5 ways ASC 606 changes how services companies book revenues

Public, private and non-profit entities are subject to a new series of accounting guidelines as of this year or next – the exact timing depends on company size and accounting period. Accounting Standards Codification 606 (ASC 606) establishes new rules for US companies about booking revenues, in the process creating a common standard for Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), which means similar changes are rolling out in most other countries. At its most basic, ASC 606 mandates that revenue is recorded once a contractual obligation is met, not at the time of payment.

For service companies, this is an important shift. They must follow five steps for booking revenues, which rest largely on the details of the customer contract. If the terms of that contract change – for example, by adding a new service or changing the scope or substance of an existing service – the five-step process may have to begin again if the modification is significant. While adopting uniform revenue recognition standards is to be welcomed as it may eliminate discrepancies that once existed between jurisdictions, it requires a new level of diligence on the part of commercial and nonprofit entities selling services in the global economy.

Step 1: Identify the contract

ASC 606 requires that there is a mutually-agreed upon contract with payment terms in place. The payment does not have to be stated explicitly to facilitate contract identification  – it is enough that cost may be reasonably estimated. Notably, the standard says the service provider must have a probable chance of collecting on the money owed under the agreement. Therefore, to book revenue from the contract, the payment must not only be enforceable but collectable. At this stage in the process, the customer's credit risk is investigated.

Step 2: Identify performance obligations

In older accounting parlance, entities might refer to performance obligations as deliverables. Under ASC 606, performance obligations are discrete activities that can be done separately, even if they are provided to the customer in conjunction with other services. The customer must be able to benefit from each one individually on an independent basis to meet the criteria of a distinct performance obligation. Performance obligations are fundamentally the services for which the customer is paying, although they may be offered as part of a package.

Step 3: Determine the transaction price

A transaction price must be attached to the performance obligations in the contract. This is often straightforward, but specific circumstances can affect the transaction price. For example, if the price point varies because of promotional discounts, the transaction price should foresee a corresponding decline in revenue.

In addition, entities must list separately an interest expense or interest income if there is more than one year between performance and payment. This adjustment, the significant financing component, records the difference in cash received and transaction price that results from when customers pay in advance or well after receipt of services.

Step 4: Allocate the transaction price

Once the transaction price is determined, it must be allocated to each performance obligation. Even if each obligation is not typically ’sold separately’, the entity must estimate a standalone selling price. This may be a reasonable estimate, or it may be determined on a proportional basis of the contract obligations. Under certain circumstances, an entity can use a ’residual’ approach to allocate price by attaching whatever is left over once the standalone prices for performance obligations are established.

Step 5: Recognize revenue as performance obligations are satisfied

Under ASC 606, entities must book the revenue of each performance obligation as they are completed for the customer. For service providers, this may happen over a period of time. There are specific criteria for when a performance obligation may be satisfied over time, such as when a customer uses up the service as it is being offered. For these types of performance obligations, entities book the amount of revenue that is enforceable against the customer, even if the agreement as a whole is not yet complete.

What service companies can expect under ASC 606

The biggest change for service companies is the frequency with which they may have to allocate revenue. Although Step 1, contract identification, mandates the combining of multiple contracts for the same client, this consolidation can happen only if the contracts are entered into at the same time. Changes to a contract become a new contract for the purposes of booking revenue if new services are sold and the price difference reflects what would be the standalone price of those new services.

It is easy to describe the new rules and what entities should be doing to abide by them. However, many service providers are still debating how ASC 606 will change their ways of doing business. Many of these steps are tricky when implemented in the real-life world of contracts. Distinguishing between a new contract and a modification of an existing contract, for example, may be easier said than done and will directly affect the financial health of the entity. It is a challenge for some companies to allocate price to performance obligations when many of those obligations have no standalone selling price.

Preparing for ASC 606 should already be well underway for private and nonprofit entities who have mere months before the new standards apply to them. To make the process more expedient, some might consider transitioning to an automated revenue-allocation program and other technological tools that make it easier to track and disclose the flow of services to customers. That way, the systems for reporting will relieve strain on accounting personnel who have new rules with which they must comply.