What Is FASB 606? The Revenue Recognition Standard

The Financial Accounting Standards Board (FASB) issued Accounting Standards Codification 606, Revenue from Contracts with Customers, to create a more consistent approach for recognizing revenue across different industries. This standard provides a single, comprehensive framework for businesses to determine how much revenue to record and when to record it. It applies to nearly all entities—public, private, and non-profit—that enter into contracts to transfer goods or services. ASC 606 replaced a patchwork of industry-specific guidance, ensuring that financial statements are more comparable and transparent for investors and other stakeholders.

The Five-Step Model for Revenue Recognition

The core of ASC 606 is a five-step model that guides companies through the process of revenue recognition. This model is designed to be applied sequentially to all contracts with customers. The process ensures that revenue is recognized when control of a good or service is transferred to the customer, and the amount recognized reflects the payment the company expects to receive.

Identify the contract(s) with a customer

The first step is to identify whether a contract exists. A contract is an agreement between two or more parties that creates enforceable rights and obligations. For a contract to be identified under ASC 606, it must be approved by all parties, identify the rights of each party regarding the goods or services, and establish payment terms. The contract must also have commercial substance, and it must be probable that the company will collect the consideration to which it is entitled.

Identify the performance obligations

Once a contract is identified, the next step is to identify the performance obligations within it. A performance obligation is a promise in a contract to transfer a distinct good or service to a customer. A good or service is considered 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 from other promises in the contract. For example, a software license, installation, and technical support would be treated as three distinct performance obligations if each component is sold separately or could be used independently by the customer.

Determine the transaction price

The third step is to determine the transaction price, which is the amount of consideration a company expects to be entitled to in exchange for transferring promised goods or services. This price may be a fixed amount, but it can also include variable consideration, such as bonuses, discounts, rebates, or performance penalties. For instance, if a construction company has a contract with a $100,000 base price plus a $10,000 bonus for early completion, it must estimate the likelihood of receiving the bonus. The transaction price also accounts for the time value of money if the contract includes a significant financing component.

Allocate the transaction price

The fourth step involves allocating the total transaction price to each distinct performance obligation identified in the contract. This allocation is based on the standalone selling price of each performance obligation, which is the price at which a company would sell a promised good or service separately. If standalone selling prices are not directly observable, they must be estimated. For example, if a software license, installation, and support have standalone prices totaling $1,000 but are sold as a $900 bundle, the $900 is allocated proportionally to the three obligations based on their standalone values.

Recognize revenue when (or as) the entity satisfies a performance obligation

The final step is to recognize revenue when, or as, each performance obligation is satisfied. A performance obligation is satisfied when the customer obtains control of the good or service, which can be transferred at a single point in time or over a period of time. Revenue for delivering a physical product is recognized at a point in time, such as when the product is shipped or delivered. In contrast, revenue for services like a year-long consulting engagement is recognized over time as the service is provided using a method that reflects the pattern of transfer to the customer.

Accounting for Contract Costs

ASC 606 provides specific guidance on how to account for certain costs related to securing and fulfilling contracts with customers. This guidance ensures that costs are recognized in a manner consistent with the timing of the related revenue. The standard distinguishes between costs to obtain a contract and costs to fulfill one.

Incremental costs of obtaining a contract

Incremental costs of obtaining a contract are costs that a company would not have incurred if the contract had not been successfully obtained, with a sales commission being a common example. Under ASC 606, these incremental costs are recognized as an asset, meaning they are capitalized rather than expensed immediately.

Once capitalized, these costs are amortized on a systematic basis consistent with the transfer of the related goods or services. For example, a commission for a five-year service contract would be expensed over that five-year period. A practical expedient allows companies to expense these costs as incurred if the amortization period is one year or less.

Costs to fulfill a contract

The standard also addresses costs incurred to fulfill a contract that are not within the scope of other accounting standards. These fulfillment costs are capitalized if they meet all of the following criteria: they relate directly to a specific contract, they generate or enhance resources that will be used to satisfy future performance obligations, and they are expected to be recovered. Examples of such costs could include direct labor, direct materials, and allocations of overhead that relate directly to the contract. If these costs are capitalized, they are amortized as the company satisfies the related performance obligation, while costs not meeting all criteria are expensed as they are incurred.

Required Disclosures

ASC 606 includes disclosure requirements to provide users of financial statements with comprehensive information about the nature, amount, timing, and uncertainty of revenue and cash flows from customer contracts. Companies must provide both qualitative and quantitative details to enhance transparency and allow for a better understanding of revenue streams.

Key disclosures include:

• Disaggregation of revenue into categories that depict how economic factors affect its nature, amount, and timing, such as by product line, geographical region, or contract type.
• Information about contract balances, including contract assets, contract liabilities, and accounts receivable, along with explanations of significant changes.
• The aggregate amount of the transaction price allocated to performance obligations that are unsatisfied at the end of the reporting period.
• Significant judgments made in applying the standard, including those used in determining the timing of satisfaction, estimating the transaction price, and allocating the price to performance obligations.
• Disclosures about capitalized contract costs, including the methods used to determine amortization for each type of cost.

Transition and Adoption Methods

When ASC 606 was implemented, companies made a one-time choice between two methods to transition from previous guidance. The two options were the full retrospective method and the modified retrospective method. The full retrospective method required companies to apply the new standard to all contracts in all prior periods presented, restating previous years as if ASC 606 had always been in effect. The modified retrospective method applied ASC 606 only to contracts not yet complete at the date of initial application, with the cumulative effect recorded as an adjustment to retained earnings in the year of adoption.