What is ASC 606?
ASC 606 is the revenue recognition standard issued by the Financial Accounting Standards Board (FASB) for all US GAAP reporting companies that outlines the principles for recognizing revenue from contracts with customers.
This (not so) new standard requires companies to recognize revenue based on the transfer of control of goods or services to customers, rather than based on the timing of cash receipts.
What does ASC 606 mean for SaaS companies?
For SaaS companies, the impact of ASC 606 is significant, as it requires companies to take a more detailed look at their customer contracts and the way they deliver their products or services to customers.
In particular, SaaS companies need to pay close attention to how they recognize revenue for contracts with multiple performance obligations, such as providing ongoing support and maintenance services.
How can SaaS companies comply with ASC 606?
To comply with ASC 606, there are 5 key steps that a SaaS company should take:
- Identify customer contracts: Review your existing contracts and determine which ones fall under the scope of ASC 606.
- Identify performance obligations: Determine the individual goods or services that are being provided to the customer under each contract, and evaluate whether they are distinct or should be combined.
- Determine the transaction price: Calculate the total amount of consideration that you expect to receive from the customer under the contract.
- Allocate the transaction price: Allocate the transaction price to each performance obligation based on its standalone selling price.
- Recognize revenue: Recognize revenue when or as you satisfy each performance obligation.
Let’s take a close look at each one of these steps.
Step 1: Identify customer contracts
The first step is to identify the contract with the customer, which is an agreement between the company and the customer that creates enforceable rights and obligations.
To determine whether a contract falls within the scope of ASC 606, consider the following criteria:
- The contract must be between your company and a customer.
Example: Your SaaS company enters into a contract with a customer to provide cloud-based software for a monthly subscription fee.
- The contract must have commercial substance, meaning that the contract is expected to result in a change in your company's cash flows
Example: Your SaaS company enters into a contract with a customer to provide a one-time training session on how to use the software. The training session has a price, but it does not have commercial substance because it is not expected to result in a change in your company's cash flows.
- The contract must be enforceable, meaning that both your company and the customer can enforce the terms of the contract.
Example: Your SaaS company enters into a contract with a customer that includes penalties for non-performance by either party. The contract is enforceable because both parties can enforce the terms.
- The contract must include identifiable performance obligations, which are promises to transfer goods or services to the customer.
Example: Your SaaS company enters into a contract with a customer to provide software and customer support services for a monthly fee. The software and customer support services are identifiable performance obligations because they are promised in the contract.
- The contract must have a transaction price that is determined or determinable.
Example: Your SaaS company enters into a contract with a customer to provide software and customer support services for a monthly fee of $100. The transaction price is determined because it is specified in the contract.
Step 2: Identify performance obligations
The second step is to identify the performance obligations in the contract, which are the promises to transfer goods or services to the customer.
To identify performance obligations under a contract, you will need to analyze the terms of the contract and assess whether each promised good or service is distinct.
Let's say your SaaS company enters into a contract with a customer to provide access to your software platform, along with training and technical support services.
The contract specifies that the customer will pay $10,000 for a one-year subscription to the software platform, along with $2,000 for training services and $3,000 for technical support services.
To identify the performance obligations under this contract, you would first need to identify the promised goods or services. In this case, the promised goods or services are:
- Access to the software platform
- Training services
- Technical support services
Next, you would need to evaluate whether each promised good or service is distinct. Access to the software platform is likely to be distinct because the customer can benefit from it on its own. However, training and technical support services may not be distinct, because they are provided in conjunction with the software platform and are necessary for the customer to effectively use the platform.
Therefore, you may need to combine the training and technical support services with the software platform to create a distinct performance obligation. This would involve determining the extent to which the training and technical support services are interdependent with the software platform and whether the customer could obtain the same benefit from the software platform without the services.
Step 3: Determine the transaction price
The third step is to determine the transaction price, which is the amount of consideration that the company expects to receive in exchange for transferring the promised goods or services to the customer.
Let's say your SaaS company has signed a contract with a customer to provide access to your software for one year, and the contract includes the following terms:
- The contract price is $120,000.
- The customer is entitled to a 10% discount if they pay the full amount upfront.
- The customer is required to pay an additional fee of $5,000 if they exceed a certain number of users.
- The contract includes a financing component, and the payment terms allow the customer to pay in three equal installments over the year.
- There are no non-cash considerations or considerations payable to the customer.
To determine the transaction price, you need to consider all of the following:
A. Variable consideration: The contract includes a discount of 10% if the customer pays the full amount upfront. Since the discount is optional and depends on the customer's payment behavior, it is considered variable consideration.
You estimate the transaction price as follows:
Contract Price - (discount % * contract price) 120000 - (10%*120000) = $ 108,000
B. Time value of money: The contract includes a financing component that allows the customer to pay in three equal installments over the year. This creates a significant financing component that needs to be accounted for.
Assuming an interest rate of 5%, you estimate the transaction price as follows:
Time Value of Money
Present value / ( 1+ Interest rate %) $108,000 / ( 1+5%) =$102, 857.14
C. Non-cash consideration: There are no non-cash considerations in this contract.
D. The consideration payable to the customer: There is no consideration payable to the customer in this contract.
Step 4: Allocate the transaction price
The fourth step is to allocate the transaction price to the performance obligations identified in step 2 based on their relative standalone selling prices.
This would involve determining the standalone selling price of each distinct performance obligation, based on what the customer would be willing to pay for each obligation on a standalone basis.
In the example above, you also have to allocate the transaction price to the performance obligations: The transaction price of $102,857.14 is allocated to the single performance obligation, which is to provide access to the software for one year.
Step 5: Recognize Revenue
The fifth and final step is to recognize revenue as the company satisfies its performance obligations. This can be done either at a point in time or over time, depending on the nature of the goods or services being transferred to the customer.
It's important to note that under ASC 606, revenue is recognized when control of the promised goods or services is transferred to the customer. This is a shift from the previous revenue recognition standard, which recognized revenue based on the completion of various milestones.
As a SaaS company, you may have performance obligations that are satisfied over time, such as hosting or maintenance services. In this case, you would need to use a method to measure progress toward completion, such as the input method or the output method, to recognize revenue over time.
Suppose your SaaS company enters into a 1-year contract with a customer for a subscription service that costs $120,000 per year. Under the contract, the customer pays the entire $120,000 upfront.
Under ASC 606, your company cannot recognize all $120,000 as revenue upfront. Instead, your company must recognize revenue over the 1-year subscription period as the performance obligations are satisfied. Let's say your company has determined that the performance obligation is satisfied evenly over the subscription period, so you will recognize $10,000 of revenue each month for the duration of the contract.
The cost of not complying with ASC 606 can be significant and can impact a company's financial stability, regulatory compliance, customer relationships, and operational efficiency. As such, companies need to ensure that they comply with ASC 606 guidelines.
To comply with ASC 606, your SaaS company may need to make changes to your accounting policies and practices, such as revising your revenue recognition policies, modifying your contract management processes, and updating your financial reporting procedures.
It’s important to ensure that your company’s systems and processes are aligned with the new standard to ensure accurate and timely compliance.
In addition, it’s important to work closely with your auditors and other financial advisors to ensure that your company is in compliance with the new standard and that any necessary adjustments are made to your financial statements.
ASC 606 is a complex standard, and it’s important to ensure that your company is following it correctly to maintain the integrity of your financial reporting.
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