The Scope and Core Principle of ASC 606

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Rarely is there an accounting change that affects all companies and all industries, however Accounting Standards Codification 606 is one such change.   Almost all entities within almost all industries will be affected by ASC 606 because of the changes in the disclosure requirements.

Scope of ASC 606

ASC 606 specifically addresses the recognition of revenue from contracts with customers.  It affects how most exchange transactions are recognized and the amount of change highly depends on the nature and terms of the entity’s revenue-generating transactions. 

Revenue is defined as inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Customer is defined as a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.

Core Principle of ASC 606

The core principle underlying ASC 606 is to 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.  There are five key steps to follow to ensure that the core principle is being applied to all revenue transactions properly.  The five steps are as follows:

  • Identify the contract with the customer
  • Identify the performance obligations in the contract
  • Determine the transaction price
  • Allocate the transaction price to the performance obligations
  • Recognize revenue when each performance obligation is satisfied

Identify the contract with the customer

The first step is to determine if a contract exists with the customer.  A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations.  Further, ASC 606 is applicable to contracts that meet the following:

  • Approvals have been obtained and a commitment to perform exists on the part of both parties
  • Rights of both parties are identifiable
  • Payment terms are identifiable
  • Commercial substance exists
  • Collection of substantially all of the amount to which the entity will be entitled in exchange for the goods and services that will be transferred to the customer is probable

Identify the performance obligations in the contract

The second step is to identify the performance obligations in the contract.  These are the units of account to which the transaction price should be allocated and for which revenue is recognized.  All promises to provide a good or service are identified and then it is determined if the promises are performance obligations and should be accounted for separately.

Determine the transaction price

The transaction price is determined as 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.  Customary business practices should also be taken into consideration when determining the transaction price.

Allocate the transaction price to the performance obligations

For this step, the goal is to allocate an amount to each performance obligation that represents the consideration to which the entity expects to be entitled as a result of transferring control of the underlying goods and services to the customer.  The transaction price must be allocated across the performance obligations if the contract has multiple performance obligations.

Recognize revenue when each performance obligation is satisfied

Revenue is recognized when the performance obligation is satisfied, which is accomplished when the control of the underlying good or service is transferred to the customer.  The transaction price allocated to the obligation is the amount that will be recognized.