New accounting standards you should know, Part 1: The 5 steps of revenue recognition under ASC 606

For anybody in the accounting world, one thing is clear: accounting standards never stay the same. Accounting standards boards are constantly updating authoritative guidance to keep accounting in step with the latest business developments and new industries, and recent years have seen an overload of completely new frameworks for critical areas of a business such as revenue recognition, leasing, acquisitions, and investments. We recently touched on the new lease standard of ASC 842; this multi-part series will catch you up on other impactful accounting standard updates to be aware of. Kicking off the series, we look at revenue recognition.

Revenue is not a new concept to anyone. It’s arguably the most important measure of a company’s growth and overall financial health. So, it’s no surprise that companies are focused, if not obsessed, on reporting the strongest revenue numbers that they can in a given period. Naturally, the way revenue is accounted for is a hot topic in the business world.  

The Financial Accounting Standards Board (FASB), which governs accounting principles in the United States, didn’t just make a few changes in the accounting for revenue recognition in recent years; they did a complete overhaul. Previously, there was open-ended guidance around the requirements for revenue recognition. In fact, companies had to meet just four conditions prescribed in the old guidance of ASC 605 resulting in a wild west of companies’ accounting for revenue. Different methods of revenue recognition were formed between industries, and even between companies in the same industry, making it difficult for investors to analyze one company’s revenue growth from another. In response, the FASB created a new, all-encompassing framework for revenue recognition in the form of the new ASC 606, under which all companies can evaluate their contracts with customers using the same methodology.  

As you might expect, a one-size-fits-all methodology for revenue recognition means a long and painful assessment under that methodology. The new 5-Step Model under ASC 606 requires a company to evaluate all of its revenue streams and contracts with customers through the following steps: 

Step 1: Identify the contract

Before you can recognize revenue under a contract, you have to know what the contract is. While some contracts have a simple structure, others involve multiple documents (such as a Statement of Work subject to a Master Services/Supply Agreement). They may be subject to terms that were rarely considered before (such as an e-commerce website’s Terms & Conditions). There may even be multiple contracts that are legally separate but required to be combined for accounting purposes. Getting the right understanding of the contract is the foundation of the 5-Step Model.  

Step 2: Identify performance obligations

Within a contract, the next step is to assess all of the promises being made by a company to the customer, and which of those are evaluated as their own distinct “performance obligation.” Some performance obligations are easy to determine, like a good or service that is sold separately from others; think of a t-shirt being easily separated from a sweatshirt within the same customer order. However, there are many products or bundles that may need to be separated into smaller performance obligations, or some items that depend on another good or service that may need to be aggregated. For some arrangements, a product warranty or discount for future goods/services could actually be considered one of these performance obligations. This can be quite the exercise when trying to cover all of the various revenue streams or contract types within a company.  

Step 3: Determine the transaction price

In parallel to the performance obligation exercise, a company must also calculate the total amount that it is entitled to within a given contract. This typically goes far beyond the stated price or amount of a contract; it should also include estimating any variable amounts (like performance bonuses, customer credits, or returns/refunds). Contracts may involve a potential financing arrangement, payment in a form other than cash, or payments made by the company to the customer, all of which can further complicate this process. 

Step 4: Allocate the transaction price over performance obligations

Now, let’s bring it all together: A company must take the total transaction price of a contract from Step 3, and allocate that amount over all of the identified performance obligations in Step 2, based on their relative standalone selling price. This step can be the most frustrating; some goods/services have pricing that is consistent and well-known, but discounts and price changes can impact the ability to use list pricing. If observable pricing is not available, then an estimation of standalone selling price is required. Combine that with the monumental task of properly allocating each customer contract, and you may already be banging your head against a wall.  

Step 5: Recognize revenue

We did it, we finally got through the painful exercise of Step 4! It’s all downhill from here, right? Wrong. The final step of ASC 606 requires an evaluation of each performance obligation to determine if its related revenue should be recognized either at a point in time, or over a period of time. That evaluation comes with certain conditions, and then a determination of the correct point of time or period and pattern of recognition. Lastly, any contracts that involve a third-party providing part of the goods or services need to be considered if they should be recognized gross or net of those third-party costs.  

Don’t Forget: Contract costs

While not included in ASC 606 or the 5-Step Model, the release of this guidance snuck in some related guidance around certain costs that a company incurs related to its contracts with customers. Certain costs to obtain a contract (like sales commissions) or fulfill a contract (such as contractor work related to a specific contract/project) must be evaluated for whether they should be immediately expensed, or capitalized and amortized over a period of time. Industries like software, where commission rates are different for initial contracts versus renewals, introduce even further complexities in this evaluation.  

The new revenue recognition guidance of ASC 606 is not a new topic in the accounting world; the FASB started releasing guidance as early as 2014. Publicly traded companies were required to adopt ASC 606 for fiscal years beginning after December 15, 2017 (calendar year 2018), and nonpublic companies were required to adopt for fiscal years beginning after December 15, 2019 (calendar year 2020). However, many startup and early-stage companies who are facing new investor/lender requirements for financial statements under US GAAP should be aware of this new rev rec framework and the accounting exercise that comes with it.  

In the next Zeroed-Insight, we will load you up with guidance on the new model for credit losses, CECL (ASC 326), that will impact a wide range of financial instruments that include receivables, investments, and even lessor-type leases.