Revenue Recognition Under ASC 606: The Five-Step Model Explained Clearly

Why Revenue Recognition Needed an Overhaul

Before ASC 606, revenue recognition in the United States was governed by a patchwork of industry-specific rules. The FASB and IASB spent years developing a converged standard: ASC 606 — Revenue from Contracts with Customers — effective for most public companies in 2018.

The Core Principle

Recognise revenue in a manner that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled. In plain language: record revenue when you have done what you promised, at the price you are going to get.

Step 1: Identify the Contract

A contract must be approved by all parties, each party's rights must be identifiable, payment terms must be identifiable, the contract must have commercial substance, and it must be probable that the entity will collect the consideration.

Step 2: Identify Performance Obligations

A performance obligation is a promise to transfer a distinct good or service. A good or service is distinct if the customer can benefit from it on its own and the promise to transfer it is separately identifiable from other promises in the contract.

Step 3: Determine the Transaction Price

For contracts with variable consideration — discounts, rebates, bonuses — companies must estimate the amount using the expected value or most likely amount method, and can only include the estimate if it is probable that a significant revenue reversal will not occur.

Step 4: Allocate the Transaction Price

When a contract has multiple performance obligations, the transaction price must be allocated based on relative standalone selling prices — preventing front-loading or back-loading of revenue recognition.

Step 5: Recognise Revenue When Obligations Are Satisfied

Revenue is recognised when — or as — control of the promised good or service transfers to the customer, either at a point in time (most product sales) or over time (services and long-term contracts).