What is ASC 606? A Guide to Its Ins & Outs

Ah, here you are — searching for articles on the riveting topic of revenue recognition and the latest accounting standard, otherwise known as ASC 606.

You’re here because you know that when you run a business, there is typically one goal. Some call it earnings, profit, or income, but at its core, it’s revenue.

You’re probably also aware that how your company accounts for revenue depends on different factors. As a business owner, you might think your company makes revenue when it receives money from a sale, but that’s not the accounting standard. Revenue has less to do with when it’s received and more to do with when it’s earned.

Let’s unpack that a bit below.

What is revenue recognition?

Revenue recognition is a generally accepted accounting principle (GAAP) that outlines the specific conditions in which a business recognizes revenue. This principle specifies whether revenue is recorded after it’s received or earned.

This method of accounting is distinguishable when comparing cash basis accounting and accrual basis accounting. For retail companies that use the former accounting method, revenue recognition is straightforward. Your company typically records its revenue when the transaction funds are received and added to your cash register or bank account.

Consider attorneys at a law firm. Under accrual basis accounting, companies recognize revenue when it’s earned. Attorneys use billable hours, a tracking system used to record time spent on a client. Once they complete the work, they send an invoice. Revenue recognition stipulates that this method of accounting requires revenue recognition once it’s earned versus at the end of the project when it’s received.

Revenue Recognition Criteria

A business must meet specific criteria to recognize revenue. If it fails, it needs to hold off on recognition until the company satisfies the conditions. The U.S. Securities and Exchange Commission (SEC) lists "that revenue is generally realized or realizable and earned when all of the following criteria are met":

1. Persuasive evidence of an arrangement exists.
2. Delivery has occurred, or services have been rendered.
3. The seller’s price to the buyer is fixed or determinable.
4. Collectibility is reasonably assured.

1. Persuasive evidence of an arrangement exists.

For revenue to be recognized, the transaction must indicate that a sale took place. It means that a transfer of goods or services occurred for a specific price. There are additional conditions associated with meeting these criteria. For example, if a buyer has no obligation to pay for received items, this is not equivalent to a sales transaction.

2. Delivery has occurred, or services have been rendered.

To satisfy this criterion, the buyer has to accept the goods or services. It also signifies that ownership and the risks of ownership have transferred from the seller to the buyer.

3. The seller’s price to the buyer is fixed or determinable.

Revenue recognition requires that a price be fixed or determinable. Why? If a business cannot determine its selling price, it cannot determine the revenue to record. An example of when a seller’s price is not fixed or determinable is when a transaction includes the option to exchange the product for another.

4. Collectibility is reasonably assured.

The last criterion for revenue recognition is ensuring that collectibility is reasonably assured. That signifies that at the time of sale, both the seller and buyer understand that the goods or services are receivable.

Revenue Recognition Methods

Revenue recognition criteria are strict; however, your business has the option to explore different methods based on your business model. The five common revenue recognition methods are:

1. Sales Basis Method
2. Percentage of Completion Method
3. Installment Method
4. Completed Contract Method
5. Cost-Recoverability Method

1. Sales Basis Method

In the sales basis method, revenue is recognized when a transaction is complete. At this time, goods or services have been delivered or rendered to the buyer. Let’s use an Amazon subscription as an example.

While yearly memberships currently costs $139, the corporation can’t recognize the revenue at the time of transaction because the buyer has not received an entire year of service. Instead, the company would have to divide this into 12 equal amounts and recognize $11.58 in monthly revenue.

2. Percentage of Completion Method

A popular method for long-term contract companies, this specifies that revenue is recognized based on the percentage of project completion. For example, a wedding planning company might employ its services to couples for months or years.

In building the contract, the two parties will decide what parameters need to be met to reflect project completion as the company secures a venue, organizes floral arrangements, hires caterers, etc.

3. Installment Method

The installment method is used for revenue recognition each time a customer or client makes a payment towards a transaction. Say you purchased a new car at $30,000 and put a $6,000 down payment on the vehicle. To pay off this car in five years, you agree to $400 monthly payments. Although the car company made a $30,000 sale, it can only recognize the $6,000 down payment. Each month, it would add the $400 payment to its revenue.

4. Completed-Contract Method

The completed-contract method recognizes revenue and profits only after a completed contract. Companies typically use this method when they cannot predict how much or when funds will be collected from the client or customer. The benefit of using this method is that the reported revenue is based on actual results versus estimates.

5. Cost-Recoverability Method

The cost-recoverability method is a conservative method where revenue is recognized only when the revenue collected exceeds the cost of the goods or services sold. It’s a popular method for companies that sell goods on credit.

Now that we’ve discussed the criteria and methods of revenue recognition, we can focus on the latest revenue recognition standard: ASC 606.

What is ASC 606?

ASC 606 is an accounting standard set by the Financial Accounting Standards Board (FASB) that defines how businesses recognize revenue in their operations. While the previous system was industry-specific, the updated structure is industry-neutral. Issued in May 2014, the goal of ASC 606 was to create transparency in revenue recognition, address revenue issues as they emerge, and standardize how all businesses recognize revenue across multiple industries.

