ASC 606 Arrived… Why Revenue Recognition Must Still React

You wouldn’t be reading this if you didn’t know something about ASC 606. A portion of you is probably beyond tired of hearing about it. However, regardless of your level of knowledge now, we ask for your attention to consider the whole story, the implications, the challenges - and the potential.

Because if you think ASC 606 doesn’t affect you, think again.

ASC 606 affects everything.

What is ASC 606?

In 2014, the Federal Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) together issued a new set of standards for recognizing revenue from contracts with customers of goods and services for all public, private and nonprofit entities. Codified in the U.S. as ASC 606 and as IFRS 15 outside the U.S., these standards were scheduled to be instituted for public companies in 2018 and for private entities a year later. Though, as recently as June 2020, FASB provided another amendment to the effective date - to January 1, 2020, for calendar year-ends - for all entities yet to adopt.

Simply put, ASC 606 is the new revenue recognition standard that affects all businesses which enter into contracts with customers to transfer goods or services, whether public, private or a no-profit enterprise. Based on those deadlines mentioned, all public and privately held companies should at this point be ASC 606 compliant.

Let's take a moment to acknowledge the many folks who’ve spent years living and breathing this new guidance. Throughout the globe, organizations have had teams attend audit bootcamps, study the rules, sit down with auditors and complete assessments to identify the impact on day-to-day business and implement policy changes.

As a result, your organization may have instituted some complex ways to get through your revenue recognition process manually - referred to as the brute force method - in the rush to adopt. You now find yourself in a place where you’ve met the requirements and adopted the new standard, but you can’t scale and adapt as needed.

Revenue recognition, for complete clarity, is the generally accepted accounting principle (GAAP) that identifies the specific conditions under which revenue is recognized and determines how to account for it. Revenue is recognized when an identified event occurs, and the dollar amount is easily measurable to the company.

The two overriding goals in bringing ASC 606 to fruition have been the following:

1. Bring consistency to a previously scattershot set of revenue recognition practices. Before these standards were issued - in a significant first for those two issuing bodies to align on such rules - the requirements for reporting revenue varied depending on industry, market and jurisdiction. That prior lack of standardization in such critical financial reporting made it difficult for investors and other consumers of financial statements to compare results, even within the same industry.
2. Establish agreement on the overriding principle of the new standards, which is that an entity must recognize  revenue when goods or services are transferred to the customer in an amount proportionate to what has been delivered up to that point.

To accomplish the goal of simplifying and harmonizing the standards, ASC 606 was summarized into a five-step model for recognizing revenue from contracts with customers:

Step 1: Identify the contract with the customer

Step 2: Identify the separate performance obligations

Step 3: Determine the transaction price

Step 4: Allocate the transaction price to the performance obligation in the contract

Step 5: Recognize revenue when (or as) a performance obligation is satisfied

Seems simple enough, but there’s a reason this new set of rules was years-in-the-making and required multiple deferments by the governing bodies before going into full effect.

Regardless of where your organization is in adoption, we feel your pain. This is a principle open to interpretation and, because of that, every business is going to adopt in a different way to meet the standard. Some companies may change the way revenue is recognized; some may not. For some, there may be added flexibility to accelerate revenue and for some, there may be a need to amortize revenue over terms because of specific obligations. Put all these - and the many other - variables together and it’s easy to see the challenges, both to scalability and to closing your books quickly and with ease. ASC 606 added a burden to day-to-day business, but it all comes back to these five steps.

Let’s dig a bit deeper into what each really means.

Step 1: Identify the contract with the customer

What’s a contract? Simply put, it’s an agreement between two or more entities that establishes enforceable rights and obligations.

Less simply put, since there can be different types of such agreements, it’s the ones that meet the following qualifications which must comply with ASC 606 (which, in a great sign of symmetry, also tallies up to five):

1. Both parties approve of and are committed to the contract
2. Include clearly identified rights of each involved party
3. Include clearly identified payment terms
4. Contain a commercial substance
5. Include terms in which an entity is entitled to collect a form of consideration in exchange for goods or services

The other consideration here is the combination of contracts and contract modifications.

