What is the 5-Step Process for Revenue Recognition Under ASC 606?

By their very nature, SaaS business revenue models are complex as they operate on subscription models as opposed to single transactions. Given that these models can vary from a plan-based approach to a usage-based or metered approach, it’s easy to see how revenue recognition can be complicated and prone to errors. 

For growing SaaS and subscription businesses, accounting and finance teams have challenges in dealing with increased complexity due to:

• High volume transactions
• Plan changes (upgrades and downgrades)  and other modifications
• Multiple performance obligations such as subscription services, implementation, and training
• Discounts, coupons, and rebates

To address these challenges, the Financial Accounting Standards Board (FASB) created ASC 606, a new set of guidelines for revenue recognition. ASC 606 aims to clarify and streamline the process of recognizing revenue from contracts with customers, including SaaS subscriptions.

Introduction to ASC 606: The new standard in revenue accounting

ASC 606, also known as the Accounting Standards Codification Topic 606, is a comprehensive revenue recognition standard established by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). ASC 606 has revolutionized financial reporting by standardizing how revenue is recognized, particularly from complex business models like Software as a Service (SaaS).

ASC 606 introduces a five-step process to ensure that revenue is acknowledged when goods and services are delivered to customers, aligning with the expected payment receipt. This approach enhances the consistency and transparency of financial statements, providing a more accurate reflection of a company’s financial health. This clarity is crucial for investors, stakeholders, and regulators, supporting their ability to make well-informed decisions.

What are the five steps of revenue recognition under ASC 606?

Under ASC 606, SaaS businesses must follow a five-step process to recognize revenue:

1. Identify the contract
2. Identify performance obligations
3. Determine the transaction price
4. Allocate the transaction price
5. Recognize revenue as the performance obligation is satisfied

How does the 5-step process of ASC 606 change revenue recognition for businesses?

Let’s break down each step along with the challenges for recognizing revenue with manual processes at each stage — and how automation solves each.

1. Identify the contract

It’s pretty typical for arrangements with customers to be covered under multiple contract documents and verbal promises or standard business practices that all constitute “one agreement.” For example, a SaaS vendor may provide separate contracts for software access and support services and also verbally agree to provide free implementation services.

Under Accounting Standards Codification or ASC 606, the essential parts of any contract include:

• Approval and commitment by both parties
• Each party’s rights regarding the goods and services 
• Payment terms 
• Commercial substance
• Collectibility is probable

Having one system that captures all relevant contract terms is essential when dealing with subscription businesses due to the high volume of transactions and contract modifications. A comprehensive revenue sub-ledger will interface with CRM and other source systems to be a single source of truth for revenue.  

2. Identify performance obligations

Performance obligations are promises made to a customer that are separate and distinct within the context of the contract. For SaaS companies, this may include subscription, implementation services, training, hardware, or other professional services. Sometimes, CRM systems are not configured to capture all performance obligations in a contract.  

For example, if a vendor gives away implementation services for free, they may never be noted in the CRM platform. Thus, the accounting and finance team must manually track new deals to allocate fees to these multiple performance obligations.

Identifying all performance obligations in an arrangement can take time, and tracking arrangements manually can be difficult. An automated revenue sub-ledger can be configured to recognize new sales and allocate a portion of the transaction fee to implementation without manual intervention.

3. Determine the transaction price

Determining the transaction price requires estimating the net revenue expected over the contract term. In some cases, the transaction price is not easily determined because of volume discounts, rebates, and other forms of variable consideration. There can be a high degree of judgment and estimation when determining the transaction price for different products and services. Accounting and finance teams are tasked with estimating the arrangement fee, establishing stand-alone selling price (SSP), and recording revenue in amounts that are not subject to a substantial risk of a reversal in future periods.

With automation, you can have your pricing plans at your fingertips and ensure that your revenue recognition is aligned for every transaction without manually adjusting sales data. This ensures the consistent application of accounting policies and avoids the risk of errors or misstatements common in manual processing. 

4. Allocate the transaction price

Unlike other businesses operating on a single transaction, SaaS product delivery is recurring via subscriptions. These recurring charges create what’s known as a continuous performance obligation, in which a share of the overall arrangement fee is recognized over the subscription period. If performed manually, this process grows exponentially with a company’s increase in sales. Additionally, transactions may often include other performance obligations such as integration services, training, or equipment that must be valued separately and recognized as they are delivered to a customer. 

With automation, the transaction price is allocated to each performance obligation based upon predefined rules sent in an SSP Library. This way, the accounting and finance team avoids manually calculating allocations outside the accounting system and maintains voluminous spreadsheets to keep track of monthly revenue, deferred revenue, and unbilled receivables.

5. Recognize revenue when (or as) the entity satisfies a performance obligation

How is the performance obligation satisfied?

