How Do You Book a Revenue Recognition Journal Entry Under ASC 606?
ASU 2014-09 Topic 606 (ASC 606), Revenue from Contracts with Customers, has been called the biggest change to financial accounting standards in the last 100 years. This new standard was issued jointly by FASB as ASC 606 and by the IASB as IFRS 15. ASC 606 replaces the ad-hoc, industry-specific, rules-based approach of legacy GAAP with a principles-based approach that applies to all industries. Doing away with specific revenue recognition rules will require more judgment and interpretation. Public companies have been applying it since 2018, while private companies have to apply it to financial periods starting after December 15, 2019.
What is Revenue Recognition?
Getting the journal entries for ASC 606 correct means we first need to define revenue recognition. Under cash basis accounting, customer sales are recognized as sales revenue as soon as the cash payment is received from the customer. But under the accrual basis of accounting, the revenue recognition principle requires revenue to be recognized as it is earned, which isn’t necessarily the same timing as the related cash flows.
For example, let’s say Cloud Company enters a three-year contract with Green Company for an annual fee of $120,000 payable at the beginning of each year. On January 1, Cloud Company received $120,000. On the cash basis of accounting, the entire cash payment of $120,000 is recognized on January 1, as soon as the customer pays. But following generally accepted accounting principles, or GAAP, that same $120,000 is recognized in monthly increments of $10,000 as services are provided to Red Company.
What are the criteria for revenue recognition?
Under the previous accounting principles, revenue was recognized on the income statement when goods or services were exchanged for cash or a promise to pay cash, and when the revenue had been earned, following industry-specific rules. ASC 606 replaces revenue recognition rules with a five-step process for recognizing revenue.
- Identify the contract with a customer. Legacy GAAP required a signed contract as evidence of a contract, but under ASC 606, all that’s required is a legally enforceable agreement. A contract exists if there is a transaction (a) for a business purpose, (b) approvals and commitments are in place, (c) the rights for each party are identifiable, (d) payment terms are identified, and (e) collection of the full fee is likely to occur.
- Identify the performance obligations. Components of the contract are separated if these also exist as stand-alone items or if they have value to the buyer on their own. Contracts that include a sale of goods and related services, such as implementation or installation, may have separate performance obligations for the goods and the provision of the services.
- Determine the transaction price. The transaction price includes all fixed cash payments and the estimated fair value of any noncash consideration that are part of the selling price. Estimates of future bonuses, penalties, or rebates are also included, even if the exact amounts are not yet known.
- Allocate the transaction price to the performance obligations. If the contract includes multiple components, the price must be allocated to these. The simplest method in ASC 606 uses the stand-alone prices for the components. Another method applies a profit margin to the estimated costs for each component.
- Recognize revenue as the performance obligations are satisfied. Under ASC 606, the trigger for recognizing revenue is the transfer of control of the goods or services. Revenue may be recognized over a period of time or at a single point in time, depending on the nature of the goods or services and the terms of the transaction.
For many companies, the only significant change to their financial reporting is additional disclosures in their financials. However, SaaS companies and companies that provide a combination of goods and services will need to carefully evaluate their contracts before recording revenue.
How are Contract Costs Accounted For?
The matching principle requires recognition of expenses in the same period as the related revenues. Because the timing of revenue recognition changes under ASC 606, the recognition of certain contract costs also changes. The treatment of contract costs is defined in a separate sub-topic of ASC 606, ASC 340-40.
Costs that are already accounted for under separate standards, such as ASC 330 for inventory and cost of goods sold or ASC 360 for property, plant, and equipment, are to be accounted for using those standards. However, for costs that don’t fit under an existing standard, ASC 340-40 requires certain costs to be capitalized.
In general, the costs of obtaining a contract or fulfilling that contract must be capitalized if the following three criteria are met:
- Incremental costs directly related to a specific contract
- Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract
- Costs that are expected to be recovered from the customer
This means that companies will be capitalizing costs that they had previously expensed, so they may see an increase to net income. To test whether a cost should be capitalized or expensed, consider whether that cost would still be incurred if all parties walked away just prior to signing the contract. For example, sales commissions related to a specific contract are capitalized, but travel expenses to present a proposal to a prospect are not. Similarly, the legal costs to prepare the contract can be expensed. Bonuses tied to a specific contract are capitalized, but bonuses tied to overall company performance can be expensed.
The capitalized costs show up on the income statement by amortizing them over the length of the contract. In some situations, the amortization period may include likely renewals. This may result in contract costs being amortized over a longer period than the original contract.
How to Record the Journal Entries
Once you’ve identified exactly how the standard will affect your industry and your business, it’s time to identify how to make a more accurate journal entry for revenue recognition. Let’s walk through the process of recording revenue recognition journal entries with the following journal entries.
Journal: Revenue Recognition under ASC 606
Frequency: Each reporting period (i.e. monthly), or as performance obligations are satisfied
FloQast folder location: ‘Deferred Revenue’ is an area of your balance sheet, and will have a corresponding folder in FloQast (LEARN MORE ABOUT FLOQAST FOLDERS)
The Debits & Credits
When you invoice the client, you record the receivable and corresponding deferred revenue liability:
|Deferred Revenue (liability) – Performance obligation A||$10,000|
|Deferred Revenue (liability) – Performance obligation B||$5,000|
|Deferred Revenue (liability) – Performance obligation C||$85,000|
Memo: To record deferred revenue when invoicing a client
As performance obligations are satisfied, you’ll debit (reduce) Deferred Revenue and credit (increase) the appropriate amount of Revenue:
|6/30/17||Deferred Revenue (liability) – Performance obligation A||$10,000|
|Deferred Revenue (liability) – Performance obligation C||$7,083|
|Revenue – Product line XYZ||$10,000|
|Revenue – Product line ABC||$7,083|
Memo: To record revenue performance obligations satisfied in June
You should be able to identify all the contracts, by performance obligation, that roll up into your deferred revenue balance at each month end. (CLICK HERE FOR 3 BEST PRACTICE EXCEL RECONCILIATION TEMPLATES)
- Contracts not designed with the new revenue recognition standards in mind: Make sure your contracts will facilitate accounting. This is also an opportunity to standardize or simplify contract provisions.
- Not bringing in your CPA early enough: Don’t wait until audit fieldwork time to show your CPA how you’ve adjusted your accounting, reporting, and disclosures. Talk to them early and often about how ASC 606 journal entries might affect your company.
- Not having the right software: your billing software may no longer be sufficient. Be sure to understand if your technology needs have changed. You may also need a software solution to help manage your contracts.
- If applicable to your business, make sure you read up on the 5 elements of a “contract:” cancellation rights, contract modifications, refund liabilities, financing components of a contract, royalties, variable consideration, discounts, and even the recognition of related expenses like customer acquisition costs (aka deferred commission). ASC 606 includes provisions that address these.
How Auditors Audit
Auditors will vouch the revenue accounting entries on your financial statements right back to your contracts. Make sure your company maintains up-to-date contract documentation, has a clean sales order to cash process, and records revenue granularly – right down to the contract line item level.