In publishing ASC 606, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) provided businesses across all industries with a unifying framework for revenue recognition.
However, establishing a universal standard with such a broad scope typically challenges adherence. For example, organizations need a grace period to adjust to new frameworks and guidance for handling cases requiring excessive compliance efforts.
The good news is that frameworks like ASC 606 account for these situations by outlining practical expedients. These conditional shortcuts help simplify and streamline accounting processes without sacrificing compliance or accuracy.
But while everyone loves a good shortcut, not every organization will benefit from adopting practical expedients. Many require specific conditions, must be applied consistently, and must be disclosed.
So, before overhauling your revenue recognition and other accounting processes, it’s crucial to understand the different types of practical expedients, which ones organizations should use, and what technologies will help finance teams make the most of them.
What Are Practical Expedients?
Simply put, practical expedients refers to accounting shortcuts that adhere to generally accepted accounting principles (GAAP) and are allowed under compliance frameworks, such as ASC 606.
These methods simplify efforts to meet these standards in certain, predetermined circumstances, often for short-term contracts with durations of up to one year, among other factors.
When applicable, organizations can use a practical expedient instead of following a framework’s primary rules to reduce compliance costs and complexity.
However, every practical expedient that an organization uses during its revenue recognition processes must be applied consistently and disclosed in its financial statements.
Organizations also can’t create their own practical expedients or apply them retroactively; the shortcuts and circumstances that allow them will be specified within the relevant framework, and businesses must decide whether to use a practical expedient in advance.
As long as the information provided on financial statements doesn’t change when calculated this way, the business can choose the portfolio approach over determining each contract individually.
Common Types of Practical Expedients
Organizations might adopt practical expedients for any number of reasons, but some common ones include:
- Organizations need time and interim guidance when transitioning to new or updated rules or business models.
- Diverse business models across varied industries rely on different approaches to comply with the same framework, such as determining how to recognize commissions earned by sales staff at the start of a year-long contract while still recognizing the customer’s payment incrementally.
- Businesses may incur various upfront costs that make sense to bundle, such as meeting brand requirements (e.g., signage, employee clothing) and fees when opening a franchised location.
- An organization may routinely encounter edge cases, unusual scenarios, or difficult-to-forecast performance obligations while navigating compliance, such as anticipating how fulfillment costs may change over the course of the contract (e.g., fuel price fluctuations, cargo space availability).
Let’s examine some practical expedients that can help simplify compliance costs and complexity in these and similar cases.
1. Incremental Costs of Obtaining a Contract
Aligning with the phrase, “You’ve got to spend money to make money,” businesses often need to incur costs before contracts are signed just to close a deal with prospective customers.
But some of these costs remain separate from standard operating regulations (e.g., building rent, utilities) and incurred costs (e.g., preparing and mailing a request for proposal (RFP)), which the business would pay regardless of whether the contract was awarded.
Conversely, some costs only result from securing a contract. These are referred to as incremental costs. For example, sales staff may only earn commissions when a sale is made or a deal is signed; without that contract, the business wouldn’t pay them the commission.
Under ASC 606’s normal revenue recognition rules, businesses must amortize a commission, the revenue earned, and some costs from the associated contract.
Luckily, to simplify compliance, ASC 606 allows for a practical expedient if the contract’s duration doesn’t exceed one year (e.g., a 12-month subscription). Rather than spreading the commission out, it can be expensed as a one-time cost incurred to obtain the contract.
Note that restrictions on using this practical expedient can become complicated, as the potential for future contracts, like renewals and amendments, will impact whether the value provided by the contract can be considered amortized within one year.
2. Significant Financing Component
Sometimes, customers pay for goods and services well before a business meets those performance obligations; sometimes, customers pay much later. In the latter case, time quickly convolutes revenue recognition.
This is because of the time value of money, which recognizes that currency valuations fluctuate and that money today holds more value than money in the future (thanks to its earning potential).
When accounting for the time value of money per ASC 606, the amount a business receives may differ from the revenue it recognizes if there’s a considerable gap between payment and fulfillment. Customers are considered to have provided a significant financing component when making advance payments.
Needless to say, calculating the additional value earned on advance payments as interest (or as value lost on late payments) introduces more complexity for accountants to manage.
