How Do You Identify a Contract Under ASC 606 and IFRS 15?

ASC 606/IFRS 15 is one of the most profound compliance changes in corporate finance since the release of the Sarbanes-Oxley regulations over 20 years ago. This new compliance standard has reshaped how businesses recognize revenue and has proven to be incredibly challenging to navigate in today’s fast-paced digital, subscription-based economy. Adopting these standards has been a significant undertaking for public and private companies in terms of their complexity, the level of judgment and estimates involved, and data availability. The first and very crucial step of ASC 606/IFRS 15 is to identify the contract with a customer.

Why is this step so important? What is technically considered a contract under ASC 606/IFRS 15? What criteria must be met to qualify a contract? How can subscription/SaaS businesses effectively and efficiently complete this step? In this blog, we’ll answer these questions and explore the revenue recognition technology and solutions available for subscription companies to meet the new revenue standard.

The Five Steps of ASC 606/IFRS 15

The standards outline five specific steps for businesses to recognize revenue:

Identify the contract with a customer

A contract can be either written or verbal but should have commercial substance with enforceable rights and obligations.

Identify the performance obligation in the contract

Performance obligation simply means a promise to transfer goods or services to the customer. In this step, any separate and distinct performance obligations to the customer need to be identified.

Determine the transaction price 

The transaction price refers to the cash and non-cash consideration that an entity is entitled to receive from the customer in exchange for goods and services provided.

Allocate the transaction price

When offering multiple products and services as part of a subscription business model, companies are required to allocate the arrangement fee to each separate and distinct performance obligation based upon a standalone selling price (SSP) methodology. SSP is the price that a vendor would charge if the product or service was offered separately.

Recognize revenue when or as the entity satisfies a performance obligation

Revenue can be recognized as the business meets each performance obligation. This step specifies when revenue should be recognized either at a point in time or over time.

Identifying a Customer Contract Under ASC 606/IFRS 15

Let’s take a closer look at the first of the five steps of revenue recognition under these standards. How can businesses ensure that arrangements meet all the conditions of a valid contract for revenue recognition? Typically, a contract is an agreement between two or more parties that creates enforceable rights and obligations.

The essential criteria for a contract under ASC 606 are:   

• All parties have approved the agreement (verbal or written agreement)
• All parties are committed to fulfilling their obligations
• Each party’s rights are identifiable
• Payment terms are identified
• The contract has commercial substance
• Collectibility is probable

How can subscription companies effectively identify customer contracts under ASC 606/IFRS 15? 

The impact of adopting the ASC 606/IFRS 15 standards for subscription/SaaS businesses may be greater due to the complexity and volume of customer contracts. Subscription-based businesses rely on detailed contracts with terms that are generally one year or longer, and include services such as the right to access software, hosting, upgrades, enhancements, and support. Due to their long-term nature, customers frequently seek to modify subscription plans and underlying products and services during their term. Under ASC 606/IFRS 15, all customer transactions negotiated at the same time or in contemplation of each other need to be treated as a single arrangement, therefore, creating challenges for companies to track multiple contracts for this purpose. In addition, reviewing and analyzing all contract types and clauses for the identification of performance obligations for proper revenue recognition can be daunting. 

Here are some tips to help subscription businesses identify and understand customer contracts in order to effectively streamline their revenue recognition process: 

Understand your Contracts

Start performing an in-depth review of all customer contracts. Collaborate across the organization (e.g., sales, product, professional service, accounting, legal, compliance teams) to:

• Obtain a comprehensive view of the contracts and modifications to assess the potential revenue impact
• Identify any interdependent performance obligations across contracts
• Evaluate common business practices or verbal commitments to determine if they also represent performance obligations
• Establish and document a detailed revenue recognition policy that covers all revenue streams

Streamline or Integrate Data Sources

Revenue recognition under ASC 606/IFRS 15 is heavily dependent on multiple data points and sources such as contracts, customary business practices, oral agreements, and invoice/payment data. Understanding and organizing all the relevant data is critical for accurate revenue recognition and reporting. Seamless integration of source systems overcomes the challenge of disparate data sourcing and streamlines the revenue recognition process. 

Automate Revenue Recognition 

Automating revenue recognition avoids costly errors and eliminates inefficiency, providing businesses with a predictable, auditable, GAAP-compliant process. Chargebee RevRec’s  revenue recognition solution does just that while scaling with your business by:

• Eliminating manual processes and providing end-to-end automation of ASC 606 /IFRS-15’s five-step model to recognize revenue
• Unburdening finance teams and creating more time to focus on value-added activities for their business
• Equipping businesses with accurate, reliable insights to make strategic decisions with business growth in mind

To learn more about how Chargebee RevRec provides end-to-end automation of ASC 606/ IFRS 15’s five-step model, download our detailed guide on identifying a contract.