volume discounts, rebates, etc. The allocated amounts are recognized as revenue when or as performance obligations are met.
- Allocate the transaction price to the performance obligations in the contract(s) – When a contract contains more than one performance obligation, the company needs to allocate the total consideration to each performance obligation based on its relative standalone selling price. We should note that ASC 606 doesn’t prohibit any methods used for estimating the standalone selling price, as long as the estimate is an accurate representation of what the price would be if it were a separate transaction. This step is a bit more challenging for software-as-a-service (SaaS) companies since their products or services are delivered on a recurring basis.
- Revenue recognition when or as the entity satisfies a performance obligation – The final step, revenue is recognized when or as the performance obligations stated in the contract are fulfilled. Satisfying performance obligations can happen either at a specific moment or over a period of time.
While the effective dates for ASC 606 are staggered, the guidance became effective in 2018 for public entities with calendar year ends, and in 2019 for nonpublic entities with calendar year ends. However, there are some exceptions. Last year the FASB voted to extend the effective dates of the revenue recognition standard to nonpublic entities that hadn’t issued their financial statements. For private companies and private not-for-profits, the effective date will be for fiscal years beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. For public not-for-profits, the effective date was December 15, 2019.
ASC 606 revenue recognition was developed for a variety of reasons, including to:
- Remove inconsistencies and weaknesses in revenue requirements.
- Provide a robust framework for addressing revenue issues.
- Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
- Provide useful information to financial statement users through improved disclosure requirements.
- Simplify the preparation of financial statements by reducing the number of publications.
In addition, the standard eliminates differences between GAAP and IFRS.
Adhering to ASC 606 has many nuances and can be difficult to navigate. To overcome some of the pitfalls, companies need a way to make revenue recognition easy.
Simplify Revenue Recognition
At its very core, ASC 606 revenue recognition is all about when contractual obligations are met – not necessarily when payment is received. Getting it right requires intelligent revenue recognition software that delivers automation, accuracy and auditability.
Obtaining the right revenue recognition solution shouldn’t be left to chance. To help you select the right cloud-based revenue recognition solution, here are four key characteristics the software should provide.
- Contract management: Be sure the billing solution enables you to easily manage contract rates and payment terms, as well as provides the ability to set specific pricing, define rules, and create account hierarchies.
- Flexible data models: An extensible data model enables you to add objects, fields, and relationships and then apply business rules to support any monetization model. A flexible data model allows you to quickly modify the application and data structure to respond to market or regulatory changes.
- Seamless integration: A fully integrated financial system requires the ability to seamlessly integrate with your other applications, such as customer relationship management (CRM), enterprise resource planning (ERP), general ledger, etc.
- Global compliance: Stay in sync across all accounting standards and ensure your revenue recognition aligns with ASC 606 or IFRS 15 with a billing solution that ensures compliance.
The right revenue recognition platform helps you simplify revenue recognition complexities even for the most complex billing scenarios. BillingPlatform delivers a rules-based revenue recognition engine that enables you to define rules specific to your company and make assignments in real-time, while providing the agility you need to speed the financial close process with real-time subledger transactions that integrate into downstream ERP and accounting systems. Are you ready to learn more? BillingPlatform’s experts are just a button click away!