Recognizing revenue is one of the most important parts of running a business. How and when a business chooses to recognize revenue has a huge impact on its financial reporting and end-of-year statements—not to mention its overall growth and sustainability.
For subscription-based businesses, revenue recognition can be considerably more complex. Not only are there multiple revenue streams to keep track of; the continuous nature of subscription products and services makes accounting processes much more stringent, especially with the introduction of the ASC 606 revenue recognition standard.Learn More
ASC 606 has introduced significant changes to how revenue recognition is conducted and has far-reaching consequences for subscription-based businesses. In this post, we’re going to cover:
- What ASC 606 is
- Why ASC 606 was introduced
- The criteria for revenue recognition
- Who is impacted by ASC 606
- How businesses need to recognize revenue under ASC 606
- The best way for businesses to stay compliant with ASC 606
What is ASC 606?
Accounting Standards Codification 606, commonly rendered as ASC 606 or Topic 606: Revenue from Contracts with Customers, is an accounting standards update (ASU) developed by Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).
The central aim of ASC 606 is to bring more consistency to revenue recognition between industries, removing variations that make it challenging to enforce transparency in financial reporting. The effective date for ASC 606 is the reporting period starting on or after January 1, 2018 for public companies, and the reporting period starting on or after January 1, 2019 for private companies.
ASC 606 brings in increased disclosure requirements for how public, non-profit, and non-public entities must recognize and account for their revenue across both annual and interim periods of reporting. By following the step-by-step process laid out in ASC 606, businesses can make sure they are staying compliant with revenue recognition standards.
Why was ASC 606 Introduced?
The key concern with previous revenue recognition guidelines was the lack of standardization between the US-based GAAP and the International Financial Reporting Standards (IFRS). This made it difficult for businesses to recognize their revenue consistently.
ASC 606, the revenue recognition standard, is designed to better align GAAP with international standards and simplify financial reporting by providing a clear revenue recognition model for when and how businesses need to account for the amount of revenue earned. This standard allows for easier comparability between companies and industries, creating more transparency within financial statements.
What are the Criteria for Revenue Recognition?
ASC 606 is a framework that falls within GAAP—i.e., generally accepted accounting principles. For the uninitiated, GAAP refers to a set of accounting standards and processes issued by the Financial Accounting Standards Board (FASB). These principles must be followed by public companies in the United States, though many private companies choose to follow GAAP anyway.
Revenue recognition determines the circumstances under which revenue can be recognized and how it should be accounted for.
Revenue recognition is a metric at the heart of running a successful business.
How revenue is recognized dictates whether a venture is running at a profit or a loss, or how much money can be dedicated towards expansion and hiring. This is why revenue recognition has been subjected to such a significant accounting standards update.
In most cases, revenue can be recognized when the following principles are met:
- Clear evidence of a financial arrangement
- Completion of product or service delivery
- Price to the buyer is fixed or measurable
- Funds are reasonably collectible
Revenue recognition is a pretty straightforward process for many businesses. This is because all the principles above will take place at the same moment in time. For instance, in a retail store, all these standards are met at the checkout counter.
But other companies, especially those in the SaaS (Software as a Service) space, will not recognize all four principles simultaneously. This is because they rely on subscription-based billing, where revenue cannot be realized at the same time that a product or service is considered “sold.”
The guidance within the ASC 606 revenue recognition system streamlines the process of recognizing revenue by introducing a 5-step process for how these criteria are applied.
What is the Impact of ASC 606?
The primary impact of ASC 606 is to its core principle: that revenue is recognized when the contractual obligation is met, not when the payment is made.
Let’s say a massage therapist is paying a $100 monthly subscription for her appointment scheduling software. The software provider is charging $100 at the start of every month, which means the payment has been made even when the service hasn’t been fully delivered when the payment was made.
Because the software vendors’ contractual obligation hasn’t actually been met at the time of payment, the company cannot recognize that $100 income as revenue.
This has served to create more stringent reporting standards for businesses than existed under the previous system, ASC 605. For example, under ASC 606, businesses must begin accounting for separate performance obligations—i.e. their promises to transfer goods or services to the customer, something they didn’t have to do previously.
Moreover, businesses who are compliant with ASC 606 must recognize both deferred and earned revenue accurately at any given moment in time.
This means they need to recognize the portion of a product or service that has been delivered to a customer versus that is still outstanding, which may require the revenue to be recognized in a series of installments.
Who is Impacted by ASC 606?
Businesses that are meeting their contractual obligations—that is, those that transfer promised goods at the same time as they receive payment, will not notice a significant change under ASC 606. Even though there may be a slight delay in customers gaining control of the goods, they do not need to recognize earned and deferred revenue separately on their balance sheets.
Because SaaS companies and other subscription-based businesses do not typically see their product or service redeemed in full at the same time as payment, these entities will need to make some significant judgments in light of this revenue recognition guidance.
