ASC 606: How to choose the right transition method

Managing your business’s accounting can feel like a juggling act. There are always multiple processes to follow and changing rules you must adhere to.

Midsize companies must comply with new guidelines for recognizing revenue, as rolled out in ASC 606. This shift in accounting standards has broad implications for things like determining when your obligations to a customer have been fulfilled. That’s why it’s important to use accounting software with the tools to guide you through this transition and ensure that you’re compliant.

Today, we’ll show you what revenue recognition is, what ASC 606 is and what this means for your business’s accounting processes.

What is revenue recognition?

Revenue recognition is the process of working out when a business has actually earned revenue. For some businesses, recognizing the correct amount of revenue can be tricky.

If your business uses cash-based accounting, it’s simple––you earn revenue when cash lands in your cash register or bank account. For example, if a product is sold and paid for, it’s clear when revenue can be added to your books.

But the process is different for businesses that use accrual accounting, where revenue is recorded only when a transaction takes place rather than when payment is taken. For example, this could be when a company takes a long time to produce promised goods or perform professional services.

How do you recognize revenue under ASC 606?

ASC 606 (Accounting Standards Codification) is a regulated approach to revenue recognition. Simply put, ASC 606 creates new standards for recognizing revenue with customers. It alters when and how your business can count customer payments.

Revenue is recognized under ASC 606 when it is realized and earned, and not always when you receive the cash.

When did ASC 606 go into effect?

Issued by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), public companies had to adhere to these standards for reporting periods from December 15, 2017, interim periods, and annual reporting periods from then on.

For private companies, the new guidelines were effective for fiscal years starting after December 15, 2019, and interim periods within annual reporting periods from December 15, 2019. However, in response to the COVID-19 pandemic, the FASB issued an ASU update which provides a one-year deferral of the effective dates the code.

Does ASC 606 replace ASC 605?

In a word, yes. While ASC 605 was the standard code for revenue recognition, the FASB amended the rules in 2014. ASC 606 now replaces ASC 605, as well as most industry-specific guidance.

What’s the difference between ASC 606 and ASC 605?

Under the latter, you could choose to either capitalize or expense sales commissions. Under ASC 606, you have to capitalize them. This change increases accrual accounting revenue in the period of the sale and decreases revenue over the length of time the commission is amortized.

Is ASC 606 the same as IFRS 15, another new revenue standard?

While both codes are substantially converged, there are key differences. For instance, under IFRS 15, the company determines if shipping and handling are distinct from the shipped goods. Whereas under ASC 606, there is a policy election to treat shipping and handling activities undertaken by the company after the customer has obtained control of the related goods as a fulfilment activity.

ASC 606 offers a five-step approach to determine the amount and timing of revenue recognition

While developing new guidance for ASC 606, FASB and IASB created a five-step framework to improve consistency in financial reporting, boost comparative analysis and reporting, as well as simplify the preparation of financial statements.

Here’s how ASC 606 accounting breaks down the customer contract process into five separate steps:

1. Identify the contract with a customer

This step defines the criteria that needs to be met when creating a contract for a customer to provide goods or services. First, you should check to see if you have a vendor customer agreement in place.

2. Determine performance obligations in the contract

This step explains how different performance obligations in the contract need to be handled.

Performance obligation is a contractual promise with a customer to hand over goods or services to that customer or to that customer’s nominee according to pre-agreed terms.

Think about which services and products that the agreement compromises, along with the timeline of the relationship with the customer.

3. Establish the amount of consideration/pricing of the transaction

This step describes what needs to be considered when deciding the transaction price, which is the amount the business expects to receive in exchange for transferring the goods or services to the customer.

Decide how much the customer is paying and when. Will the customer pay everything up front or in instalments over an agreed period of time?

For example, if you run a chocolate subscription business, the customer might pay $240 for a yearly subscription, but only receive $20 of products each month. Even though you may receive $240 in January, you’d only be recognizing $20 of revenue each month.

4. Allocate the determined amount of consideration/price to the contractual obligations

This step outlines recommendations for assigning the transaction price across the contract’s individual performance obligations and is the agreed selling price for the transfer of control for the goods or services.

For example, in the case above, the amount of chocolate your customer will receive each month.

5. Recognize revenue when the performing party satisfies the performance obligation

Revenue can be defined as your business meeting each performance obligation. When the customer receives a product or service, record the money earned from the sale of that specific item or service.

How to transition to ASC 606 accounting

If your business used GAAP (generally accepted accounting principles) previously, ASC 606 will likely alter your usual accounting practices. Choose from two different transition methods to help you move from your original accounting practices to ASC 606.

Modified retrospective method

A modified retrospective method enables you to cumulatively apply the effect of ASC 606 from the date of your application.

It’s applied on a go-forward basis with all contracts on or after the effective date (which is the date your company chooses to adopt it).

It’s a simpler method than full retrospective but requires you to provide additional disclosures. For example, you need to keep books under both methods for the first year. It’s generally preferred by private companies.

Full retrospective method

This method involves restating financials for all prior reporting periods as if ASC 606 were in effect from the start of the first period.

There are more disclosure requirements, so public companies prefer this approach since it’s easier to provide information for shareholders.

How to choose the right method for you

Before you choose your transition method, ask yourself a couple of questions:

How much information do investors and stakeholders need?

If you’re a public company or thinking of going public in the future, the full retrospective method may be a better fit for your business since it enables you to provide more details about your company’s financial reporting periods.

Shareholders may need to dig deep into your financial records before making a decision, and providing them with full reports will help them in the process.

How much time will it take?

The modified retrospective method is less time-consuming. If you run a nonpublic entity, you may find it unnecessary to spend time switching to using the full retrospective method.

How QuickBooks can help you become ASC 606 compliant

Storing all your financial records in QuickBooks can help streamline the transition process and ensure you manage your financial records to be in line with new revenue recognition standards.