Question

What are the basic differences between the revenue realization principle and revenue from the contract with customers (ASC 606)? Do you think ASC 606 is better than the realization principle? Why? Give your reasons.

Answer 1

Revenue realisation principle is a generally accepted accounting principle (GAAP) that determines the specific conditions in which revenue is recognized or accounted for. Generally, revenue is recognized only when a critical event has occurred, and the amount of revenue is measurable. However, there are several situations in which exceptions may apply.

The revenue recognition principle, a combination of accrual accounting and the matching principle, stipulates that revenues are recognized when realized and earned, not necessarily when received. Realizable means that goods and/or services have been received, but payment for the product or service is expected later. Earned revenue accounts for goods and/or services that have been provided or performed, respectively. In addition, the revenue generating activity must be fully or primarily complete to include its revenue during the respective accounting period, and there must be a reasonable level of certainty that earned revenue will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.

On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers. ASC 606 provides a uniform framework for recognizing revenue from contracts with customers. The old guidance was based on industry-specific guidance, which created a system of fragmented policies. The new guidance is industry-neutral and therefore more transparent. The core principle of ASC 606 is that revenue is recognized when the delivery of promised goods or services matches the amount of consideration expected in exchange for the goods and services. There are five steps that allow the recognition of revenue under that core principle:

• Identify the contract
• Identify the contractual performance obligations
• Determine the amount of consideration/price for the transaction
• Allocate the determined amount of consideration/price to the contractual obligations
• Recognize revenue when or as the performing party satisfies a performance obligation

Three important differences between I ASC 606 and earlier revenue recognition standards:-

1.One framework with many judgments and estimations

The US Generally Accepted Accounting Principles (GAAP) issued by FASB has over 180 papers regarding revenue recognition which include specific industry guidance, while the IFRS issued by IASB has further differing standards for contract revenues from customers including IAS 11, IAS 18, and IFRIC 13. The use of these varying standards meant that inconsistencies arose between financial statements issued which affect the goal of having a comparable financial statement; all previous standards are now being replaced by one framework but with many possible judgments and estimations.

ASC 606 is an objective-based standard, meaning that reporting entities have the flexibility to choose various methods based on the standard’s principles and objectives. The reporting entity shall determine which methods provide the most relevant and useful information for its business and the external users of their financial statements.

2.Detailed disclosure

ASC 606 standard’s detailed disclosure requirements arose in part because regulators and the board members believed that existing financial statements inadequately disclosed revenue information and because of the nature of the new revenue recognition standard which requires more judgments and estimation. Thus, new guidelines were needed to provide more detailed disclosers requirements regarding revenue recognition.

The new standard specifies that financial statements disclose sufficiently detailed information to enable the user to understand the nature, amount, timing, and uncertainty of cash flow and revenue related to customer contracts. Contract details, significant judgments, any changes to judgments, as well as assets related to the contract cost, must now be clearly disclosed.

3.From income statement to balance sheet

Under the existing GAAP, the entity recognizes revenue when it is both realized (or realizable) and is earned. This approach centers on the income statement. As the entity, your revenue would be realized when you receive the consideration (payment); if you are entitled and guaranteed to receive the consideration in the future, your revenue would be realizable. And, revenue is earned when the customer owes you, and you can increase your account-receivable balance; the earning process is complete when you deliver the goods or render the service.

The core principle of IFRS 15/ASC 606 is to “ recognize revenue to depict 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 exchange for those goods or services.” Thus, under the new recognition standard, the focus shifts from the income statement to the balance sheet. As stated above, the revenue should depict the transfer of goods or services. Consequently, entities will need to make certain changes to their balance sheets under the new revenue recognition standard: moving an asset out of the balance sheet, or satisfying liability to recognize revenue, would require the entity to create new assets and liability accounts

ASC 606 is better than the realization principle:-

There are several reasons why ASC 606 is better than ASC 606. Here, describe some excellent benefits for companies and help them create globally standardized financial accounting practices:-

Global Compliance

ASC 606 is a revenue recognition practice, which offers global compliance. This allows your business to have an international appeal, where your business information can always be presented in an ideal form to international investors. If you are an investor, global compliance offers you the benefit of comparing across industries and geographies, and selecting the best company to make your own investments.

Make Finance Strategic

The need to revisit revenue recognition practices provides an opportunity for finance teams to strategize with their leadership to ensure financial disclosures accurately represent the strength of their business. In some cases, the new standard may allow for recognition of more contract revenue upfront to boost toplines. Other arrangements will allow the amortization of contract expenses like commissions under the new standard, increasing the bottom lines. With the new standard, revenue teams can spend more time on strategic analysis and less time interpreting revenue arrangements under loose standards.  

Better Controls for contracts and finance

The ASC 606 standard is based specifically on contracts with the customer rather than other items like invoices. This will put pressure on sales teams to standardize their contract offerings and reduce one-off exceptions and special arrangements with customers.. Sales and legal departments of companies must now collaborate, and ensure that they prepare contracts that best represent the business and its revenue goals.

The revenue from the contract with customers ASC 606 standard aims to:

• Remove inconsistencies and weaknesses in revenue requirements
• Provide a more robust framework for addressing revenue issues
• Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets
• Provide more useful information to users of financial statements through improved disclosure requirements
• Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.