What's the financial accounting standards board?
The Financial Accounting Standards Board (FASB) issues the Accounting Standards Codification (ASC), which is the authoritative source of generally accepted accounting principles (GAAP) for public and private companies in the United States. The ASC includes all current standards of the FASB, as well as those from other organizations whose pronouncements have been incorporated.
The ASC is revised periodically to reflect changes in the financial markets, to provide further clarity on existing guidance, and to maintain consistency and transparency in financial reporting. It provides timely information on changes in GAAP so you can stay abreast of new developments and ensure adequate financial reporting — improving business operations all around.
So what is ASC 606?
ASC 606 is one of FASB’s most important — and recent — standards. According to FASB’s Accounting Standards Updates, ASC 606 went into effect for public businesses for annual reporting periods beginning after December 15, 2017, and it went into effect for private or nonpublic entities for fiscal years beginning after December 15, 2019*.
As this is the current standard for revenue recognition under GAAP, all organizations that follow GAAP and enter into contracts with customers to transfer goods or services must comply. Organizations subject to ASC 606 must also understand the impact of this standard and how to best implement it into their revenue recognition methods.
ASC 605 vs 606: How does the new standard differ?
The change from ASC 605 to ASC 606 helps to make revenue recognition more standard across all industries. And there are several notable changes.
ASC 606 provides a new way of recognizing revenue: when control is transferred to the customer. Control, as defined by ASC 606-10-20, occurs once an entity gains "the ability to direct the use of and obtain substantially all remaining benefits" from a good or service. Therefore, recognition should be given when customers are in full possession of an asset and obtain substantially all the benefits from it.
Another difference between ASC 605 and ASC 606 is that commissions have to be capitalized under the new standard. ASC 605 gave businesses the option to expense or capitalize their sales commissions. ASC 606 spreads revenue out since commissions will be amortized. In other words: Immediate revenue will increase in the sale period, but the commission being amortized means that revenue is less in the long term until the commission has been entirely accounted for.
Additionally, ASC 605 made it so software sales could only be split into two revenue parts — one for support and one for the product itself. ASC 606 makes it easier to define a multitude of revenue parts.
ASC 605 required companies to record variable revenue as it happened. ASC 606 requires estimating variable revenues for the product life cycle. This means recognizing more revenue upfront.
ASC 606 doesn’t include sell-through revenue recognition. So under ASC 606, businesses must now recognize revenue when they sell to a reseller (instead of when the reseller delivers the product to a customer). Businesses will need to estimate returns and price changes when recording initial revenue.
In short, the most significant change from ASC 605 to 606 is that businesses now recognize more upfront revenue and will see expenses spread out since commission is amortized.
How does ASC 606 recognize revenue compared to IFRS 15?
While the ASC 606 and IFRS 15 standards generally follow the same five steps, there are some notable differences: one of the main ones being that IFRS 15 is for international businesses.
Contract Costs: IFRS 15 allows for the limited reversal of impaired contract acquisition or fulfillment costs, which is prohibited under ASC 606.
Non-Cash Transaction Price Measurement: Under ASC 606, non-cash transaction price must be measured at fair value when the contract begins. IFRS 15 has no specific date for measurement and fair value can be considered at a reasonable time.
Transaction Price Sales Tax: Under ASC 606, all sales tax must be presented on a net basis. Under IFRS 15, companies can evaluate if third parties collect sales taxes on a jurisdiction-by-jurisdiction basis.
Shipping and Handling: Under ASC 606, shipping and handling are treated as fulfillment activities after the customer has control of the goods. Revenue and costs are recognized upon transfer. Under IFRS 15, the company decides if shipping and handling is a distinct performance obligation. Revenues are allocated to shipping and handling, which is deferred until distinct performance obligations are satisfied.
Completed Contract Definition: Under ASC 606, the contract is complete if all revenue is recognized under legacy GAAP. Under legacy IFRS, it completes when all goods and services are transferred, regardless of revenue recognition status.
Interim Disclosures: ASC 606 is similar to annual disclosure for interim disclosures. IFRS 15 has fewer disclosure requirements.
Sales Outside of Ordinary Activities: Under IFRS 15, the measurement and derecognition guidance applies to nonfinancial assets like property, plant, equipment, or intangible assets. Under ASC 606, the contract existence, separation, measurement, and derecognition guidance applies to nonfinancial assets and in-substance nonfinancial assets (as scoped in ASC 610-20). The key difference between ASC 606 and IFRS 15 is that many more nonfinancial assets will be included under ASC 606 than IFRS 15, as the former follows guidance that nonfinancial assets would not follow under IFRS 15.
Onerous Contracts: Under IFRS 15, onerous contracts are accounted for under provisions, contingent liabilities, and contingent assets. There is no general guidance under ASC 606.
Remaining Performance Obligations Disclosures: Under IFRS 15, there is disclosure relief in two situations: if the contract is one year or less or if the entity qualifies for the practical expedient to recognize revenue in the amount that it has the right to invoice. ASC 606 has the same disclosure relief situations in addition to two more: It is a sales or usage-based royalty for a license of intellectual property or meets the criteria to be allocated entirely to a wholly unsatisfied performance obligation.
