How Private Companies Should Implement ASC 606 Revenue Recognition
Accounting Standards Codification (ASC) Topic 606 created a five-step process that companies must use when recognizing revenue. The Financial Accounting and Standards Board (FASB) issued the new guidance to provide more transparency through extended disclosure requirements about revenue recognition.
Private companies that have not yet applied the revenue recognition standard must do so for annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020 (source). Implementation involves a detailed look at a company’s contracts which requires technical accounting expertise – something smaller, private companies may not have. This article covers the 5-step revenue recognition process in detail.
ASC 606 Revenue Recognition Requirements
Revenue recognition is the process of accounting for the payment a company expects to receive for goods and services provided to customers. Simply put, it’s how businesses record sales transactions from customers.
Previous accounting standards required companies to recognize revenue as it was earned regardless of when cash is received. This is the definition of accrual accounting. Revenue recognition under ASC 606 goes deeper into contracts with customers - this includes evaluating the type of services provided (nature), how long services will be provided (timing), and the amount. Specifying the type of services provided is important to identifying the performance obligations of the contract.
The timing of services indicates the number of periods (i.e. months or years) you will recognize the revenue.
The amount to record in the financial statements represents the price of all performance obligations specified in your contract with your customer.
Implementing ASC 606 for Private Companies
Small businesses usually have simple revenue cycles which makes identifying contract terms, prices, and performance obligations easier. The implementation creates challenges because most small businesses don’t have the internal expertise in technical accounting to successfully implement complex standards like ASC 606.
Other issues include creating repeatable processes for contract reviews while improving systems to accommodate revenue recognition standards. Here’s a detailed look at what companies need to consider as they move forward with ASC 606 implementation.
1. Identify the contract(s) with a customer.
Contracts exist in written or oral form with enforceable rights and obligations. When identifying contracts with customers, companies must consider the following criteria: commitment and rights of the parties, payment terms, collectability, and the commercial substance of the transaction.
Example: If your firm charges customers fees for consulting services and workshops, your contracts must specify your agreement to provide services to a customer. The contract must also specify the customer’s agreement to pay along with the amount and timing of payment. While some fee revenue will be recognized immediately, the revenue that hasn’t yet been earned will be recorded to deferred revenue and recorded in the period that the company’s performance obligations are met.
2. Identify the performance obligations in the contract.
The key takeaway here is understanding the obligations in the contract that can be separated from the others.
Example: If your consulting firm agrees to provide services to a client for one year, a one-time client onboarding fee, and a workshop 6 months from now, these all count as 3 distinct performance obligations. This step of contract evaluation often involves communication between accounting, legal, and sales to ensure clear communication on what’s being provided to customers for how much and when.
3. Determine the transaction price.
Next, you must determine the transaction price of the separate performance obligations. The transaction price is the payment or consideration given to the company in exchange for providing products and/or services.
4. Allocate the transaction price to the performance obligations in the contract.
When there is more than one performance obligation, the firm must allocate the transaction price to each obligation. The Financial Accounting Standards Boards (FASB) provides guidance for estimating standalone pricing. It also includes guidance for allocating discounts or accounting for changes in contract terms.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Revenue is recognized when the company satisfies the performance obligation. When a contract applies to multiple periods like a one-year contract would apply to 12 periods, revenue is recognized over the 12 periods as performance obligations are satisfied.
Implementing ASC 606 gives business owners a chance to look into the business including the sales process, supply chain, relationships/contracts with vendors, and staffing needs. Going through the 5-step revenue recognition process requires companies to ask questions surrounding typical customer’s needs, performance obligations, pricing, and determining the point when obligations have been satisfied to recognize revenue. Answering these questions will provide companies with the added commentary needed for financial statement disclosures while highlighting areas to improve for operational efficiency.
In our next blog post, we will go over a tactical example on how private companies should implement ASC 606 revenue recognition. Stay tuned!