Starting December 15, 2018 all small businesses will need to implement Accounting Standard Codification (ASC) 606 to properly file 2019 annual income taxes. This upcoming change will definitely require some preparation since it is a complete revamp of current revenue reporting guidelines. These new revenue recognition standards will be used for accounting revenue from customer contracts for all industries. ASC 606 will not be used for lease contracts, insurance contracts or financial instruments.
ASC 606 was established by both Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) to simplify financial statement preparation. The core principle of the new revenue recognition standard is to “depict the transfer of promised goods or services to customer in an amount that reflects the consideration to which the entity expects to be entitled in change for those goods or services.” This core principle can be broken down into two parts that answers the questions of when and how much.
Recognizing Revenue Under ASC 606
- 1st Principle = When to Recognize Revenue? Revenue should be recognized once it satisfies a contract obligation in a way that reflects the transfer of promised goods or services.
- 2nd Principle = How much revenue to recognize? The amount of revenue recognized should be equal to what the business expects to be entitled to under the contract for the transferred goods or services.
This new revenue recognition standard offers a significant increase in using personal judgement over the current industry specific GAAP guidelines. That is not the only difference small businesses will see as we transition from rule-based ASC 605 to principle-based ASC 606.
One key change is that AC 606 gets away from the standard of recognizing revenue once the “revenue is realized or realizable and earned.” With ASC 606 revenue is recognized as soon as there is persuasive evidence of an arrangement. This will greatly affect those companies that offer goods or services before a contract is signed by both parties. Previous guidance prohibited revenue recognition if no signed agreement existed.
ASC 606 5-Step Model For Recognizing Revenue
- Identify customer contract. This could be an oral, written or implied agreement.
- Identify performance obligations. Another big change here that could be difficult in interpreting. The standard states that a performance obligation is “a promise in a contract with a customer to transfer to the customer a distinct good or service or a series of distinct goods or services that are substantially the same and have the same pattern of transfer.” An obligation is considered distinct if it meets these two criteria:
- Capable of Being Distinct. Customer can benefit from this good or service without using other obligations in the contract or can benefit if used with other readily available goods or services.
- Distinct In Contract. The good or service is separately identifiable in the contract from other promises.
- Determine transaction price. Small business utilizing variable payment arrangements will have adjustments. The transaction price will now be based on the amount of consideration expected to be entitled; which could differ from contract price. Variable considerations should be estimated at contract inception and include the consideration in the transaction price.
- Allocate the transaction price to performance obligations. The transaction price needs to be allocated to each separate performance obligation in proportion of its stand-alone selling price. The selling price should be what the good or service would sell for during contract inception combined with variable considerations. This process will often require observable information estimated by using one of the following estimation methods:
- Adjusted Market Assessment
- Expected Cost Plus Margin Approach
- Residual Approach
- Recognize revenue when or as performance obligations are satisfied. Revenue is recognized once the business has satisfied a performance obligation and the customer has control over that good or service.
Start Preparing For ASC 606
The new standards could be considered complex and will definitely change business processes. Impacts ASC 606 strategies could have on other departments of the company must be considered before taking action.
It is common for these new standards to make businesses existing forecasting and revenue-tracking processes useless. Companies should use this opportunity to upgrade their accounting systems and adopt innovative financial tracking technologies. The deadline for these big changes are just a couple of months away for small business so they need to start planning now.