What Was ASC 605 Revenue Recognition?

Accounting Standards Codification (ASC) 605, Revenue Recognition, was the guidance under U.S. Generally Accepted Accounting Principles (GAAP) for how most entities recognized revenue. It provided a “rules-based” framework, meaning it prescribed specific conditions that had to be met before a company could record revenue. This standard has been superseded by ASC 606, Revenue from Contracts with Customers.

The transition to the new standard was phased in, with public companies adopting it for fiscal years starting after December 15, 2017, and private companies following a year later. Understanding ASC 605 remains relevant for analyzing financial statements from prior periods. For investors, analysts, and accounting students, a grasp of ASC 605 is helpful for interpreting historical performance and the evolution of financial reporting.

The Four Core Criteria for Revenue Recognition

ASC 605 was structured around four main criteria that all had to be satisfied for revenue to be recognized. This approach was designed to ensure that revenue was not recorded prematurely. The standard’s rigidity meant that if any one of the four conditions was not met, revenue recognition was deferred, impacting a company’s reported financial performance.

Persuasive Evidence of an Arrangement Exists

The first criterion required a company to have convincing, documented proof that a deal was in place with a customer. This evidence could not be a verbal agreement and typically took the form of a signed contract or a legally binding purchase order that detailed the terms of the sale.

This requirement established a formal record of the transaction, outlining the specific goods or services to be provided and the obligations of both parties. For example, a software company could not recognize revenue based on a client’s interest alone. The company had to wait until a formal license agreement was executed by both parties, creating a legally enforceable arrangement.

Delivery Has Occurred or Services Have Been Rendered

The second criterion focused on the seller’s performance. For the sale of goods, “delivery” was often tied to shipping terms like “Free on Board” (FOB) shipping point, which signifies that the transfer of title and risk of loss occurs when the goods are passed to the shipping carrier.

For services, revenue was recognized as the services were performed over time. For instance, a year-long consulting engagement would see revenue recognized incrementally each month, rather than all at once at the start of the contract. This part of the standard ensured that revenue was directly tied to the fulfillment of the promised goods or services.

The Seller’s Price is Fixed or Determinable

The third condition mandated that the sales price be firmly established and not subject to future changes or contingencies. A price was considered “fixed or determinable” if it was explicitly stated in the arrangement, preventing the recognition of revenue that might have to be refunded or adjusted later.

An example of a price that would not be determinable is one contingent on the customer achieving a certain resale value for the product. The standard did allow for exceptions, such as sales with a right of return, but only if the company had a sufficient history of similar transactions to reliably estimate future returns. If the price was not determinable, revenue recognition was delayed until the price became fixed.

Collectibility is Reasonably Assured

The final criterion required the seller to have a reasonable expectation of receiving payment from the customer. This involved an assessment of the customer’s creditworthiness and ability to pay based on factors like past payment history and overall financial health.

If collection was not deemed reasonably assured, the company could not recognize revenue, even if all other criteria were met. In such cases, the company would use a different accounting method, such as the cash basis, where revenue is only recognized upon the receipt of payment.

Key Industry-Specific Applications

A defining characteristic of ASC 605 was its extensive and detailed guidance tailored to specific industries. This specificity arose because the four general criteria were often difficult to apply to complex business models, leading to the creation of numerous sub-topics and interpretations. This proliferation of rules created a complex system that could lead to different accounting outcomes for economically similar transactions in different industries.

Software Revenue Recognition

The software industry faced unique challenges under ASC 605, as a single sale could include a license, future upgrades, and technical support. The guidance in ASC 985-605 required companies to establish “Vendor-Specific Objective Evidence” (VSOE) of fair value for each undelivered item to recognize revenue for the delivered items.

VSOE was a strict standard, requiring proof that the company regularly sold the undelivered element, like technical support, on a standalone basis at a consistent price. If a company could not establish VSOE for an undelivered item, it was often forced to defer all revenue from the arrangement and recognize it over the entire contract term.

Multiple-Element Arrangements

Many businesses sell products and services together in bundled packages, known as multiple-element arrangements. For example, a telecommunications company might sell a mobile phone with a voice and data plan as a single package. ASC 605-25 provided guidance on how to determine if these components should be treated as separate “units of accounting.”

To separate the deliverables, a company had to prove that each item had value to the customer on a standalone basis and that there was objective evidence of the fair value of any undelivered items. If these criteria were not met, the entire bundle was treated as a single unit. As a result, revenue was often deferred until the final item was delivered or was recognized ratably over the service period.

The Supersession by ASC 606

The framework of ASC 605, with its rigid rules and extensive industry-specific guidance, was eventually replaced. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) collaborated to create a converged, global standard. This effort culminated in the issuance of ASC 606, Revenue from Contracts with Customers, which fundamentally changed how companies account for revenue.

A primary driver for this change was the desire for greater comparability between companies. The industry-specific nature of ASC 605 meant that two companies could have economically similar transactions but report revenue differently. ASC 606 was designed to eliminate most of the industry-specific guidance and create a more uniform, principles-based approach.

The new standard moved to a five-step model that focuses on the transfer of control of goods or services to a customer, rather than the transfer of risks and rewards. The core principle is that a company recognizes revenue to show the transfer of goods or services in an amount that reflects the payment it expects to receive. This shift requires more judgment from management but provides a more consistent framework across all industries.