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Have you started to work on implementing the new revenue recognition standard, ASC 606?
If you haven’t, you’re not alone. A study by MorganFranklin of accounting and finance leaders at nearly 70 emerging and middle-market U.S. companies found that only 9 percent had completed implementation of this new standard; 72 percent had not yet made significant progress.
For public companies, this standard is in effect for periods beginning after Jan. 1, 2018, while private companies have an extra year.
Legacy GAAP guidance for revenue recognition was developed on an ad hoc, industry by industry basis with specific guidance for many industries, such as construction, real estate, software and franchises. ASC 606 applies to all types of businesses and all types of customer contracts with the exceptions of leases, insurance, guarantees and some non-monetary exchanges, for which separate guidance exists.
For many businesses, such as retailers, there will be little difference other than additional disclosures in their financials, but for others, this is a whole new world.
Companies offering subscription-type services, and provide a combination of physical goods and services, will need to carefully consider the agreements they have with customers now and in the future.
ASC 606 introduces a five-step process for recognizing revenue. Let’s look at those five steps.
Step 1: Identify the contract. Under legacy GAAP, a signed contract was the typical evidence of a contract, but under ASC 606, all that’s needed is the existence of enforceable rights and obligations. A contract exists if there is a transaction (a) for a business purpose, (b) with approvals and commitments in place, (c) with identifiable rights for each party, (d) which has payment terms identified, and (e) for which collection of the full fee is likely to occur.
Step 2: Separate the performance obligations. The components of the transaction are identified and separated if appropriate. Components are separated if the company also sells those components as stand-alone items or if they have value to the buyer on their own. For example, a contract for the sale of a piece of complex equipment that includes installation and setup may be just one component if installation is performed exclusively by the seller, and the equipment is useless without this service.
Step 3: Determine the transaction price. The transaction price includes all fixed cash payments to be received by the seller and the estimated fair value of any noncash consideration promised by the customer. If the transaction includes future bonuses, penalties or rebates whose value is uncertain, estimates of those amounts must be included. The transaction price also includes benefits to the buyer or to the seller when there is a significant financing component, which may be in the form of advance or deferred payments. These provisions may result in sellers recognizing revenue earlier than under legacy GAAP.
Step 4: Allocate transaction price. If the transaction includes separate components identified in Step 2, the price must be allocated across these components. ASC 606 provides several methods for doing this. The simplest is based on the prices for the components when sold separately. Another method starts with the seller’s expected costs for the components and adds a profit margin.
Step 5: Recognize revenue. As the performance obligations are met, revenue is recognized. Under legacy GAAP, revenue recognition focused on the transfer of the risks and rewards of owning the goods or services and required consideration of whether revenue had been earned and was realized or realizable. The new model focuses on the transfer of control of the goods or services. Recognition may be over time or at a single point in time, depending on the nature of the goods or services and the terms of the transaction. The standard provides several tests for determining whether the transfer is over time or at a single point in time.
Finally don’t underestimate the time it will take to tour company to implement these new standards!