What is the 606 rule?

18 Apr.,2024

 

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Businesses tend to become more dynamic and complex as they grow, which can mean increased payment volumes, diversification of payment methods, and additional revenue streams through new products and services. These changes can significantly impact a business’s financial statements and require an agile, nuanced approach to accounting that can accommodate numerous intricacies at each stage of growth.

Revenue recognition is a concept with practical applications for all businesses. But for certain types of businesses, a particular method of revenue recognition is necessary to maintain compliance with ASC 606 accounting standards. Here’s what you need to know about ASC 606, including what it is, why it’s important for businesses, and the five-step process that can help you stay compliant within the ASC 606 framework.

What’s in this article?

  • What is revenue recognition?
  • What is ASC 606?
  • Why does ASC 606 compliance matter for businesses?
  • The five-step model for ASC 606 revenue recognition
    • Identify the contract with a customer
    • Identify the performance obligations in the contract
    • Determine the transaction price
    • Allocate the transaction price
    • Recognize revenue when the entity satisfies a performance obligation
  • Revenue Recognition with Stripe

What is revenue recognition?

Revenue recognition is a generally accepted accounting principle (GAAP) that defines when and how a business’s revenue should be recognized. Revenue recognition defines the accounting period to which a business’s revenue and expenses are attributed. However, given the complexities and variations in revenue due to factors such as timing and certainty, correctly recognizing revenue can be a challenging process. In fact, 40% of finance leaders surveyed in our recent study reported their finance teams spending over 10 hours each month correcting errors or discrepancies to reconcile their data.

This highlights the importance of accurate revenue recognition, which aims to standardize how businesses structure their revenue accounting, dictating that revenue should be recognized in the accounting period during which the revenue is earned and realized (or realizable), which might happen before or after the payment is received.

What is ASC 606?

Accounting Standards Codification (ASC) 606 provides businesses with a universal framework for recognizing revenue from customer sales. The ASC 606 standards affect pricing and customer contracts for both private and public businesses and describe how to recognize the revenue from those contracts.

In May 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly released ASC 606. They designed ASC 606 to solve the complicated challenge of aligning the revenue reporting practices of businesses across industries, despite variations in how revenue functions within different sectors and businesses. ASC 606 creates a shared understanding of revenue recognition that accommodates revenue’s inherent complexities.

Why does ASC 606 compliance matter for businesses?

Revenue recognition in compliance with ASC 606 is a useful way for many businesses to get a clear picture of their financial health. However, it’s especially important for the following types of businesses:

  • Public companies or large businesses with over $25 million in annual revenue; these businesses are legally required to comply with ASC 606, GAAP, and International Financial Reporting Standards (IFRS)
  • Startups that might need to follow accrual accounting principles to raise money from investors or apply for a bank loan
  • Subscription- and service-based businesses selling digital or physical goods that customers pay for up front, before receiving the goods or services

The five-step model for ASC 606 revenue recognition

For subscription businesses that need to manage changes to customers’ subscriptions, refunds, disputes, and prorations, revenue recognition can be especially complex. Updates to customer subscriptions can complicate the process of recognizing and deferring revenue accurately. To help cut through this complexity, the following five-step approach is useful for helping subscription businesses recognize revenue consistently and methodically.

1. Identify the contract with a customer

This step details the criteria that must be met when a business first enters into a contract with a customer to deliver goods or services. Per ASC 606, the key components of the contract are:

  • The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
  • Both the business and customer can identify each other’s rights regarding the goods or services to be transferred.
  • Both parties can identify the payment terms for the goods or services to be transferred.
  • The contract has commercial substance—that is, the risk, timing, or amount of the entity’s future cash flows are expected to change as a result of the contract.
  • The business is likely to collect the payment to which it’s entitled in exchange for the goods or services it will transfer to the customer.

2. Identify the performance obligations in the contract

Performance obligation is the promise the business makes to transfer goods or services to the customer. During this step, businesses should itemize every distinct performance obligation. A good or service is considered distinct when it’s of value to the customer and can stand alone and be transferred independently of other goods or services in the contract.

3. Determine the transaction price

The next step is to calculate the transaction price. The transaction price can include cash and non-cash compensation that the business will receive from the customer, per the contract. Businesses should factor in any discounts, prorations, upgrades, or pricing customizations.

4. Allocate the transaction price

In this step, businesses distribute the total transaction price across the unique performance obligations in the contract. For subscription-based transactions that use recurring payments, the performance obligation is continuous, which makes proper deferment and allocation especially complex—and important.

