ASC 606-10-25: The 5-Step Revenue Recognition Model

Accounting Standards Codification (ASC) Topic 606 provides the guiding framework for how entities report revenue from contracts with customers under U.S. Generally Accepted Accounting Principles (GAAP). The standard moves from industry-specific guidance to a principles-based approach to create a more uniform system for revenue recognition. The core of this standard is a five-step model designed to systematically determine when and how much revenue should be recognized.

The Core Principle and Step 1 Identify the Contract

The fundamental principle of ASC 606 is that a company should recognize revenue to show the transfer of promised goods or services in an amount that reflects what the company expects to receive. This principle shifts the focus from the transfer of risks and rewards to the transfer of control over goods or services, requiring a detailed analysis of contract terms.

Before recognizing revenue, a company must determine if a contract exists according to the standard’s criteria. For an agreement to be treated as a contract, it must meet five conditions.

• The parties have approved the agreement and are committed to their obligations.
• Each party’s rights regarding the goods or services are identifiable.
• The payment terms for the goods and services are identifiable.
• The contract has “commercial substance,” meaning the entity’s future cash flows are expected to change as a result of the contract.
• It is probable that the entity will collect the consideration to which it is entitled.

This collection assessment evaluates the customer’s ability and intent to pay the amount due under the contract.

Step 2 Identify Performance Obligations

Once a valid contract is identified, the next step is to pinpoint the specific promises made to the customer, known as “performance obligations.” A performance obligation is a promise to transfer a good or service to a customer. This step determines how revenue will be broken down and recognized over the life of the contract.

The main task is to determine whether promised goods or services are “distinct.” A good or service is distinct if it meets two criteria. First, the customer can benefit from the good or service on its own or with other readily available resources, meaning it has standalone value.

Second, the promise to transfer the good or service must be “separately identifiable” from other promises in the contract. This involves assessing whether the good or service is integrated with, modifies, or is highly dependent on other items in the contract. For example, a software license and a routine installation service would likely be two distinct performance obligations.

Step 3 Determine the Transaction Price

After identifying performance obligations, a company must determine the transaction price, which is the consideration the company expects to receive for transferring the promised goods or services. This price is not always a fixed amount and requires evaluating several factors that can cause it to vary.

Variable Consideration

Many contracts include variable consideration, such as discounts, rebates, refunds, incentives, and performance bonuses. A company must estimate this amount using one of two methods. The “expected value” method is a sum of probability-weighted amounts and is suitable for contracts with many possible outcomes. The “most likely amount” method uses the single most likely amount and is better when there are only two possible outcomes.

Significant Financing Component

Companies must assess if a contract contains a significant financing component, which occurs when payment timing provides a significant financing benefit to either the customer or the entity. If payment is expected more than a year after goods or services are transferred, the transaction price must be adjusted for the time value of money. The difference is recognized as interest income or expense.

Noncash Consideration

A customer may pay with noncash consideration, such as materials or equipment. This consideration must be measured at its fair value and included in the transaction price. If fair value cannot be reasonably estimated, the entity should measure it indirectly by referencing the standalone selling price of the goods or services promised in exchange.

Consideration Payable to a Customer

A company must account for any consideration it pays to its customer, such as cash for slotting fees or cooperative advertising. This is treated as a reduction of the transaction price, lowering the amount of revenue recognized. The payment is only treated as a separate expense if it is for a distinct good or service that the customer transfers to the entity.

Step 4 Allocate the Transaction Price

With the transaction price determined, the next step is to allocate it to each distinct performance obligation identified in Step 2. The allocation is based on the relative standalone selling price (SSP) of each distinct good or service. The SSP is the price at which a company would sell a promised good or service separately to a customer.

The best evidence of SSP is an observable price from a similar transaction. When an SSP is not directly observable, the standard requires companies to estimate it using a method that best reflects the price it would charge.

One method is the “adjusted market assessment approach,” where a company estimates the price a customer in its market would be willing to pay. Another is the “expected cost plus a margin approach,” where the company forecasts its costs and adds an appropriate margin. A third method, the “residual approach,” may be used in limited circumstances by subtracting the sum of observable SSPs from the total transaction price.

Step 5 Recognize Revenue

The final step is to recognize revenue when the company satisfies a performance obligation by transferring control of the good or service to the customer. Control is the ability to direct the use of and obtain substantially all the benefits from the asset. This step determines if revenue is recognized over a period of time or at a single point in time.

Revenue Recognition Over Time

A company recognizes revenue over time if one of three criteria is met. The first is if the customer simultaneously receives and consumes the benefits of the company’s performance. The second is if the company’s performance creates or enhances an asset that the customer controls as it is created. The third is met if the performance does not create an asset with an alternative use to the company, and the company has an enforceable right to payment for performance completed.

If revenue is recognized over time, the company must select a method to measure its progress, such as using outputs like units produced or inputs like costs incurred. The chosen method should faithfully depict the transfer of control to the customer.

Revenue Recognition at a Point in Time

If a performance obligation does not meet the criteria for recognition over time, revenue is recognized at the point in time when control is transferred. To determine when control has transferred, a company evaluates several indicators.

• The company has a present right to payment for the asset.
• The customer has legal title to the asset.
• The customer has physical possession of the asset.
• The customer has the significant risks and rewards of ownership.
• The customer has accepted the asset.

These indicators are evaluated together to assess the overall transfer of control.