On December 15, 2018, all small businesses were instructed to implement Accounting Standard Codification to file their 2019 income taxes. This change requires some preparation because it completely revamps the current revenue reporting guidelines.
The new standards are used for accounting revenue from customer contracts across all industries. However, it does not apply to financial instruments, insurance contracts, or lease contracts.
Establishing the ASC 606
The ASC 606 was established as a joint effort by the Financial Accounting Standards Board and the International Accounting Standards Board. The goal of this was to help simplify the preparation of financial statements.
The main principle of this new revenue recognition standard is depicting the transfer of the promised services or goods to a customer in the total amount that will reflect the consideration that any entity expects to be entitled in exchange for the services or products. This primary principle can be further broken down into two different parts that will answer the questions of how much and when.
Recognizing Revenue Under the ASC 606
The first principle is when to recognize revenue. According to the rule, revenue needs to be recognized after it has satisfied a particular contract obligation in a way that will reflect the transfer of the promised services or goods.
The second principle is how much revenue to recognize. The total amount of revenue that is recognized needs to equal what the business expects to receive based on the contract for the transferred services or goods.
The new revenue recognition standard provides a substantial increase in the use of personal judgment over the existing GAAP guidelines. This isn’t the only difference that small businesses are going to see as they transition from the rule-based ASC 605 to the principle-based ASC 606.
A significant change is that the AC 606 will get away from the standard that recognizes revenue once it is realized or realizable and earned. Using ASC 606 revenue will be known when there is some type of persuasive evidence of a particular arrangement. This is going to have a significant impact on companies that provide services or goods before both parties have signed a contract. In the past, guidance prohibited revenue recognition if there was no signed agreement in place.
ASC 606 Model to Recognize Revenue
The first step in this process is to identify the customer contract, which could be done orally, in writing, or as an implied agreement. The next step is to identify the performance obligations. A significant change in this is the challenge of interpreting.
According to the standard, the performance obligation is the promise in a contract with the customer for transferring a distinct service or good to them. An obligation is considered distinct if it meets two criteria.
The first is if it is capable of being distinct when a customer could benefit from the service or good without other obligations in the contract or can benefit if it is used with another available service or good. The second is distinct in contract, which means the services or good is identifiable within the contract from the other promises.
Step three is to determine the transaction price. A small business using variable payment arrangement will have certain adjustments. This transaction price is based on the total amount of consideration that is expected. This number may differ from the contract price. The variable considerations need to be estimated at the inception of the contract and include the transaction price consideration.
At this point, the transaction price should be allocated to each separate performance obligation related to the stand-alone selling price. The selling price is what the service or good sells for at the inception of the contract with variable considerations.
Are You Ready for ASC 606?
The new standards are complex and will change business processes. The impacts ASC 606 strategies may have on the departments in various companies need to be considered before taking any action.