Okay, you likely understand something about ASC 606, or else you wouldn’t be reading this article. But, on the other hand, you might not have a complete grasp of Accounting Standards Codification (ASC) 606, or you might have had considerable exposure to it since its implementation. Either way, you must understand the implications of ASC 606, its challenges, and the potential benefits it offers.
If you believe you’re unaffected by ASC 606, you should reconsider because it affects all aspects of your operations. Therefore, read on to get a complete understanding of these crucial accounting standards codification.
What is ASC 606?
In accounting terms, the acronym ASC means Accounting Standards Codification. It was defined by the FASB (Financial Accounting Standards Board) and International Accounting Standards Board (IASB). These organizations’ purpose is to set up best practices in accounting teams, professionals, and organizations worldwide.
In 2014, the FASB and IASB established ASC 606 for codification in the U.S. and IFRS 15 for outside the U.S. Both these standards were scheduled for initiation into public companies in 2018 and privately owned entities the following year. The FASB issued a further amendment in June 2020 as a catch-all for any entities yet to adopt ASC 606.
Of course, many of you will have spent the past three years living and breathing ASC 606. Since its introduction, many organizations have had extensive study into implementing the new policy and assessing the impact on their operations. Therefore, you may have put in place hasty and complex finance processes to comply. This practice is common and is known as the brute force method.
Going down this road may lead you to a short-term solution. However, it leaves you with no scope to scale or adapt as you grow.
ASC was designed with two goals in mind:
- Provide Consistency. Before ASC 606, revenue recognition practices were somewhat inconsistent, varying drastically between industries, jurisdictions, and markets. This lack of consistency made it challenging for consumers, investors, or analysts to compare different sets of financial results. ASC 606 aimed to provide consistency and standardization to address these issues.
- Establish Agreement. The second aim of ASC 606 was to establish an agreement as to entities recognizing the transfer of goods and services proportionate to the amount delivered at a given point.
To achieve consistency and standardization, ASC 606 is implemented using a 5-step model, as follows:
- Customer contract identification.
- Performance obligations identification.
- Determination of the transaction price.
- Allocation of the transaction price to the performance obligation (Steps 2&3)
- Recognize revenue as performance obligation becomes satisfied.
This process might appear straight. However, it took many years of negotiations and amendments to get the policy adopted by all governing bodies.
Regardless of the stage, your organization sits in the ASC 606 adoption process, and you are undoubtedly experiencing some challenges. In addition, you can interpret the principles of ASC 606 in different ways. Therefore, every organization will have a different approach to meeting the standard.
For instance, many businesses might adapt their method of revenue recognition. Some may add some flexibility, while others could consider amortization as their best option. Given these factors, it’s little wonder organizations face challenges implementing ASC 606. However, by sticking to the 5-step model mentioned above, you can easily cope with scaling and quick book closure challenges. Therefore, let’s take a closer look at each one of the five steps.
Step 1: Customer Contract Identification
To begin with, ask this question; what constitutes a contract? A contract is an agreement between at least two entities in which rights and obligations are established and enforceable in its most basic form.
Of course, there are specific nuances to this basic concept. However, contracts with the following criteria must be compliant with ASC 606:
- The contract has been approved and committed to by all parties.
- The rights of each party have been clearly defined.
- Payment terms have been clearly defined.
- The contract contains a commercial substance.
Includes the terms through which entities are entitled to collect for goods or services rendered.
Another consideration is when contracts get combined or modified. ASC 606 addresses the entire contract, and it will deal with every function within said contract regardless of whether it is combined or modified. As such, you should view ASC 606 as the centerpiece of the contract when considering how your organization will implement the policy.
Step 2: Performance Obligations Identification
Performance obligations are those things that have been promised within the contract. There may be a single performance obligation in a basic contract, but there are likely to be more than one in more complex agreements. A performance obligation needs to be accounted for separately if it is distinct from others or for a series of similar but distinct bundled goods or services.
If you are unsure if a performance obligation is distinct, ask these questions:
- Can the customer benefit from the obligation on its own or combined with other resources?
- Can you separately identify the promise to transfer goods or services?
If the answer to both these questions is Yes, the performance obligation is classified as distinct. You should bundle goods or services identified as non-distinct together with a bundle of distinct goods or services for inclusion in the contract.
Step 3: Determine Transaction Price
A transaction price is defined as the consideration an entity receives for rendering goods or services. The following can impact the transaction price of a contract:
- Varying Level of Consideration. If the consideration level varies, you should include an estimate based on either the expected value or the most likely sum.
- Constrained Estimates When Consideration Level Varies. Suppose there are any constraints to an estimate of consideration. In that case, you should only consider if you are confident it will not be reversed should the constraint be removed.
- Financing Is Involved. Should there be any financing involved in the transfer by either party, you must include it in the price. However, this clause doesn’t apply to contracts under 12 months’ duration.
- Non-Cash Consideration. Transaction prices must reflect the consideration’s value in a non-cash form.
- Considerations Paid To Customers. Should consideration be paid to a customer and apply it to previous amounts owed by that customer, there are two options. Either the transaction price is reduced, or the consideration is allocated as full or partial payment for distinct goods or services.
