Revenue recognition continues to be a critical issue for the SaaS industry, as SaaS businesses have been particularly impacted due to their complex subscription models, pricing structures, and recurring revenue contracts. How can SaaS companies stay compliant with Accounting Standards Codification (ASC) 606 and set themselves up for success?
In this article, we’ll navigate the requirements of ASC 606, answer commonly asked questions, and provide some best practices to build more efficiency into your revenue recognition process.
What is ASC 606?
ASC 606, Revenue from Contracts with Customers, is the latest accounting standard for revenue recognition. Developed by the Financial Accounting Standards Board (FASB), ASC 606 sets out the principles and requirements for recognizing revenue from contracts with customers across all industries.
ASC 606 was implemented to establish a single, principles-based standard for revenue recognition in the United States, replacing the industry-specific guidance of ASC 605. The standard aims to provide greater comparability, transparency, and consistency in revenue recognition, helping businesses and organizations to better understand the timing, amount, and uncertainty of revenue.
When compliant under ASC 606, companies can expect the following benefits:
- Enhanced comparability: ASC 606 aims to provide a single, principles-based standard for revenue recognition across industries. This enhances the comparability of financial statements among companies, making it easier for investors, stakeholders, and users of financial statements to understand and compare performance across different entities.
- Improved financial visibility: A lack of standardization has led to gaps in comparability, poor disclosure requirements, and revenue reporting discrepancies. ASC 606 allows external parties, such as shareholders, investors, or banks to have an accurate picture of revenue earned over a certain amount of time, leading to increased and more consistent financial visibility.
- Consistency in revenue recognition: ASC 606 promotes consistency in revenue recognition practices by focusing on the transfer of control as the core principle. It provides a structured five-step model that guides companies in recognizing revenue based on the satisfaction of performance obligations. This consistency improves the reliability and accuracy of reported revenue figures.
- Addressing industry-specific challenges: ASC 606 provides specific guidance for industries with complex revenue recognition arrangements, such as the SaaS industry. It helps address industry-specific challenges, ensuring that revenue is recognized appropriately and in accordance with the principles of the standard.
Who is required to adopt ASC 606?
ASC 606 applies to all businesses or organizations that enter into contracts with customers to transfer goods or services. The companies required to adopt ASC 606 include, but are not limited to:
- Publicly traded companies: Publicly traded companies, including those listed on stock exchanges, are required to adopt ASC 606. This applies to companies filing financial statements with the U.S. Securities and Exchange Commission (SEC).
- Private companies: Private companies are also required to adopt ASC 606. The standard applies to companies that follow Generally Accepted Accounting Principles (GAAP) in the United States for their financial reporting.
- Nonprofit organizations: Nonprofit organizations that follow GAAP for their financial reporting are required to adopt ASC 606 if they enter into contracts with customers to transfer goods or services.
Who is exempt from ASC 606?
Certain entities are exempt from ASC 606, including certain types of leases, insurance contracts, financial instruments, guarantees, and nonmonetary exchanges between entities in the same line of business. It is advisable for entities to consult with accounting professionals or auditors to determine the applicability of ASC 606 to their particular situation.
How does ASC 606 apply to SaaS companies?
ASC 606 provides a clear framework for SaaS companies to recognize revenue. Many of the changes heralded in ASC 606 reflect the evolving business models of SaaS companies, where there is less of a clear line between a customer paying and services or products being delivered.
In the old days of software, a customer would purchase a piece of software that they would own. They could install the software on their computer and immediately get access to the product. In this scenario, it's clear that when the customer pays for the software, the product or service is immediately delivered.
Today's software world, however, is vastly different. While customers can pay for a SaaS product upfront, they don't typically own the software and are only given access to it. Payment is often collected at predefined intervals (e.g., monthly, quarterly, annually, etc.) on an ongoing basis. Customers can choose to upgrade, downgrade, change the number of licenses, or otherwise modify their subscription on the fly, making it a bit more complex in understanding exactly when revenue should be recognized by the business.
ASC 606 helps to remedy the complex nature of SaaS business models by providing a comprehensive framework for revenue recognition, including a principle-based approach and five-step model to revenue recognition.
What are the 5 steps of revenue recognition under ASC 606?
For SaaS companies, ASC 606 outlines the principles for recognizing revenue from contracts based on the transfer of control of promised goods or services to customers. Here are some key considerations for your business under ASC 606:
Step 1: Identifying the Contract with the Customer
The contract should clearly specify the rights and obligations of both the customer and the company. It should outline the services to be provided, any performance obligations, and the payment terms, including the pricing and payment schedule. SaaS companies must ensure that both parties have approved the contract and are committed to fulfilling their respective obligations. This typically involves assessing whether the customer has committed to pay the consideration and your company has committed to providing the services. Additionally, your company must determine the amount of payment (consideration) they expect to receive from the customer under the contract.
Step 2: Identifying the Performance Obligations in the Contract
Next, determine the distinct items or services (performance obligations) promised to the customer within the contract. This involves evaluating whether each promised item can be considered separately identifiable and capable of being distinct. A performance obligation is considered separately identifiable when the customer can clearly see the distinct benefit or easily understand the value provided by the specific item or service. If the specific item or service can be used or enjoyed independently or with other resources that are readily available to the customer, it is likely to be considered distinct. Conversely, if a change in the contract impacts the standalone value, the item or service is not distinct.
Step 3: Determining the Transaction Price
Once you’ve identified the performance obligations, determine the transaction price by considering all relevant factors that could affect the consideration you expect to receive in exchange for transferring the promised goods or services to the customer.