5. Recognize revenue when the entity satisfies a performance obligation

This step specifies that revenue should be recognized as each performance obligation is met, as opposed to when the contract is initiated or when the funds associated with the contract are received. Here are two examples:

  • For a single performance obligation:
    If a customer purchases a made-to-order sofa that will take 12 weeks to build and ship, the revenue from that contract should be recognized in the accounting period when the order is fulfilled, not when the order was originally placed.

  • For a continuous performance obligation:
    If a customer signs a contract committing to a year of subscription software service at a rate of $29 per month, then the business should attribute each month’s payment to its respective accounting period. The business should not treat the entire year’s worth of fees as a lump sum to be recognized in the period during which the contract was signed.

Revenue Recognition with Stripe

Even though the five-step process makes ASC 606 compliance straightforward in theory, its execution can be messy and error-prone. It’s difficult to manually manage revenue recognition without making mistakes. For most businesses, the best way to tackle this process is finding an automated solution to manage the details of revenue recognition and prepare audit-ready financial statements.

Stripe Revenue Recognition helps businesses streamline accrual accounting and untangle the process of recognizing revenue, without the need for engineering resources or intricate configurations. With minimum effort, you can customize and automate your reporting to stay compliant with ASC 606 and IFRS 15.

Stripe Revenue Recognition gives you access to:

  • Recognized and deferred revenue summaries at a glance
  • Downloadable accounting reports and waterfall reports
  • Interactive revenue numbers for full audit transparency
  • Configurable revenue recognition rules and accounting period controls

To learn more about Stripe Revenue Recognition, start here.

What is ASC 606?

ASC 606 provides a single comprehensive model for entities to use in accounting for revenue arising from contracts from customers and is the current standard. Compliance with ASC606 regulations regarding revenue from contracts with customers can be challenging. ASC 606 outlines a five-step model that requires companies to exercise more judgement and make more estimates when considering the terms of a customer arrangement or contract.

The ASC 606 5-Step Process

This executive overview is a high-level, simplified understanding of ASC 606, the five steps involved, and the revenue recognition tools needed for consulting companies to get it right.

These are the 5 steps that comprise the revenue recognition standard.

Step 1 – Identify the contract with a customer

ASC 606-10-25-2 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” This means a contract needs to show:

  • Commercial substance exists
  • Approvals have been obtained and a commitment to perform exists on the part of both parties
  • Rights of both parties are identifiable
  • Payment terms are identifiable
  • Collection of substantially all of the amount to which the entity will be entitled in exchange for the good or services that will be transferred to the customer is probable (likely to occur)

Guidance on contract modifications is provided in the ruling to help model contracts that may change over time, including pricing and scope changes. These and other changes might result in a separate contract to the current one, or possibly an entirely new contract for the engagement.

BigTime Tip: Establish consistent language with your sales, executive and project teams for determination of contract type; identify ahead of time which exceptions may occur (as much as you can) and decide on appropriate action to take when changes arise.

Step 2 – Identify the performance obligations in the contract

In other words, establish what you’ve agreed to deliver in exchange for payment. Many times, services related to a given contract will need to be accounted for separately. It is the responsibility of the service provider (agency, consultant, etc.) to determine whether all services it provides for a given customer should be accounted for as one unit or as separate items. There are generally two steps:

  1. First, understand and identify all deliverables (promises to provide services)
  2. Second, determine whether the promises/goods or services that will be delivered should be accounted for separately

Some service contract types referred to as “stand ready obligations” have very specific rules. An example of this type of professional services contract might be a maintenance agreement where an agency contract agrees to provide services when needed or desired. If the type or quantity of services planned to be provided is unknown or unspecified, it is likely a stand-ready obligation.

BigTime Tip: Different contract structures have different requirements for revenue recognition. Projector by BigTime, for instance, has seven default types as well as the ability to add other contract types as needed. You can read more about professional services contract structures, and you can always refer to this Financial Accounting Standards Board (FASB) resource on ASC 606 and revenue recognition for more on the topic.

Step 3 – Determine the transaction price

The transaction price is the amount of consideration (e.g. payment or contract revenue) to which a reporting organization expects to be entitled to in exchange for transferring promised goods or services to a customer. This amount excludes third party obligations like sales tax. It should take into consideration discounts, incentives, rebates and other price concessions.

