Revenue Recognition Under ASC 606

ASC 606, Revenue from Contracts with Customers, establishes a comprehensive framework for determining when and how much revenue to recognize. This standard applies to virtually all industries and transaction types, making it critical for CMA candidates to master.

The Five-Step Revenue Recognition Model

Step 1: Identify the Contract with a Customer

A contract exists when all of the following criteria are met:

If collectibility is not probable, revenue is recognized only when:

• Performance is complete and substantially all consideration is received, OR
• The contract has been terminated and consideration received is nonrefundable

Exam Tip: "Probable" under GAAP means likely to occur (generally interpreted as >75% likelihood).

Step 2: Identify the Performance Obligations

A performance obligation is a promise to transfer to the customer either:

• A distinct good or service (or bundle of goods/services), OR
• A series of distinct goods/services that are substantially the same

A good or service is distinct if:

1. The customer can benefit from it on its own or with readily available resources, AND
2. It is separately identifiable from other promises in the contract

Common Performance Obligations:

Warranties:

• Assurance-type warranty: Not a separate performance obligation; accounted for under ASC 460 (Guarantees)
• Service-type warranty: Separate performance obligation; revenue deferred and recognized over warranty period

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration the entity expects to be entitled to in exchange for transferring goods or services. Consider these elements:

Variable Consideration:

• Discounts, rebates, refunds, credits, bonuses, performance incentives
• Estimate using expected value (probability-weighted amounts) or most likely amount
• Apply the constraint: Include variable consideration only to the extent it is probable that a significant reversal will not occur

Non-Cash Consideration:

• Measure at fair value
• If fair value cannot be reasonably estimated, use standalone selling price of goods/services promised

Consideration Payable to Customer:

• Reduces the transaction price unless it is payment for a distinct good/service

Significant Financing Component:

• Adjust transaction price for time value of money if payment timing provides significant financing benefit
• Practical expedient: Ignore if collection expected within one year

Step 4: Allocate the Transaction Price

When a contract includes multiple performance obligations, allocate the transaction price based on relative standalone selling prices (SSP).

Determining Standalone Selling Price:

Allocation Formula:

Allocated Price = (SSP of Obligation / Total SSP of All Obligations) x Transaction Price

Example: A company sells software ($80 SSP), installation ($30 SSP), and one-year support ($40 SSP) for a combined price of $120.

Step 5: Recognize Revenue

Revenue is recognized when (or as) each performance obligation is satisfied by transferring control to the customer.

Control Transfer Indicators:

• Entity has present right to payment
• Customer has legal title
• Customer has physical possession
• Customer has significant risks and rewards of ownership
• Customer has accepted the asset

Over Time Recognition:

A performance obligation is satisfied over time if ANY of these criteria is met:

1. Customer simultaneously receives and consumes benefits (e.g., monthly cleaning service)
2. Entity's performance creates or enhances an asset the customer controls (e.g., building on customer's land)
3. Entity's performance does not create an asset with alternative use AND entity has enforceable right to payment for performance completed

Measuring Progress (Over Time):

Cost-to-Cost Method (Most Common Input Method):

Revenue Recognized = (Costs Incurred to Date / Total Estimated Costs) x Total Contract Price

Contract Modifications

A contract modification is a change in scope, price, or both. The accounting treatment depends on whether the modification creates a separate contract:

Separate Contract Treatment (New Contract):

• Additional goods/services are distinct, AND
• Price increases by standalone selling price of additional goods/services

Modification of Existing Contract:

• If remaining goods/services are distinct: Allocate remaining transaction price prospectively
• If remaining goods/services are NOT distinct: Cumulative catch-up adjustment

Principal vs. Agent Considerations

When another party is involved in providing goods/services, determine whether the entity is acting as:

Exam Tip: The key question is whether the entity controls the good or service before it is transferred to the customer. If yes, the entity is a principal.

Contract Costs

Costs to Obtain a Contract:

• Incremental costs (e.g., sales commissions) expected to be recovered are capitalized as an asset
• Amortize over the period of benefit
• Practical expedient: Expense if amortization period is one year or less

Costs to Fulfill a Contract:

• Capitalize if not covered by other standards AND directly relate to the contract AND expected to be recovered
• Examples: Setup costs, design costs, direct materials

Disclosures

ASC 606 requires extensive disclosures including:

• Disaggregation of revenue by category
• Contract balances (receivables, contract assets, contract liabilities)
• Performance obligations (when satisfied, significant payment terms)
• Significant judgments (timing of satisfaction, transaction price estimation)