To calculate the transaction price, start by identifying the various elements of the transaction, which may include the base subscription fee, implementation fees, customization charges, or any other elements agreed upon in the contract.
Next, evaluate both fixed and variable components of the transaction price. Fixed consideration refers to the amount that is agreed upon and does not fluctuate based on future events or performance. Variable consideration, on the other hand, represents amounts that may vary due to factors, such as discounts, refunds, or credits. For variable consideration, your company can estimate the amount using either the expected value method or the most likely amount method. The expected value method involves assigning probabilities to potential outcomes and calculating the weighted average of those outcomes. The most likely amount method relies on determining the single most likely outcome based on available information. If it’s not “probable” that a significant reversal of revenue will not occur, your company can apply a constraint to the estimated variable consideration. A constraint ensures that revenue recognition is conservative and reflects a more accurate representation of the revenue they will ultimately receive from the contract.
If your company agrees to receive payments over an extended period, it should account for the time value or money. This means that your company recognizes that the timing of cash flows affect the value of those cash flows. To account for the time value of money, adjust the transaction price to ensure that the revenue recognized over the contract term appropriately reflects the timing of cash flows.
If there are any contract modifications, your company must reassess the transaction price and adjust it accordingly based on the updated terms and conditions.
Step 4: Allocating the Transaction Price to the Performance Obligations
Once you calculate the transaction price, determine the standalone selling price for each performance obligation. The standalone selling price is the price at which the company would sell the good or service on a standalone basis if it were sold separately. Then, allocate the total transaction price to each performance obligation in proportion to the standalone selling prices. The objective is to reflect the amount of consideration your company expects to be entitled to for transferring each distinct good or service.
Step 5: Recognizing Revenue when (or as) the Performance Obligations are Satisfied
Lastly, your company recognizes revenue when (or as) the performance obligations are satisfied. If control of the specific items or services is transferred over time, revenue is recognized over the duration of the performance obligation. On the other hand, if control of the specific items or services is transferred at a point in time, revenue is recognized when control transfers to the customer. This typically occurs when there is a distinct event or milestone that signifies the transfer of control, like when your company delivers the software or grants access to the customer.
What are the key ASC 606 challenges for SaaS companies?
Timing and Allocation of Revenue
As per ASC 606, SaaS companies are required to recognize most of their revenue over the subscription period. SaaS companies offer a variety of product lines and pricing models to scale their business and meet the needs of their customers. This means revenue will be recognized at predefined intervals (monthly, quarterly, annually, etc.) as the company delivers the service to the customer. While revenue recognition for a few customers is manageable, building revenue recognition schedules according to payment terms for hundreds to thousands of customers can be a time-intensive process.
Identifying Performance Obligations
ASC 606 defines a performance obligation as any good or service the customer can benefit from. In other words, if your business provides a customer access to a single product, there would be one performance obligation in the contract. Challenges arise when you have multiple products and services included in the contract. If the products or services in the contract can be identified as separate promises, you have to recognize that revenue separately. Coupling support fees with add-on services and usage-based billing often leads to complex revenue scenarios.
In the SaaS world, it’s not uncommon for businesses to modify the contract before the end of the subscription period. Per ASC 606, judgment is required to determine whether contract modifications are to be accounted for as a separate contract, as a modification with a retrospective adjustment, as a modification with a prospective adjustment, or under a combination of the methods. While there is guidance, businesses may find it difficult to determine the appropriate accounting treatment. And when there are multiple different contracts with modifications you have to account for, things become hard to manage.
What are the differences between ASC 605 and ASC 606?
ASC 605 and ASC 606 are two different sets of accounting standards that govern revenue recognition. The main difference between the two standards lies in their approach to revenue recognition and the principles they emphasize. Here’s a breakdown of the key distinctions:
ASC 605 Revenue Recognition:
- Rules-based: ASC 605 is a rules-based standard that provides specific industry guidelines and criteria for revenue recognition. It consists of specific guidance for various industries, including software and technology companies.
- Multiple revenue recognition criteria: ASC 605 contains various criteria for revenue recognition, such as the passage of title and risks, delivery of goods, persuasive evidence of an arrangement, and fixed or determinable prices.
- Vendor-specific objective evidence (VSOE): Under ASC 605, companies often had to rely on VSOE of fair value to allocate revenue to different elements within a multiple-element arrangement, particularly in the software industry.
ASC 606 Revenue Recognition:
- Principle-based: ASC 606 is a principle-based standard that establishes a comprehensive framework for revenue recognition across all industries. It focuses on recognizing revenue when control of goods or services is transferred to customers in amounts that reflect the consideration the company expects to receive.
- Five-step model: ASC 606 introduces a five-step model for revenue recognition, emphasizing the identification of contracts, performance obligations, determination of transaction price, allocation of transaction price, and recognition of revenue when (or as) performance obligations are satisfied.
- More emphasis on control: ASC 606 places greater emphasis on the transfer of control as the key determinant for revenue recognition. It requires companies to assess whether control of goods or services has transferred to the customer over time or at a point in time.
- Enhanced disclosure requirements: ASC 606 also includes enhanced disclosure requirements, with companies being required to provide more information about the nature, amount, timing, and uncertainty of revenue and cash flows.
Overall, ASC 606 aims to provide a more consistent and comprehensive framework for revenue recognition across industries, focusing on the transfer of control and the depiction of the transfer of goods or services to customers. It replaces the industry-specific guidance of ASC 605 with a more principle-based approach.