What ASC 606 means for revenue recognition

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.

Previously, there was ASC 605, which emphasized collectibility, which means companies could collect revenue before recording it. ASC 605 provides industry-specific guidance, with specific revenue recognition guidance for over 200 industries. 

The ASC 606 process

The following are the five steps of the process involved in ASC 606:

1. Identify the contract with the customer
2. Identify performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to performance obligations in the contract
5. Recognize revenue when or as the entity satisfies the performance obligation

 

Related: Read this article for more details on recognizing revenue under ASC 606

 

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 

 

What changed and why?

The previous revenue recognition standard for reporting revenue—a critical metric for evaluating a company’s financial performance—varied across different industries, jurisdictions, and markets. These discrepancies created incongruent accounting results for economically similar transactions, rendering macro-level comparisons nearly impossible.

The FASB worked on aligning US GAAP (ASC 606) with the International Accounting Standards Board’s (IASB) IFRS 15. The goal of ASC 606 was to simplify and harmonize revenue recognition practices through convergence between U.S. and international guidelines.

Through this, ASC 606 and IFRS 15 established unified principles as the premier standards for revenue recognition globally, superseding the previous patchwork of inconsistent industry-specific rules. 

The new standards are based on one overarching principle: companies must recognize revenue when goods and services are transferred to the customer in an amount that is proportionate to what has been delivered at that point.

 

Why is ASC 606 compliance important?

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.