When you run a business, your prime focus is often on the revenue earned during a specified period. It is essential for companies to ensure proper accounting for revenue, based on the accepted practices. Many executives tend to believe that revenue is made when the money is received from the customers. However, the accounting standards state that revenue has more to do with when it is earned, not when it is received.
Revenue recognition is one such accounting principle that specifies the conditions under which a company must recognize its revenue. Thus, the principle helps specify if the revenue has been recorded after it has been earned or when it has been received. ASC 606 is the latest revenue recognition standard that pertains to all entities that engage in contracts with their clients for the sale of goods and services. As per the 2017 and 2018 guidelines, all public and private companies must be ASC 606 compliant.
A survey of 300 CFOs and CIOs from prominent corporations having revenues up to $10 billion revealed that implementation of new revenue recognition standards would cost them around $3.3 million. The benefits offered by the new standard are expected to easily outweigh the costs involved.
What is ASC 606? What are the key aspects of ASC 606 revenue recognition? Read on to know more.
What is ASC 606 Revenue Recognition Accounting Standard?
ASC 606 is a new revenue recognition standard that has been jointly developed by the International Accounting Standards and Financial Accounting Standards Board. ASC 606 delivers a well-defined framework for enabling companies to recognize their revenues consistently. The key objective of this standard is to remove variations in the methods undertaken by professionals to account for comparable transactions. As the accounting industry in the US crosses $141 billion in 2022, streamlining the revenue recognition standards is essential.
Earlier, the variations in financial reporting practices made it tough for key stakeholders and investors to undertake a detailed comparison of financial results across multiple companies. This is the reason that the new ASC 606 revenue recognition standard is being hailed as the biggest change to accounting standards in the last century. Several iterations of ASC 606 were tried before giving it the final shape that it currently enjoys.
ASC 606 also has a profound impact on SaaS revenue recognition. It factors in the customer lifecycle and costs incurred by customers at every stage of the sales cycle. This includes stages like training, upgrades, discounts, downgrades, and several others. 94% of CIOs and CFOs believe that implementation of revenue recognition changes can deliver better value return than the cost incurred for the same.
Before ASC 606, the entire revenue is recognized in the next year per dollar for the revenue recognized in the present year. Though, after ASC 606, the revenue cycles will shorten from 24 months to 18.7 months, with 56 cents of revenue recognized in the subsequent year per dollar revenue recognized in the ongoing year.
5 Steps of Revenue Recognition
While developing the ASC 606 revenue recognition standard, IASB and FASB intended to deliver a well-defined framework that will usher in consistent financial reporting practices. The other key objectives were improvement in comparative analysis and reporting & simplification of the processes involved in financial statements preparations. These objectives are achieved through a stated 5-step model under this new revenue recognition standard. Detailed here are the 5 steps of revenue recognition under ASC 606:
Identify the contract with a customer
As per ASC 606 accounting standard, there is no need for a signed contract. Though, it specifies that any contract with rights and obligations that can be enforced is valuable. Accordingly, the pivotal aspects of a contract are,
- The agreement has been approved by all the parties.
- Parties are fully committed to meeting their specified obligations.
- The rights of every party can be identified.
- Payment terms have been identified.
- Contact has defined commercial aspects.
- There is a high probability of collectability.
Identify the Performance Obligation in the contract
As per this step, the meaning of performance obligation is a promise to transfer services or goods to the customers. Herein, any unique services being offered to the customers must be identified.
The actual good or service can offer some benefits to the customer. The performance obligation can be independently transferred without affecting any other performance obligations mentioned in the contract.
Determine the transaction price
The actual good or service can offer some benefits to the customer.The performance obligation can be independently transferred without affecting any other performance obligations mentioned in the contract.
Allocate the transaction price
SaaS is unlike other businesses; hence, SaaS revenue recognition is also different. Here, the service or product delivery is of recurring nature, so there is always an ongoing performance obligation. To handle this, the vendor can divide the entire consideration amount to be identified as revenue separately for every performance obligation.
