Revenue recognition gets complex for businesses that are very large and legally required to follow established standards, including GAAP, ASC 606 and International Financial Reporting Standards (IFRS). However, even new small businesses may need to establish a revenue accrual account system that meets the same standards to land working capital at a bank or obtain investor funding.
Basics of the ASC 606
ASC 606 emerged from the convergence of IFRS and the International Accounting Standards Board (IASB) standards on reporting revenue from customer contracts based on performance. There are standards for recognizing revenue when contract performance occurs over time and different standards for recognizing revenue when a contract is fully satisfied at a single time point. Section 25 of Financial Accounting Standards Board (FASB) standards codification discusses the principles of revenue recognition.
There are five basic steps to get to the point of ASC 606 revenue recognition by an entity.
1. Identify the customer contract and ensure the ASC 606 key components are included, such as rights concerning the transfer of goods and services, payment terms and payment collection.
2. Identify contract performance obligations that lead to a good or service having distinct value to the customer as a standalone item, separate from other goods or services identified in the contract.
3. Establish the transaction price, including cash and non-cash compensation and factors like discounts, pricing customization and upgrades.
4. Distribute the total transaction price across the contract’s performance. Contract performance and pricing will accommodate either recurring payments for a contract that occurs over time or one-time pricing for a point-in-time contract.
5. Recognize the revenue as each contract performance requirement is met.
Gaining Control of an Asset at a Single Time Point
It is, of course, easier to manage a contract with a point at which there is agreement on when a contract performance requirement will be met and revenue recognition is needed. Determining the time point at which a customer gains control of the deliverable is guided by FASB ASC 606-10-25-23 through 25-26. Some ways to identify an asset’s control include the following.
• Customer is obliged to pay for a good or service indicating the customer can use and benefit from the asset
• Customer legally owns the asset
• Entity has transferred asset possession to the customer
• Customer has assumed the risk exposure and asset ownership benefits
• Customer has physically accepted the asset
When these conditions are met, the revenue is recognized.
Gaining Control of an Asset Over Time
Contracts that perform “over time” recognize revenue over time and require multiple payments. There are three basic criteria for establishing an over time performance obligation. The customer receives and uses the goods or service at the same time or controls the asset as it is created, like a work in progress. A third criterion for determining an asset over time says the entity’s (seller’s) performance does not result in an asset being created that could be used differently.
The over time contract gives the entity the right to collect payment for contract performance completed by specific dates as long as progress can be reasonably measured. A subscription contract is an excellent example of an over time contract.
Recognizing Revenue Based on the Principle of Distinct
ASC 606 revenue recognition is based on meeting contract performance requirements and the customer taking control of the contract’s deliverables. As explained, customers may take control of an asset and obtain the benefits of an asset in different ways. Once the customer has control, revenue is recognized.
Determining a performance obligation requiring revenue recognition is based on two primary criteria. First, the customer must receive a benefit from simply buying the contract item or get a benefit from the contract item when using available resources. Second, the seller has promised to convey the contract item separately from other contract promises.
The principle of “distinct” is important but not always easy to determine. For example, the revenue standard allows the second criterion to include a promised transfer of combined goods and services as separate asset transfers. Good examples are building construction, providing periodically updated software and customizing equipment.
The ACS revenue standard is quite complex and covers many topics like licensing and using subcontractors. Ultimately, the standard aims to promote transparency and consistency in revenue reporting in financial statements across industries and types of companies.