Sam Patel, Managing Director at Graphite
One of the core considerations of a SaaS organization’s financial processes is revenue recognition. And with the accounting standards surrounding this topic shifting from time to time, it’s important to stay informed to keep your operations at their peak.
One relevant update, ASC 606, went into effect in 2017. And since then, it has significantly impacted organizations’ reporting practices. For founders and operators, it’s in your best interest to gain a solid understanding of what ASC 606 is and what it means for your financial statements and reporting.
Overall, ASC 606 gives organizations a consistent approach to follow with revenue recognition.
And, here’s where it really matters…startups looking to attract investors will need to follow ASC 606 standards in order to pass the litmus test and secure funding.
What is ASC 606?
ASC 606 stands for Accounting Standards Codification 606. It outlines key principles that organizations need to follow when accounting for revenue from ongoing customer contracts.
This standard went into effect for public companies in fiscal years beginning after December 15, 2017. For private companies, it went into effect in fiscal years beginning after December 15, 2018.
Developed in conjunction with the International Accounting Standards Board (IASB) by the Financial Accounting Standards Board (FASB), it was proposed to fill a major gray area financial leaders had to deal with before.
What is Revenue Recognition?
Revenue recognition is an accounting technique that helps to spread out large up-front payments from customers for services that happen over time by matching them to the time period in which the services or products are provided. This is crucial for many service or software organizations that have large contracts and upfront payments (think annual contracts) before delivering full services.
One of the easiest ways to imagine how this works is with a gym membership. Consider that you pre-paid your gym membership for the year. Although you pay up-front, you do not receive all of the services up-front. Instead, you receive services throughout the year and accounting splits up the revenue accordingly. In this situation, the gym would likely recognize the revenue from your membership monthly over a 12 month time period.
Revenue recognition is considered a generally accepted accounting principle (GAAP) and a key component of accrual basis accounting. Regardless of when payment is received, this dictates that revenue should be accounted for or “recognized” at the time that products or services are rendered.
To illustrate this with a software example: One tool in your tech stack costs you $240k per year, up front, to use. Once you pay, the company who sold you this software would put $240k in a Deferred Revenue account, and would recognize $20k in revenue monthly, over 12 months.
Why Was ASC 606 Created?
Previously, there weren’t any universal accounting standards regarding revenue recognition.
Before the implementation of ASC 606, revenue recognition guidance was complex and industry-specific. This left organizations more or less to figure it out on a case-by-case basis.
For example, different organizations recognized revenue for similar transactions in different ways. These inconsistencies made it difficult for investors and other stakeholders to compare financial statements across organizations and industries.
How Does ASC 606 Solve This Major Problem?
ASC 606 provides a single, principles-based framework for revenue recognition.
ASC 606 requires organizations to follow a five-step process to determine when revenue should be recognized. This process has increased transparency, comparability, and consistency in financial reporting.
Although implementing this new standard was initially a big change for many startups, it resulted in clearer and more effective financial reporting in the long run.
So while the name itself doesn’t sound all that intriguing, it’s a pretty significant shift. This standardization helps organizations create more effective reporting that communicates their value better to investors, and investors and other stakeholders are more able to make better-informed decisions. It also gives founders a better picture of the true economics of their business.
Are ASC 606 and IFRS 15 the Same?
Since the implementation of ASC 606, another update to reporting standards has been launched as well: IFRS 15.
IFRS 15 is the International Financial Reporting Standards (IFRS) equivalent of ASC 606 that went into effect about a year later, and the two are often conflated.
While the two share the same basic principles of revenue recognition, there are some key differences. The primary difference is what comprises a “contract.”
So, What Changed?
These new standards, both ASC 606 and IFRS 15, significantly differ from the revenue recognition guidelines that they disrupted.
For example, under previous standards, our clients could recognize revenue from software licenses they sold up front, while their customers would pay in installments over several years.
Now, under ACC 606, organizations must recognize revenue from software licenses over the period of time the customer is entitled to use the software, rather than all at once at the beginning of the contract. This delays when that revenue is reported, potentially impacting key financial metrics like earnings and revenue growth.
Although implementing ASC 606 may seem daunting at first, it ultimately makes revenue recognition a more straightforward, standard process across a wide range of industries.
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How to Recognize Revenue Under ASC 606
ASC 606 defines five specific steps for revenue recognition. Let’s take a look at what these steps are, how to implement them in your organization, and why they’re important.
1. Identify the contract with a customer.
The first step is determining whether a contract exists between an organization and their customer.
A contract is defined as an agreement between the company and the customer that creates enforceable rights and obligations.
During this step, you’ll also need to identify the parties involved, the contract terms, and the payment terms.
2. Identify the performance obligations in the contract.
Once you’ve identified the contract, the next step is to identify the performance obligations within that contract.
A performance obligation is a promise to transfer a distinct good or service to the customer. You’ll need to identify each distinct performance obligation in the contract and the goods and services that are associated with them.
These goods and services can be used on their own or with other resources.
3. Determine the transaction price.
The next step is to determine the transaction price, which is the amount your organization expects to receive in exchange for providing goods and services to the customer.
During this step, you’ll need to evaluate variable considerations like rebates or performance incentives and estimate the impact these constraints have on the transaction price.
4. Allocate the transaction price to the separate performance obligations.
In this step, you’ll allocate the transaction price to each distinct performance obligation. This is done based on the relative standalone selling price of each obligation.
If you don’t have a standalone selling price for a specific item, you’ll need to estimate the transaction price.
5. Recognize revenue upon satisfaction of the obligation.
The final step is to recognize revenue once your performance obligation has been satisfied. This happens when the customer obtains the promised good or service under the terms of their contract.
Depending on what you’re selling, control could be transferred at a single point in time or over a period of time.
Using the software license example, revenue would be recognized at the end of the license term.
Make Your Revenue Recognition Process Airtight
Overall, ASC 606 is a positive update for the financial industry. But, it can lead to a few hiccups along the way if your revenue recognition processes looked vastly different before.
Graphite’s expert team is here to help you get things under control so you can focus on growing your business. We offer specialized accounting services for startups and understand the unique challenges you face.
Reach out now to get started.
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