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Business transactions involve the transfer of monetary considerations in exchange for the transfer of goods or services. The monetary consideration received is the revenue for a business.
Do you know when businesses should recognize this revenue? Businesses were following different practices of revenue recognition. This impacted the financial reporting and statements of accounts of organizations and led to legal complications.
Since the recognition of revenues is an important part of a business, a new revenue recognition standard was introduced in 2018. This is Accounting Standard Codification (ASC) 606, which replaced ASC 605. The article below explains what it is, to whom it is applicable, and the mode of revenue recognition.
What is ASC 606?
ASC 606 is the latest revenue recognition standard for all businesses, namely, public, private, and non-profit entities. ASC stands for Accounting Standard Codification. This standard was framed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB).
ASC 606 enlists when companies should account for revenues earned. All business organizations that enter into contracts with customers to transfer goods and services are obliged to follow this standard. ASC 606 also helps streamline revenue for tax purposes.
The standard applies to various types of companies, like manufacturing,hospitality sector, engineering, SaaS, telecommunications, software, mining, airlines, energy, automotive, insurance, and more.
Why was ASC 606 introduced?
The reasons for the introduction of ASC 606 are enlisted below:
- ASC 606 aims to provide a framework whereby revenue recognition can be more consistent.
- IASB and FASB aimed to update the existing revenue recognition standards to make them more relevant across industries.
- Variations were observed in the accounting for revenues of similar transactions across industries that needed to be changed.
- The difference in accounting procedures failed to provide a basis for comparing results from the stakeholder's point of view.
- With the introduction of ASC 606, IASB and FASB intended to create guidelines for revenue computation for tax purposes.
Who does ASC 606 apply to?
Based on the 2017 and 2018 deadlines, all public and private companies and non-profit organizations must comply with ASC 606 for revenue recognition.
All the business entities that enter into a contractual agreement with the customers post 15 December 2017 are impacted by ASC 606.
Simply put, if your business is involved in selling goods or services, you should adhere to the new ASC 606.
This applies to businesses that distinguish between revenues earned and deferred. Unless the product or service is delivered, revenues cannot be recognized.
To ensure compliance, the FASB and IASB have established a five-step process for revenue recognition.
The five-step model of revenue recognition under ASC 606?
The five-step process refers to how ASC 606 helps to break down the contract process into the following steps:
Step 1: Identify the contract with the customers
This step will outline the criteria for entering into a customer contract. A contract defines the rights and duties of the parties involved in the deal. Revenue is recognized when the vendor delivers all the goods as per the contract and receives the transaction price.
If there is any modification t and new goods are added at an additional cost, it should be accounted for as a separate contract. Revenues should be recognized only after the realization of the price and delivery of goods as mentioned in separate contracts.
Step 2: Identify the performance obligations mentioned in the contract
This step describes the obligations that must be fulfilled as per the contract. Performance obligations may either be explicitly written in a contract or may be implied by general practice.
As mentioned in the contract, the supply of goods or services is the obligation that should be performed. It may be a single good, service, or a series of the same or distinct goods. The promise to transfer goods or services under the contract should be distinguished from other promises in the same contract.
Step 3: Determine the transaction price
This step seeks to establish the price for the transaction, namely, the selling of goods and services. It also mentions what should be considered to establish the price.
The price is the amount a business expects in return for the transfer of goods or services. This does not include the amount collected for third parties like agencies. While determining the price, variable considerations also have to be accounted for. Variable consideration indicates that the payment may vary due to an expected outcome of a future event. The future event may be an early payment discount or cash discount.
Step 4: Allocate the transaction price
This step indicates the criteria for allocating the transaction price to different performance obligations. When there are several performance obligations, the respective standalone selling price will be the reference for allocating the transaction price.
There are three methods to determine the standalone selling price:
- It can be fixed by the adjusted market assessment approach, whereby the price is adjusted to match the competitors’ as per customers’ demand.
- The price is also fixed by adding a margin to the expected cost.
