The new ASC 606 principle goes into effect in four months. Are you ready for this “accounting storm”?
The new ASC 606 accounting principle goes into effect for private companies at the end of this year. This new standard affects how SaaS enterprises account for revenue. In addition to core, recurring revenue, this also will change how implementation and setup fees, and sales commissions, are accounted for.
“We have before us a perfect accounting storm,” said Denis Pombriant of Beagle Research. It took the Financial Accounting Standards Board (FASB) – working with the International Accounting Standard Board – twelve years to create the standards, which completes its roll-out at the end of 2018. Many companies have been preparing for this new accounting principle for years and for some, it represents a heavy lift.
“The new standards are based on one overarching principle: companies must recognize revenue when goods and services are transferred to the customer, in an amount that is proportionate to what has been delivered at that point,” explains Forbes. It has been a struggle to regulate revenue reporting for the digital economy due to the ever-shifting nature of SaaS products. For example, many SaaS startups rely on subscription models, but this type of revenue is hard to report in the new regulation.
ASC 606 replaces all industry-specific guidance with a new 5-step process. Let’s review what the new process looks like, along with ways that a startup may especially be affected.
ASC 606 Step 1: Identify Contracts
Do you have a contract? Are you sure? Most of the time, a contract is pretty cut and dry for SaaS startups and their customers. But with the new ASC 606 regulations, there’s one little detail that you must pay attention to: “distinct” contracts.
If you have more than one contract with a client (for example, separating contracts for software and for training/implementation), these two contracts must truly be “distinct.” Otherwise, SaaS companies should combine them to form a single performance obligation. Here are some indicators that your contract can be classified as distinct:
- A customer benefits from each contract separately (not combined)
- The goods or services are non-transferable
- The contract is not part of a series or pattern of transfer
Particularly for SaaS startups, contracts should be combined for software and training/implementation. This is because the training/implementation does not provide a standalone value without the software. As always when it comes to compliance issues, you should consider consulting a professional as you build contract policies around the new revenue regulations.
ASC 606 Step 2: Identify Performance Obligations and Units of Accounting
Step 2 in the new revenue regulations involves a less-restrictive definition than the legacy GAAP (605). The new guidance found in 606 is more SaaS specific, and allows for a series of distinct good and services. Something to keep in mind is how critical it is for your tech startup to correctly identify and implement this step. It will be difficult to comply with 606 overall if you aren’t able to specify the distinct goods and services your startup offers.
Again, let’s look at what qualifies a good or service as being “distinct.” A SaaS startup can identify products or services as being distinct if:
- A customer can benefit from the product or service on its own or with readily-available resources AND
- The performance obligation is distinct within the contract: ex. SaaS contracts where an offered professional service is significantly changing the SaaS solution.
ASC 606 Step 3: Determine Transaction Price
Current guidelines are markedly different than the new 606 regulation when it comes to transaction price. In 2019, SaaS startups will be required to include variable considerations in their transaction price. As it stands today, considerations are fixed or determinable.
The following are considerations that can make a transaction price variable:
- Discounts or rebates
- Refunds or credits
- Performance bonuses
- Penalties and/ or contingencies
- Price Concessions
- Service Level Agreements (related refunds and credits)
Should a variable consideration exist, entities must estimate the amount of consideration to be received. Under this step, companies will recognize revenue earlier than current guidelines permit. A word of advice for new SaaS startups: now is a good time to get disciplined with cash.
Another change that this step brings is to consider significant financing components. Transaction prices may be affected by significant financing components if a customer pays more than one year in advance.
ASC 606 Step 4: Allocate Transaction Price to Different Units of Accounting
Many contracts involve the sale of more than one good or service. For example, they might involve the sale of multiple goods, goods followed by related services, or multiple services. The transaction price in an arrangement must be allocated to each separate performance obligation based on the relative standalone selling price (SSP) of the goods or services being provided to the customer. The allocation could be affected by variable consideration or discounts.
Maximize the use of observable inputs and be consistent when you apply estimation methods. Remember:
The Standalone Selling Price is NOT equal to the Price Per Listing!
Standalone selling price can be configured by different approaches. The goal in this practice is to establish what most people would pay for the good or service you offer. Approaches include:
- Adjusted Market Assessment
- Expected Cost Plus a Margin
- Residual Value Approach
Discounts and variable consideration are typically allocated to all of the performance obligations in an arrangement based on their relative standalone selling prices. However, if certain criteria are met, a discount or variable consideration is allocated to only one or more performance obligations in the contract, rather than to all performance obligations.
ASC 606 Step 5: Recognize Revenue when Performance Obligation is Satisfied
A performance obligation is satisfied, and revenue recognized, when control of the promised good or service is transferred to the customer. A customer obtains control of a good or service if it has the ability to (1) direct the use of and (2) obtain substantially all of the remaining benefits from that good or service.
A SaaS arrangement that does not include a license of IP would typically be accounted for as a service. In most cases, SaaS arrangements will meet the criteria to be accounted for as a series of distinct service periods (e.g., daily or monthly service periods) because each distinct service period is substantially the same, meets the criteria for over-time recognition, and the same method would be used to measure progress over each distinct service period.
Therefore, revenue from SaaS arrangements will generally be accounted for as a single performance obligation, except when accounting for contract modifications and allocating variable consideration.
Get Professional Help Implementing ASC 606
Though we’ve covered the 5 steps associated with ASC 606, there are further sub-topics to be considered by SaaS startups as they implement the new revenue recognition standards. Consider Growthwright as a business partner in these matters. For more information on outsourcing accounting services for your SaaS startup, contact us.
Michael Cerino is the CEO of Growthwright. Growthwright helps emerging technology companies with necessary business operations so they can focus on company growth without the distractions of critical financial, technical, human resources, sales and marketing tasks.