ASC 606 for Subscription Revenue Explained
The subscription-based business model is a rewarding one. Through this model, you’re able to collect monthly subscription or annual subscription premiums, generating consistent recurring revenue every billing period.
However, there’s one thing that nearly all subscription-based businesses struggle with — when to recognize revenue.
Although your customers pay you every month or every year, the revenue your company generates shouldn’t be reported as recognized until your obligations to the client are met. That’s where the ASC 606 revenue recognition framework comes in.
What Is ASC 606 and Why Do Revenue Recognition Standards Matter?
ASC 606 is a set of criteria for revenue recognition that was specifically designed for subscription models. The criteria provide revenue recognition guidance, a framework that tells you when the revenue you collect is earned revenue, even if the subscription service hasn’t been completed yet.
This is important for a few reasons:
- Understanding your performance: As a business owner, your goal is to grow your business, but to do so, you’ll need to know where your business stands today and use accurate metrics to measure growth. Accurate revenue recognition gives you the ability to do so.
- Access to funding: Lenders and investors alike will look for financial data about your company before they provide funding. When you follow the ASC 606 revenue recognition framework, the reporting you provide to lenders and investors is more widely accepted, helping you get the funds you need when you need them.
- Accounting: As a subscription service, you must account for the long-term costs of maintaining subscriptions. ASC 606 gives you an accurate way to determine what revenue is recognized and assess that portion of revenue to determine your costs and profit margins, even when the entire subscription isn’t complete.
Who Does ASC 606 Apply To?
ASC 606 was specifically designed for the subscription business. These businesses often find it challenging to determine when they should recognize revenue because they typically accept monthly or annual payments but perform services for those payments over the term of the subscription.
How ASC 606 Compliance Compares To Previous Accounting Standards
The most recent previous accounting standard for subscription revenue is ASC 605. When you compare ASC 606 vs ASC 605, there’s one significant difference — that difference is how sales commissions are reported.
Under ASC 605, sales commissions could be reported as an immediate expense, or they could be capitalized and amortized. That’s not the case under ASC 606. Under this newest accounting standard, sales commissions must be capitalized.
That means if a salesman earns $120 for selling an annual subscription, under ASC 606 revenue recognition requirements, that $120 must be capitalized over the term of the year, appearing in financial reports as a $10 per month cost.
The 5-Step Subscription Revenue Recognition Process
If you’re interested in implementing the ASC 606 accounting standard in your subscription service accounting process, you’re on the right track. Doing so will help you better understand when you earn your revenue and the cost of that revenue.
There are five steps to recognizing revenue under this accounting standard. Find the details of the ASC 606 in five steps below.
1. Identify the Contract With a Customer
In this step, you’ll identify the criteria that have to be met in order for you to provide subscription products or services to your customer. For example, your criteria may be:
- The customer agreed to pay $10 per month.
- You agree to provide monthly services.
- The client agrees to provide seven days’ notice to cancel.
Your contract criteria may be significantly different from the criteria above. Nonetheless, in this step, it’s important to establish what a contract with your customer means.
2. Identify Different Performance Obligations
In this step, define the exact performance obligations you’re expected to meet for your customers. For example, if you own a weekly education subscription, your obligations to your customers may include:
- Producing new educational content each week
- Mailing educational content to your customer
- Providing online support to help your customer understand the educational content
The important factor here is to set obligations that you expect to meet for every customer that signs up.
3. Determine Transaction Price
In this step, you’ll determine the overall price of the subscription, not necessarily the amount of money that meeting each obligation is worth. For example, you may decide that your monthly service is worth $19.99 per month or $199.99 per year.
No matter how you decide to price your subscription service, the important factor here is defining your pricing and keeping that pricing consistent across all customers.
4. Allocate Transaction Price
This step is a bit more intuitive. It requires you to think of each individual obligation you have under your contract as a separate transaction and allocate prices to those transactions. For example, say you have a coffee box subscription service through which you send your customers coffee variety boxes every month. In exchange, your customers pay a subscription fee of $200 per year.
In this case, you have 12 monthly obligations to your customer over the term of the one-year subscription. Determining the transaction price for these obligations is simple. Divide the total you earn per year by the 12 equal obligations, and you’ll find that the transaction price is $16.67.
This is a very basic example, but the key here is to make sure you place a value on each obligation you’re expected to meet.
5. Recognize Revenue When the Performance Obligation Is Satisfied
Under the ASC 606 model, subscription fees collected are counted as deferred revenue until that money is earned. When you satisfy each obligation, the value of that obligation moves from deferred revenue to recognized revenue.
Streamline Your Business With a Complete Subscription Management Platform
One thing that can streamline your business, the adoption of ASC 606 revenue recognition standards, and your accounting process as a whole is a solid billing platform. Consider working with the team at Revolv3. Our state-of-the-art subscription billing software makes it easy to automate this entire process along with other crucial accounting processes you likely handle on a regular basis. Chat with Revolv3 to discover how we can help your subscription business thrive.
Disclaimer: Nothing in this article constitutes professional and/or financial or accounting advice, nor does any of the information constitute a comprehensive or complete statement of the matters discussed. Readers should use this information to consult with their accounting professionals.
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