Knowing when and how to transition to Accounting Standards Codification (ASC) 606 is an important step toward implementing the new standard. The Financial Accounting Standards Board (FASB) has issued multiple effective dates for public and non-public entities. The new standard allows for two different transition methods when first applying ASC 606: the Modified-Retrospective Method and the Full-Retrospective Method. This article will explain which effective dates apply to various entity types, discuss the details of the two transition methods, and address other issues to consider before transitioning to ASC 606. For more information regarding transition plans, refer to Connor Group and RevenueHub’s study of US public companies’ ASC 606 transition disclosures.
The FASB has changed the effective dates of ASC 606 since its initial release (Accounting Standards Update (ASU) 2014-09); only the updated effective dates are presented here. The FASB makes a distinction between two types of entities, with each type having its own effective date guidance.
Type A entities are (i) public entities, (ii) certain not-for-profit entities (those with securities traded on an exchange or over-the-counter market), and (iii) employee benefit plans that report to the Securities and Exchange Commission (SEC). These entities are collectively referred to as “public entities.” Public entities must start applying ASC 606 to annual and interim financial statements for periods beginning after December 15, 2017. These entities may adopt the new standard for periods beginning after December 15, 2016, but they must begin applying the new standard to both annual and interim statements at the same time.
Type B refers to all other entities, including private entities that choose to follow US Generally Accepted Accounting Principles (GAAP) and adopt ASC 606. These entities must begin applying ASC 606 to annual financial statements for periods beginning after December 15, 2018; they must apply the standard to interim financial statements for periods beginning after December 15, 2019. These entities can also adopt the standard as early as periods beginning after December 15, 2016. Type B entities must apply the new standard to interim statements at the same time as or one year after ASC 606 is applied to the annual statements.
The FASB recognizes that lack of comparability may last for a three-year period with the new option to early adopt. However, the FASB views this as “a fairly short period” that should not have an unacceptably large or negative effect on financial statement users. The FASB notes that while this period of lack of comparability is not optimal, “there would be some degree of noncomparability during the transition period” anyway because “different entities have different year-ends.” According to the FASB, the three-year adoption window for the various entities is preferred over alternatives. For example, forcing all entities to transition on the same date in 2016 or 2017 would encourage poor-quality financial reporting by entities that are not ready for such a quick transition. In the FASB’s view, it is better to have diminished comparability between some entities than to have diminished reporting quality from many entities.
IFRS (International Financial Reporting Standards) have a single effective date for all entities: periods beginning on or after January 1, 2018. Early adoption is permitted, for periods beginning on or after January 1, 2017.
The table below summarizes the effective dates:
|Entity Type||Effective Date (Annual)||Effective Date (Interim)||Early Adoption Date|
|US GAAP Type A: Public||15-Dec-17||15-Dec-17||15-Dec-16|
|US GAAP Type B: Nonpublic||15-Dec-18||15-Dec-19||15-Dec-16|
When applying ASC 606, entities must recast or adjust their financial statements to reflect the effect of ASC 606 on reported financial data. The FASB allows two methods for transitioning to ASC 606, commonly referred to as the Modified-Retrospective Method and the Full-Retrospective Method.
In the Modified-Retrospective Method (“MRM”), sometimes called the Cumulative-Effect Adjustment Method, the prior years’ data is not recast. Instead, a single adjustment is made to equity (usually retained earnings) at the beginning of the initial year of application. For example, an entity presenting comparative statements for the years ending Dec. 31, 2016, 2017, and 2018 would make the single cumulative adjustment to the beginning equity of year 2018 without recasting 2016 and 2017 financial data. This single entry should adjust the beginning equity balance to what it would have been if the entity had applied ASC 606 to either (a) all unfinished contracts (unfinished under ASC 605) as of the beginning of the current period, or (b) all contracts pertaining to the years presented. Entities are free to choose either of these options.
At a minimum, all contracts that have not yet been completed as of the initial application date need to be analyzed under MRM. The definition of a completed contract was clarified in May 2016 when the FASB issued ASU 2016-12: “A completed contract is a contract for which all (or substantially all) of the revenue was recognized in accordance with revenue guidance that is in effect before the date of initial application.” This means that when transitioning to ASC 606, a completed contract is one where substantially all revenue has already been recognized under ASC 605. When evaluating its contracts, an entity might reapportion revenue to different periods during the contract and/or identify additional performance obligations that were not considered when previously applying ASC 605. These additional performance obligations must become part of the contract under ASC 606, and the transaction price must be allocated to the updated set of performance obligations. The example presented later in this article will illustrate the application of the Modified Retrospective Method.
If an entity chooses to apply MRM, additional disclosures are required. The entity must disclose how each line item of the financial statements is affected by the adjustment. Also, the entity must provide an explanation of how the new revenue standard led to any significant changes to reported results as compared with the previous standard. Essentially, the entity must keep two sets of books during the first year of application to fulfill the additional disclosure requirements.
