If you are an accountant, you are probably familiar with the 5-Step Model for revenue recognition. In fact, you are probably too familiar… you know…
Step 1: Identify the contract with a customer
Step 2: Identify the performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations in the contract
Step 5: Recognize revenue when or as the entity satisfies a performance obligation
I was recently in a client meeting and was asked what ASC 606 was by a non-accountant. To my utter horror, the only thing I could think of was the 5-Step Model for revenue recognition. Thank you to my teammates for bailing me out!
OK – so what is the problem with the 5-Step Model? Nothing really, but if you only know the five steps, you are going to sound like a broken record. In order to explain ASC 606, you need to APPLY it.
Laying the Foundation…
To effectively communicate ASC 606, familiarize yourself with the following questions:
1. What revenue streams does your client have?
Common examples are management fees, arrangement fees, or consulting fees. This question is key because each revenue stream tends to have a separate contract.
2. What contracts are associated with each revenue stream?
Contracts drive the entire ASC 606 analysis. To answer the next few questions, you need to ask your client for a contract for each revenue stream. Management fee contracts are commonly in the form of an investment advisory agreement. Arrangement fee contracts are usually a closing memo or fee letter. Consulting fees typically have some sort of agreement with a third party as the contract.
Hitting the Key Points…
After you have reviewed a contract for each revenue stream, make sure you can answer the next three questions for each revenue stream. As an example, if a client had three revenue streams, you would have to answer nine total questions.
3. What is the promise for each contract?
Most contracts will explicitly state the promise in the contract. For example, a clause in an investment advisory agreement could be “The Company will allocate the client’s assets amongst various investments.”
When communicating to a client with a non-accounting background, there is no need to get technical here. What is the main purpose of each contract? For management fees, the main purpose is to provide investment advisory services. For arrangement fees, the main purpose is to set up a deal between two parties. For consulting fees, the promise is – you guessed it – to provide consulting services.
4. How is revenue earned for each contract?
The two methods to recognize revenue are over time or at a point in time. Do not over think this. The revenue stream is a good indicator of how revenue is earned. Management fees are almost always earned over time because investment advisory services are being provided over time. Arrangement fees are usually earned at a point in time when a deal is found between two parties. Consulting fees can vary – if the promise is for a service to be provided every year or quarter than revenue would be earned over time. However, if the consulting service was for a one-time thing than revenue could be earned at a point time.
5. How is the payment made for each contract?
While not directly a part of the five-step recognition model, it is important to communicate the payment method for each contract to your client. After all, do you know a client who doesn’t care about getting paid? When I say payment method, I am referring to when your client receives money.
For revenue streams that earn revenue at a point in time, such as arrangement fees, payment is usually made when the service is completed. However, for revenue streams that earn revenue over time, such as management fees and consulting fees, the payment can be made at varying time periods. For example, the client could be billing quarterly in arrears (which means at the end of each quarter) or quarterly in advance (which means at the beginning of each quarter).
Wrapping Up…
The next time your client asks you what ASC 606 is, you can say that it is a way to standardize revenue recognition that emphasizes executed contracts. If you think that your client is still paying attention, explain the answers to questions three – five for each of your client’s revenue streams. No need to bring up transaction costs, variable consideration, or performance obligations!