What is ASC 606?
Mandatory and extensive new accounting standards in revenue recognition from contracts with customers now exist for technology companies.
For private companies with fiscal years beginning after December 15, 2018 (i.e., starting calendar 2019), ASC 606: Revenue from Contracts with Customers will become effective, issuing in sweeping changes in revenue recognition and certain cost accounting across almost all industries. Technology companies will be particularly affected.
The Financial Accounting Standards Board launch the FASB Accounting Standards Codification (FASB ASC) represents a significant restructuring of standards in accounting and financial reporting.
ASC 606 Questions to Consider
Complying with ASC 606
Compliance ensures that your company not only adopts accepted standards and best practices but you achieve proper and full credit for your contracts, revenue, and, ultimately, value of your company.
The new revenue standard is wide ranging and addresses issues, including: restrictive definitions of a contract, potential straight-line accounting for SaaS revenue, new rules for licenses and allocation of revenue requirements; accounting for discounted goods, accounting for commissions and set-up costs, as well as revenue presentation, and more.
The Core Principle of the New Revenue Standard
The core principle of the new revenue standard is that an “entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” The IASB and the FASB (the “Boards”) developed a five-step model and related application guidance, which will replace substantially all current revenue recognition guidance in U.S. GAAP and IFRS, excluding contracts that are out of scope – e.g., leases, insurance, certain arrangements that fail to qualify as a contract with a customer under ASC 606 due to non- collectability, etc.).
Shortly after the new revenue standard was released the Boards announced the formation of the Joint Transition Resource Group for Revenue Recognition (TRG). Members of the TRG include financial statement preparers, auditors and users representing a wide spectrum of industries, geographical locations and public and private companies and organizations.
The TRG informs the Boards about potential implementation issues that could arise when entities implement the new revenue standard. The TRG also provides stakeholders with an opportunity to learn about the new revenue standard from others involved with implementation. The TRG will not issue authoritative guidance. However, the SEC attended all TRG meetings and is expected to use the discussions as a basis to assess the appropriateness of registrants’ revenue accounting practices. We believe that these TRG papers will and should likewise apply to private companies as they adopt the new standard for periods. Specific TRG papers are noted throughout this policy in the relevant section.
ASC 606 Remediation
The core principle behind the revenue recognition accounting changes is that: An entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
A five-step model has been suggested to help those companies in need of remediation. Generally stated, they are:
1. Identify contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract 5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Step 1: Identify the Contract(s) with the Customer
Step 1 – Identifying the Contract With a Customer, including 1) when customer contracts are within the scope of the new standard (including Letters of Intent/LOIs and considerations of collectability); 2) when multiple contracts should be combined and accounted for as a single contract, among other items and 3) the length of the contract term.
To determine if a contract is in the standard, it must meet the requirements of ASC 606-10-25-1, including approval, identifiable rights and obligations, commercial substance (the risk, timing, or amount of future cash flows will change), AND collectability of substantially all of its consideration (net of expected concessions)is probable. For startup companies, collectability may more often than not be a gating agent into the model given the companies’ lack of payment history and or absence of a valid credit risk (e.g., D&B) report. In such cases, these contracts will require judgment and may result in the contract being treated as consideration received outside the model.
Step 2: Identification of Promised Goods and Services and Evaluation of Whether the Promised Goods and Services are Distinct Performance Obligations
A performance obligation (PO) represents a distinct promised good or service, which is the basic unit of evaluating revenue recognition in the new standard. XYZ is required to determine, at contract inception, whether the promises (both explicit and implicit) in the arrangement to transfer goods or services are distinct or whether such promises constitute a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (606-10-25-14 through 25-16, and 25-18).
Notice that although the contract itself must be legally binding in all jurisdictions to which it relates, a PO does not need to be legally binding- it simply must be validly expected by the client.
A good or service (or bundle of goods or services) is distinct (and therefore, constitutes a PO) if both of the following criteria are met (606-10-25-19):
1. the customer can benefit from the good or service on its own or together with other readily available resources (i.e., the good or service is capable of being distinct, or “capable”) and
2. the good or service is separately identifiable from other promises in the contract (i.e., the promise to transfer a good or service is distinct within the context of the contract – “DICC”).
In determining whether the good or service is DICC, or separately identifiable by the nature of the promise, the new standard provides the following indicators (606-10-25-21):
1. The Company provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted….
2. One or more of the goods or services significantly modifies or customizes, or is significantly modified or customized by, one or more of the other goods or services promised in the contract.
3. The goods or services are highly interdependent or highly interrelated, such that each of the goods or services is significantly affected by one or more of the other goods or services.