ASC 606 is a cross-functional standard, addressing not just revenue but the entirety of a contract. Think of that contract as the center of the universe to everything it touches, from billing to revenue and compensation. In considering how your organization is going to handle the new standard, it’s best to look at your contracts with this wide lens.

Step 2: Identify the separate performance obligations

The term “performance obligation” refers to a promise in a contract between a company and customer to transfer goods or services to that customer. Suppose that promise is for more than one good or service to the customer. In that case, each needs to be accounted for as a performance obligation if it is distinct or as a series of similar, but distinct, goods or services with the same pattern of transfer bundled together.

Not sure if a particular performance obligation is distinct? Think of it this way: If the customer can benefit from the good or service on its own or in combination with other resources available to them, and the promise to transfer that good or service is separately identifiable from other promises within the contract, then you’ve got yourself a distinct performance obligation.

A good or service not identified as distinct within the contract should be combined with other goods or services into a bundle that can be identified as distinct within the contract.

Step 3: Determine the transaction price

The amount of consideration entitled to the company in exchange for its goods or services provided is the transaction price.

A contract’s transaction price can be impacted by the following:

• Variable consideration: If the amount of consideration is variable, the amount to be included in the transaction price should be estimated based on either (1) expected value or (2) the most likely amount.
• Constraining estimates of variable consideration: For any situation with a constraint to estimate the variable consideration, a company should only account for consideration if it is confident there would not be a reversal of revenue upon removal of the constraint. 
• Financing: If either the company or customer benefits from financing for the transfer of goods or services, this must be factored into the transaction price. The financing doesn’t need to be applied to contracts of a year or less.
• Non-cash consideration: The transaction price needs to accurately reflect the value of any consideration promised by a customer in a form other than cash.
• Considerations payable to the customer: In a scenario in which a company pays consideration to a customer, which can be applied back against amounts the customer owes to the company, either the transaction price should be reduced or that payable consideration should be considered payment (full or partial) for a distinct good and/or service.

Step 4: Allocate the transaction price to the performance obligation in the contract

A separate transaction price should be allocated to each based upon the amount expected to be received for contracts containing more than one performance obligation.

A company seeking to allocate the correct amount of consideration to each performance obligation should determine the standalone selling price (or fair value) of goods and services identified in each performance obligation at the creation of the contract. This standalone selling price should be considered the basis upon which to perform a relative allocation of the transaction price.

A standalone selling price may need to be estimated if it’s not readily available.

Keep in mind that any discount or variable consideration included in a transaction price should only be allocated to the applicable performance obligations in a contract. Also, if there’s a change to a transaction price during the contract term due to any reason, such as a constraint to variable consideration being removed, any resulting addition or reduction in transaction price value is to be allocated on the same basis as at the contract creation. If this allocation results in an amount assigned to a previously satisfied performance obligation, the resulting revenue should be recognized within the period during which the transaction price changes.

Having fun yet?

Step 5: Recognize revenue when (or as) a performance obligation is satisfied

A company should recognize revenue as soon as a performance obligation has been satisfied by transferring a promised good or service to a customer, meaning when the customer obtains control of that good or service.

There are two ways a performance obligation can be satisfied:

• Over time, which should be used when a company transfers a good or service over a period of time
• At a point in time

Here are some details from the ASC 606 guidance itself regarding criteria for satisfying a performance obligation:

• A customer simultaneously receives and consumes the benefits provided by a company’s ongoing performance.
• The company’s performance creates (or enhances) an asset, such as a work in progress, under control by the customer while the asset is created or enhanced.
• The company’s performance doesn’t create an asset with an alternative use to the company, and the entity has an enforceable right to payment for any performance completed to date.

Over time recognition of revenue will require a company to measure progress toward complete satisfaction of the performance obligation using output or input methods, updated throughout as transaction circumstances dictate.

