Recognizing revenue with ASC 606: A guide for SaaS companies

The US Financial Accounting Standards Board (FASB) issued the ASC 606 — Accounting Standards Codification 606 — regulation in 2014 to standardize the revenue recognition model across public companies. 

Four years later — in 2018 — private companies in the United States were given an early option to adopt ASC 606, with the official deadline to comply being for annual reporting periods beginning after December 15, 2019. Today, it’s the default standard for revenue recognition across entities that enter into contracts with customers to transfer goods or services (including SaaS) that use sales agreements and contracts. However, it may not apply uniformly across all sectors.

And though revenue accountants have had quite some time to get used to ASC 606, it hasn’t been an easy shift. Even some of the more seasoned professionals consider the five-step RevRec framework to be complex. Others, especially beginner accountants, find it challenging to understand how different ASC rules interact with Topic 606 and impact revenue recognition.

In this blog, we explore ASC 606’s impact on SaaS businesses (both benefits and challenges) and how you can implement and comply with its five-step revenue recognition model. 

First, the TL;DR —

• ASC 606 or Accounting Standards Codification 606 by the US FASB governs how businesses recognize revenue from customer sales and contracts. This accounting standard was introduced to ensure consistency across all industries.
• The main difference between ASC 606 and legacy GAAP regulations is that it requires businesses to recognize revenue as and when each performance obligation is fulfilled, rather than at the beginning or end of a contract.
• Complying with ASC 606 not only helps SaaS businesses ensure accurate financial reports but also supports investor relations by improving business credibility and reducing risk perception.
• It comes with a structured, five-step framework that asks businesses to identify contracts, performance obligations, transaction price, allocation, and finally the recognized revenue in a step-by-step manner.
• By automating your revenue recognition workflows with software like Zenskar, you can reduce errors and improve operational efficiency.

What is ASC 606? 

ASC 606 is a set of standardized accounting principles that outlines how a company recognizes revenue. As per the ASC 606 framework, revenue is recognized when the goods are delivered or services are rendered to a customer.

Unlike the previous framework (ASC 605), ASC 606 aims to create a unified revenue recognition methodology for all industries in the United States and more importantly, remain consistent with international revenue recognition frameworks like the IFRS-15.

For example, in ASC 605, you could recognize revenue from a yearly subscription upfront. Under ASC 606, revenue is recognized based on performance obligations and the transfer of control. For instance, if a yearly subscription costs $100,000, you might recognize revenue on a daily basis ($100,000/365 * 31 for January) or on a monthly basis ($100,000/12), depending on how the performance obligations are fulfilled.

How does ASC 606 benefit SaaS companies?

Here’s how the ASC 606’s industry-agnostic and structured approach to revenue recognition can benefit you —

• By recognizing revenue as the service is delivered, ASC 606 provides a more accurate representation of your company's revenue stream.
• It helps improve investor relations as they can rely on your financial reports to gauge your company's revenue growth and long-term profitability.
• ASC 606 aligns with the SaaS business model like usage-based pricing and contracts with multiple performance obligations — making it easier for you to both recognize revenue and generate GAAP-compliant financial reports.

Plus, following ASC 606 means your financial reports are IPO-compliant by default — making it easy for you to take your company public. 

The difference between ASC 606 and ASC 842?

While both ASC 606 and ASC 842 involve analyzing contracts and transactions, they address distinct aspects of financial reporting. 

The main difference is that ASC 606 dictates how companies recognize revenue from customer contracts for the sale of goods or services. ASC 842, on the other hand, governs how companies account for leases and liabilities.

While both ASC 606 and ASC 842 involve analyzing contracts and transactions, they address distinct aspects of financial reporting. ASC 606 pertains to revenue recognition from contracts with customers for the sale of goods or services. In contrast, ASC 842 focuses on lease accounting, detailing how companies should recognize, measure, present, and disclose leases.

While ASC 842 is predominantly used by real estate companies, it can impact XaaS companies as well. For example, if you’re an IoT company, then your software services come under ASC 606, but the hardware (or specialized equipment) that you lease out will come under ASC 842. 

