Compliance with ASC 606 regulations regarding revenue from contracts with customers can be challenging.
Passed in 2014, the US GAAP ASC 606 accounting rule change was issued as Accounting Standards Update (ASU) 2014-09. ASC 606 provided a single comprehensive model for entities to use in accounting for revenue arising from contracts from customers and superseded the most current revenue recognition guidance at the time and remains the current standard. ASC 606 outlines a five step model that requires companies to exercise more judgement and make more estimates when considering the terms of a customer arrangement/contract.
This executive overview is a high-level, simplified understanding of ASC 606, the steps involved, and the revenue recognition tools to use to get it right.
Step 1 – Identify the contract with a customer
ASC 606-10-25-2 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” Which means a contract needs to show:
Commercial substance exists
Approvals have been obtained and a commitment to perform exists on the part of both parties
Rights of both parties are identifiable
Payment terms are identifiable
Collection of substantially all of the amount to which the entity will be entitled in exchange for the good or services that will be transferred to the customer is probable (likely to occur)
Guidance on contract modifications is provided in the ruling to help model contracts that may change over time, including pricing and scope changes. These and other changes might result in a separate contract to the current one, or possibly an entirely new contract for the engagement.
Projector Tip: establish consistent language with your sales, executive and project teams for determination of contract type; identify ahead of time which exceptions may occur (as much as you can) and decide on appropriate action to take when changes arise.
Step 2 – Identify the performance obligations in the contract – or put another way, establish what you’ve agreed to deliver in exchange for payment
Many times, services related to a given contract will need to be accounted for separately. It is the responsibility of the service provider (agency, consultant, etc.) to determine whether all services it provides for a given customer should be accounted for as one unit or as separate items. There are generally two steps:
First, understand and identify all deliverables (promises to provide services)
Determine whether the promises/goods or services that will be delivered should be accounted for separately
Some contract types referred to as “stand ready obligations” have very specific rules. An example of this type of professional services contract might be a maintenance agreement where an agency contract agrees to provide services when needed or desired. If the type or quantity of services planned to be provided is unknown or unspecified it is likely a stand-ready obligation.
Projector Tip: Different contract structures have different requirements for revenue recognition. Projector has 7 default types as well as the ability to add other contract types as needed. You can read more about contract types here. And you can always refer to this Financial Accounting Standards Board (FASB) resource section on ASC 606 for more on the topic.
Step 3 – Determine the transaction price
The transaction price is the amount of consideration (e.g. payment or contract revenue) to which a reporting organization expects to be entitled to in exchange for transferring promised goods or services to a customer. This amount excludes 3rd party obligations like sales tax. It should take into consideration discounts, incentives, rebates and other price concessions.
For considerations promised in a contract that are of variable amounts, you must make a good faith estimate of the amount, only to the extent that it is probable that a significant reversal in the amount of the revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. For more on Variable Considerations refer to this detailed explanation.
Projector Tip: Integration of project accounting with your PSA and CRM is key to ensuring contract details are seamlessly collected, associated and tracked at a project level. Manual revenue reconciliation using excel spreadsheets simply will not scale.
Step 4 – Allocate the transaction price to the performance obligations
This step is all about mapping what you’ve promised to what you expect to be paid on the basis of the relative standalone selling price of each distinct good or service promised. Once again, if you’re using a PSA this is simply breaking down the contract into the logical parts based on what and when obligations will be delivered.
Variable considerations require additional scrutiny to properly apply revenue recognition rules, specifically as it relates to distinct goods or services that make up a series but are treated as a single performance obligation.
PPSA Tip: Organization-wide visibility of timelines and deliverables is easily achieved with even a basic PSA tool. The best PSA will allow the organization to customize their accounting structures based on their needs, acting as revenue forecasting software to include everything from modeling managed services contracts to accounting for business development work.
Step 5 – Recognize revenue when (or as) each performance obligation is satisfied
Revenue is reported when (or as) it satisfies the performance obligation by transferring a promised good or service to a customer. This differs from when cash is received (more on that concept here). The amount recognized is the amount allocated to the satisfied performance obligation established in Step 4. Obligations can be satisfied at a point in time (typically when promised goods are transferred to a customer) or over time (typically used for services delivered to a customer across a duration of time). Revenue recognition for consulting firms, agencies and IT services teams typically work with an “over time” model and it is essential that an appropriate method for measuring and reporting progress is in place.
Projector Tip: Project reporting and financial reporting must work together. Ideally, the system for revenue recognition that you put in place will include integration with project planning and time tracking. This allows forward looking projections that enable proper accounting when the time comes, but also insight into issues like missing time or projects going off track.
A note about disclosures:
Part of the burden of reporting revenue is also the need to provide disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from an organization’s contracts with customers. This information is both quantitative and qualitative in nature and serves to help financial statement users understand the nature, amount, timing and uncertainty of revenue and related cash flows. It is important to note that while publicly traded entities have the largest burden for disclosures, non-public entities must also provide context for their financials.
You can find out more about FASB accounting, ASC 606 rules and the latest questions on ASC 606 in the FASB’s revenue implementation FAQ.
As ASC 606 clearly outlines, contracts are the basis for how organizations must recognize revenue, but this doesn’t need to be a burden on your accounting staff or on anyone else in the organization. With a bit of forethought and planning, and the right tools (e.g. a PSA system) for revenue recognition and reporting, you can easily:
- Establish the processes and automate the data necessary to conform with ASC 606
- Manage allocation methods based on the type of performance obligation specified in the contract
- Configure and add new types of contracts or allocation methods as your business evolves
Talk to us any time about how PSA software like Projector helps services organizations follow GAAP accounting rules, better manage their operations and drive higher profits.