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ASC 606 Long Term Contracts

ASC 606 Long Term Contracts

This article will review the five steps of ASC 606 adoption, looking at how each can be impacted by entering into a long-term contract.

Identify the contract with a customer

Whether written or oral, a contract needs to have “commercial substance” and be identifiable. Identification is generally not a problem with long-term contracts, as most businesses do not enter into long-term oral contracts. 

You need to see what other contracts exist with the same customer, looking at when they were entered into and what goods or services they cover. You may need to combine or separate contracts as a result.

Long-term contracts are more likely to include change orders or other contract modifications that require you to analyze them to determine if they should be separate contracts or just different performance obligations within the same contract.

Identify the performance obligation

A performance obligation is a distinct good or service that you promise to deliver to a customer. Some of the contract modifications made during your contract term will be distinct performance obligations, while others may be grouped with existing performance obligations.

You will need to analyze them to determine if that modification is capable of being distinct, and examine the contract to understand if it is separately distinct or identifiable within the contract. As mentioned under step 1, it is also possible that the modification constitutes a separate contract altogether. This step can be challenging, as you need to use judgment, follow the principles outlined in the standard, and remain consistent in your approach across all your customers and contracts.

Determine the transaction price

In the third step, you need to determine the price of the transaction. To determine the correct price, you need to use the basic contract price as your starting point, then factor in customer payments or any other variable consideration that may change that price.

Some factors that change the amount of consideration are rebates, discounts, change orders, bonuses, or performance penalties. The longer your contract term is, the higher the likelihood you will have changes to your contract that result in variable consideration.

You also need to be aware of the timing of customer payments as they relate to the transfer of goods and services to your customer. If those payments span more than one year, there may be a “significant financing component” for which you will need to account. 

Allocate the transaction price

The complexity of step four has less to do with the contract term and more to do with whether the contract contains multiple elements or performance obligations.

A contract that only contains one performance obligation, for example, will not need to go through a lengthy process to allocate the price. Usually, SaaS contracts are more complex and contain multiple elements like access to the program, professional services, training, etc. You will need to allocate the price across those elements, as directed in the standard.

Recognize revenue

In the final step of the ASC 606 process, you will use one of the revenue recognition methods to complete the process. Long-term contracts are ideal for methods that allow you to recognize revenue throughout the contract so you don’t have to wait until the end when everything has been delivered.

When you recognize revenue, you need to account for the costs associated with acquiring and fulfilling the contract because those need to be recognized in the same period as the revenue, according to the matching principle. Companies have to include specific costs associated with capturing that recognized revenue, which includes sales commissions. Organizations have to capitalize commission costs and amortize those costs over a given period to match the time that they recognize revenue for any given period. For some businesses, the accounting changes required for sales commissions are more impactful than the changes required for revenue. 

For instance, if a SaaS company aggregates sales data based on ARR for the month and calculate the sales commissions based on that data, under ASC 606, they may have to disaggregate the data to show multiple products including revenue for software, services and revenue recognized over time post the contract being signed. This then would necessitate separating commission calculations at the contract or product level.

When you are accounting for long-term contracts under ASC 606, be aware of these factors and how they make accounting more complex than short-term contracts. If you need help with accounting for sales commissions under ASC 606, please don’t hesitate to contact us.

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