What is the Five Step Revenue Recognition Procedure called ASC 606?

ASC 606 codifies clarity and consistency into the revenue recognition process of a business, marking a responsible, nuanced and agile approach to accounting in a complex new age. 

Business is about selling and earning. But at what point can you rightfully say you have sold something, or earned something? When, legally speaking, are goods and services officially considered to have exchanged hands?

The answer carries serious ramifications in business and cannot be left open to interpretation. Understandably, the world of accounting takes a very precise view of the matter, laying down the rites and rules in no uncertain terms.

The principles of accrual based accounting - the method of accounting followed by larger businesses, public companies and GAAP driven businesses – mandates that companies recognize revenue as-and-when it is earned, not when they receive payment for it. However, this still begs the question: When exactly have you earned revenue, in accounting language?

Does revenue earning happen when the dotted line is signed? When the product is shipped to the buyer’s address? Or when the seller has received full payment for it? If you have just answered the three questions in um’s, uh’s and maybe’s, ASC 606 is for you. Indeed, ASC 606 is for any business that sells a product, service or subscription.  

ASC 606, a global standard in accounting, standardizes the above three critical answers for businesses. It regulates the precise stage when revenue can be considered as earned, and financial statements must be updated accordingly. With this, it ensures synchronicity and alignment in accounting books and records across companies and industries. 

The gold standard of accounting

ASC 606 is a response to a sophisticated and demanding age of commerce, and marks a responsible, nuanced and agile approach to accounting. It was jointly conceived by the International Accounting Standards Board (IASB) and Financial Accounting Standard’s Board (FASB) to bake consistency into financial reporting across sectors. ASC 606 regulates accounting not just in the USA but globally, with certain notable exceptions. The standard is an upgrade from ASC 605: It requires more comprehensive and detailed disclosures than its predecessors, and lifts compliance to the next level. 

What is revenue recognition in business and why is it important?

Revenue is generally considered ‘earned’ only after a critical incident or development has occurred along the timeline of give and take. Some events involved in this chain are identification of contracts, determination of transaction prices, fulfilling of performance obligations, and recording of revenue. 

Revenue recognition – a part of business accounting and revenue operations (RevOps) - is a Generally Accepted Accounting Principle (GAAP) that aims to understand when expenses and revenue arising from contracts and transactions can be officially recognized, reported and disclosed in financial statements.

By doing so, revenue recognition serves the following important purposes:

1. It enables better decision making for business leaders. 

2. It maintains the credibility and integrity of the financial accounting function for the organization.

3. It influences the way companies design their contracts, and the way they deliver products and services to customers. 

4. It gives an accurate indication of the company’s performance. 

5. It helps the organization stay compliant with bank and institutional stipulations.  

6. It enables investors, analysts and stakeholders to conveniently compare financial statements of different companies within an industry.

A new standard for a new reality

Business has changed. A host of forces makes the modern sale and revenue landscape both dynamic and complex than it ever has been in the past. Some of ‘whats new’ are:   

(A) Evolving buyer habits. 

(B) Erratic buying cycles.  

(C) Variations in timings and certainty of transactions.

(D) Peculiarities ingrained in terms, conditionds and obligations in contracts. 

(E) Multiple revenue streams.

(F) Increased payment volumes.

(G) Diversification of payment methods.

(H) Rise of new and digital business models like SaaS.

(I) There are other factors to navigate as well, such as geography, status (public or private entity), bank, investors and others. 

Caught in the crossfire, companies can reach for sanity by devising their own path and following their own formula in defining the time period of officially recognizing revenue in their accounting books. With everyone going their own way, that can potentially result in a nightmare situation and throw the system out of gear. 

ASC 606 - the most recent iteration of the Accounting Standards Codification (ASC) – douses the fire in advance. It irons out the creases and wrinkles with a shared understanding of revenue recognition that acknowledges the subtleties and intricacies at each stage of business growth. 

By tying companies to a common policy and benchmark on revenue recognition for deals, transactions and compensation across a comparable class and category, the ASC 606 eliminates jarring notes and discrepancies from the ecosystem that connects sales, revenue and accounting. 

For subscription based businesses like SaaS that grapple with issues (performance obligations) like customer subscriptions, updates, grievances, ongoing support, maintenance services, disputes, refunds and prorations, recognizing and deferring revenue meticulously can be particularly tortuous. 

With a comprehensive, unified and industry-neutral framework for best practises, ASC codifies clarity, order and efficiency into the revenue recognition process. And can be a heavensent when the nature, surety and timing of revenue is unpredictable. 

Within the organization, ASC 606 helps Revenue Operations (RevOps) teams create frictionless interoperability between sales, marketing, finance and operations, thereby streamlining revenue strategies, lifting operational efficiencies and sharpening forecasting accuracy.

Establishing the criteria groundwork for ASC 606   

IFRS, the body responsible for developing global accounting and sustainability disclosure standards, prescribes the following preliminary boxes be ticked before a systematic revenue recognition system can be rolled out.   

