Why Departments Outside of Accounting Must Understand ASC 606

By Kris Blackmon

Earlier this year, corporate finance regulations underwent the biggest compliance change since Sarbanes-Oxley went into effect more than 15 years ago. The new standard, ASC 606, reimagines the ways in which businesses recognize revenue in a digital, subscription-based economy. Fully implemented, the standard provides a widespread, industry-neutral revenue recognition model designed to level the playing field between companies, lines of business, and different verticals.

Why was such a sweeping overhaul of financial reporting necessary? Current reigning accounting methods were designed for a cash-based economy, where payment is exchanged for products provided or services rendered in a one-time transaction. In a digital economy, however, the prevailing financial model is quickly evolving to support a subscription economy, in which customers consume products and services on a pay-as-you-go model. We don’t buy or rent movies in a one-time purchase model anymore like we did in the days of Blockbuster. We pay a monthly fee for streaming services such as Netflix or Amazon Prime.

Before ASC 606, there was no standard for recognizing or reporting recurring revenue between industries. A subscription software as a service (SaaS) provider had different requirements and reporting processes than a data center renting storage space, for instance. Recurring revenue is a critical KPI for the evaluation of a company’s financial performance, which touches everything from how potential investors may view a business' potential to how individual departments within an organization jockey for their share of the annual budget.

The need for a new revenue recognition standard was clear, and the benefits of ASC 606, once widely adopted, are far-reaching and significant. But the change is a fundamental one, requiring finance teams from every sector to re-evaluate internal processes. This, in turn, impacts every line of business within an organization, and managers and department leaders can no longer view the accounting department as something that doesn’t touch their day-to-day job functions. Even if you’re not in accounting, you need to understand the basics of ASC 606 to perform successfully in a digital economy.

Revenue Recognition for the Uninitiated

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.

Bringing Accounting into Every Corner of the Organization

Let us be completely clear: ASC 606 is not just an accounting and finance issue. The transition to the new standard will impact just about every department in your organization in one way or another because of the significant change to the standard operating procedures that underpin your company’s operations.

Consider your company’s computing platforms and processes. The amount of information required by ASC 606 is significantly higher than in traditional accounting procedures. The number of reported data points that are required under the new standard is vast, as is appropriate for the digital age where Big Data reigns supreme. The sheer amount of information required by 606 renders the requirement impossible to satisfy using manual processes. The only viable option for tracking all of this critical data is through extensive automation of front-end systems in a way that eliminates the silos between reporting departments throughout the entire quote-to-cash cycle. One recommendation is to use a comprehensive platform such as an enterprise resource planning (ERP) system. If your company is used to each department operating on its own, learning how to craft policies and implement new systems that integrate job functions will be a big shift for everyone in the organization.

The role the finance team plays within the overarching organization is evolving, too. They’re no longer there to just record the sales reported to them by the sales team. In a subscription economy, sales and finance must work closely together to craft pricing models, contract language, reporting requirements, and approval processes. Internal processes have to be revisited to ensure that accounting is roped into every stage as necessary, which means that whatever your department is, your reporting procedures will have to evolve to accommodate this new need.

Sales commissions should and will change. As sales teams everywhere can attest, traditional compensation models just don’t work in a digital economy. Commissions are based on when revenue is recognized. If the revenue is reported as earned upon finalization of the sales contract, that historically has meant a big one-time commission payment to the salesperson. But under the new standard, commissions can be capitalized over the life of the contract and paid out over the course of months, rather than in one lump sum.

Because of the need for automation, real-time reporting, and data management, IT’s function has evolved from troubleshooting network connections to establishing a foundational technical system that ties in all lines of business and reporting functions in a way that supports ASC 606. Have you experienced the headaches that come when IT is updating the office to a new version of common software or password management platform? Take that experience and multiply it exponentially to get a good idea of how intensive the new standard will be for your in-house IT teams.

Because the auditing requirements are more extensive, finance teams need to rope in frontline employees who may not have previously understood how integral their job functions are to revenue recognition efforts. Accounting needs to know from these employees about any contract modifications, off-the-books side contracts, or business dealings that may not comply with contract language to the letter. For businesses involved in a two-tier distribution model, auditors may need to speak to distributors or third-party service providers, too.

In other words, ASC 606 isn’t just important to your finance team. It’s a big deal — a really big deal — to everyone within your organization, and carries potential impact on sales strategies, routes-to-market, compensation structures, budget line-item requests, and the essential contractual and compliance efforts that lie at the core of any organization. If revenue is recognized improperly, it messes with a business’ ability to forecast, allocate budgets, and adequately compensate employees.

Breaking It Down

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.

  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5. 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.

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