So, what is revenue recognition in the first place? When your company makes a sale, it has to record the revenue from that sale so it’s reflected in the company’s books. But when should that revenue be recognized?
When the contract is signed?
When payment is collected?
When the service contract has ended?
And what happens when that revenue doesn’t come from a one-time sale, but instead from a regular recurring charge? Should it be reported on the books as one lump transaction? Broken down by month or quarter? A mix of the two?
These questions are what ASC 606 was designed to answer, standardize, and implement across every business, job function, and industry. Without getting a detailed briefing on the history of accounting best practices or the philosophy that lies behind the new standard, you should be able to take away from this article the essential points of ASC 606 and how it may impact your line of business.
The new revenue recognition standards are based on the application of the following five steps. These steps are extremely important for any managerial roles within an organization to understand, at least on a high level.
Identify the contract. A contract is an agreement between two or more parties that creates enforceable rights and obligations. That’s a pretty broad definition. It’s important to know that a contract doesn’t have to be written: It can be a verbal agreement, created by the arrangement of side agreements, or even derived from a pattern and standard practice of doing business.
Identify contractual performance obligations. A contract is a promise to deliver goods or services (also referred to as performance obligations) to a customer. If a customer can benefit from those goods or services on their own merits or with other readily available resources, they may be considered distinct from the overall contractual promise, and are thus accounted for separately.
Determine the transaction price. This may be the most ambiguous of the standard’s five steps. The transaction price refers to what a company expects from a customer in return for providing the good or service. It sounds cut-and-dried, but it may include variable or non-cash considerations. It’s also adjusted to account for any financing components such as discounts, refunds, incentives, rebates, or payment terms.
Allocate the transaction price to each contractual performance obligation. If a contract has more than one performance obligation, the entity has to allocate the transaction price across all obligations. In other words, if your organization provides an offering that rolls several goods and/or services into one price, it must estimate what the selling price is of each performance obligation.
Recognize revenue when (or as) the entity satisfies a performance obligation by transferring promised goods or services. A performance obligation is considered transferred when (or as) a customer gains control of a promised good or service. For performance obligations satisfied over time, revenue is recognized over time depending on the selected method a company chooses to measure progress toward satisfying the promises held forth in the contract.
While ASC 606 provides extremely detailed guidance to finance teams as to how to recognize, record, and report revenue in a digital age, other managers or line of business leaders only need to understand that accounting is an integral part of all business functions today. No matter the department, you must work closely with finance to ensure all of your i’s are dotted and t's are crossed so you can understand how best to run your team and optimize the value you bring to your organization.