• Ensure a financial arrangement has been clearly established. 
• Ensure all distinct revenue streams have been disclosed. 
• Ensure a correlation has been acknowledged between contract liabilities disclosed at the beginning of an accounting period which are to become revenue at the end of the period.
• Ensure seller has transferred risk and rewards to buyer. 
• Ensure seller does not retain any control over the goods and services sold. 
• Ensure cost of revenue can be reasonably measured.
• Ensure price to buyer is reasonably measurable. 
• Ensure payment is reasonably collectible. 
• Ensure company has capitalized sales commissions as opposed to expensing them. 
• Ensure that along with quantitative data, qualitative data – facilitating correct comprehension regarding the nature, volume, timing and certitude of cash flow and revenue – has been shared as well. 

The three themes of ASC 606

The above can be bucketed under three main pillars: Performance, collectability and measurability.

The seller achieves performance by undergoing tasks necessary to warrant a payment. Collectability strengthens the reasonable expectation of getting paid. Measurability implies both expenses and revenue are rationally quantifiable and calculable. 

How to recognize revenue under ASC 606?

For companies, ASC 606 lays down a five-step approach for recognizing revenue from contracts with customers:

Step 1: Identify the contract

There must be an agreement with enforceable rights applicable to company and customer and approved by both. Company and customer should both be committed to performing their respective obligations and duties as implied in the contract towards the exchange of the goods or services in question.

Company and customer must also recognize each other’s rights regarding the goods or services. Pricing and payment terms should be tangibly determinable, and acknowledged by both parties. The contract should possess sufficient commercial substance to affect a distinct change in future cash flow of the business.

Finally, there should be positive probability of collectability – that is, of the likelihood of realizing payment. That last point also means that the customer’s credit risk must be properly evaluated, and method of collection suitably reviewed.

Step 2: Identify performance obligations

Performance obligation can be defined as a unit of account for which revenue is recognized. It is an implicit commitment from a business to its customer regarding offerings in a transaction. A single contract may include multiple promise or obligations. For considerations that are variable in nature – as those incorporating performance based incentives and penalties, royalties and price concessions – revenue recognition is usually subject to conditions. All separate products and service experiences mentioned in the contract, along with the distinct promise or obligation of performance each entail, must be evaluated and listed out clearly. 

Step 3: Determine transaction price

The business must now figure out the amount of consideration it expects to receive in return of the goods or service transferred, as per the contract. Mode pf pay (cash or non-cash), discounts, upgrades, prorations, pricing customizations and other related elements must all be taken into account.

Step 4: Allocate transaction price

This is the stage where each component of performance obligation implicit in the contract (as identified in step 2) must be assigned a specific price, while ensuring the customer is willing to pay for it. Another way to look at it, is to map the total monetary value of the transaction to each distinct performance obligation. For SaaS transactions where payment is recurring, the total amount can be broken down into revenue corresponding to each performance obligation. 

Step 5: Recognize the revenue

This step mandates that once performance obligations have been fulfilled, revenue must be recognized. The contract will decide whether this will happen all at once, or must be stretched over a period of time. If, for instance, a product takes time to assemble and ship, revenue needs to be recognized after delivery and fulfilment has happened and not at the time of placing the order. For SaaS style continuous obligation of performance, payment of each month must be recognized as revenue for the respective accounting period. 

How to implement ASC 606 in your organization

Neglecting ASC 606 can avalanche into a slew of headaches for businesses: From operational hiccups to run-ins with statutory authorities to disrupted customer experiences.

That said, ensuring your business stays in step with ASC 606 - while could be messy at first, all change is - doesn’t have to be complicated. Here are some pointers to make the transition to the new standard seamless. 

• Audit your current accounting policies and practises. If they are not aligned with ASC 606 standards, make the necessary modifications and adjustments to your revenue recognition frameworks, contract management procedures and financial reporting processes. 
• Consult and collaborate with financial experts and auditors to build-in compliance with new ASC 606 benchmarks. 
• Incorporate and institutionalize new systems and controls for teams to curate, manage and report information.
• Make sure you are tracing, capturing and structuring contract related data effectively across contracts, quotes and other sources. 
• Try to use a single platform or system for simplified and unified visibility and control from one place. 
• AI and automation are table stakes in the current time: Leverage them strategically to add speed and accuracy to outcomes while freeing up resources. 
• Reporting is a core mandate under the new standard. Implement ASC 606 in a way that lets you monitor contractual obligations, pricing structures and deal progression in real time. 
• Make teams across sales, operations, finance and legal appreciate the reason and gravity of the paradigm shift to ASC 606. Organize custom training and initiation sessions to ensure smooth knowledge transfer, alignment and implementation. 
• Alignment with ASC 606 is critical, it cannot be a one-off affair. Prioritize conformity, consistency and transparency to build a culture of compliance across roles and departments.
• ASC 606 requires in-depth information about revenue and cash flows resulting from the exchange of goods and services to customers. Make disclosure a key focus area in your financial statements.
• Regularly audit and adjust your revenue recognition system to ensure teams don’t stray or step or stray. 

Give your business the edge of ASC 606 compliance. Streamline, empower and position your business to make the most of new age opportunities.