Recognize Revenue
Once the performance obligation has been fulfilled, the revenue is recognized. Also, as the enterprise meets every performance obligation, the revenue can be thus identified.
How is ASC 606 implemented?
As a new revenue recognition standard, ASC 606 offers company leadership the opportunity to analyze key business aspects like supply chain, contracts, staffing needs, and sales processes. Implementation of the ASC 606 SaaS revenue recognition standard requires considerable expertise and time. Detailed here are the steps involved in the implementation of this revenue recognition standard in sales commission plans: -
Analyze your sales commission types
At the outset, you must gather the previous sales commission data. This will help you understand the various commission types that you are offering to your salespersons and how the commission is being ascertained. You must also attempt to understand the rationale behind every incentive being offered and how it relates to business goals. This will help you understand the true state of commissions being offered by your company. Moreover, you will also be able to undertake an analysis of the various aspects of your variable salary plans. Having access to the variable compensation data and commission plans will help create financial reports that are compliant with ASC 606 accounting standard.
Categorize the Commissions
Now, you need to undertake the categorization of commissions being paid to salespersons as per the customer benefits. There can be numerous components to the commission plan to motivate the individual toward achieving a specific goal. Though, many components are also liked to services offered to the customers. You must therefore analyze the existing data to determine total commission expenditure as per their links with services in the original contract.
Determine the commission cost of treatment
Incremental costs are defined as those expenses that must be incurred to secure a contract with a customer, including sales commission. Hence, you need to determine those commission costs that need to be capitalized from those that must be accounted for when incurred. If the expenses can be capitalized, it is ideal that you capitalize it at the accrual point.
Determine the Amortization Period
It is important to ascertain the long-term benefits of the commission expenses to ascertain the amortization duration for the incremental costs. You also need to determine the inputs that create the basis for those benefits. Based on the customer's lifetime and duration of the contract, you need to define the amortization period for every input.
For sales commission software, important inputs can be the original contract duration and expected renewals, along with the estimated life of the technology.
There is no need to amortize the expenses uniformly. It is your discretion to ensure an amortization period based on a logical rationale. If some basic criteria are being fulfilled, then you can also account for multiple contracts in the form of a portfolio as per the portfolio expensing approach.
Allocate Discounts and Transaction Prices
As per ASC 606 revenue recognition accounting standard, if the contract features more than a single performance obligation, you need to allocate the transaction price based on the stand-alone selling price determined at the contract creation. Due to the unavailability of this price in some cases, you can undertake alternate methods like the residual approach or adjusted market assessment approach.
This SaaS revenue recognition standard also specifies that if the customer is being offered a discount for buying several services or products, then the discounts must be equally distributed for all performance obligations detailed in the contract. For a SaaS business, a pre-defined allocation methodology can work well where the contract cost is allocated entirely to services that are responsible for the contract cost asset.
Comprehensive Data Reporting
Based on ASC 606 revenue recognition standard, businesses must share detailed data to depict multiple products and services that have varying revenue patterns, including post-contractual services and upfront fees. For this, you must allocate commission calculations at the contract level or undertake a sound estimation method to analyze the commission data. This will help you ensure ASC 606 compliance while using the data for the preparation of financial statements.
ASC 606 revenue recognition accounting standard offers clear guidelines to adjust the entire range of changes in revenue recognition practices that have an impact on the financial statements. Moreover, the comparability aspect of revenue recognition practices across various companies would also improve.
FAQs
Q1. What is the purpose of ASC 606?
A1. ASC 606 has been created with the purpose of removing variations in the way businesses take care of accounting related to similar transactions across domains.
Q2. What are the 5 steps of ASC 606?
A2. The five steps of ASC 606 are: identify the contract with a customer, identify the performance obligation in the contract, determine the transaction price, allocate the transaction price, and recognize revenue.
Q3. What does ASC mean in accounting?
A3. In accounting, ASC means Accounting Standards Codification.
