As part of its continuing efforts to restructure and simplify accounting standards, the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) standard 606 (ASC 606). ASC 606 is a framework that enables more consistent revenue recognition for businesses engaged in contract-based selling. Given the criticality of revenue recognition in financial reporting, ASC 606 is worth a moment to review.
ASC 606 was developed jointly by the FASB and the International Accounting Standards Board (IASB). The intention was to get rid of variations in ways that businesses handled similar transactions across multiple industries. For example, a 12-month contract to sell sugar should result in revenue reporting equivalent to a 12-month software licensing contract. However, a previous lack of standardization led to differences in revenue reporting in different sectors. This, in turn, proved confusing for investors and other readers of financial statements.
Not all businesses will be affected by ASC 606. Retailers, for example, generally recognize revenue at the point of sale. They aren’t stretching revenue out over the life of a contract. For contract- or subscription-based businesses, the rule will change results—mostly improving them. Previously, a company could only have applied six months of revenue out of a 12-month contract to the current year. Now, under ASC 606, they can recognize all the revenue at once.
ASC 606 is required today. Implementing the standard will likely involve a fairly in-depth project. It will affect information systems, legal, accounting and beyond. To make the implementation easier to manage, FASB and IASB recommend a 5-step model for implementation:
- Identifying the contract with a customer—Outlining the various criteria that need to be met when a contract is established to provide goods or services to a customer.
- Identifying the contract’s performance obligations—Specifying how to handle the distinct performance obligations in a given contract.
- Determining the transaction price—Outlining considerations in establishing the transaction price, i.e. how much revenue the business expects to receive for fulfilling the terms of the contract.
- Allocating the transaction price—Understanding the guidelines for allocation of the transaction price across a contract’s individual performance obligations. This is what the customer agrees to pay for the goods and services specified in the contract.
- Recognizing revenue when or as the entity satisfies a performance obligation—pairing revenue with the business meeting each performance obligation.
As one might imagine, this process can get pretty involved. The American Institute of CPAs (AICPA) publishes Industry-Specific Guidance to help you make the transition to ASC 606 revenue recognition as smooth and accurate as possible. At a minimum, the implementation process will mean developing a rules-based framework for accounting policies based on your contract assessments. This approach is advantageous for companies that have highly variable contracts. Without a rules-based framework, it could be quite burdensome to evaluate each contract one at a time.
It will also be necessary to choose a transition method between the earlier revenue recognition method and the one based on ASC 606. There are two methods: “full retrospective” and “modified retrospective.” With full retrospective, the business has to restate two prior comparative years, or in some cases, three years. In contrast, the adoption year with the modified retrospective method means doing dual recordkeeping for the period. Each method comes with a systemic burden. It’s wise to understand how one’s chosen method will affect accounting operations.
FASB ASC: What It Means for CPAs (AICPA)