What Is ASC 606 and the Five-Step Revenue Recognition Model?

Understanding ASC 606

ASC 606 is the comprehensive accounting standard for recognizing revenue from contracts with customers. Developed jointly by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), it created a unified framework for revenue recognition across industries. Its objective is to enhance comparability and consistency in financial reporting, replacing older guidance. Most companies adopted ASC 606 around 2018.

The standard introduced a principles-based approach, focusing on transferring control of goods or services to customers. Revenue is recognized when a company satisfies a performance obligation by transferring a promised good or service. ASC 606 applies to virtually all entities that follow U.S. Generally Accepted Accounting Principles (GAAP) and enter into contracts with customers.

The standard’s fundamental idea is that revenue should reflect the consideration a company expects to receive for transferred goods or services. This framework aims to provide a more accurate depiction of financial performance by aligning revenue recognition with the actual transfer of economic value. It also standardizes how companies account for contract complexities.

The Five-Step Revenue Recognition Model

The core of ASC 606 is its five-step model, a systematic approach for determining the timing and amount of revenue recognition from customer contracts.

Identify the Contract(s) with a Customer

The initial step requires identifying a contract with a customer that meets specific criteria. A contract is an agreement creating enforceable rights and obligations. To qualify, parties must approve the contract and be committed to obligations, rights regarding goods or services must be identifiable, and payment terms must be clear.

The contract must also have commercial substance, meaning it is expected to change the entity’s future cash flows. It must be probable that the entity will collect substantially all consideration. If these criteria are not met, payments may only be recognized as revenue when they are nonrefundable and no remaining obligations exist.

Identify the Performance Obligations in the Contract

Once a valid contract is identified, the next step is to pinpoint distinct performance obligations. A performance obligation is a promise to transfer a distinct good or service, a bundle of distinct goods or services, or a series of distinct goods or services with the same transfer pattern. A good or service is “distinct” if the customer can benefit from it on its own or with other readily available resources, and the promise to transfer it is separately identifiable.

Identifying these distinct obligations is crucial because revenue is recognized as each is satisfied. If a promised good or service is not distinct, it must be combined with other promises until a distinct bundle or series is formed.

Determine the Transaction Price

The third step is to determine the transaction price, the amount an entity expects to receive for transferring goods or services. This price can be fixed or include variable consideration like discounts, rebates, or bonuses. When variable consideration is present, the entity must estimate the amount it expects to receive.

Entities estimate variable consideration using methods like the expected value method or the most likely amount method. The chosen method should best predict the amount the entity will be entitled to. Variable consideration is included only if it is probable that a significant revenue reversal will not occur when the uncertainty is resolved.

Contracts may also contain a significant financing component if payment timing provides a substantial benefit of financing. If the period between payment and transfer is expected to be more than one year, the transaction price must be adjusted for the time value of money. This adjustment can be foregone if the period is one year or less.

Allocate the Transaction Price to the Performance Obligations

After determining the transaction price, the fourth step is to allocate this price to each distinct performance obligation. Allocation is based on the relative standalone selling price (SSP) of each good or service, which is the price an entity would sell it for separately.

If an observable SSP is not available, the entity must estimate it using various methods. When a contract includes a discount, it is allocated proportionately across all performance obligations unless specific criteria allow allocation to particular obligations.

Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation

The final step is to recognize revenue when the entity satisfies a performance obligation by transferring control of a good or service to the customer. Control means the ability to direct the use of, and obtain substantially all benefits from, an asset. Revenue can be recognized either over time or at a point in time, depending on specific criteria.

Revenue is recognized over time if one of three criteria is met:
The customer simultaneously receives and consumes benefits as the entity performs.
The entity’s performance creates or enhances an asset the customer controls.
The entity’s performance does not create an asset with an alternative use, and the entity has an enforceable right to payment for performance completed.

For obligations satisfied over time, entities use input or output methods to measure progress.

If not recognized over time, revenue is recognized at a point in time. This occurs when control transfers to the customer, evidenced by indicators such as:
The entity having a right to payment.
The customer having legal title.
The customer having physical possession.
The customer bearing significant risks and rewards of ownership.
The customer having accepted the asset.

Applying the Model to Specific Scenarios

Applying the five-step model requires careful consideration in specific business scenarios for accurate revenue recognition.

Principal vs. Agent Considerations

A key determination is whether the entity acts as a principal or an agent, which affects whether revenue is recognized on a gross or net basis. An entity is a principal if it controls a good or service before transferring it to the customer, recognizing the gross amount of consideration. Indicators of control include primary responsibility, inventory risk, and pricing discretion.

Conversely, an entity is an agent if its obligation is to arrange for another party to provide the good or service. The agent recognizes revenue on a net basis, typically its commission or fee. This distinction impacts reported top-line revenue and gross profit percentages.

Contract Costs

ASC 606 guides accounting for costs related to obtaining and fulfilling contracts. Costs to obtain a contract, like sales commissions, must be capitalized if they are incremental and expected to be recovered. These capitalized costs are amortized over the period the related goods or services are transferred.

Costs to fulfill a contract are capitalized if they relate directly to a contract, generate or enhance resources for future performance obligations, and are expected to be recovered. Costs not meeting these criteria, like general administrative expenses, are expensed as incurred.

Licenses of Intellectual Property

Applying the revenue recognition model to intellectual property (IP) licenses depends on whether the license grants a “right to use” or a “right to access” the IP. A “right to use” license grants the customer the right to use the IP as it exists when granted, without significant future updates. Revenue from these licenses is recognized at a point in time, often when the license is provided.

A “right to access” license grants the customer access to the IP throughout the license period, with the entity undertaking ongoing activities that affect the IP. This applies to symbolic IP or software with continuous updates. Revenue from these licenses is recognized over time, as the entity provides ongoing access or services.

Repurchase Agreements

Repurchase agreements involve a company selling an asset and agreeing to repurchase it. Accounting for these depends on whether the customer obtains control. If the entity has an obligation or right to repurchase the asset for an amount less than or equal to the original selling price, the transaction is treated as a financing arrangement or lease, not a sale.

If the entity has an obligation to repurchase the asset for an amount greater than the original selling price, or if the customer can require repurchase, it might be accounted for as a sale with a right of return. The core principle is to determine if the customer gains control of the asset and its risks and rewards; if not, revenue recognition is deferred.

Financial Statement Presentation and Disclosures

ASC 606 significantly impacts financial statement presentation and disclosures. It aims to provide users with a clearer understanding of a company’s revenue streams and cash flows.

On the income statement, the primary impact is on the timing and amount of revenue recognized. Revenue is presented when performance obligations are satisfied, which may differ from cash receipt or contract signing. This provides a more faithful representation of economic activities.

The balance sheet is affected by new asset and liability classifications. Contract assets arise when an entity has a conditional right to consideration for transferred goods or services. Contract liabilities, or deferred revenue, are recognized when an entity receives consideration before transferring goods or services.

ASC 606 enhances disclosure requirements, mandating qualitative and quantitative information. Companies must disaggregate revenue into categories illustrating how economic factors affect revenue and cash flows. Examples include:
Type of good or service
Geographical region
Market or customer type
Contract duration
Timing of transfer (point in time versus over time)

Further disclosures include:
Information about contract balances (e.g., opening and closing balances of contract assets, liabilities, and receivables).
Details about performance obligations, including satisfaction timing and payment terms.
Significant judgments made in applying revenue recognition guidance (e.g., determining transaction price, allocation, and satisfaction assessment).