The Full-Retrospective Method (“FRM”) requires recasting all prior years’ data on comparative financial statements, following the guidance for any change in accounting principle found in ASC 250-10-45, Accounting Changes and Error Corrections—Other Presentation Matters. Aside from a few allowed practical expedients, this method requires entities to look at every contract or contract class, including those that are considered complete under ASC 605 as of the beginning of the period. Entities must evaluate the performance obligations attached to both the completed and uncompleted contracts and adjust revenue recognition in past periods accordingly. ASC 606 is applied to all contracts that were open under ASC 605 standards as of the beginning of the earliest period presented. In some situations, new performance obligations may still be pending, and part of the revenue previously recognized must be reversed and deferred until actions are taken to perform the remaining obligations. In preparation for ASC 606, entities may choose to keep two sets of books for the years leading up to initial application of the new standard. This will allow entities to recast prior years’ data accurately and efficiently once ASC 606 is adopted.
Due to the vast scope of the analysis required to transition to ASC 606 using FRM, the FASB allows for three practical expedients, and each must be disclosed if used.
- Contract starts and ends in a single annual period. This practical expedient allows companies to not reevaluate a completed contract if it begins and ends in the same annual period. Again, a completed contract refers to a contract where substantially all revenue has been recognized under legacy GAAP, or ASC 605. For example, assume that Vernon Company chooses to early adopt the standard for the annual period beginning January 1, 2017. Vernon has Contract A which begins January 2015, and Vernon recognizes substantially all revenue from Contract A by December 2015. Because Contract A begins and ends in one annual period, Vernon can apply the first practical expedient. Therefore, Vernon can consider Contract A complete, and no further analysis is necessary. This will be a very useful expedient for contracts that receive very different treatment under ASC 605 versus ASC 606, such as construction contracts where revenue was recognized at a point in time under ASC 605 but would be recognized over time under ASC 606. Now assume that Vernon has Contract B beginning in December 2015, and a substantial portion of the revenue is recognized in January 2016 under ASC 605. Even though the contract lasts less than two months and was completed under legacy GAAP before the transition, Vernon cannot apply this practical expedient because the contract was active during multiple annual periods. Vernon must evaluate this contract and reallocate and/or defer revenue to different periods as necessary.
- Final transaction price for variable consideration contracts. For completed contracts with variable consideration, the transaction price determined upon contract completion may be used as the allocable transaction price. This is more reliable and accurate than attempting to estimate the variable transaction price over the prior periods. For example, on January 1, 2015 Vernon entered into a contract to sell License X and License Y to Customer Hill Company. Licenses X and Y were separate performance obligations with standalone selling prices of $800 and $1,000, respectively. The contract stated that the fixed price of License X was $300 and the price of License Y was five percent of Hill’s future product sales that use License Y in the following two years. Using the Full-Retrospective Method without the second practical expedient, Vernon would have to calculate in 2017 the variable consideration estimate that would have been used in 2015 and 2016 using the ASC 606 guidance and include those estimates as the allocable transaction price for each year. In contrast, this second practical expedient allows Vernon to use the known final transaction price at contract completion and allocate it to the different performance obligations instead of using the estimated 2015 and 2016 amounts. For more information about variable consideration and including it in transaction price, see the RevenueHub article “Allocating Variable Consideration,” which uses a similar example to Vernon Company.
- No disclosure of share of transaction price for remaining performance obligations. This expedient allows companies to not disclose the transaction price that is allocated to the remaining performance obligations for the comparative years in the financial statements. For example, assume Contract B (from expedient 1 example) has an overall transaction price of $100, and that the transaction price allocated to the performance obligations remaining at the end of 2015 is $20 (to be completed in January 2016). Vernon Company does not have to disclose in their 2017 financial statements that $20 of Contract B is allocated to remaining performance obligations as of December 31, 2015. Further details about disclosure requirements under ASC 606 can be found in the RevenueHub article “Disclosures.”
The following example illustrates the application of the two methods to the same scenario.
Saunter Company enters into a 3-year contract on January 1, 2015 to deliver a one-time cell phone software update and ongoing technical support. The contract value is $600, and under the previous standard, this $600 was recognized on a straight-line basis over three years. However, Saunter determines that under ASC 606, two performance obligations exist. One performance obligation, valued at $300, is delivering the software update and is met during the first year; the second performance obligation, also worth $300, is the technical support and would be recognized on a straight-line basis over the three years: $100 each year for the years 2015, 2016, and 2017. Saunter applies ASC 606 for the first time in 2017.
