**What Is ASC 606?**
ASC 606 is a revenue recognition standard codified by the Financial Accounting Standards Board (FASB). It was introduced in May 2014 and is set to supersede the previous revenue recognition standards in the US financial reporting. ASC 606 aims to provide a single, coherent framework for businesses to work under.
The primary goal of ASC 606 is to establish a more uniform approach to the recording of revenue across industries and organizations. It will provide much more clarity about the way that financial figures are delivered by companies.
The objective is not just to make accounting simpler, although it will hopefully achieve that. It exists in order to provide greater transparency and internal consistency and to improve comparability between organizations and industries.
It is important to note that ASC 606 is not concerned with items like expenses, or how to count goods produced but not sold – its only focus is with revenue, specifically, how and when that is recognized in a company’s accounts.
ASC 606 can be seen as a successor to the previously existing ASC 605 standard. However, rather than a straightforward update, it represents a substantial overhaul.
ASC 605 broke down revenue recognition into several categories: product sales , services and rentals. Each of these had its own subcategories with their own specific rules.
The new standard ASC 606 and its -"core principle" in full states: "An entity recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services."
This "core principle" central to ASC 606 is intended to be applicable for all types of contracts across all industries. It states that revenue should be recognized in a way that reflects the transfer of goods or services in a way which also reflects what is given in return for that transfer.
The main directives in ASC 606 state that companies should recognize revenue in the following ways:
This also means obtaining and recognizing any documents related to the contract, or information relevant to the contract reliably.
The timing of revenue recognition is key to the new standard, and determining when or how much revenue to recognize is one of the key challenges with it.
So what does it mean for project based businesses? For those with multiple projects or contracts on the go simultaneously, it presents a particular challenge.
Many project businesses take their revenue from both service and product sales, which can be tricky to record within the previous ASC 605 standard. This is why there is much to be gained from the new standard ASC 606 for projects businesses specifically.
The standard outlines some specific rules for recognizing revenue from project-based contracts including:
Clearly determining which of these factors apply the most to projects is essential to maximizing the efficiency of ASC 606.
Contract Assets Explained
Under ASC 606, contract assets are defined as present rights to consideration and should be recognized "when an entity performs by transferring goods or services to a customer before that transfer of goods or services results in a right to consideration that is contingent on the future transfer of goods or services." Contract liabilities on the other hand, are deferred revenue that exist when the entity has received consideration in advance of providing the related goods or services. Accounts receivable are recognized when "an entity has a right to consideration from a customer." In other words, when the customer has paid or promised to pay the entity upon completion of performance obligations within a contract.
Companies should account for contract assets using the new criteria outlined in ASC 606, including the following:
•Contract assets are presented separately from all other contract-related assets and liabilities in a specific balance sheet line item entitled "contract assets" or similar term.
•Contract liabilities are presented separately from all other contract-related assets and liabilities in a specific balance sheet line item entitled "contract liabilities" or similar term.
•Companies should recognize the contract asset or liability regardless of whether the revenue recognized is subject to a refund or specified return right.
•Companies should also consider any rights to invoice customers (i.e., trigger points to bill customers) as a contract asset.
Although the new standard diverges from previous literature on contract management, the core concept of contract assets remains similar in the context of recognizing accounts receivable. Account receivables focus on performance obligations while contract assets account for all rights to consideration generally.
How to Recognize and Measure Contract Assets
In accordance with ASC 606-10-25-21, contract assets are recognized during the reporting period or immediately before revenue recognition upon completion of a specific performance obligation. Contract assets are measured at the transaction price when that is a standalone selling price based on a relative standalone selling price or a residual approach when applicable. The consideration transferred is allocated at the contract inception and updated each reporting period. In the event that payment terms extend beyond one year, the transaction price can be discounted for time value of money and will also consider whether the contract includes a significant financing element. The guidance under the old revenue recognition rules for contract assets is not impacted by ASC 606 and shall continue to be accounted in accordance with existing guidance.
Contract Assets vs. Accounts Receivable
Contract assets and receivables are fundamentally different in terms of the timing of their recognition. Contract assets arise when control of goods or services is transferred to a customer before the customer pays consideration or promises to pay for the same. Receivables arise when payment is unconditional. In the context of a customer, the definition of a contract asset is any asset arising from an entity’s right to consideration in exchange for goods or services promised to that customer if, and only if, the good or service has been transferred to the customer and that right is conditioned on something other than the passage of time, such as future performance.
To illustrate, consider the following facts: Company A enters into a sales agreement with Customer B under which Company A will pay 3% of the entered value of the product as a discount to Customer B in lieu of the timely payment discount (which is 5% paid by the customer if payment is made on or before 30 days from the invoice date or 2% paid by the customer if payment is made on or before 60 days from the invoice date).
