ASC 606: A Guide to Revenue Recognition Compliance
Prior revenue recognition standards under US GAAP were inconsistent and complex. Numerous guidelines governed various industries and transaction types differently, leading to confusion and opportunity for manipulation.
This made financial reporting less transparent for stakeholders. Patchwork rules enabled firms to boost revenue numbers artificially, undermining credibility and comparability across reporting. Investors and regulators demanded simplified, uniform standards.
The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) 606 to address this. ASC 606 provides a comprehensive framework to standardize revenue recognition practices.
The core principle is that revenue is recognized when control of goods or services is transferred to the customer. This reflects the FASB’s customer-focused approach. ASC 606 establishes consistent guidelines across sectors for identifying performance obligations, determining transaction prices, and recognizing revenue upon fulfillment of obligations.
With ASC 606 in place, organizations have clearer principles governing timely and accurate revenue recognition.
What is ASC 606?
Account Standard Codification, or ASC 606, enables businesses to recognize revenue as it’s earned. The Financial Accounting Standards Board (FASB) issued this accounting principle in May 2014. It’s the GAAP-based rules that apply to U.S. companies.
One key difference between ASC 606 and previous revenue recognition standards like ASC 605 is the principle-based approach. ASC 606 focuses on recognizing revenue when control of goods or services is transferred to customers, unlike the previous rules-based approach. This shift aims to provide a more comprehensive and consistent framework for revenue recognition across industries.
Adopting ASC 606 offers several benefits for businesses. Firstly, it enhances comparability and consistency in financial reporting, making it easier for investors and stakeholders to evaluate and compare companies’ performance. Additionally, ASC 606 provides clearer guidelines for contract modifications, variable consideration, and accounting for costs incurred to obtain or fulfill contracts. This increased transparency can lead to improved decision-making and a better understanding of revenue streams.
The ASC 606 process
To properly recognize revenue under ASC 606, businesses need to follow a 5-step model. This model provides a structured approach to ensure that revenue is recognized accurately and in compliance with accounting standards.
Step 1: Identify the contract. The first step is to identify the contract with a customer. This involves determining whether an agreement exists that creates enforceable rights and obligations between the parties involved.
Step 2: Identify performance obligations. Once the contract is identified, businesses need to identify the performance obligations within the contract. Performance obligations are promises to transfer goods or services to the customer and can be explicit or implied.
Step 3: Determine transaction price. The third step is to determine the transaction price, which is the amount of consideration a business expects to receive in exchange for transferring the promised goods or services to the customer.
Step 4: Allocate transaction price to performance obligations. After determining the transaction price, businesses need to allocate it to the identified performance obligations based on their relative standalone selling prices.
Step 5: Recognize revenue when performance obligations are satisfied. Revenue should be recognized when control over the goods or services is transferred to the customer and the customer is able to benefit from them.
By following this 5-step model, businesses can ensure they are recognizing revenue correctly and in accordance with the ASC 606 standard.
Asc 606 revenue recognition
ASC 606 allows for various revenue recognition methods, including the recognition of revenue over time or at a point in time, depending on when control is transferred to the customer. The following are examples of different revenue recognition methods.
Sales-basis method
The sales-basis method recognizes revenue as soon as the company renders the transaction of goods or services — that’s when the company makes a sale. Whether a customer pays with cash or on credit, the sales-basis method of revenue recognition is a function of delivery of goods or services, not payment.
Percentage of completion method
This method is widely used for long-term projects by many companies. The company recognizes revenue progressively as they complete project work. You can measure the completion stage through cost-to-cost efforts expended, etc.
For example, a construction company gradually recognizes revenue as it completes each building project milestone.
Installment method
As installments are due/received, companies can recognize revenue proportionately for long-lived agreements. This method is common in post-paid subscriptions or financing arrangements.
For example, for a 3-year magazine subscription, here is how you’ll recognize revenue using the installment method:
Year 1: Recognize 1/3 of the total contract value as revenue for the year
Year 2: Recognize the next 1/3 as revenue, making it 2/3.
Year 3: Recognize remaining 1/3 as revenue
Completed contract method
This is the opposite of percentage completion, as revenue and profits are deferred until the entire project or contract is fully executed or substantially completed. It has a single revenue recognition point. This method is most used when you can’t ascertain or predict the amount needed for project execution.
