By Rachel Polson, Partner
The new Accounting Standards Update 2014-09 (Topic 606), Revenue from Contracts with Customers creates a unified, principle-based standard on accounting for revenue from customers and replaces hundreds of pages of rules-based guidance designed for specific industries.
ASC 606 impacts all entities that enter into contracts to provide goods or services to their customers and has forced many organizations to evaluate their contracts with customers. The accounting change will be especially notable for software and technology companies, and may require them to modify their systems, processes, controls and documentation to meet the new requirements. This article will review the process for applying the new standard and key considerations for software and technology companies.
ASC 606 standard effective dates
Fiscal years beginning after December 15, 2017
- Public companies
- Certain not-for-profit entities that have issued conduit debt obligations
Fiscal years beginning after December 15, 2018
- All other entities
ASC 606 and what you need to know
ASC 606 provides a more defined structure for assessing all revenue transactions and consists of five elements:
- Identify the contract with a customer
- Identify the performance obligations (promises) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize the revenue when (or as) the reporting organization satisfies the performance obligations
Each step is outlined below at a high level with specific items software and technology companies will need to take into consideration when implementing the new standards noted.
Specific considerations for software and technology companies
Step 1 – Identify the contract
The first step in applying ASC 606 is to identify the contract(s) with the customer. Identifying if a contract exists should not be difficult, however software and technology companies should note:
- Prior guidance with requirements for a written contract is no longer the key metric for revenue recognition
- Companies should consider any history of amendments or side agreements
- Contract modifications will most likely be identified as a separate contract if services are distinct and the price is at the standalone price
Step 2 – Identify the performance obligations (promises) in the contract
Once a contract with a customer has been identified, the company must determine its performance obligations. Specifically, software and technology companies will need to keep the following in mind:
- It will need to be determined if goods or services are distinct, which will be similar to determining if deliverables have standalone value under existing U.S. GAAP
- A key factor in assessing if the promises are distinct will be if the customer obtains an economic benefit from the use of the good or service
- Promise for performance is transferred individually or combined
- A promise in a contract can be defined as a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer
- Free or discounted goods or services in the future might be a material right
Steps 3 and 4 – Determine and allocate the transaction price
Within ASC 606, the transaction price should be allocated so a company recognizes revenue for each performance obligation in the amount the company expects to receive in exchange for the promised goods or services. However, the transaction price must first be determined and this may be more complex than companies are used to. Once the transaction price has been determined, it must be allocated to the promises based on the relative standalone selling price of the separate goods or services. Software and technology companies should bear in mind that:
- Use of the residual method is allowable, but only when the selling price is highly variable or uncertain
- Allocation of discounts and variable consideration amounts to specific performance obligations if certain criteria are met
Step 5 – Recognize the revenue
The final step to ASC 606 is recognizing revenue as your company satisfies the performance obligations within the contract. Much of this relates to when and how control is transferred to customers, specifically if it is transferred over time or at a point in time. To comply with ASC 606, software and technology companies will need to:
- Assess if the contract has over time control transfer indicators, and if not, use point in time recognition
- Depending on the assessment, potentially adjust methods based on the new criteria
Software and technology companies will need to assess how the company will be impacted by the new principles-based standard. The new standard will necessitate companies to evaluate their contracts with customers and the systems, processes, controls and documentation they have in place. The time to start analyzing contracts and revenue streams is now, as companies are expected to be in compliance soon.
For more information on this topic, or to learn how Baker Tilly software and technology specialists can help, contact our team.