ASC 606 provides five steps for adoption and implementation. Businesses have to follow these steps for long- and short-term contracts alike, but long-term contracts may require greater attention to detail. In this article, we’ll examine each of the five steps, specifically considering how the ASC 606 revenue recognition framework applies to long-term contracts.
Here’s a summary of the ASC 606 implementation steps and how they apply to your long-term contracts.
Any business contract, whether written or oral, needs to have commercial substance—meaning the risk, timing, or amount of the business’s cash flows are expected to change as a result of the contract—and it needs to be identifiable. To identify a contract, you should be able to demonstrate that the contract exists, show the terms and agreements, and prove that the involved parties have made a commitment.
This is obviously more difficult to establish with an oral contract than a written contract, so most businesses avoid entering into long-term oral contracts.
You’ll also need to determine whether other contracts exist with the same customer, looking at when they were entered into and what goods or services they cover. You may need to combine or separate contracts as a result.
Long-term contracts are more likely to include change orders or other contract modifications that require you to determine if they should be separate contracts or different performance obligations within the same contract.
A performance obligation is a distinct good or service that you promise to deliver to a customer. Some of the contract modifications made during your contract term will be distinct performance obligations, while others may be grouped with existing performance obligations.
You’ll need to determine whether any modification is capable of being distinct, identifiable within the contract, or constituting a separate contract altogether. This step requires you to use your own judgment while following the principles outlined in the standard. And it’s important to maintain a consistent approach across all of your customers and contracts.
To determine the correct price, you start with the basic contract price and factor in customer payments or other variables that may change the price. This could include things like rebates, discounts, change orders, bonuses, and performance penalties. The longer your contract term, the more likely it is that you’ll need to make changes to your contract that result in variable consideration.
You should also be aware of the timing of customer payments as they relate to the transfer of goods and services to your customer. If those payments span more than one year, you may have a “significant financing component” for which you’ll need to account.
For price allocation, you’ll have to determine whether the contract contains multiple elements or performance obligations.
Contracts with only one performance obligation allow for a fairly straightforward process. However, SaaS contracts are more complex and contain multiple elements like access to the program, professional services, and training. You’ll need to allocate the price across all of these elements, as directed in the standard.
You can use one of multiple revenue recognition methods to complete the ASC 606 process. When working with long-term contracts, you’ll typically want to use a method that allows you to recognize revenue throughout the contract. Otherwise, you’d have to wait until the end once everything has been delivered.
The matching principle specifies that for costs associated with acquiring and fulfilling the contract, you need to recognize them in the same period as the revenue.
You must include specific costs associated with capturing that recognized revenue—such as sales commissions. And you need to capitalize and amortize commission costs to match the time that they recognize revenue for any given period. For some businesses, the accounting changes required for sales commissions are more impactful than the changes required for revenue.
For example, if a SaaS company aggregates sales data based on ARR for the month and calculates sales commissions based on that data, they may have to disaggregate the data to show multiple products including revenue for software, services, and revenue recognized over time post the contract being signed. This would necessitate separating commission calculations at the contract or product level.
Revenue recognition has become more complex under ASC 606. You now have to deal with the amortization of sales commissions, rebates, and sales incentives, along with including performance obligations and other qualitative elements.
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