In short, ASC 606 ensures standardized revenue recognition and ASC 842 ensures transparency in lease accounting.

Implementing the 5-step ASC 606 revenue recognition model

ASC 606's strength lies in its structured 5-step model which streamlines the entire revenue recognition process — ensuring consistency across industries (and pricing models), allowing for easier implementation and ultimately, more comparable financial statements.

Let’s take a closer look at the five steps involved in the ASC 606 revenue recognition model —

1. Identify the contract with the customer

“A contract is an “agreement between two or more parties that creates enforceable rights and obligations and specifies that enforceability is a matter of law. Contracts can be written, oral, or implied by an entity’s customary business practices.” 
– From ASC 606-10

This means for a contract to be recognized in your revenue report, it has to be enforceable by law and meet the following criteria:

• Both parties must agree to the contract and be committed to fulfilling their obligations.
• The contract must clearly outline each party's rights regarding the goods/services and the payment terms.
• The contract cannot be subject to major uncertainties, like additional approvals needed.
• Letters of intent or agreements requiring further negotiation don't qualify as contracts. 

Also, while legacy GAAP required businesses to have a signed contract, ASC 606 is a lot more flexible and accepts oral, written, and implied agreements (like SaaS subscriptions). 

The collectibility threshold

An important element in the contract identification process — ASC 606 mandates that you can recognize revenue only if a contract matches a collectibility threshold of 75% – 80%. This way, you avoid recognizing revenue you might never collect. 

You can assess a contract’s collectibility threshold by considering a customer’s ability and willingness to pay (such as their creditworthiness and past behavior) and legal rights. 

Let's say you have a two-year contract, but both sides can cancel anytime after one year with no penalty. In this case, you'd only consider if the customer can likely pay for the first year (the guaranteed period) for revenue recognition.

2. Identify the performance obligations in the contract

The second step of the ASC 606 RevRec framework is to identify the services that you promised customers in the contract. You have to break down each service in the contract into a distinct "performance obligation." 

This means each obligation should be a separate deliverable that the customer could receive even if other services aren't completed. Put simply, administrative or setup services can’t be listed as a performance obligation. Custom integrations or implementations, on the other hand, can be considered.

Performance obligations for variable pricing

Let’s say you offer a cloud storage service with a 1-year contract. The customer pays a monthly fee based on the amount of storage used. The variable consideration (monthly fee) can be directly allocated to each month based on the actual storage used in that specific month. 

3. Determine transaction price

“The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.”
– From ASC 606-10

In short, the transaction price is the amount you’re entitled to in exchange for your service, minus the sales tax. Here’s what you should consider when determining your transaction price —

• Variable payments: This is the money the customer pays you, which can fluctuate based on usage or other factors.
• Non-cash considerations: Sometimes, customers might pay with vouchers or credit points. The fair market value of these non-cash items gets added to the price.
• Consideration payable: If you offer money-back guarantees or refunds, the amount refunded gets subtracted from the initial transaction price.

While the transaction price takes into account your refund and reimbursement policies, it doesn’t consider your customer’s creditworthiness — that has to be decided in the first step itself.  

Accounting policy elections and taxes

While ASC 606 aims to standardize revenue recognition, it acknowledges that businesses operate in diverse ways and that’s why it allows accounting policy elections — so you can choose how to handle some scenarios. 

In this case, when determining your transaction price, you can set an accounting policy election to exclude all applicable taxes (like sales tax) from the final price to avoid inflating the transaction price.

4. Allocate the transaction price to performance obligations 

Here's where you split the total contract value (transaction price) among the different performance obligations you identified earlier. It's not about finding an exact individual price for each service, but rather about assigning a portion of the total fee based on the relative value of each service.

Determining the standalone selling price (SSP) 

The SSP is the price you’d expect to receive if you sold the service separately, independent of your contract. You can set your SSP by considering past sales of the service or market research. 

However, there may be times when you can’t estimate the SSP for a performance obligation. For such cases, you can use the residual approach —  take the total price of the contract and subtract the combined price of all the other goods or services sold separately in the market (their observable SSPs). 

