Last year, Uber reported revenue numbers that dropped to half of their usual profits. Retailers like Amazon, Starbucks, and Wal-Mart expect a rise in revenue numbers by hundreds of millions of dollars. While many different factors affect revenue numbers, the single reason for these swings are new accounting rules. If you’re in charge of sales operations, commissions, product offerings, IT, legal and of course finance or accounting, you are experiencing the biggest change in accounting in the last 15 years.
The new accounting rules ASC 606 in the U.S., and its international counterpart IFRS 15, standardize and simplify revenue recognition across all industries. Revenue recognition is an accounting principle that determines what a company claims as revenue from the cash received in bookings, which of course, signifies a company’s profitability to shareholders, investors, and customers.
The new revenue recognition standard affects all entities that report (issue financial statements) under Generally Accepted Accounting Principles (GAAP) —public, private, and not-for-profit—that either enters into contracts with customers to transfer goods or services or enters into contracts.
Imagine I purchase a 12-month subscription for ad-space inside an online magazine. I pay for the subscription up-front, so at $100 a month, the company receives $1200 total. Service fees are included for free, since I purchased the ad-space from a promotional marketing email.
According to the rules, the magazine must first identify their contract with me, with the contract understood as the legal representation of all obligations involved in a deal between two parties i.e., the terms and conditions I agree to when purchasing ad-space online.
Then, the magazine must identify distinct performance obligations in the contract. A performance obligation is the promise to transfer a good or service. In this case, the magazine providing ad-space for me to use, and related services, like access to a customer service rep who can help me troubleshoot technical issues.
Next, the magazine must determine the transaction price, which is the amount a business expects to be entitled to in exchange for fulfilling the performance obligations. Since the contract includes a “variable consideration,” (discounts, rebates, refunds, bonuses, etc.), the magazine must estimate how much they will receive based on how much of the goods and services they deliver. There are two methods to estimate, and each company will pick a method most effective for their business. Here, $1200 will be part of the transaction price since its the subscription rate, and the normally $30 per month service fee which is discounted, may also be included. ASC 606 states that “variable considerations” can now be recognized.
Step 4 is to allocate the transaction price to performance obligations in the contract, relative to the Standalone Selling Price (SSP).
Finally, in Step 5, the magazine recognizes revenue upon transfer of control over goods and/or services. The magazine recognizes the $100 subscription fee as it is completed per month, regardless of the fact that I paid for it up-front. They also recognize the $30 per month for services as it is completed, even though I, the customer, don’t pay for it. Prior to 606, this discount may have been accounted for as a selling cost. So, the magazine still recognizes $1200 for the year, but monthly, the amount might be less than $100, depending on how the magazine pro rates charges or weights the probability of contract outcomes.