A promised good or service that the Company determines is not distinct should be combined with other goods or services until a distinct PO is formed (606-10-25-22). Promised goods or services do not include activities that an entity must undertake to fulfill a contract unless those activities transfer a good or service to a customer. For example, a services provider may need to perform various administrative tasks to set up a contract such as conversion activities (Saas) or set up activities (licensing) etc. The performance of those tasks does not transfer a service to the customer as the tasks are performed. Therefore, those administrative activities are not considered a PO in the contract with the customer (606-10-25-17) and thus do not hamper nor promote revenue recognition on their own.
Step 3: Estimating the Transaction Price
The transaction price is the amount of consideration to which the Company expects to be “entitled” and includes an estimate of any variable consideration (performance bonuses, penalties, click revenue, the effect of a significant financing component (i.e., the time value of money), discounts, rebates, refunds, concessions, the occurrence or non-occurrence of an event, the fair value of any noncash consideration and the effect of any consideration payable to the customer (ASC 606-10-32-6). The entitled amount is meant to reflect the amount to which the Company has rights under the present contract and may be the same as the contractual price. The transaction price does not include estimates of consideration from future change orders for additional goods and services (ASC 606-10-32-2 through 32-4) and does not consider future cancellation, renewal or modifications (ASC 606-10-32-4).
Recognize Revenue When or As the Entity Satisfies is Performance Obligations
As noted in the previous step, if the criteria to apply direct allocation of variable consideration are met, the amount invoiced each month would be recognized as revenue and there would be no further attribution considerations as it relates to variable consideration.
However, if the Company does not meet the criteria to apply direct allocation of variable consideration, the Company would evaluate alternative attribution models for merchant processing as discussed below.
Following allocation of the transaction price, the Company must apply the new revenue standard’s control model and will recognize revenue when or as it satisfies a performance obligation by transferring control of the related asset. Goods and services are both viewed as assets, even if only momentarily, aligning the model with the guidance for de-recognition of assets under ASU 2017-05.
The model defaults to a point in time transfer, unless the PO is satisfied over time. A PO is satisfied over time if any of the criteria below are met (ASC 606-10-25-27):
a. Customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (Note: this is the criterion most SaaS providers will meet to achieve over time recognition); OR
b. The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; OR
c. 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.
Accounting for Contract Costs under ASC 606/ASC 340
Although the revenue standard directly addresses revenue from contracts with customers, it also addresses and amends current GAAP as it relates to 1) incremental costs of obtaining a contract (e.g., commissions) and 2) cost to fulfill a contract.
Commissions that would not have been payable if the contract had not been obtained must be capitalized (ASC 340-40-25-2) over the period to which the underlying asset relates (ASC 340-40-35-1). (Exception: such costs should be expensed if the amortization period is less than 12 months and/or if there are other requirements the recipient must meet in order to receive the payment e.g., a stay requirement through the quarter, expected service requirement to maintain relations with the customer, per TRG paper 43, etc.). These points of consideration can be tricky and require XYZ review of the terms and conditions of the payout. The fact that the commissions may be tied to customer performance or non/performance (i.e., a variable payout) does not affect the determination of whether these costs should be capitalized.
Furthermore, commissions payable in installments but which are fixed should be capitalized immediately (considering the time value of money) in accordance with ASC 450.
Fulfillment costs (such as setup costs) that are not in the scope of other guidance (e.g., software costs, inventory, PP&E etc.) are capitalizable under ASC 340-40-25-5 if they:
• Relate directly to an (anticipated) contract;
• Generate or enhance resources that will be used to satisfy a PO; and
• Are recoverable (including anticipated contract renewals–unlike under current US GAAP)
ASC 340-40-25-7 provide for examples of direct fulfillment costs but complicate the accounting by adding additional considerations than were used under current US GAAP such as:
• Note that unlike commissions, fulfilment costs need not be directly attributable and can/must include allocations of overhead and shared costs;
• Must include costs (e.g., travel) that are explicitly chargeable to the customer, etc.
Similar to commissions, fulfillment costs must be amortized over the period to which the asset relates. Such results very often in a mismatch between revenue (which is recognized during the accounting contract term) and contract cost expense which is extended, potentially, by several years beyond the accounting contract term. (Note: according to ASC 606-10-55-50ff, one exception to consider is whether any non-refundable upfront fee is received e.g., activation fee etc.—that is related to an administrative task that does not transfer value to the customer; instead such fee may represent an advanced payment that should be allocated in part to a material right, if any, embedded in the renewal option. This is the only case in which revenue would be spread beyond the initial accounting contract term. Further evaluation and judgment will be required to determine the appropriate accounting for such arrangements).