Assume that the first product worth $1000 is delivered by Company A to Customer B on June 1, 20X1. Company A’s invoice to the customer has a payment term of 60 days and its total entered value is $1000 whereas its contracted value is $970 (i.e., less the agreed discount of $30). Company A invoices Customer B on June 1 and ships the goods. The performance obligation is satisfied on June 1 and the transaction price ($970) is recognized as a contract asset. When the payment is received by Company A on July 1, there is a reduction in the contract asset which is now classified as a receivable. Likewise, assume that the second product worth $5000 is delivered by Company A to Customer B on August 1, 20X1. The performance obligation is satisfied on August 1 and the transaction price ($4850), net of discounts is recognized as a contract asset on August 1. The customer pays the invoice on September 15, 20X1. Since the payment is within the discount window, a contract asset of $450 is recognised which is the difference between the contract asset of $4850 and discounted consideration ($4850 less $450). From October 5, 20X1 onwards, there is a reduction, or derecognition, of $450 from the previously recorded contract asset and the same amount is recognised as a receivable.
As this example shows, although both the contract asset and the receivable are recorded using the same underlying price that is due, the timing may be different.
Accounting Challenges and Implications
A challenge that companies are faced with is determining the proper accounting treatment for contract assets at the year end to determine present value. In some instances, an end-of-year adjustment to contract assets may be necessary. Contract costs that are not capitalized into contract assets are charged to income as incurred, but contract costs that qualify for capitalization are recognized as contract assets and are included in work in progress inventories on the balance sheet. Costs that are attributable to a specific performance obligation must be capitalized if they generally meet the capitalization criteria. Companies also need the ability to properly assess whether costs should be amortized . If there is a change on when a promised good or service is transferred to the customer, the asset would need to be reallocated and an impairment test would be performed, and impairment losses will be recognized if the carrying amounts of contract assets exceed the remaining amount to recognize as revenue to the satisfied performance obligations.
Other compliance issues include the determination of variable consideration. Whether pricing varies and whether a reduction of amount is considered variable consideration is a challenge. Judgement is required to identify when the price is representative of the selling price in the market during the period. Assumptions used to estimate variable considerations should be clearly stated and fully disclosed. In addition, the transaction price may be influenced by 3rd party fees or rebates that need to be taken into consideration.
Examples and Illustrative Cases
Consider the following examples:
Company A is in the recruitment business and receives a fee for each successful placement of personnel. A contract is created when a customer engages Company A to find personnel, at which point the customer is obligated to pay for the recruiting services. This organization has a right to consideration for providing the recruitment services to its customers. In this case, Company A recognizes a contract asset to the extent that the recruitment services are provided in advance of the customer’s payment.
Company B provides construction services under a contract in which the customer pays a percentage of the total transaction price as work is completed. The payments do not represent a financing component in accordance with ASC 606-10-32-28. Because the initial payment is less than the value of the performance obligation that has been satisfied, there is a contract asset. The contract asset decreases as progress is made toward satisfying the performance obligation and when the performance obligation is satisfied, the contract asset is reclassified as a receivable. If a contract is terminated, the transaction price allocation of the contract asset is performed so that an organization recognizes a contract liability, if necessary, up to an amount equal to the cumulative billings made to a customer or an allowance for expected impairment losses on the contract asset.
Company C has contractual arrangements with various suppliers that require approval from a customer prior to shipping products to customers. A contract asset is recognized upon receiving approval because the supplier has transferred control to the supplier, which is then required to resell the products to customers and earn a return on the investment. Company C records the asset as inventory (if it intends to resell the products) and reduces the asset when the products are sold to customers.
Best Practices
Emails are often a good way to track an issue, but a contract asset can be more difficult to manage. Entities should have similar processes in place for each department involved in revenue recognition. All departments that touch an ASC 606 transaction should ideally be involved in the contract asset discussion. In particular, the sales, accounting and project management functions should follow best practice approaches to manage contract assets.
Even if you consider yourself revenue recognition experts, there can be hurdles to overcome with contract assets. Contract assets can be difficult to identify and segregate from receivables. You may not necessarily want to label something as a contract asset if it is going to be paid quickly. In such cases , the best option may be to leave it on the receivable side of the balance sheet. Companies with accounting software may find themselves getting frustrated with trying to set up the software correctly to track contract assets as opposed to receivables or payables. A standard process across departments will limit mistakes and improve efficiency. A universal approach to managing contract assets can help to identify them correctly and in a timely manner. This also allows departments to implement the appropriate accounting controls and safeguard measures to reduce restatements of financials.