15.1 The ASC 606 Five-Step Revenue Recognition Model

15.1 The ASC 606 Five-Step Revenue Recognition Model

In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued ASU 2014-09, codified as ASC 606 (Revenue from Contracts with Customers). This historic accounting standard replaced virtually all legacy, industry-specific revenue recognition rules under US GAAP (such as specialized software or real estate revenue recognition guidance) with a unified, principles-based framework. The core principle of ASC 606 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

To apply this core principle, ASC 606 establishes a rigorous Five-Step Revenue Recognition Model:

1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognize revenue when (or as) the entity satisfies a performance obligation

This section explores the technical details, accounting criteria, and practical applications of the first three steps of this model.

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Step 1: Identify the Contract with a Customer

A contract is an agreement between two or more parties that creates enforceable rights and obligations. Under ASC 606-10-25-1, a contract with a customer exists only when all five of the following criteria are met:

1. Approval and Commitment: The parties to the contract have approved it (whether in writing, orally, or in accordance with other customary business practices) and are committed to performing their respective obligations.
2. Identification of Rights: The entity can identify each party's rights regarding the goods or services to be transferred.
3. Identification of Payment Terms: The entity can identify the payment terms for the goods or services to be transferred (e.g., net 30 days, progress payments).
4. Commercial Substance: The risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract.
5. Probability of Collection: It is probable that the entity will collect the consideration to which it will be entitled. Under US GAAP, "probable" is defined as "likely to occur" (generally interpreted by practitioners as a threshold of approximately 75% to 80% or higher). In evaluating collectibility, the entity considers only the customer's ability and intention to pay that amount of consideration when it is due.

Accounting for Consideration Received Before Contract Establishment

If a contract does not meet the five criteria above, any consideration received from the customer must be recognized as a liability (typically deferred revenue or customer deposit). The entity can only recognize this cash as revenue when one of the following events occurs:

• The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received and is non-refundable.
• The contract has been terminated, and the consideration received from the customer is non-refundable.

Contract Modifications

A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties. Under ASC 606, a contract modification is treated as a separate contract if and only if both of the following conditions are met:

• The scope of the contract increases because of the addition of promised goods or services that are distinct; and
• The price of the contract increases by an amount of consideration that reflects their standalone selling prices (SSP), adjusted for contract-specific circumstances.

If these criteria are not met, the modification is accounted for as:

• Prospective Adjustment: If the remaining goods or services are distinct from those already transferred, the entity terminates the old contract and creates a new one, allocating the remaining transaction price to the remaining performance obligations.
• Cumulative Catch-Up Adjustment: If the remaining goods or services are not distinct, the modification is treated as part of the original contract. The entity updates the transaction price and measure of progress, creating an immediate adjustment to revenue (recognized as a gain or loss in the current period).

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Step 2: Identify the Performance Obligations

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

• A good or service (or a bundle of goods or services) that is distinct; or
• A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.

Criteria for a "Distinct" Good or Service

A good or service promised to a customer is distinct if both of the following criteria are met:

1. Capable of being distinct: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (i.e., the good or service can be sold separately).
2. Distinct within the context of the contract (Separately Identifiable): The promise to transfer the good or service is separately identifiable from other promises in the contract.

Evaluating whether promises are "Separately Identifiable"

FASB provides specific indicators to determine when promised goods or services are not separately identifiable (and must therefore be combined into a single performance obligation):

• Significant Integration Service: The entity provides a significant service of integrating the goods or services with other goods or services into a combined output for which the customer contracted (e.g., integrating various software modules and hardware components into a customized IT infrastructure).
• Significant Modification or Customization: One or more of the goods or services significantly modifies or customizes (or is significantly modified or customized by) one or more of the other goods or services in the contract (e.g., custom software modification to run on a customer's proprietary operating system).
• Highly Interdependent or Interrelated: The goods or services are highly dependent on, or highly interrelated with, other goods or services in the contract (e.g., design and manufacturing services where the design cannot be used without the manufacturing, and vice versa).

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Step 3: Determine the Transaction Price

The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (such as sales taxes).

In determining the transaction price, the entity must account for the effects of all the following elements:

1. Variable Consideration

If the consideration promised in a contract includes a variable amount (e.g., rebates, discounts, refunds, performance bonuses, penalties, or price concessions), the entity must estimate the amount of consideration.

• Expected Value Method: The sum of probability-weighted amounts in a range of possible consideration amounts. This method is most appropriate when the entity has a large number of contracts with similar characteristics.
• Most Likely Amount Method: The single most likely amount in a range of possible outcomes. This method is most appropriate when the contract has only two possible outcomes (e.g., an entity either achieves a performance bonus or does not).

The Variable Consideration Constraint

An entity can include variable consideration in the transaction price only to the extent that it is probable that a significant reversal in the cumulative amount of revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

2. Significant Financing Component

If the timing of payments agreed to by the parties to the contract provides the customer or the entity with a significant benefit of financing the transfer of goods or services, the transaction price must be adjusted for the effects of the time value of money.

• Interest Accrual: If financing exists, the entity recognizes interest revenue (if the customer is financed) or interest expense (if the entity is financed by receiving advance payments).
• Practical Expedient: An entity is not required to adjust the promised amount of consideration for the effects of a significant financing component if the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service is one year or less.

3. Non-Cash Consideration

If a customer promises consideration in a form other than cash (e.g., equity shares, materials, equipment, or advertising), the entity measures the non-cash consideration at its fair value at contract inception. If the fair value cannot be reasonably estimated, the entity refers to the standalone selling price of the goods or services promised to the customer.

4. Consideration Payable to a Customer

Consideration payable to a customer includes cash amounts, credits, or coupons that the entity pays, or expects to pay, to the customer. The entity accounts for consideration payable to a customer as a reduction of the transaction price (and, therefore, a reduction of revenue) unless the payment is in exchange for a distinct good or service that the customer transfers to the entity.