The standard applies to all contracts with customers, except the following:

• Lease contracts
• Insurance contracts
• Financial instruments
• Guarantees (other than product or service warranties)
• Non-monetary exchanges between entities in the same line of business used to facilitate sales to customers

ASC 606 Effective Date

Although public, private, and non-profit companies are held to the new revenue recognition standards, the ASC 606 effective date differed for these entities. Public businesses were required to adopt the new guidelines for reporting periods beginning after December 15, 2017, while others (private and non-profit) were not required to implement the new standards until December 15, 2018.

ASC 606 Revenue Recognition Steps

To help your business determine how to recognize revenue under ASC 606, you need to:

• Step 1: Identify the contract(s) with the customer. The company and customer are aware of the payment terms, collectibility, and involved parties.
• Step 2: Identify the performance obligations. To create a clear image of transaction processes, set milestones for recognizing revenue.
• Step 3: Determine the transaction price.
• Step 4: Allocate the transaction price. Assign an expense to each performance obligation. It should equal the total transaction price.
• Step 5: Recognize revenue when or as the entity satisfies the performance obligation.

The need for each step will vary based on the business; however, these steps can help most companies identify how to recognize revenue. To understand the process of revenue recognition under ASC 606, we use the following examples to demonstrate its application.

ASC 606 Revenue Recognition Examples

Example 1: Intellectual Property

The professional services network and accountancy firm, CliftonLarsonAllen, applied the ASC 606 revenue recognition steps to an example of intellectual property.

The scenario states: “— A university has a world-renowned marching band that recently completed a recording of marches by famous composers. The university enters into a contract with a vendor that wishes to use the recordings in advertisements. Significant terms of the contract include: the term is two years, the vendor receives a license to use the recordings in advertisements for that period, and the university receives a payment of $40,000 at the start of the two-year term.”

To recognize its revenue, they will:

• Step 1: Identify the contract(s) with the customer. A contract exists between the university and the vendor in which the vendor will pay $40,000 for a license to use the university's intellectual property.
• Step 2: Identify the performance obligations. Under the contract, the university is required to provide the license for two years.
• Step 3: Determine the transaction price. The transaction price is $40,000.
• Step 4: Allocate the transaction price. The transaction price ($40,000) is allocated to the intellectual property license, as there is only one performance obligation in the contract.
• Step 5: Recognize revenue. The university recognizes the revenue ($40,000) at the start of the two-year contract because ASC 606 allows for this if the functionality of the property will not change throughout the contract.

Example 2: Subscription Revenue

You own a quarterly subscription box company. Customers can sign up for an annual subscription where they prepay $199.99 for four boxes at $49.99 per box. As an alternative, customers can also pay quarterly at $54.99 per box. Consider a customer who signs up for an annual subscription.

To recognize revenue, you would:

• Step 1: Identify the contract(s) with the customer. A contract exists between your company and its customer where the customer pays an annual sum of $199.99 to receive a quarterly subscription box from your business.
• Step 2: Identify the performance obligations. Under the contract, your company has to provide a quarterly box to your customers.
• Step 3: Determine the transaction price. The transaction price is $199.99.
• Step 4: Allocate the transaction price. Allocation is not required as there is only one performance obligation.
• Step 5: Recognize revenue. Revenue would be recognized over four quarters when your company provides the subscription box to the customer. Every quarter, your company would recognize $49.99.

Now, let’s look at the changes in the process if a customer signs up for a quarterly subscription.

• Step 1: Identify the contract(s) with the customer. A contract exists between your company and its customer where the customer pays $54.99 each quarter to receive a quarterly subscription box from your business.
• Step 2: Identify the performance obligations. Under the contract, your company has to provide a quarterly box to your customers.
• Step 3: Determine the transaction price. The transaction price is $54.99.
• Step 4: Allocate the transaction price. Allocation is not required as there is only one performance obligation.
• Step 5: Recognize revenue. Revenue would be recognized over four quarters when your company provides the subscription box to the customer. Every quarter, your company would recognize $54.99.

Are you able to notice the differences? To highlight the differences between these two processes, we have underlined them. Note, the changes are insignificant. The only changes are due to the price differences within the contract. It’s to stress that ASC 606 revenue recognition has little to do with how much or when a customer pays.

This example is an efficient way to reiterate the revenue recognition definition. In the situation of the annual subscriber, although your subscription box company has received revenue ($199.99) from its customer, this amount cannot be recognized because it has not been earned. It can’t be earned until it satisfies the four revenue recognition criteria.

In this case, the delivery hasn’t occurred, and ownership of the product hasn’t been transferred. This is why your company can’t recognize the revenue until each box has been delivered to the customer.

ASC 606 is complex.

Revenue recognition is a principle that determines whether revenue should be recorded after it is received or earned. Before the introduction of ASC 606, companies were required to recognize revenue when it was earned.

Now, the framework creates a new system where companies are required to conduct deeper evaluations into their contracts with customers. While implementing and even understanding ASC 606 can be overwhelming, this post and the five steps needed to recognize revenue are a good place to start.