- Prices are fixed using the residual approach also. Here, the standalone selling price of other goods is deducted from the total contract price to arrive at the selling price of the particular goods and services.
Step 5: Recognize revenue
This is the final step in the five-step revenue recognition model. Revenues are recognized when all performance obligations are met. This happens when the physical possession of goods passes to the ultimate consumer.
Why should your business comply with revenue recognition?
ASC 606 impacts the policies of an organization in several ways. The following pointers indicate why it is important to comply with the standard:
1. Legal requirement
It is a requirement under the law for every business to comply with ASC 606, irrespective of whether they are private, public, or not-for-profit organizations. You are bound by the standard if your business is involved in a contract to transfer goods or services for monetary consideration. There are no exceptions to this under the law.
2. Financial clarity
A business's performance and financial position are important information for several stakeholders. They are interested to know the revenues earned in a period.
Compliance with ASC 606 eliminates inconsistencies in revenue reporting and gives clarity to all. The comparison of revenues across industries is made easier with this new standard.
3. Business acumen
The new revenue recognition method benefits your organization by providing a deep insight into the organization's workings. A business should have definite knowledge of its financial position so that predictions on cash flow can be made precisely. Revenues that have not yet accrued are not accounted for here; therefore, it gives a correct view of the financial position of a business.
4. Identifying refunds
Identifying refunds and processing them, specifically for subscription-based companies, becomes easier with revenue recognition. ASC 606 emphasizes revenue recognition for completed services, and therefore if a subscription is canceled mid-way, a refund is issued for the portion of the contract that has not been performed.
5. Tax purposes
As per IASB and FASB, compliance with ASC 606 is necessary for tax purposes also. Reporting the right amount of taxes is possible only when the revenues are recognized without any flaw. It may otherwise invite investigations by tax authorities.
Assessment criteria for revenue recognition
Revenue recognition follows the below-mentioned criteria:
1. Evidence of arrangements in financial terms
There should be clear evidence in the form of a written contract between the customer and the business. The agreement should establish that the customer intends to buy the product or service from the business for a specified monetary consideration.
2. Delivery of goods
As per the contract, the products or services mentioned should be delivered. Revenue recognition can be accounted for only when the delivery is completed in full. There have been complications before ASC 606, with assessing revenues as industry practices differ. But after ASC 606, delivery of goods is also one of the important criteria for revenue recognition.
3. Price fixed by the seller
The price is fixed, and the buyer agrees to the same by entering into a contract. There can be no two views onthis since it is only based on the contract. Negotiations, if any, can be done before the contract is finalized. The seller fixes the price, and the contract is executed for the same price.
4. Reasonable assurance of collectibility
Reasonable assurance is mentioned as a criterion to make a provision for uncollectible amounts in certain cases. This happens when the seller observes that the collectibility of debt is doubtful. In such cases, cash-basis transactions are allowed to maintain reasonable assurance of collection.
Penalties for non-compliance
Companies are monitored for non-compliance with ASC 606, and a lapse could impact them greatly. IASB and FASB, along with the Securities and Exchange Commission, lay down strict rules for complying with ASC 606. In case of non-compliance, companies face heavy penalties and may even face a jail term. Your business may also invite a tax audit by the IRS in case the reported revenue differs from the actuals.
Benefits of compliance with ASC 606
We have stressed the importance of complying with ASC 606. Apart from the legal requirement, there are some benefits you should look into while complying with the new standard. These are the main benefits of complying with ASC 606:
- Your business may get a clean chit for a public offer. This is possible only when you comply with ASC 606, as this implies compliance with IPO regulations too.
- Compliance with ASC 606 ensures that inconsistencies in contracts are reduced. This is done by standardizing the quoting process. Similar contracts see consistent treatment under this standard.
- The stakeholders, mainly investors, are confident about the business due to compliance with ASC 606. This will invite more investments and lead to the growth of the company.
Revenue recognition methods
Some common revenue recognition methods followed by companies are mentioned hereunder.
1. Sales-basis method
This method of revenue recognition is mostly used in the retail sector, where payment and delivery follow each other almost immediately. Even if payment is not received, but the seller believes there is a high likelihood of the buyer paying, revenue can be recognized.