For considerations promised in a contract that are of variable amounts, you must make a good faith estimate of the amount, only to the extent that it is probable that a significant reversal in the amount of the revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

BigTime Tip: Integration of project accounting with your professional services automation (PSA) software and CRM is key to ensuring contract details are seamlessly collected, associated and tracked at a project level. Manual revenue reconciliation using Excel spreadsheets simply will not scale.

Step 4 – Allocate the transaction price to the performance obligations

This step is all about mapping what you’ve promised to what you expect to be paid on the basis of the relative standalone selling price of each distinct good or service promised. Once again, if you’re using a PSA, this is simply breaking down the contract into the logical parts based on what and when obligations will be delivered.

Variable considerations require additional scrutiny to properly apply ASC 606 revenue recognition rules, specifically as it relates to distinct goods or services that make up a series but are treated as a single performance obligation.

BigTime Tip: Organization-wide visibility of timelines and deliverables is easily achieved with even a basic PSA tool. The best PSA software will allow the organization to customize their accounting structures based on their needs, acting as revenue forecasting software to include everything from modeling managed services contracts to accounting for business development work.

Step 5 – Recognize revenue when (or as) each performance obligation is satisfied

Revenue is reported when (or as) it satisfies the performance obligation by transferring a promised good or service to a customer. This differs from when cash is received (more on the revenue recognition concept here). The amount recognized is the amount allocated to the satisfied performance obligation established in Step 4.

Obligations can be satisfied at a point in time (typically when promised goods are transferred to a customer) or over time (typically used for services delivered to a customer across a duration of time).  Revenue recognition for consulting companies, agencies and IT services teams typically work with an “over time” model and it is essential that an appropriate method for measuring and reporting progress is in place.

BigTime Tip: Project reporting and financial reporting must work together. Ideally, the system for revenue recognition that you put in place will include integration with project planning and time tracking. This allows forward-looking projections that enable proper accounting when the time comes, but also insight into issues like missing time or projects going off track.

A Note About Disclosures:

Part of the burden of reporting revenue is also the need to provide disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from an organization’s contracts with customers. This information is both quantitative and qualitative in nature and serves to help financial statement users understand the nature, amount, timing and uncertainty of revenue and related cash flows. It is important to note that while publicly traded entities have the largest burden for disclosures, non-public entities must also provide context for their financials.

You can find out more about FASB accounting, ASC 606 rules and the latest questions on ASC 606 in the FASB’s revenue implementation FAQ.

ASC 606 Revenue Recognition Summary

The ASC 606 5-Step process for revenue recognition includes the following:

  1. Identify the contract with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations
  5. Recognize revenue when (or as ) each performance obligation is satisfied

As ASC 606 clearly outlines, contracts are the basis for how organizations must recognize revenue, but this doesn’t need to be a burden on your accounting staff or on anyone else in the organization. With a bit of forethought and planning, and the right tools (e.g. a PSA system) for ASC 606 revenue recognition and reporting, you can easily:

  • Establish the processes and automate the data necessary to conform with ASC606
  • Manage allocation methods based on the type of performance obligation specified in the contract
  • Configure and add new types of contracts or allocation methods as your business evolves

Talk to us any time about how revenue recognition software like BigTime helps services organizations and consulting companies follow GAAP accounting rules, better manage their operations and drive higher profits.

Frequently Asked Questions About ASC 606 Revenue Recognition

What is ASC 606?

ASC 606 outlines a 5 step model for entities to use in accounting for revenue arising from contracts from customers. It requires companies to exercise more judgement and make more estimates when considering the terms of a customer arrangement or contract.

What is ASC 606 revenue recognition?

ASC 606 is a revenue recognition standard for entities to use in accounting for revenue arising from contracts from customers.

What are the 5 steps for revenue recognition with ASC 606?

The 5 steps that comprise the revenue recognition standard are:

1. Identify the contract with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations
5. Recognize revenue when (or as) each performance obligation is satisfied

What does ASC 606 stand for?

ASC 606 means Accounting Standards Codification and is an accounting standard defined by the Financial Accounting Standards Board (FASB) that outlines how to recognize revenue arising from contracts from customers.

Does ASC 606 replace ASC 605?

Yes, ASC 606 is a revenue recognition accounting standard that replaces the former ASC 605 and requires more comprehensive disclosures.

What is the 606 rule?

5-Step Basics of ASC 606 Revenue Recognition Rules

Read more

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