Revenue is the key indicator of your company’s financial performance and health. That’s not news. What is news? The accounting rules you must follow to recognize and report on that revenue are about to change. ASC 606 creates a major shift in how your business handles its accounting—particularly if you have a subscription-based business that derives revenue from contracts with customers.
What’s the big deal? For starters, the impact of the change extends beyond a mere tweak to your accounting methods. It necessitates changes to your tracking, processes, and internal controls. The purpose of this blog post is to highlight the basics of ASC 606, what it means for your business, and the risks of not taking action. When the Financial Accounting Standards Board (FASB) originally issued ASC 606, it was supposed to be effective in 2017. However, due to the magnitude of the change, the effective date has since been delayed until the start of 2018 for public companies, and the start of 2019 for private companies. Although you may think you have plenty of time, the reality is the contracts you are writing today that extend into the 2018/2019 adoption date must be accounted for under ASC 606.
It’s essential to ensure revenue recognition processes are running smoothly, well in advance of the ASC 606 deadline. Whether you are seeking additional funding, planning an acquisition, or planning to go public, the new standard has the potential to reshape your revenues and valuation. Subscription-based businesses must take special care with ASC 606. The standard has broad ramifications based on how you structure your agreements with customers—the terms, bundling, discounting, and more.
Things to keep in mind?
- If you have a subscription-based business, you likely enter into complex contracts and agreements with customers. The new standard requires your company to capture and report on this information, which your accounting system may not currently track. As a result, you need to identify and remedy critical data gaps.
- Preparing your business for the shift will be a time-consuming process—especially if your accounting system lacks built-in readiness. Anticipate significant time and resource contributions on the part of your management, accounting, and IT teams. The good news is, the earlier you identify the implications of the new standard, the better positioned you will be to ease the transition.
- For the purpose of revenue recognition, the new ASC 606 standard requires businesses to treat multiple related contracts with customers effectively as one contract. In addition, you’ll need to track the likelihood that the revenue in a contract will actually be collected. You can’t recognize this revenue until it meets the collect-ability threshold—or the contract is amended.
- A performance obligation is a promise to deliver a good or service. Identifying performance obligations has an important impact on when and how much revenue will be recognized.
The ASC 606 criteria for determining whether a good or service is a performance obligation include two key targets – capable of being distinct and distinction within the contract. In the case of capable of being distinct, the customer can benefit from the good or service either on its own or together with other resources that are readily available. In the instance of distinction within the contract, the promise to transfer the good or service is separately identifiable from other promises in the contract. - Before adoption, you need to identify variable pricing terms in contracts and understand the impact to revenue under the new guidelines. After adoption, you’ll want to automate transactions by applying variable consideration using consistent methods and flagging contracts that have non-standard terms.
- Under ASC 606, allocating transaction prices will require a complex rules-based approach that is beyond the scope of most accounting solutions used by organizations today. Organizations that attempt to allocate on a per arrangement basis using spreadsheets expose the business to risk, and the accounting team to significant headaches.
The New Bottom Line
Under ASC 606, subscription-based companies will recognize revenue over time as the performance obligation is delivered to the customer. The new standard specifies that an entity transferring control of its service over time must recognize revenue when one of the following criteria is met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
- The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
Companies also need to consider how they amortize expenses over the term of a contract. With the new standard, you may need to amortize costs (such as commissions and royalties) based on the delivery of products and services to customers, ensuring your amortization is linked with timing of satisfying the performance obligation. For organizations operating under complex billing arrangements, like usage based billing, it’s incredibly important that billing and revenue recognition systems work in sync, so that when the customer consumes the benefits of the performance obligations, your organization can recognize it. Unfortunately, businesses unable to handle complex contracts within their accounting systems will get overwhelmed with spreadsheets and subjective decisions. To maintain efficiency, and not increase risk, technology is the only answer to this new standard.