However, ASC 606 includes a practical expedient that lets businesses disregard significant financing components and any time value of money calculations. For this practical expedient to apply, the business must anticipate that payment and performance obligation fulfillment will occur within one year of each other.
3. Shipping and Handling Costs
When fulfilling performance obligations, transferring goods and services to a customer establishes the point where associated revenue can be recognized under ASC 606 for private companies.
But determining this transfer becomes complicated when using third-party shipping and handling services. These services may count as a separate performance obligation and require a business to determine whether it, another entity (acting as the business’s agent), or the customer takes control of the goods before delivery.
To avoid this, businesses can instead choose to mark shipping and handling as fulfillment costs, including any collected fees, under the transaction price.
4. Right to Invoice
In many cases, satisfaction of the performance obligation corresponds directly with the invoices issued to the customer. In these circumstances, the business providing the service has already met (some portion of) its performance obligations. Per one of ASC 606’s practical expedients, the business holds the right to invoice its customer for those services rendered. So, the business can recognize that revenue according to the invoices issued.
Bear in mind, the revenue recognized must reflect the value provided to the customer, regardless of any payment.
When to Use Practical Expedients (and When Not to)
Many businesses can avoid overly complex and costly compliance requirements thanks to practical expedients. But as mentioned above, not every organization will benefit from adopting them.
This is primarily because practical expedients must meet certain conditions to prevent abuse and depend on a given contract’s structure; their usage is always predetermined by the business, consistently applied, and disclosed in financial statements.
In fact, practical expedients might also complicate existing accounting processes and add more work if an organization’s compliance requirements aren’t complex enough already.
An organization’s audit readiness might also affect whether to use practical expedients. Even when a business correctly complies with the guidelines, it could still run afoul of authorities if it can’t produce an audit trail of clear, thorough documentation and system logs.
While practical expedients provide shortcuts, they should only be used if there’s a specific reason to do so. In other words, they primarily suit businesses that benefit from adopting a given practical expedient as part of their default accounting processes.
How RightRev Supports Practical Expedients
Practical expedients become easy to adopt after implementing automated revenue recognition because solutions like RightRev minimize their complexity and better ensure consistency.
The practical expedients are configured, rules-based, and automated within the system, so organizations don’t need to worry about how or when they’re applied.
Businesses start by determining contract rules and aligning costs with different revenue items, as they normally would, before configuring which practical expedients to follow under specific circumstances. Additionally, extensive activity logs provide ready-made audit trails for demonstrating compliance.
Given RightRev’s seamless integrations with Salesforce and other billing tools, plus the solution’s proven ability to manage high volumes of contract modifications, any practical expedient automations scale effortlessly and flexibly. Should any practical expedients or other rules require adjustment, all it takes is updating the configuration.
Practical Expedients in Action: A Hypothetical Example
To examine how and where a company might apply practical expedients, let’s consider a software-as-a-service (SaaS) business signing a one-year contract with a new customer.
Before the contract gets finalized, the business decides to have its lawyers review the language; once both parties sign, the sales staff who helped bring in the deal earn their commission.
Because the contract’s duration doesn’t exceed one year, the finance team could choose to expense the legal fees and sales commissions as one-time, incurred costs under ASC 606’s practical expedient. Neither of these costs would be incurred without the finalized contract.
Behind the scenes, RightRev automates the journal entry, ties it to the order, enforces the configured rules and practical expedients, and then reports and records the revenue.
No spreadsheet wrangling required.
Don’t Let Compliance Weigh You Down
Practical expedients offer shortcuts to businesses navigating complex compliance requirements. They’re the smart method for simplifying and streamlining revenue recognition and other accounting processes.
However, remember that not all entities might benefit from adopting them. Organizations that stand to realize the most significant impacts generally already meet a certain complexity threshold, and the adopted shortcuts must be predetermined, consistently applied, and disclosed in financial statements.
But for those contending with complex accounting operations, you can minimize manual efforts, better ensure consistency, and optimize compliance by managing practical expedients with automated revenue recognition. Contact RightRev to learn more about how you can eliminate guesswork and revolutionize your revenue accounting processes.
