After a Covid-related grace period, new contract accounting standards — ASC 606 — are in effect for both public and private companies. Tom Zauli of Softrax, explores what you need to know about meeting accounting standards in an uncertain economy.
In 2020, the U.S. economy entered a recession resulting from the global Covid pandemic. This recession was different in length — it was the shortest on record — and in government response: the US government took unprecedented action to get financial aid to citizens and businesses. Similarly, in mid-2020 the Financial Accounting Standards Board (FASB) delayed by one year the date for private companies to comply with ASC 606/IFRS 15, which deals with revenue from contracts with customers. The FASB took this action based on feedback from companies, which were finding the economic climate difficult.
At the start of 2023, we are in a business environment in which the chances of a recession remain high. What companies should know is that the compliance delays and other actions by FASB for ASC 606 compliance are likely coming to an end. Private and public companies alike should be adhering to the five-step process for revenue recognition outlined in the ASC 606 standard. This action will not only help them with their compliance obligation, but it could allow a better picture of the company’s bottom line.
Auditors need a complete understanding of the standard and how it affects their clients’ financial statements. AICPA’s Deana Thorps suggests four considerations auditors need to keep in mind when performing high-quality audits based on common challenges with accounting estimates.Read more
What is ASC 606?
ASC 606/IFRS 15 is guidance developed by FASB and the International Accounting Standards Board (IASB) to drive consistency in financial reporting across industries through a five-step model for revenue recognition. Its goal is to create a standard method of recognizing revenue at the contract level for companies in the public, private and nonprofit sector. The five steps are:
Identify the contract
This step includes evaluating whether the contract creates enforceable rights and obligations and whether it has commercial substance. Where contract identification can get tricky under ASC 606 is when upgrades or the chance to buy additional products or services are included.
Identify the performance obligations
Performance obligations are the promises of a good or service provided to a customer. With complicated contracts, companies need to define performance obligations carefully, making sure that each good or service that can stand on its own is in its own performance obligation, for example.
Determine the transaction price
This involves estimating the net revenue expected for each contract term, but this price can be difficult to determine because of rebates or discounts.
Allocate the transaction price
The objective is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
Recognize revenue when or as the entity satisfies a performance obligation
This step determines that a good or service is transferred when the customer obtains control.
ASC 606 is straightforward, but it can vary from past accounting practices. Companies implementing ASC 606 may find disparities with their previous practices that can affect the bottom line. In February 2023, Open Lending Corporation announced that its “total revenue for the fourth quarter of 2022 was $26.8 million, which includes an ASC 606 negative change in estimate of $12.8 million associated with our profit share, compared to $51.6 million in the fourth quarter of 2021.”
5 additional steps for revenue management
In addition to following the five steps of ASC 606/IFRS 15, companies can take additional actions in light of ASC 606 to better their overall revenue management:
- Put all revenue in ASC 606, including past revenue: By including all past revenue in ASC 606, companies can ensure consistency in their financial reporting and avoid any potential issues with auditors or regulators.
- Make sure your measurement and reporting are comprehensive: Companies need to ensure that their systems and processes for measuring and reporting revenue are up to date and comply with the requirements of ASC 606. This includes ensuring that they have appropriate controls and procedures in place for identifying performance obligations, determining transaction price and allocating revenue to each obligation.
- Have a long-term view without ad hoc solutions: It’s important for companies to take a long-term view and avoid making ad hoc solutions to comply with ASC 606. This means investing in the necessary systems and processes to ensure ongoing compliance with the standard, rather than implementing short-term fixes that may not be sustainable in the long run. These short-term fixes can include doing parts of the record keeping on Excel spreadsheets.
- Realize the impact of correct renewal billing: Renewing on time and for the right amount is important to avoid revenue leakage. This importance is heightened given how much revenue that a typical company gets from renewals.
- Understand that revenue recognition and billing have investors and customers in mind: Revenue recognition is a back-office function, but one that investors care about. They invest based on their confidence in the proper accounting for revenue in the books. Subscription billing is all about maintaining a balance between customer satisfaction and optimized monetization of value. For this reason, it is critical that billing remains close to the customer relationship, so this balance is constantly maintained.
Although compliance with ASC 606/IFRS 15 is required, companies can find benefits through using the framework. These include improved financial reporting, better alignment of revenue recognition and business operations, and improved contract management. In addition, the steps of ASC 606/IFRS 15 can help with better customer relationship management by putting a laser focus on the terms of all customer contracts. These additional benefits are also ones that will help navigate the uncertainty of recessionary environments.