ASC 606 commissions: What is ASC 340?
ASC 606's guidance for how companies must report revenue recognition also changed ASC 340 — and that’s where the commission accounting rules live. ASC 340 is promoted by FASB and addresses how costs incurred by means of obtaining or fulfilling contracts with customers should be accounted for. It includes four subtopics:
- Capitalized advertising costs,
- Insurance contracts that do not transfer insurance risk, and
- Other assets and deferred costs — contracts with customers.
ASC 340 targets matching the time at which costs are incurred with the time that revenue is recognized. However, the timing may not necessarily correspond to when the actual contract is officially closed; it can be for an estimated customer life as well.
This can be applied in different ways: take monthly revenue for instance — even if sales made on credit and cash receipts are delayed beyond the month-end closure date, revenues should still reflect performance completed during the period and have evidence-backed probabilities that payment will eventually arrive. Crucially too, it has to be reasonably estimated how much those incoming funds might amount to!
To sum it up:
- A company may recognize revenue in one period but not receive payment until a later period. Likewise, a company may receive payment in advance of providing goods or services, resulting in deferred revenue, which is recognized as revenue when the company has fulfilled its obligation to provide those goods or services.
- When revenue is deferred, any commission related to that revenue must also be deferred and recognized over the same period as the related revenue. The reason for this is that commission is a cost directly related to generating revenue, and recognizing it before revenue could distort the timing of revenue recognition and expense recognition, which could result in incorrect financial reporting.
Now that you understand how ASC 340 can directly affect your company, let's explore how you can book more accurate journal entries for revenue recognition.
How to record the journal entries for deferred commissions under ASC 606
Journal entries for sales commissions under ASC 606 are generally simple to record as most companies classify them as selling expenses.
A deferred commission journal entry can likewise help track expenses like customer acquisition costs (or deferred commissions) or commissions that have been capitalized but are not recognized as costs yet.
Commission costs to be paid out of commission software
||Wages payable, taxes payable, bonus payable, accrued balances for items not paid out
Deferral of commissions
|Prepaid/deferred commissions - short-term
Amortization of commissions
|Commission amortization expense
||Prepaid/deferred commissions - short-term
Long-term, short-term sweeps
|Prepaid/deferred commissions - long-term entry
||Prepaid/deferred commissions - short-term
How is ASC 606 implemented?
When you pursue a new ASC 606 implementation, there are several steps that you should follow. These include the following, and they'll vary according to the size and other conditions of your business.
- Identify the contract with a customer
- Identify any performance obligations in the agreement
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue
Identify the contract with a customer
ASC 606 removes the need for a signed contract, but the rights and obligations outlined should be enforceable. Under ASC 606, there are certain parts that are essential to any contract, including:
- The agreement has been approved by all parties involved.
- All parties are committed to the fulfillment of their obligations.
- Each party has identifiable rights.
- Payment terms have been laid out and identified.
- The contract has commercial substance.
- Collectibility is likely.
Once your contract has been identified, you need to determine the distinct performance obligations.
Identify any performance obligations in the agreement
The distinct performance obligations of your contract need to be clearly outlined. In most cases, performance obligations simply refer to the transfer of goods and services. A good or service must also be distinct.
Determine the transaction price
In this step, you simply need to determine the transaction price for each performance obligation. This is the amount that your business will expect to receive for your delivered goods and services. Variable considerations such as discounts or rebates also must be factored in.
Allocate the transaction price
If you have more than one performance obligation in the contract, you must allocate your transaction price to each obligation. SaaS, for instance, would typically be considered a continuous obligation, so the price would likely need to be allocated throughout the service agreement.
Once your obligations are satisfied, you can recognize your revenues. In addition, revenue can be recognized over a period if you have a continuous contract.
What SMBs need to know
Adopting ASC 606 can be complex and challenging, with common pitfalls for organizations that are new to it. Businesses that already have experience with earlier versions of the revenue recognition rules might face a smaller learning curve than those that have never dealt with this type of accounting before.
For small, private businesses that follow GAAP, the first thing to know about ASC 606 is that for non-public companies, it applies to every fiscal year after December 15, 2019*. That means small businesses subject to ASC 606 should have already implemented the standard into their accounting or be working on implementing it as soon as possible.
Here are a few other common pitfalls to watch out for:
- Bring in your CPA early and often: It's never too soon to review your books with a CPA! Don't wait until the time of your audit to discuss how you've adjusted your accounting, reporting, and comprehensive disclosures. Let your CPA know well in advance how ASC 606 journal entries may affect your company's financials!
- Acquire a tech stack that keeps you on top of best practices and industry standards: If you've been using the same billing or contract management or commission software for years and your business needs have changed, you may need to upgrade to new systems.
- Read the fine print: If you're selling a product or service, it's a good idea to know the key elements of a contract, such as cancellation rights, commission adjustments, and refunds.