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Revenue Recognition for Professional Services: Understanding ASC 606

Posted on November 17, 2023 at 4:48 PM
Written by Jonathan Kittel

Revenue recognition is an accounting principle that identifies the specific conditions in which revenue is recognized and determines how to account for it. Recognition is generally triggered when a critical event happens, such as the delivery of a product or service, and an amount is measurable.

Understanding when, and how, to recognize your company’s revenue is one of the most important principles to understand – and to get right. Without accurate monthly revenue no accurate analysis can be performed.

Our role at Plumb is to understand ASC 606 and directly apply it to your business. We’re able to break down the 5 Step Model (see below) and apply them to our clients.

What is Revenue Recognition?

  • GAAP states that revenues are recognized according to the revenue recognition principle, which means when it’s realized and earned, not paid.
  • Why revenue recognition matters:
    • Accurate Financial Reporting

Professional service companies often bill ahead. This might be a deposit or a cash flow tool to acquire needed items for the job. If revenue is not recognized accordingly, the financial reporting will likely be inaccurate each month.

    • Legal and Regulatory Compliance

GAAP states ASC 606 must be followed for all public and private companies. Following any other rule is non-compliant.

    • Informed Decision-Making

By having revenue recognized in a consistent manner, you’re able to make real time decisions for the benefit of your company.

  • Three common revenue recognition methods:
    • Sales-basis method

In this method, revenue is recognized when a sale or transaction is made. This is most commonly seen in retail businesses.

    • Completed-contract method

In this method, revenue is recognized upon fulfillment of the contract. Typically, this method is used in projects that are completed quickly.

    • Percentage-of-completion method

In this method, revenue is recognized based on the cost incurred. For example, if 50% of the budget is spent, 50% of the income is recognized. This method is mostly seen in the construction industry where there are long-lasting contracts.

  • There are numerous ways to recognize revenue which leads to a difficult process – and indicates the importance of working with accounting professionals who understand each of these different processes and the impact they have on your business.

The Complexity of Revenue Recognition for Professional Services

When looking specifically at professional service firms, the biggest challenge comes from the scope of the project.

  • Professional Services versus Time-Hire contracts
    • Professional services generally have a broad-scope contract with their client, and it might be for several different services for a set amount - not based on time spent. This can make recognizing the revenue difficult.
    • A Time-Hire contract is much more straightforward because there is a direct correlation between payment and deliverable. The person hired is paid for their time spent on a specific deliverable.
    • Large projects that use percentage-of-completion method present a revenue recognition challenge. A common example of this is a construction contract. The company might be able to bill 50% up front, so it appears as if 50% of revenue has been recognized, but in reality, very little work has been completed. Revenue recognition is based on which recognition method the company uses. ASC 606 states that transaction prices need to be assigned to performance obligations, and that makes the accurate tracking of these projects and contracts much more important.
    • Legal services have other specific revenue recognition challenges. They generally have a retainer and/or a flat fee for services. The way they recognize revenue over time, as well as account for the ongoing payments received, can be a challenge.
  • Revenue forecasting vs. revenue recognition
    • Revenue forecasting is the practice of evaluating upcoming revenue to help make business decisions today. It’s used in conjunction with revenue recognition to understand the impact today as well as in the future.
  • Benefits of ASC 606
    • Before ASC 606, different industries had different reporting standards and rules on revenue recognition. ASC 606 created a general framework for how to recognize revenue but still allows for flexibility for industry specific needs.

Accounting Standards Codification 606 Fundamentals

  • ASC 606 shifted the industry from a conservative risk approach where revenue was recognized only when most or all risk of loss was gone, to an approach that is about completing a defined objective to be delivered to the client.
  • It was created because of both the need for industry-neutral guidelines for revenue recognition as well as the need for more consistent reporting from industries and globally.
  • It has a five-step model for recognizing revenue.
    1. Identify the contract with a customer.
    2. Identify the performance obligations in the contract.
    3. Determine the transaction price.
    4. Allocate the transaction price to the performance obligations in the contract.
    5. Recognize the revenue when or as the entity satisfies a performance obligation.
  • ASC 606 makes the revenue recognition process defined and structured. It clearly outlines the tasks that need to be completed and gives the end user guidance on how to complete the process.

Understanding the Five-Step Model

  • Step 1: Identifying the Contract
    • All parties must approve the contract with each person committing to fulfilling their obligation.

Each person’s right must be identifiable, and ensure the contract has substance, and that payment is likely to be received.

  • Step 2: Identifying Performance Obligations
    • Performance obligations must be identified and understood.
  • Step 3: Determining Transaction Price
    • There are different factors such as variable consideration, non-cash consideration, and time value of money. Noncash is considered at fair market value and it’s reflected in the transaction price. Variable consideration is used and reassessed at each reporting date.
  • Step 4: Allocating Transaction Price to Performance Obligations
    • Distributing the transaction price among different obligations should be done proportionately based on the standalone selling price (SSP) determined for each obligation. If there is only one obligation this isn’t needed. However, with multiple obligations (as identified in Step 2) then a price will be attached to them at that point.
  • Step 5: Recognizing Revenue
    • Recognizing over time is a simple equation of total revenue divided by something (time, costs, budget, etc.) and it allows for some judgment to be made. After following Step 3 and assigning a price to certain obligations, the amount of revenue assigned to each obligation might not be equal, so revenue will be recognized on obligations completed and the amount assigned to each by your company.

Make Service Revenue Recognition Easy with Plumb

At Plumb we help to simplify these complex issues.

We are experts in accounting, and we are experts in the industries we support. We understand how to read contracts and projects, how to assign prices to deliverables, and how to work with the different revenue recognition methods.

If you have any professional service-related accounting questions, please reach out. We get it. We’re here to help.

Please schedule a complimentary consultation with our accounting experts. We’re here to help.

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