Under ASC 606, businesses must practice the separation of revenue into earned and deferred. This must be tracked across the entirety of a subscription period.
For example, a SaaS business may bill a customer for 12-month subscription upfront. However, they cannot recognize this revenue in one go until the entirety of the product or service has been redeemed. The longer the subscription, the more complex this revenue recognition process becomes, especially if a customer cancels their subscription or upgrades to a different plan.
In sum, subscription businesses need to ensure that they are meeting these revenue recognition standards to stay compliant with ASC 606.
What is the Process for Recognizing Revenue Using ASC 606?
ASC 606 breaks down the process of revenue recognition into five steps (which we’re going to cover in-depth):
- Identify the contract with the customer
- Identify the performance obligation
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue
1. Identify the contract with the customer
ASC 606 defines contracts in broad terms. Under ASC 606, a contract refers to any agreement between two parties. This typically means a business and a customer create enforceable rights and obligations between them.
A contract doesn’t necessarily have to be a signed agreement; it can be verbal, written, or implied within documents such as Terms & Conditions or Terms of Service.
For a contract with a customer to be able to be counted as revenue, it must contain the following:
- All parties involved in the agreement are committed to fulfilling their respective functions
- The rights of each party are clearly identifiable
- The payment terms for the product or service are clearly identifiable
- The contract has commercial substance
- Collectibility of the transaction price is probable
If the above criteria are not met in an agreement, it does not qualify as a contract and cannot be recognized as revenue for the purposes of ASC 606.
2. Identify the performance obligation
The performance obligation is a business’s promise to transfer a good or service to the customer according to the terms set out in the contract.
Under ASC 606, the business must identify and define all distinct goods and services that are being provided to the customer separately from other performance obligations. A good or service is considered distinct if:
- The customer can benefit from the actual goods or services on their own or with resources that are available to the customer
- The transfer of goods or services to the customer is standalone from the remaining performance obligations in the contract.
3. Determine the transaction price
Under ASC 606, the transaction price needs to include any and all variable considerations such as rebates, contract modifications, price concessions, or customer incentives.
Businesses can use one of two methods to estimate the total value of variable considerations within a contract:
- Expected value: the total sum of a business’s probability-weighted estimates.
- Most likely amount: the amount with the highest likelihood of occurrence in a range of possibilities.
4. Allocate the transaction price
Step 4 is most relevant to subscription-based businesses that receive recurring revenue from customers, meaning they have continuous performance obligations they need to account for. To address this, entities need to practice the allocation of the transaction price to their performance obligations so they can recognize revenue as and when each of those obligations is fulfilled.
This is referred to as standalone selling price, or the price that a good or service would be sold at separately to the end customer. If these goods and services would never be sold separately in real terms, they must estimate the allocation price.
5. Recognize revenue
At the end of the 5-step model, businesses should have recognized their performance obligations and know how to determine and allocate the transaction price. Next, they need to determine the timing of revenue recognition according to when each performance obligation is fulfilled.
For a SaaS company, control of goods is typically established once the control of a license or software lease has started or once a subscription has begun. From this point onward, they should recognize their allocated revenue as each separate performance obligation is satisfied.
How Can Businesses Stay Compliant with ASC 606?
The introduction of these guidelines can be stressful and overwhelming, especially for comprehensive changes like those represented by ASC 606. For subscription-based businesses that bear the brunt of the adjustments to revenue recognition, it’s important to make sure that you have the right support on your side to recognize revenue and contract modifications correctly.
Making compliance easy
By embracing a scalable, automated subscription management platform like Stax Bill, your business can quickly and accurately recognize revenue at any point in time across multiple subscription and pricing plans.
As the only fully ASC 606 compliant app available on the marketplace, businesses don’t require any additional software to manage revenue recognition while using Stax Bill. Our platform allows your subscriptions to be broken down effortlessly into their component goods and services to build a compliant revenue recognition schedule, meaning you don’t have to waste valuable time checking your ASC obligations.
Best of all, there’s no need to worry about your customers making changes to their subscription mid-term and throwing your projections out of sync. Thanks to the power of automation, any adjustments made through your self-service portal are automatically handled on the backend in real-time. It’s subscription billing and ASC 606 management, made simple.
Stax Bill also integrates with ERP solutions, which means any revenue recognition data recorded in the billing solution syncs with your ERP, thus reducing admin work.
ASC 606 marks a significant shift in how SaaS and subscription-based businesses need to manage and recognize revenue. More stringent reporting standards for earned revenue and changes to how performance obligations are classified have put a greater burden on businesses to keep track of their revenue streams.
Need Help with ASC 606?
With the assistance of a full-fledged subscription management solution like Stax Bill, you can make sure that your revenue recognition goes without a hitch.