ASC 606: The Ultimate Guide to Revenue Recognition

Step 1. 

Identify the Contract

Before any revenue recognition can take place, it is crucial to determine the contractual obligations between your business and your customers. This can take various forms such as written or verbal agreements, or even implied arrangements based on industry norms or established practices. It is essential to have a precise understanding of the terms and conditions, payment details, and any other rights and obligations of both parties.

To properly identify the contract, you need to review existing documents and look for any new agreements. You should also take note of any changes in the terms of the contract, particularly payment dates or additional items requested by either party. It is also important to identify each individual customer involved in the contract separately, so they can be accounted for accordingly during the revenue recognition process.

In addition to written contracts and verbal agreements, implied contracts may also need to be considered, depending on the industry or established practices between yourself and your customers. Once the contract is identified, you can move on to the next step of identifying performance obligations within the contract to ensure proper and timely revenue recognition.

What about collectability?

The Collectability Threshold is an important concept in Accounting Standards Codification (ASC) 606 that refers to the amount of payment a company is expected to receive from its customers. The threshold is used to determine whether or not revenue from a particular contract should be recognized. The Financial Accounting Standards Board (FASB) has established guidelines for this threshold in ASC 606-10-25-1(e) and 606-10-55-3(a) through 55-3(c).

According to ASC 606-10-25-1(e), a company should not recognize revenue until it is probable that the payment for that revenue will be collected. This means that a company must consider the creditworthiness of its customers and any other factors that may affect their ability to pay before recognizing revenue from a particular contract. The collectability threshold is used to ensure that a company does not overstate its revenue by recognizing revenue from contracts that are unlikely to be paid.

ASC 606-10-55-3(a) through 55-3(c) further clarify the collectability threshold by providing examples of when revenue should and should not be recognized. For example, if a customer has a history of paying their bills on time and there are no other factors that may affect their ability to pay, then revenue from a particular contract should be recognized. However, if a customer has a history of late payments or there are other factors that may affect their ability to pay, then revenue from that contract should not be recognized until payment is received. Overall, the collectability threshold is an important aspect of revenue recognition that helps to ensure accurate financial reporting.

GAAP vs IFRS

Under IFRS, the collectability threshold is more subjective than under GAAP. IFRS requires companies to assess the probability of collecting payments from the customer based on its creditworthiness and ability to pay, among other factors. If the company determines it is probable that it will receive the payment, then revenue can be recognized. This means that a higher degree of judgment is required, and there is more flexibility in determining collectability.

On the other hand, GAAP has a stricter approach to collectability. Under GAAP, revenue can only be recognized when it is considered "collectible." The collectability threshold is met only when the payment is probable and can be reliably estimated. In addition, GAAP has specific guidance on evaluating the collectability of contract assets, which are the right to receive payment for goods or services that have been transferred but not yet billed to the customer.

Overall, while both IFRS and GAAP have a collectability threshold, the approach and guidance provided for evaluating collectability differ. IFRS allows for more judgment and flexibility in determining collectability, while GAAP requires more objective criteria to be met before revenue can be recognized.

Step 2. 

Identify Performance Obligations

Once you’ve identified the contract with your customer, it's time to identify each promise you make to them. This is known as a performance obligation. A performance obligation is a distinct good or service, or a series of goods and services that are substantially the same and have the same pattern of transfer to the customer.

When determining what constitutes a performance obligation, consider how much control over each item you will retain during delivery and whether any items can be sold separately from other items in the contract. For example, if your company sells software subscriptions bundled with technical support services, then both would constitute separate performance obligations since they can be sold independently of one another.

In addition, think about how long it takes for each part of the transaction to be completed; if something takes longer than one year to complete then it likely qualifies as its own performance obligation too. When calculating revenue recognition, it is essential to bear in mind that varying types of products and services may necessitate distinctive approaches.

In Step 2, you must identify the performance obligations in the contract to ensure that your revenue recognition is accurate. Now it's time to move on and determine the transaction price for each of these identified performance obligations.

Step 3.

Determine the Transaction Price

Determining the transaction price is an important step in recognizing revenue. Estimating the amount of consideration to be received for transferring goods or services is an integral part of determining the transaction price. The contract may include fixed consideration, variable consideration, or both types. If it includes variable consideration, you must estimate the amount of variable consideration you’re entitled to using either the expected value method or most likely amount method.

Pay close attention to the payment timing and the gap between transferring promised goods/services and when customers pay, in order to identify if a financing component is present. For instance, should your customer have requested an extension of credit terms beyond normal ones, this could signify a substantial financing element which needs to be accounted for separately from other components such as delivery fees per FASB's Accounting Standards Codification 606-10-25-18.

Under GAAP and IFRS, companies must only recognize satisfied revenue at each reporting period's end; any remaining revenue should be deferred until future periods when they become performance obligations that have been fulfilled according to the company's accounting method. Thus, cumulative revenues recognized over annual reporting periods beginning after December 15th 2017 cannot exceed the total transaction price minus amounts already acknowledged during prior intervals.

Step 3 of the revenue recognition process is an important step that requires careful consideration and analysis to ensure accuracy. With this in mind, Step 4 will focus on allocating the transaction price to each performance obligation within the contract.

Step 4.

Allocate the Transaction Price

Allocating the transaction price to each performance obligation in a contract is an important step of revenue recognition. This process requires assigning a value to each individual component or service provided within the agreement. To do this, you can use relative standalone selling prices, such as those from similar goods or services, a contractually stated price, or a list price.

If you cannot directly observe these prices, then other methods must be used for estimation. The adjusted market assessment method involves looking at comparable items and adjusting them based on factors like quality and quantity. Expected cost plus margin looks at expected costs associated with providing the good/service plus any desired profit margins added by the seller. 

Step 5. 

Recognize Revenue As the Performance Obligation is Satisfied

Step 5 of the revenue recognition process requires businesses to recognize revenue when, or as, they satisfy a performance obligation.

When recognizing revenue over time, businesses must apply a single method of measuring progress for each performance obligation. Progress can be assessed using a variety of approaches, e.g., units-of-delivery (quantity of goods provided) or cost-to-cost (cumulative costs compared to total estimated). It’s important to apply this same measurement consistently across similar performance obligations and remeasure it at the end of each reporting period.

Determining when a performance obligation has been fulfilled is paramount for recognizing revenue at the most appropriate point in time. If selling software licenses with immediate delivery, revenues can be recognized instantaneously upon purchase completion; conversely, if dealing with physical items which require shipment to customers, only then can related revenues be taken into account. To stay ahead of the curve and keep on top of your game, it's essential to apply consistent measurements across similar obligations while remeasuring progress at each reporting period.

Overall, accurately determining when to recognize revenue is essential for any business wanting to ensure proper financial reporting compliance while also avoiding costly penalties from potential audit findings down the line. By understanding these five steps of revenue recognition and implementing best practices accordingly within your organization’s internal processes you can rest assured knowing that your company’s financial statements are up to par with industry standards and regulations alike.

Recognizing revenue when or as the entity satisfies a performance obligation is an essential step in any business's financial process. Documenting these processes will help ensure that all transactions are properly accounted for and recorded accurately.