For example, a complex customized I.T. system contractor defers all revenue recognition until the client signs off on final system acceptance testing.
Cost-recoverability method
In scenarios where the contract parties cannot reliably estimate the future profit, the cost-recoverability method recognizes revenue only up to the costs incurred until the project achieves breakeven or resolves uncertainties. Common in early-stage software firms.
For example, an early-stage biotech firm with a lengthy drug development cycle only recognizes revenue to the extent costs are covered until completion risks subside.
ASC 606 vs. IFRS 15
ASC 606 and IFRS 15 are both standards that ensure revenue recognition compliance.
ASC 606
The Accounting Standards Codification Topic 606 for revenue from contracts with customers was issued by the Financial Accounting Standards Board (FASB). It has been effective for public companies since 2018, private companies 2019, and is primarily followed in the United States.
ASC 606 follows a 5 step revenue recognition model. It may require adjusting for the time value of money in certain circumstances.
Performance obligations: identifies distinct performance obligations and provides criteria for their separation
The transaction price for principal and agent relationships with an unknown end price: ASC 606 takes a more conservative approach, only recognizing the known principal fee if the end price is variable
Determine the transaction price for noncash consideration: fixation on contract inception is more restricting
IFRS 15
The International Financial Reporting Standards 15 for revenue from contracts with customers was issued by the International Accounting Standards Board (IASB). It has been in effect since 2018, and has been adopted by over 140 companies globally.
IFRS 15 follows the same 5 step revenue recognition model as ASC 606. It requires adjusting for the time value of money when there is a significant financing component.
Performance obligations: defines criteria for identifying distinct performance obligations and separating them in the contract
The transaction price for principal and agent relationships with an unknown end price: allows for more judgment. The principal can forecast the total price and estimate variable consideration
Determine the transaction price for noncash consideration: it provides more room for judgment on when to measure the fair value of noncash payments
ASC 606 Implementation Challenges
Implementing ASC 606 can pose several challenges for organizations, but with careful planning and best practices, these challenges can be overcome. Here are some common challenges faced by organizations and the best practices for successful ASC 606 implementation:
Common challenges faced by organizations:
Understanding the new revenue recognition rules: ASC 606 introduces significant changes to revenue recognition practices, which can be complex and challenging to understand.
Data collection and analysis: Gathering and analyzing the necessary data to comply with ASC 606 requirements can be time-consuming and labor-intensive.
System and process changes: Implementing ASC 606 often requires organizations to make changes to their existing systems and processes, which can be disruptive if not managed properly.
Best practices for successful ASC 606 implementation:
Educate and train employees: Providing comprehensive training and education to employees involved in revenue recognition is crucial to ensure a clear understanding of ASC 606 requirements.
Collaborate with cross-functional teams: Successful implementation of ASC 606 requires close collaboration between finance, sales, and other relevant teams to align processes and data.
Utilize automation tools: Leveraging automation tools can streamline data collection, analysis, and reporting, saving time and reducing errors.
Zuora provides robust Revenue Recognition Software that can keep your business ASC 606 Compliant. These tools can assist organizations in managing revenue recognition processes, automating calculations, and generating accurate financial reports.
Why is ASC 606 compliance important to my business?
ASC 606 compliance enables accurate and transparent financial reporting that satisfies regulatory requirements, retains investor confidence, and prevents unfavorable audit outcomes. These are some of the reasons why ASC 606 compliance is critical.
Material weakness due to deficiencies
Noncompliance with ASC 606 can lead to deficiencies or a combination of deficiencies in internal control, causing material misstatement of financial statements. Also, material weakness could spiral into the following impact:
Regulatory scrutiny
External audit leading to high costs
Loss of investor, stakeholder, and analyst confidence may negatively impact the stock price, credit rating, and company valuation
Incurs noncompliance penalties
FASB, IASB, in conjunction with the Department of Justice (DOJ) and Security and Exchange Commission (SEC), made it mandatory for any business that enters a contract or sales with customers to comply with ASC 606 — although the penalty depends on the severity of noncompliance but the penalties range from fines to jail terms.
Transparency into corporate performance
By recognizing revenue upon fulfilling performance commitments, ASC 606 provides clearer visibility into the economics and substance of corporate deals and activities for investors. This provides transparency into deal structures and links revenue reporting to underlying economic performance.