Application of the Modified-Retrospective Method
Using MRM in the transition to ASC 606, Saunter would keep revenues from the contract under the legacy standard of $200 in 2015 and $200 in 2016. By the beginning of 2017, $400 of the $600 contract would have been recognized. However, had Saunter applied ASC 606 to the current contract, $300 + $100 + $100 = $500 would have been recognized by the beginning of 2017. To apply the modified retrospective method, Saunter adjusts the beginning retained earnings balance by the difference of $100 ($500 – $400) and recognizes the last $100 of income over the final year of the contract.
As a disclosure, Saunter would have to include an explanation of how applying ASC 606 led to any significant changes in the reported results. In this case, Saunter might mention how revenue in the current period was significantly less than what would have been expected under ASC 605 due to implementation of the new revenue standard. Saunter may also say that ending retained earnings and overall equity were not impacted because the contract was completed in the current year, and no performance obligations remain (i.e., ending equity would have been the same under both ASC 605 and ASC 606). Saunter would also have to show the difference in each line item that was affected by the transition: revenue was $100 less than it would have been under ASC 605. To have the data to disclose these items, Saunter would probably have to maintain two sets of books during 2017.
Application of the Full-Retrospective Method
Using the FRM to transition, Saunter recasts the prior periods listed on the financial statements. Revenues are adjusted and recast as $400 for 2015 and $100 for 2016, leaving $100 of revenue for 2017. This would carry through to retained earnings as in the previous method. Saunter cannot apply expedient 1 because the contract is ongoing and expands over multiple periods. Saunter cannot apply expedient 2 because the contract does not involve variable consideration and is not yet completed. Saunter may apply expedient 3 and choose not to disclose that $200 of the $600 transaction price remained as of the end of 2015, and $100 remained as of the end of 2016. However, Saunter must disclose its application of expedient 3.
Entities applying ASC 606 should take many things into account when selecting a method to use. Entities should first consider which method would provide the most meaningful information to the users of their financial statements. After conducting an analysis, if an entity determines that applying ASC 606 will result in significant differences in recognized revenue, they may opt to use the FRM transition method. This approach would boost comparability between the periods presented, allowing current and potential investors to make better decisions. As shown in the example above, the alternative MRM may significantly distort revenue and income trends, thus FRM may prove to be the better option. However, if only minor changes to revenue occur due to application of ASC 606, it may be in the entity’s best interest to use MRM in the transition. Entities with many high-dollar, long-term, specialized, or incomplete contracts should strongly consider implementing the Full Retrospective Method to ensure comparability. Entities with homogenous or short-term contracts may find that the Modified Retrospective Method maintains comparability with substantially less effort and costs.
FRM requires access to more historical data than MRM, which may inhibit some entities from transitioning with FRM. When changing systems, data may be lost or may require manual extraction.
Entities should consider the benefits of each method as well as the costs of implementation. For example, the different methods may result in different costs when evaluating contracts and performance obligations. With MRM, entities’ costs include those of revaluating currently open contracts and dual bookkeeping during the initial year of application. On the other hand, entities applying FRM will not incur costs of dual bookkeeping during the initial year of application but may choose to keep dual records (one for each standard) over the next few years in preparation for recasting comparative data once ASC 606 is adopted. Entities using FRM will have to analyze the majority of their multiple-period contracts, even those that are completed under ASC 605 as of initial application of ASC 606. The costs of each method will depend on an entity’s industry, business model, innovation, and cost structure, among other things.
Internal control design and implementation will be a big part of the transition effort. Entities will need to adjust their systems to transition to ASC 606. ASC 606 requires more judgement and estimates by management than ASC 605, and entities will need to design and implement controls to validate those judgements and estimates when they are made. Many judgements and estimates are made over the life of a contract, and entities will need to design and implement controls to monitor changes when they occur during the contract period.
Public entities, including some not-for-profit organizations and employee benefit plans, must implement ASC 606 for annual and interim periods beginning after December 15, 2017. All other entities must implement the new revenue standard to their annual statements for periods beginning after December 15, 2018, and to their interim statements beginning after December 15, 2019. All entities have the option to adopt ASC 606 as early as periods beginning after December 15, 2016.
When adopting ASC 606, entities are given two transition methods to choose from: the Modified-Retrospective Method and the Full-Retrospective Method. With the Modified-Retrospective Method, an adjustment to beginning retained earnings is made in the year of initial application, and additional disclosures are required. The Full-Retrospective Method requires entities to recast prior period financial data in comparative financial statements. Practical expedients are permitted to facilitate the transition.
- ASC 250-10-45-5 to 45-10
- ASC 606-10-65
- ASU 2015-14: “Deferral of the Effective Date.”
- ASU 2016-12: “Narrow-Scope Improvements and Practical Expedients.”
- Deloitte, “A Roadmap to Applying the New Revenue Recognition Standard.” November 2018. Section 15.
- IFRS 15
- KPMG, Handbook: “Revenue Recognition.” November 2018. Section 16.
- PwC, “Revenue from Contracts with Customers.” September 2018. Section 13.3.