When the sale happens and the product is delivered, revenue is recognized. Here we see that only the delivery of goods matters the most in this method.
2. Percentage of completion method
When there is a long-term contract, there are various stages at which revenue is recognized. Waiting till the completion of the entire term of the contract may not be possible in that case.
In such cases, detailed terms are laid down in the contract that mention the various stages at which payment has to be made by the buyer. Payment is made for the percentage of work that is completed or products that have been delivered.
3. Installment method
This method of revenue recognition is best used when the seller does not have sufficient information about when payments will be received. This happens mostly in high-value transactions. The company cannot trust the buyer's credibility and so recognizes revenue in installments, i.e., as and when received.
This method is not followed by companies that have put down, in writing, the expected receipt of payment.
4. Completed contract method
As the name suggests, this completed contract method recognizes revenue after completing the contract terms in full. This is not suitable for long-term contracts, as we have seen above in the percentage of completion method. The completed contract method is used by companies when they enter into a short-term contract.
5. Cost-recoverability method
This is quite similar to the installment method but with a small difference. In the installment method, the company can identify/estimate the cost of goods and services mentioned in the contract, but the date by which the buyer will make the payment has yet to be ascertained. Under the cost-recoverability method, the company is not sure of the associated costs and follows a conservative approach to revenue recognition.
Revenue is recognized only when all the costs incurred are recovered, and the obligations as per the contract are completed.
Case studies: Implementing ASC 606 in different industries
Case study 1
Client: Hotel ABC is a luxury hotel that has a presence in nearly 12 countries. It caters to high-profile customers who organize business conferences and high-end parties. Starting in 2018, the hotel chose the modified retrospective application of ASC 606 for revenue recognition.
Problem: ABC Hotel offers various facilities like renting rooms, renting out business centers, gym facilities, restaurant services, car rentals, and so on. The stage of recognizing revenues differs for each of these services.
Contracts in hotel management are complex, and they may need to use historical data for the consideration they expect from the contract. Accounting for loyalty programs also poses an issue.
Solution: ASC 606 mentions the five stages of revenue recognition, and this applies to ABC Hotel as well. The difference in the treatment of performance obligations and contract liabilities as per ASC 606 is accounted for. The hotel conducts a regular analysis to determine the standalone selling price of the goods and services delivered.
This helps determine whether the various goods or services have an observable standalone selling price. A right to consideration becomes unconditional when the payment is delayed. These will be considered receivables, and those payments made immediately will be under contract liability. The hotel does not net these two amounts.
Case study 2
Client: Blueberry Inc, the client, provides video game console add-ons. It enters into a contract with Dyno LLC to supply console add-ons to retailers and non-local customers. Blueberry gives regular concessions to Dyno on the sale of add-ons.
Problem: Each console add-on offered by Blueberry is unique; therefore, a separate contract is entered into by Blueberry. This necessitates the determination of the contract price at the beginning of each contract.
Also, the price concession for each contract and the stage for recognizing revenues are issues. During the contract, a difference in the actual transaction price and the estimated price is expected by Blueberry. Based on this, the company may drop concessions.
Solution: Step 3 of revenue recognition in ASC 606 deals with determining price. It also details dealing with price concessions and considers this variable consideration in such cases. Accordingly, revenue is recognized when the add-ons are transferred to Dyno.
The total contract cost is spread over the total number of sets transferred. Also, due to the console add-ons becoming very popular, Blueberry did not give concessions and increased the estimated price for revenue recognition purposes.
It is clear from the above that ASC 606 applies to all companies that enter into contracts. Do refer to the five-step model that can help identify the right time for revenue recognition. The standard is more complex and has to be assessed with respect to each industry. Get the help of an expert to assist you in this process in case it is overwhelming.
While there are many benefits for complying with the standard, non-compliance can prove costly too. Businesses should keep track of their revenues with reference to the criteria mentioned for the same. This can keep them stress-free and also abide by the standard at the same time.