5. Recognize revenue when (or as) the entity satisfies a performance obligation 

“An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.”
– From ASC 606-10

Basically, revenue is recognized every time a performance obligation is fulfilled. There are two ways to recognize revenue— 

• Single performance obligation: Revenue is recognized when the product is delivered (like license-based pricing models and one-time upgrades) or when a service is completed (like custom integrations).
• Continuous performance obligation: Revenue is recognized as the service is made available to the customer over the subscription period. 

Related reading: 6 revenue recognition methods you need

3 challenges that SaaS businesses might face with ASC 606 

While structured, the ASC 606 five-step model for revenue recognition can involve complex scenarios (and formulas) especially when you take into account the intricate nature of SaaS pricing models and contracts. 

Here are some ways that ASC 606 makes SaaS revenue recognition tricky —

Pre-payments before contract identification

There may be cases where you accept an advance payment from a customer even while the contract negotiations are happening — which means your contract hasn’t been identified. Here, you record the payment as a liability to represent the money you owe the customer until the contract is finalized and you can recognize revenue.

Contract modifications

Amendments are an integral part of the sales contract process in SaaS and there are two ways you can handle this — 

• End your old contract and create a new one with the recent amendments. Revenue that’s already been recognized remains unaffected. 
• Create a separate contract just for your amendments and recognize the revenue separately.

Here’s how you can check if you need to modify your existing contract — 

Variable consideration

Unlike other industries, SaaS businesses often come with variable components (like usage-based pricing models) that make gauging the final cost tricky.

 ASC 606 addresses this by allowing SaaS companies to estimate the variable consideration based on the most likely scenario of future events — either by looking into your historical data or predictive analytics that forecast revenue. 

Why automate revenue recognition with Zenskar?

Automating your revenue recognition process comes with a lot of benefits — it reduces the chances of human error (and audit risks), and frees up your team’s time so they can focus on other — more important — things. 

And if you’re considering automating your revenue recognition workflows, then may we suggest Zenskar? Purpose-built for SaaS businesses, usage-based billing, and complex contracts, it can help you —

• Create flexible RevRec rules: Recognize revenue however you want with multiple revenue recognition options — straight line, fixed period, milestone, or usage-based.
• Track performance obligations: Pull out contract obligations from customer contracts and recognize them periodically.
• Maintain sub-ledgers: Set up entity or jurisdiction-specific revenue sub-ledgers and stay compliant with local accounting regulations.
• Automate journal entries: Set up accrual accounting and create balanced entries for accrued and deferred revenue.

Plus, all revenue calculations are adjusted in real-time. Whether that’s a customer updating their subscription plan or a sales rep amending a multi-year contract — all changes will be reflected in your revenue reports. Convenient, right?

Even better, Zenskar accommodates custom integration requests so you can easily integrate with your existing CRM and ERP platforms without any hassle. 

Curious to learn more? Book a demo with our product experts, and see for yourself how Zenskar can help you comply with the ASC 606 revenue recognition standards. 

Frequently asked questions (FAQs)

1. How does ASC 606 affect SaaS revenue recognition?

ASC 606 dictates that revenue should be recognized only after performance obligations are fulfilled rather than when a customer first signs a contract. This means SaaS companies with subscriptions or contracts have to recognize revenue over the contract or subscription period instead of at the beginning or end of it. 

2. What is the difference between ASC 606 and IFRS 15?

The IFRS 15 regulation is the international standard for revenue recognition unlike ASC 606 which is specifically for US-based companies. While they are similar in their core principles for revenue recognition, there are some differences in how they approach the actual methodology.

For example, the collectibility threshold — which assesses the probability of payment by the customer — is 75% to 80% for ASC 606 and 50% for IFRS-15.

3. What are the criteria for revenue recognition under ASC 606?

Revenue is recognized under ASC 606 when the control of products or services has been transferred from the seller to the buyer. It involves the transfer of risks and rewards and the customer’s acceptance as well as the assurance to pay for the products and services.