Revenue is recognized as each performance obligation is fulfilled, which can occur at a specific point in time or incrementally over time. Manual processes are prone to errors, such as inaccurately estimating delivery dates or miscalculating progress toward completion. If you have experience in financial reporting, you know the significant challenge each error presents—it’s like finding a needle in a haystack.

This necessitates a strong collaboration between revenue and financial reporting teams to ensure you have a clear understanding of when, how, and to what extent performance obligations are met. Instead of retrospectively fixing errors, this partnership allows for proactive, forward-looking projections, providing peace of mind that the figures presented are accurate and comprehensive.

Managing revenue recognition manually can be time-consuming, tedious, and expensive, especially for SaaS businesses dealing with the complexities of recurring billing and revenue recognition. To simplify and enhance efficiency, adopting a software solution that automates the complete revenue recognition process is crucial. This enables your finance team to evolve from being purely operational to playing a strategic role in fostering business growth.

Useful read: A guide to ASC 606 Revenue Recognition and Implementation
This ultimate guide to ASC 606 will help you understand, implement, and automate Accounting Standards Codification or ASC 606 revenue recognition.

What to look for in revenue recognition software

When evaluating revenue recognition software, it’s crucial that the solution complies with ASC 606 and IFRS 15 standards. Beyond these essential compliance requirements, consider these additional factors for an ideal revenue recognition software:

• GAAP and SaaS reporting: The software should offer comprehensive visibility through advanced reporting and analytics that align with Generally Accepted Accounting Principles and SaaS-specific metrics.
• Management of modifications: Effective handling of changes occurring mid-cycle, such as upgrades, downgrades, and cancellations, is critical. The software should manage these seamlessly to maintain accurate financial records.
• Integration with billing and collections: Seamless integration with your existing billing and collections systems is essential to ensure the completeness and accuracy of financial data.

Choosing a revenue recognition software that meets these criteria will help ensure efficiency in the accounting close process, accurate revenue reporting, and enable management to make forward-looking, data-driven decisions.

Elevate your financials: Why choose advanced revenue recognition tools

The accounting department of your company likely dedicates numerous hours of manual labor due to the many moving parts and constant changes, to ensure accurate reporting.

But, revenue recognition software makes life easier for the following reasons:

1. Helps access all the data in one place

A good revenue recognition platform helps you understand the financial health of your business. The right software will not only help you recognize revenue in the most complicated billing scenarios in less time but also help you maximize your revenue by giving you an end-to-end picture of the entire process. 

Chargebee goes one step further in reporting by understanding your global needs. It takes into account contract modifications and provides well-organized reports for each currency that your business handles. It lifts the pressure off your finance teams by providing a summary report from tracking to summarising all your payments and receivables.

2. Ease of implementation

Implementing new software into your existing systems can be daunting. Integrations make this easier. For this reason, Chargebee offers direct integrations with a range of third-party systems, including Salesforce, Stripe, Hubspot, Xero, Quickbook, Intacct, and Netsuite, to sync subscriptions and related data such as invoices and credit notes, products, and transaction prices.

3. More flexibility in billing operations to boost revenue operations

Building your revenue recognition system is time-consuming and takes time away from your core business priorities. Every time a new change happens, you have additional work apart from recognizing revenue. A good revenue recognition software should be easy to manage and run well on its own. It can also be configured based on your specifications, making it more flexible than the other options for recognizing revenue.

How does the 5-step process of ASC 606 impact the timing and amount of revenue recognized?

By stipulating that revenue must be recognized when performance obligations are fulfilled, ASC 606 (Accounting Standards Codification 606) fundamentally changes both the timing and the amount of revenue that companies report. This standard ensures that revenue recognition aligns closely with the delivery of goods and services, thereby enhancing the accuracy and compliance of financial reporting.

Next, let’s consider how you can effectively implement this framework.

Implementing the 5-step revenue recognition process as outlined in ASC 606

Implementing ASC 606 standards involves a detailed review of your contracts, identifying and mapping out all performance obligations, determining the transaction price, allocating the transaction price to the performance obligations, and finally, recognizing revenue as these obligations are fulfilled. 

With tools like Chargebee RevRec, this process is streamlined, ensuring compliance and accuracy in your financial reports.

Why Chargebee RevRec is your strategic financial partner

With Chargebee RevRec, you gain more than just a tool for automation; you get a partner in compliance and strategic financial management. Chargebee RevRec simplifies the complexities of ASC 606 compliance, significantly reducing the time and effort required for accurate revenue recognition. 

By automating critical processes and ensuring data integrity, Chargebee enables your finance team to focus on strategic growth rather than routine tasks.

Transform your revenue management today

Interested in leveraging these benefits for your business? 

Schedule a demo today with one of our revenue recognition specialists. Discover firsthand how Chargebee RevRec can elevate your company’s financial management, ensuring that you stay ahead in a rapidly evolving market. Start transforming your revenue processes with Chargebee RevRec and see immediate improvements in efficiency and compliance.