Businesses that enter into contracts with their customers must develop a rock-solid understanding of revenue recognition and all its nuances or face potential legal, regulatory, and reputational harm. In essence, revenue recognition serves as the linchpin of financial reporting, reflecting a company’s financial health and performance. It accounts for a business’s income from selling its goods or services.
In this article, we’ll walk through the 5 steps of revenue recognition outlined by ASC 606 and explore its impact on companies. A framework that has revolutionized how businesses recognize revenue, the ASC 606 5-step model increases the transparency, accuracy, and consistency of financial statements.
We will also highlight the importance of automating revenue recognition processes in the modern business landscape. These insights are not merely theoretical—they are absolutely critical for businesses and professionals seeking to navigate the complexities of financial reporting and achieve compliance with evolving industry standards.
What Is Revenue Recognition?
Revenue recognition is a generally accepted accounting principle (GAAP) that records revenue when it is earned and realized (that is, once a company has fulfilled its performance obligations by transferring its goods or services to its customers). When performed properly, it helps ensure that financial statements are clear, correct, and comparable so executives, investors, and stakeholders can make informed decisions.
There are many different accrual-based methods that companies traditionally use for revenue recognition, including:
- Ratable over term
- Sales-basis (delivery of goods/services)
- Percentage of completion
- Cost recovery
- Completed contract
These methods typically recognize revenue when it is realized or realizable and earned, usually at the point of sale or over time as services are provided. Certain business models often introduce recurring revenue with multi-year contracts, multiple performance obligations, and other complexities that complicate the revenue recognition principle and make its related processes arduous (lots of confusing spreadsheets), error-prone, and time-consuming.
On top of all that, revenue recognition can be a challenge for a company’s legacy accounting software and ERP systems that weren’t meant to accommodate recurring revenue.
Newer accounting software that automates revenue recognition for recurring revenues helps address these limitations. So, while on the surface, revenue recognition may appear relatively cut-and-dry, it can be an extremely challenging process for recurring revenue models—especially when it’s done manually.
However, using an automation service like RightRev that automates the ASC 606 framework drastically cuts the amount of time and effort that goes into it.
What Is ASC 606?
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) released ASC 606 in 2014. A set of accounting standards, ASC 606, provides guidelines for companies on recognizing and reporting revenue from contracts with customers, emphasizing the importance of accurately reflecting the transfer of goods and services in financial statements.
Why Does ASC 606 Compliance Matter for Businesses?
The 5-step model under ASC 606, issued by the Financial Accounting Standards Board (FASB), significantly improves transparency and standardization in financial reporting. As a result, companies can now achieve a much clearer picture of their own financial health.
The 5-step framework also emphasizes the identification of performance obligations (distinct promises to transfer goods or services to a customer). This focus helps guarantee that revenue is recognized when these obligations are satisfied, providing clarity around when revenue is earned.
Furthermore, Step 4 of ASC 606 requires that companies allocate a transaction price to each separate performance obligation. This step helps avoid manipulating revenue recognition to favor a company’s reporting objectives. By following ASC 606 and consistently accounting for comparable transaction types, companies can increase their financial statement comparability from company to company.
International revenue recognition standards are set by the International Accounting Standards Board (IASB) IFRS 15 (International Financial Reporting Standard) is the international equivalent of ASC 606, and its alignment facilitates the global comparability of financial statements, benefiting investors and shareholders.
To sum it all up, ASC 606 compliance matters to businesses because, beyond keeping them out of legal and regulatory trouble, it dramatically increases the quality of their financial reporting so they can generate reliable financial information for their top decision-makers. It also makes it easier for investors and others to value their worth and compare their financials to other companies.
The Five-Step Model for ASC 606 Revenue Recognition
Now that we’ve covered why ASC 606’s revenue recognition principles benefit businesses, it’s time to dive into all the nitty-gritty details. Below, we explore all 5 steps of revenue recognition, from identifying the contract and every single performance obligation to determining and allocating the transaction price and recognizing revenue upon transferring control of the good or service.
Without further ado, let’s get started!
1) Identify the Contract With a Customer
The first step in the 5-step model is to identify a contract with a customer. In this context, a contract is an agreement between parties that creates enforceable rights and obligations.
To identify a contract, specific criteria must be met, including:
- Approval and commitment: The parties must agree to the contract’s terms, and it must be evident that they intend to perform their respective obligations.
- Identifiable rights: The parties must have identifiable rights to goods or services that can be transferred.
- Payment assurance: It should be probable that the entity expects to collect the consideration it’s entitled to in exchange for the goods or services.
Meeting these criteria is crucial for recognizing revenue under ASC 606.
2) Identify the Performance Obligations in the Contract
The second step in the process involves identifying the performance obligations within the contract. Performance obligations are a company’s distinct promises to transfer goods or services to its customers. They are significant because they help determine when revenue can be recognized.
To identify them, businesses must assess whether promised goods or services are separately identifiable and distinct within the contract. This requires a careful analysis of the contract terms, customarily accepted business practices, and the nature of the goods or services offered to ensure compliance with accounting standards codification and accurate revenue recognition.
3) Determine the Transaction Price
The next step under ASC 606 is to determine the transaction price. This involves identifying the consideration an entity expects to receive in exchange for transferring goods or services to a customer.
The transaction price sets the foundation for recognizing revenue and includes variable consideration, non-cash consideration, and considerations for the time value of money. Factors affecting it include discounts, rebates, refunds, and changes in the estimate of variable consideration, all of which can impact revenue recognition timing and amounts.
4) Allocate the Transaction Price
The fourth step in the framework is to allocate the transaction price to each performance obligation based on their standalone selling price. The standalone selling price is the amount an entity would sell the promised goods or services individually to a customer in a standalone situation. This is essential for accurate revenue recognition as it assigns the total contract value to each distinct performance obligation or component. This helps guarantee revenue is recognized when obligations are met.
Various methods for determining standalone selling price include:
- Adjusted market assessment
- Expected cost plus margin
- Residual approach
It is critical that businesses correctly allocate transaction prices to fairly represent the value delivered by each part of the contract.
Simple Allocation Example:
|Contractual Price||Stand-Alone Sell Price||% of SSP||Allocated Revenue|
5) Recognize Revenue When the Entity Satisfies a Performance Obligation
The final step in the 5-step model for ASC 606 revenue recognition recognizes revenue when the entity satisfies a performance obligation. Revenue can be recognized either over time or at a specific time.
Scenarios for recognizing revenue over time include when the customer continuously consumes or benefits from the performance obligation or when the company’s work creates or enhances an asset controlled by the customer. Meanwhile, revenue at a specific point occurs when the customer pays upfront or when the performance obligation is satisfied at a distinct moment within the respective accounting period.
Automatic Revenue Recognition With RightRev
The 5-step ASC 606 revenue recognition framework enables companies to produce clear and accurate financial statements. This benefits key decision-makers, investors, and other stakeholders, making it easier for them to compare the financial health of a business with others not only nationally but also globally.
Hence, companies must follow this framework—identifying contracts and their performance obligations, determining transaction prices and their allocations, and then recognizing revenue once the performance obligations have been satisfied—to achieve compliance and ensure accurate financial reporting.
If your accounting team runs into any challenges implementing these standards, they shouldn’t hesitate to contact an expert like RightRev. Built by one of the “Godfathers of Revenue Recognition,” RightRev’s revenue recognition solution is powerful, flexible, and scalable. It automates and streamlines the 5-step ASC 606 process so your finance team can step away from all their spreadsheets and get back to work on the strategic initiatives that really move the needle.