Revenue Recognition Standard ASC 606 Explained
Revenue Recognition Standard ASC 606 is a new accounting standard that covers revenue recognition for publicly listed SaaS companies. It provides a comprehensive, industry-neutral revenue recognition model that is intended to increase financial statement comparability across companies and industries. The standard also applies to other companies that have subscription-based business models or long-term contract services revenue streams.
By extension, the ASC 606 standard covers the recognition of expenses that are directly related to revenue recognition example sales commissions & incentives. The important note here for CFOs and Finance Managers that have been affected by it is that commission expenses can no longer be expensed 100% in the current year. Under this new standard, companies are required to report the estimates and then change them each period as they evolve. If they are not managed carefully, this could be perceived as earnings management or even worse than that. To prevent such issues from occurring, additional controls, such as review controls, may be necessary.
The purpose of the ASC 606 standard is to ensure better alignment and timing of expenses against the period in which the revenue is recognized. For example, a $2M annual subscription fee might generate $20M over ten years. The commission expense that is incurred in generating that revenue should be spread over a number of years – not booked to the P&L in the month the deal was closed.
This new revenue recognition standard comes with a significant amount of judgment, and companies should realize that applying judgment under ASC 606 (IFRS 15) does not mean any and all judgments are acceptable. There are a few instances when differing judgments under 606 might be acceptable, but in the majority of the cases, similar facts will result in similar judgments.
The ASC 606 accounting standard will come in to effect in a corporation’s fiscal year ending in 2019. From here on, companies are required to ensure their reporting and processes are in order during FY18 so they are fully prepared and compliant when the 1st quarter of FY19 starts.
ASC 606 implementation will remove inconsistencies and weaknesses in existing revenue reporting requirements and provide a more robust framework for addressing revenue issues. It is expected to improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; and also provide more useful information to users of financial statements through improved disclosure requirements.
Accounting Impact of ASC 606
The standard will have two impacts on the accounting for sales commission expenses:
The commission paid on a sales order will need to be amortized across an agreed number of years.
Customer churn events that occur prior to the agreed number of years will trigger an accounting adjustment.
In terms of journal entries prior to Revenue Recognition ASC 606, currently the accounting each month is simply:
Dr Sales commission expense $xx,xxx
Cr Bank Account $xx,xxx
The new process will require an additional two steps each month. The example below assumes a 36 month amortization period.
1) Adjusting journal to reflect 606 recognition of the expense – calculated as follows
Dr Asset = $total commission payable – $total commission payable / 36
Cr Sales commissions expense = $total commission payable – $total commission payable / 36
2) Scheduled journal to amortize the existing book of commission paid on opportunities – calculated as follows
Dr Sales commission expense $total current asset value / 36
Cr Asset $total current asset value / 36
There is a debate within the SaaS industry with regards to the appropriate number of years to amortize the commission expense.
Many companies are leaning towards 5-6 year amortization periods. Others are advocating a 36 month period. The argument for 36 months is that this is reflective of the customer lifetime value and the technology lifecycle. That is, a customer might be an active customer for eight years but after three years the product being paid for has almost totally changed since the initial purchase order.
How Performio Helps
Our product already includes the granular data needed to support the production of the journal entries.
Performio will be adding some new features to make Revenue Recognition ASC 606 compliance a less onerous accounting task. The ASC 606 accounting journals (as described above) relating to sales commissions will be sourced from within the application. That is, subsequent manipulation will not be required to produce the journals.
Revenue Recognition ASC 606 Features
There will be a clean register of Sales Orders detailing
- The total commission paid per Order ID (e.g. Opportunity ID).
- The month the Order ID was paid.
- Granular detail of payments “per product” per OrderID.
- Deferred commissions and bonuses would also need to be accounted for.
- There will be a separate “Revenue Recognition ASC 606” table (separate to the Sales commission table) that keeps a record of the total commission paid per Order ID.
How It Looks
The table structure will facilitate a “bottom-up” approach to calculating the above journal entries
Every opportunity will record these items PER PERIOD
- Total Commission Paid
- Product Category
- The period in which commission was paid
- Amortization amount (a) / 36)
- PTD amount expensed
- Asset balance
The opportunity record is closed when the balance reaches $0.
We will also apply an adjustment record where the customer churns early.
The system will show the order-level detail.
We will also show the calculated Journal entries based on the calendar month selected.