In 2014, the Financial Accounting Standards Board introduced one of the most important developments in the accounting business. It was the bringing forth of something called ASC 606.
ASC stands for Accounting Standards Codification. The number 606 is because this is the 606th version of this standard, which replaced ASC 605. In this article, you are going to provide a basic understanding of what 606 is — and in a way that it might be explained to a beginner. So, let’s go!
Revenue Recognition
The first thing to understand is the basic concept of “revenue recognition.” This is considered the cornerstone of the process of accrual accounting. Accrual accounting is the addition of interest or other investments over a specified time.
Revenue recognition and accrual accounting work with the “matching principle.” This is the instruction that an expense must be reported at the same time at which a revenue is earned.
This is how the accountants organize the revenue earned from customer sales.
What is ASC 606
As commerce processes get more complex in your Digital Age and modern world, the way companies earn money has been evolving rapidly.
For example, an online or e-commerce company may collect revenues in complex ways by selling subscription products, charging fees, offering services, charging for repairs, selling maintenance contracts or offering warranties for a one-time fee.
All this revenue must be accounted for and kept track of in a very exact and specific way. Without it, a firm is basically working blind in terms of knowing its own revenue flow, the money it expects to receive, on what date and so forth.
Also, ASC 606 provides a crystal-clear picture of a company’s financial health. That’s important for investors as well as the people managing the company. They need to understand revenue flow to make key business decisions and plan for the company’s future growth.
Of course, the revenue numbers are important for compliance issues, such as paying taxes, reporting to government agencies that regulate some industries and more.
Key Terms
Here are some important terms to know and learn as they come into play with ASC.
- Contract – An agreement between two or several parties that governs obligations and enforceable rights.
- Contract Assets – This is a firm’s right to consideration in exchange for products and services that a company sells to customers.
- Contract Liabilities – An organization’s obligation to deliver goods and/or services for which it receives customer payments. This is similar to deferred revenues.
- Customer – Defined as a “party” that contracts with a company to obtain products and/or services resulting from the company’s routine output as part of its “ordinary activities” exchanged for consideration.
Disclosure Requirements for Private Companies
Disclosure requirements have become extremely complex, and understanding them within the context of 606 is important. There are five basic categories of disclosure:
1. Contracts with Customers
This includes two subcategories:
- Revenue recognized from customer contracts is separate from other kinds of revenue sources.
- Impairment losses are recognized on contract assets or receivables that come from a firm’s customer contracts.
2. Disaggregated Revenue
Examples of disaggregated revenue include things like the type of product or service, market type, type of customer, sales channels, geography and more. The new 606 requires that a firm must present additional information about revenue in such a way that it shows “the nature, timing, amount and potential uncertainty of cash flows that are derived from customer contracts.”
3. Reconciliation of Contract Balances
This pertains to opening and closing balances of contract-derived assets, liabilities and trade receivables.
4. Performance Obligations
This refers to the balance of “unsatisfied or partially unsatisfied performance obligations.
5. Significant Judgments
This refers to performance obligations satisfied over time. The rules state that a firm must describe its methods to recognize revenue. The latter includes a description of input-output methodologies and more.
A Challenge to Comprehend
Keep in mind that this article offers a bare-bones basic definition of this new ASC. Grasping this subject in depth is challenging and is the realm of highly trained professional accountants and CPAs.
Even so, a thorough working understanding of this accounting process is of prime importance for both privately held business models, public entities and non-profit organizations alike.