Compliance enables investors, stakeholders, and banks to obtain comprehensive insights into overall company operations and the revenue earned over time.
Makes refunds from cancellations easier
Businesses that adhere to ASC 606 guidelines experience little or no dispute regarding refunds and cancellations. Compliance ensures that companies have structured processes, making it easier to handle refunds and cancellations by accounting standards, thus minimizing potential disputes or complications.
What to look for in ASC 606 software
GAAP compliance
Ensure your revenue recognition solution incorporates the necessary features and functionality supporting compliance with (GAAP), ASC 606, and IFRS 15. You want software with built-in compliance checks and validation. Any solution without the required features and functionality for compliance may pose a risk of restatement or SEC scrutiny.
Automated recognition process
Look for software that offers automated recognition processes. It saves you the stress and difficulty associated with the complexity of compliance with ASC 606 in a manual process. Automation also prevents costly mistakes and increases efficiency. The software should configure workflows to recognize revenue upon completion of performance obligations to eliminate manual analysis/booking to avoid the loss of valuable data.
Contract management
Does the software enable customer contract modification to identify performance obligations and accurately determine transaction prices? Software with an effective contract management system provides adequate features for customer contract management modifications. The system should automatically assess common contract add-ons, terminations, renewals, etc., and reallocate revenue appropriately.
Without a proper contract management feature, you’re susceptible to missing customer contract details, which may lead to errors in identifying performance obligations and incorrect revenue bookings.
Revenue subledger
Do you want to track revenue recognition down to individual contract line items at a granular level? You need a revenue subledger for a 360-degree comprehensive revenue report in compliance with ASC 606 guidelines and principles. Revenue recognition software with a revenue subledger connects with your CRM, ERP, and other tech stacks to serve as the single source of truth. This should provide you with a comprehensive understanding and management of all your revenue transactions.
Related: Struggling to meet your revenue accounting needs with your ERP?
Automated stand-alone selling price (SSP)
You want the system to perform SSP allocation immediately after receiving orders. The revenue recognition software should have the means to use historical sales, product lifecycle, and pricing data to determine the SSP without observable evidence.
An ASC 606 software should automate the stand-alone selling prices for each good and service in a customer contract. Users should be able to configure the software easily to define SSP criteria based on product, customer type, and geographical region to save time in the closing process. Manually determining SPP can be complex; automation simplifies this by recognizing revenue based on the transaction price of each performance obligation.
This includes the capacity to apply essential factors like variable considerations, such as discount, time value of money, and incentives in determining SPP. The revenue recognition should automatically update pricing as it changes over time.
Revenue allocation tools
Stand-alone selling prices feed into the relative allocation approach to assign revenue to performance obligations. The software should be able to distribute transaction prices among performance obligations within a contract accurately.
Rev rec without a revenue allocation tool would make it difficult for you to assign the appropriate share from the overall transaction price of each obligation for a multiple contract.
Integration with the entire tech stack
Compliance with ASC 606/IFRS15 guidelines requires a sound internal control system — a function of how your entire tech stack is integrated. The software should enable seamless data connectivity across billing, accounting, CRM, CPQ, and ERP systems for accurate revenue recognition triggering. Without connectivity to source systems like billing and accounting, revenue recognition triggering will have blind spots.
Real-time reporting and analytics
Revenue recognition software should offer robust reporting and analytics features, including generating financial reports in compliance with ASC 606. It should provide a detailed dashboard for some or all of the following revenue metrics:
Revenue trends
Customer analysis
Sales analysis
Contract analysis
Selling price analysis
Incentives and discounts
Disclosure and financials
Pre-configured real-time reports and analytics help drive informed revenue management.
Revenue recognition with Zuora
Zuora Revenue is purpose-built to automate revenue recognition for complex, recurring revenue businesses. It provides end-to-end capabilities to model customer contracts, continually recognize revenue, generate accounting entries, and power revenue-related reporting in compliance with ASC 606 and IFRS 15.
Key benefits include:
Automated revenue recognition model creation and management
Waterfall analysis for contract allocation and calculation validation
Amortization schedule design and simulation modeling
Out-of-the-box integrations with leading ERPs and CRMs
Compliance documentation, including disclosures and checklists
Ready to implement revenue automation? Explore the revenue automation software buyer’s guide for a complete roadmap for researching, testing, and selecting the right revenue automation software for your company.