If you have service contracts or other sources of deferred revenue, the accounting rules for when you can report that income are changing. Under ASC 606, you will need to divide your contracts up into specific products or services, assign a price to each product or service, and recognize the revenue only when you deliver the product or perform the service. Here's a look at what's changing.
Who Does ASC 606 Apply To?
ASC 606 applies to all public and private companies following Generally Accepted Accounting Principles (GAAP). Even if you're a private company with no legal or contractual obligation to follow GAAP, it's still a good practice. Having a consistent accounting system makes your financials easier for lenders, investors, or potential buyers to understand.
Also note that while ASC 606 initially only applied to public companies as part of a phase-in period, it is now in effect for virtually all companies and will be required for the remaining companies in the immediate future.
What Do the New Accounting Rules Require?
The new accounting rules establish a five step process for recognizing deferred revenue.
- Identify a contract (e.g., a contract for an installation plus future service).
- Separate performance obligations (e.g., the installation, 12 monthly checkups, and annual maintenance).
- Determine the transaction price for the entire contract (e.g., $125,000 for everything).
- Allocate the transaction price to each performance obligation (e.g., installation is $100,000, monthly checkups are $1,000 each, and annual maintenance is $13,000).
- Recognize revenue when each obligation is satisfied (e.g, report $100,000 when you finish the installation, $1,000 each month when you do the checkup, and $13,000 when you perform the annual maintenance visit).
What Does This Mean for Deferred Service Contracts?
If you offer service contracts and use accrual accounting, you need to follow the above process when reporting the profits and losses on your contracts. The two big takeaways are:
- You can't recognize revenue when you sign the contract or receive payment. You have to recognize revenue as you actually complete your obligations under the contract.
- The process is now more black and white. Previously, you could follow industry standards or even your own consistent business practices for revenue recognition and be in compliance with GAAP. For example, you might have called a service portion free and recognized the entire contract price on installation. Under the new rules, you must divide up the contract using the five steps.
How Will This Change Your Bottom Line?
Your actual take-home profits and losses will not change. Only the timing of when you can record revenue on your books is changing which could mean that a small amount of your profits or losses shift from one year to another. This could potentially result in a small tax difference, but other than that, this is primarily a technical change in accounting rules.
To learn more about how to update your accounting systems to follow the new rules, contact us.