What subscription-based companies need to know about ASC 606
ASC 606: Revenue from Contracts with Customers is a new revenue recognition standard applicable to non-public companies in 2019. (Technically, for annual reporting periods beginning December 15, 2018.) Public entities were required to switch over last year. So, I’m talking to you, Private Co.
What does “Revenue from Contracts with Customers” have to do with your cancel-at-any-time subscription service? Probably more than it seems.
First, some basics. Accountants use these guidelines called Generally Accepted Accounting Principles, or GAAP, to report on a company’s sources and uses of capital. ASC 606 replaces well over 150 individual pieces of guidance that instructed accountants how to recognize revenue relating to all types of contracts for things from software (with or without services), tic tacs, lawyering, building malls, and making dog food. With ASC 606 we’re not talking about revenue from leases, stocks, or other instances where revenue is not earned from a client contract. We’re looking at what would be considered the company’s product or service by a reasonable person.
Second, revenue is hugely important. How revenue is calculated impacts everyone! Investors, distribution partners, fulfillment, finance, IT, marketing, and sales. Everyone. Just to emphasize the point, I’ll use a double negative: No one doesn’t care about revenue. Think sales quotas. Lifetime value. Executive bonuses. You get the point.
The internet is filled with all kinds of superb places to find very technical information on ASC 606.
Here are my two big take-aways from this new piece of guidance.
DELIVERY vs. PERFORMANCE OBLIGATIONS
Before ASC 606, for most customer contracts, the final criteria to recognize revenue was to demonstrate that the company delivered what it said it would. In other words, the company would have to demonstrate that “delivery occurred.” With ASC 606, this no longer exists. Now, companies have to “satisfy a performance obligation” as the last gate to earn revenue. The difference may seem nuanced, but do you have a crystal-clear understanding of what your performance obligations are to your customers?
A simple example. Let’s say I buy a couch from Ikea to be delivered to my home. Is Ikea obligated to deliver a couch? Or a big box of couch parts? What if there is one bolt missing and I’m swearing at Ikea, unable to assemble the couch until they deliver it? What if 99% of the parts are delivered? In this new era, they won’t be able to recognize 99% of the revenue because they have not met its obligation to deliver 100% of the couch.
Consider your business model. Can you describe to me what exactly what your performance obligation are to your clients? Most companies can’t. Really. Because it is a ton of stuff, peppered all across the organization.
For example, do you offer the right to return? A discount on future orders? Warranties? Loyalty programs? Referral programs? Access to something else licensed or borrowed by you? In exchange for their money, did you agree to provide your customer anything in addition to what they are subscribing to?
I bet yes.
Looking to the performance obligations rather than to a simple internal standard of delivery is what I call customer-centered accounting.
To me, the key takeaways in ASC 606 are:
Generally, internal milestones do not count towards revenue recognition. Your ability pack a box does not impact the books.
“Percent Complete” is on life-support. You may have shipped 50% of the boxes your client is entitled to, but that does not mean you can earn 50% of the revenue.
Self-compliance is critical. Don’t depend on your auditors tell you what your performance obligations are.
When marketing programs change, your obligations change, and your revenue changes. If your marketing department creates performance obligations through offers or incentives, be prepared to track both your obligations and your fulfillment of these obligations.
EARNED vs. REALIZED REVENUE
The other big change ASC 606 makes to our world is the new definition of “contract.” I mean, this was motherhood-and-apple-pie. Not anymore. Does the contract need to be in writing? No. Do they need to have “commercial substance?” Yes.
Here’s how ASC 606 defines a contract, in excerpts:
…parties of the contract have approved and are committed to the fulfillment of the contract
…the entity can identify payment terms and each party’s rights regarding the goods and services to be transferred
…the contract has commercial substance (risk, timing, or amount of future cash flows are expected to change as a result of the contract)
…collection of consideration is probable
Translation? If you do something for a client, but your future cash flow is not expected to change, then ASC 606 does not believe you have a contract. No contract? You are not entitled to recognize revenue that results from that relationship.
This brings revenue recognition more in line with the spirit of its intention.
No cash. = No contract. = No recognized revenue.
For us accounting nerds, this eliminates the concept of “unrealized revenue” which has no obligation to actually become “realized revenue.” Now a company cannot write off deferred revenue when clients, who are not obligated to pay, don’t pay.
WAAAAAAAAA??? Who does this?
Let’s be real here. Part of the reason why these revenue recognition rules needed to be updated is because they were terribly complicated. Some accountants specialize in a very narrow band of revenue accounting. The more complicated the rule, the more complicated the get-around. The need for specialists and consultants is a direct result of the complexity of the revenue rules. This change helps move away from a dependency on these specialists. No cash. = No contract. = No recognized revenue. Pretty simple, right?
There are still lots of unanswered questions as to how ASC 606 will play out in the real world. The first 10-Ks will be like the canary in the coal mine in the Private Co subscription ecosystem. Once they are issued, we will be able to dissect how the auditors are handling this standard. Stay tuned!
More of a listener than a reader? Check out my webinar offered through Subscription Insider: Understand New Tax and Revenue Reporting Requirements For Your Subscription Business (September 2018).