Step 4: Allocate Transaction Price to Performance Obligation
Each performance obligation should have a separate transaction price allocated to it. This price should be based on the amount expected to be received for a contract containing at least one performance obligation. When determining the correct amount to allocate to each performance obligation, you should first determine the selling price, or fair value, of each obligation when the contract is created. This value or price should then be considered as the basis for allocating a transaction price.
You may need to estimate a standalone selling price if you don’t have the actual price available. Should this be the case, bear in mind that you will need to allocate any discounts or variations in the consideration to the contract performance obligations to which they apply. Also, if the transaction price changes during the contract, the relevant increase or decrease must be applied on the basis it was initially on the contract’s creation. Any resulting amount previously allocated to a satisfied performance obligation should be recognized within the period of transaction price change.
Step 5: Recognize Revenue as Performance Obligation Becomes Satisfied
As soon as a performance obligation becomes satisfied, revenue should be recognized. A satisfied obligation can be achieved by transferring goods or services to a customer as promised. Therefore, when the customer gains control of the good or service, it is transferred.
You can satisfy a performance obligation in two ways:
- At a certain point in time.
- Over a set period. You would use this method if goods or services were not all transferred at once but in stages over some time.
ASC 606 gives guidance on the criteria for which a performance obligation is satisfied, as follows:
- When the customer immediately and simultaneously consumes the benefits of an ongoing performance on receipt.
- The customer creates an asset such as work in progress due to controlling a performance obligation.
- No asset is created from the performance, and there is an enforceable right regarding payment for the elements of performance already completed.
As time goes by, the need to recognize revenue will require companies to measure their progress regarding satisfying the performance obligation. This measurement can include inputs of outputs, which will be updated throughout the process as needed.
Performance obligations that are satisfied when the customer takes control at a specific time have some of the following indicators for a said particular point in time:
- Payment for the asset is due.
- The customer has taken legal ownership of the asset.
- Physical possession of the asset has been transferred to the customer.
- The customer owns specific risks or benefits of the asset.
- The customer has accepted the asset.
Point in time revenue recognition can take place as soon as the required criteria have been met.
The ASC 606 5-step model applies beyond financial departments. Indeed, it impacts every aspect of a company, including IT, Legal, Accounting, Sales, and Marketing. Next, we’ll look at how ASC 606 is complied with within critical areas of a business. You’ll see it is not merely the CFO or Finance Vice-President that it concerns.
There used to be wide variations in revenue recognition, particularly across industry sectors and geographical regions. However, now ASC 606 provides consistency worldwide for recognizing revenue either in earned value or over time.
To achieve this consistency, ASC 606 relies more upon judgments and estimates. Now, organizations must focus on bringing together data and reporting it. These reports should include disclosures detailing the data being used and the judgments of estimates applied.
Compliance with the ASC 606 approach requires a company to overhaul its accounting procedures, processes, and controls, including controls relating to any estimates of judgments applied in implementing the new standard.
As you might expect, most of the data requirements for ASC 606 compliance may not have previously been gathered, processed, or reported. Therefore, to comply with the new standard, your company’s IT department will be at the center of the operation.
However, most IT systems were not designed with gathering performance obligations as one of their specifications. Therefore, new data points, such as contract commencement and end dates, are now required to be captured using existing IT infrastructure.
Moreover, there will likely be data entered into contracts as text. Extracting such information poses its own set of challenges when automating the procedure. Establishing an automated system will take time, resources, and effort from your IT department. To develop such a system takes considerable planning and design, so you should not think it can be cobbled together at the last moment.
ASC 606 will dictate that some contract elements need to be handled differently than before, which will place an additional burden on your legal department. Contracts will need to be scrutinized, with close attention paid to aspects such as termination provisions, enforcement, and pricing.
Legal departments also need to analyze existing contracts to identify areas where current terminology will produce an undesirable revenue impact on ASC 606’s introduction.
Without a doubt, implementing ASC 606 will require a significant amount of staff and resources. In addition, training for the new standard will extend beyond the accounts department and involve all staff dealing with contracts, including sales, account managers, and executives.
One of the most significant impacts of ASC 606 relates to the timing of revenue recognition. The new standard is likely to have an exponential effect on compensations linked to revenue, such as sales commissions and executive bonuses.
You can address this issue in two ways:
- Conduct a program terms redesign, replicating the previous standard’s pay structure.
- Maintain separate records under the previous standard allowing for revenue recognition for compensation purposes.
Either of these options has its challenges. The first option will involve significant time and effort and may not achieve legal approval. Option number 2 may be more straightforward; however, it requires long-term duplication, which also could face legal challenges.
ASC 606 is now at the stage where every company, regardless of industry sector, should be well down the line in their preparations for meeting the standards for pricing and selling. If an automated solution is your choice, either as an alternative or follow-up to brute-force, remember that ASC 606 offers cross-functional collaboration.
Your solution should focus on billing, compensation, and revenue. Validation is required for revenue automation systems to ensure they understand the standard and that the system complies with ASC 606 while providing flexibility in configuring and changing rules as needed.
To succeed, organizations need to adopt new business models and consider new selling techniques. How Tridens Monetization’s order-to-cash solutions already have ASC 606 standard compliance designed into them. Contact us today for help in dealing with the monumental changes ASC 606 presents for your business.