For those performance obligations in which the obligation is considered satisfied - when the customer takes control - at a specific point in time, the following are some of the potential indicators of when during the transfer of control that time is:

• The company has a present right to payment for the asset.
• The customer has legal title to the asset.
• The company has transferred physical possession of the asset.
• The customer has the significant risks and rewards of ownership of the asset.
• The customer has accepted the asset.

Once the necessary criteria have been met, point in time revenue recognition can take place.

The changes to the revenue standard in these five steps go beyond a company’s finance department. The impact of this touches sales, marketing and established pricing strategies. The decisions to be made do not stop at the office of the CFO or VP of Finance.

Let’s dive into a few of the key areas a company needs to address to comply with the new standard, starting with the most obvious.

Accounting

Considering the wide variation - especially among different industries and geographies - in how revenue was recognized previously, the new standard finally offers a consistent global framework for recognizing revenue, both in timing and earned value.

To do this, ASC 606 is more reliant on estimates and judgments. Organizations need to focus on harvesting data and reporting, including detailed disclosures, about not only the data put to use, but the judgments applied to produce estimates. 

To comply with this new approach, organizations must overhaul accounting processes and controls. And we’re not just talking about the controls over new data needed to comply with ASC 606, but controls related to judgments and estimates as well as controls established for the actual implementation of the new standard.

IT

As one might surmise, much of the data necessary for a company to comply with ASC 606 has not previously been collected, aggregated or reported, and that’s where an organization’s IT systems take center stage.

Most existing IT systems weren’t designed with the need to gather material rights as performance obligations in mind, a requirement under ASC 606. Contract start and end dates are another couple of data points now required which are unlikely to have been captured through existing systems. 

Add to that the likelihood of data elements in contracts being captured as text fields, posing all sorts of challenges in extracting specific information to automate revenue recognition, and you can see the IT effort - and time - necessary.

Such system changes, more of the customized software development than the standard update variety, can’t just be thrown together at the eleventh hour of implementation without significant design, development and testing time allotments.

Legal

Some elements of customer contacts will, of course, need to be handled differently under the new standard, requiring the time and effort of a company’s legal department to study the standard very closely and adjust contract terms accordingly. Elements to garner close attention include provisions for termination, pricing and enforcement.

As importantly, legal teams will be put to work analyzing existing contracts for situations in which current terminology creates an undesirable revenue impact once ASC 606 is applied.

Human Resources

For an implementation undertaking of the size and scope of ASC 606, a company should expect to devote significant resources and staff. The ensuing training will encompass not only the wider accounting team, but any staff involved in negotiating and reviewing customer contracts, including sales team members, investor relations and executive leadership.

Compensation

ASC 606 impacts the timing of when revenue is recognized, which will likely have an exponential impact on executive bonuses, sales commissions and any other form of compensation linked to revenue-related metrics.

When it comes to how best to address this for existing compensation programs, a company can do one of two things: (1) Redesign program terms to replicate the pay structure from the previous standard or (2) keep a separate set of records to allow for the continued revenue recognition under the previous standard for compensation purposes.

Each of those options comes with challenges. Go with the first option and you’re looking at a great deal of time and effort spent, as well as a potentially futile effort for legal approval. The second option, while somewhat more straightforward, requires a long-haul duplication effort open to legal challenges itself.

Regardless of sector, each and every company should already be well within the painstaking process of a good hard look at how business has been done and what needs to change in pricing and selling in order to meet ASC 606.

If you’re considering automation to address these challenges - as follow up to an earlier brute force method or instead of it - remember the cross-functional collaboration offered by ASC 606. This is about billing, revenue and compensation and the solution you select should be as well. You should be validating revenue automation systems that understand the standard for what it is and have responded with a solution designed to comply with the standard while giving you the flexibility to configure the rules and change them as needed. Successful organizations are adopting new business models and always considering new ways to sell to customers given all the new consumption models available.

Contact us today to learn how RecVue's order-to-cash solutions have been designed with the new standard in mind to help your organization address these landscape-altering changes to your business’s past, present and future. Yeah, ASC 606 is that big.