A company’s transformation to ASC 606 compliance involves three important phases: initial implementation of the standard, ASC 606 controls and evidence of the controls. A wealth of information is available on the initial implementation of ASC 606, and many tools and consulting services exist to help companies to implement the standard. By contrast, less is available regarding how companies can establish appropriate ASC 606 controls post-implementation.
A set of appropriate internal controls is critical to ensure the initial implementation is done correctly, the 606 requirements are met and reviewed on a regular basis and related support is collected and evidenced. Every company is unique, and as such, a set of ASC 606 internal controls should be a customized product for a company’s specific processes complying with initial implementation.
Considerations for ASC 606 Controls
In general, when a company establishes ASC 606 controls, it will need to consider that:
Controls must cover all five steps and all sub-areas in each step in ASC 606 if they are applicable to the company’s processes.
Similarly, the control list needs to be complete and comprehensive sufficiently covering all required steps and areas in the ASC 606. Although some of the steps and areas may not be applicable to a specific company, the inapplicable subjects need to be addressed in the list and include explanations if not relevant to a company.
Controls must be well designed for cross-functional applicability.
Most of the controls not only involve the accounting & finance department, but other departments such as legal, IT, logistic, sales & marketing. Some common failures in control design are due to a single focus on accounting and finance procedures, without the necessary considerations for work required in other functions within an organization.
Controls must be realistic for a company to obtain relevant evidential supports for the review and approval process.
Controls which look perfect on paper but unrealistic in compliance and verification are useless. When designing controls, keep in mind the various options and methodologies available to achieve the same control targets, and choose the most suitable options.
ASC 606 controls must be time and cost efficient based on a company’s practice.
Implementing a new practice may be a very expensive and/or a time-consuming endeavor for a company. To the extent possible, controls should maximize a company’s current resources, yet minimize additional costs. Using existing systems, tools and manpower are always appreciated regardless of the company’s financial situation, assuming the control targets can be met correctly and efficiently.
Controls should comply with other regulatory areas such as SOX, GAAP and both internal and external audit requirements.
Although ASC 606 is a separate topic and some of the definitions are different than traditional rules and practices, conflicting issues usually fall under errors. When a company is designing its ASC 606 controls, it needs to ensure these controls are not only in compliance with revenue recognition requirements, but also support other regulatory requirements.
Next, the company should make sure contracts and the contract approval process consider the following:
The customer contract should contain clear evidence of agreement terms.
A contract must be approved by both parties and can be written or verbal. A list of controls should be established and tracked for evidence of approvals and commitments of the involved parties, including copies of signed contracts with all valid terms or email communications with proper authorization or thorough documentation of any verbal communication approvals.
Each party’s rights regarding goods or services should be identified.
A contract only exists when related parties’ rights are explicit. A list of controls should be created based on the goods and services included in a contract.
Payment terms should be defined in the contract.
A list of controls to check price, discount rates, rebate rates, due dates must be clearly established. In addition, a contract must have commercial substance. Donations and internal non-commercial transfers usually do not require the commercial substance requirement.
A reasonable exception for the collectability of the considerations must exist.
A control list should be enough to review and support the collectability, such as historic customer performance, customers’ accounts receivable aging, customers’ recent related business events and announcements, any future risks for the collectability, current market trends and all others. This step requires many departments and functions to work together, including accounting & finance, legal, IT and sales. Additionally:
- Each contract should properly address all the required areas and key terms.
- Each contract should be reviewed and approved for procedure compliance.
- Any changes to the terms of a contract must be communicated in a timely manner before obtaining any appropriate approvals.
Additional Considerations for ASC 606 Controls During COVID-19
The business constraints caused by COVID-19 amplify the need for standardization, efficiency and cost savings. As such, the contract approval process must flow efficiently to avoid unnecessary bottlenecks yet be clear enough to protect against potential disputes and lawsuits.
A set of standardized contracts can simplify the process. If all customers cannot use one uniform contract format, standardize contracts to fewer fixed templates based on customer types or product/service types. Now is probably not the best time for excessive contract customization.
Simplify products and services.
Under the current pandemic, a company should focus on its essential businesses, allocate resources to key products to achieve overall efficiency and maximize its competitive advantages. Contracts for new products and/or new customers often require more resources and produce less returns at the beginning.
Implement a proper contract review database and system.
Revenue management software options abound for companies that want to streamline their ASC 606 compliance. If you’re exploring software, we offer a whitepaper to help you through the process of selecting the best fit for your company.
Identify performance obligations.
Goods or services in a contract must be considered distinct under ASC 606. In order to satisfy the requirement for distinction, goods or services must meet two criteria:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available.
- The organization’s promise to transfer the good or service is separately identifiable from other promises in the contract. In order to control this step, a company should create a list of check points for different types of obligations.
Types of obligations include constructing, manufacturing or developing an asset on behalf of the customer, granting licenses and granting options to purchase additional goods or services. The controls should be specifically designed for certain obligations in a contract. Under the current pandemic, some companies are developing accessories and derivative products to their core business. In such circumstances, it’s important the company can properly and successfully identify the performance obligations for these new products and services and meet the distinction requirement. Many of these new products and services may not look much different than the traditional ones and as a result, a detail review list need to be put in place for this control process.
Determine the transaction price.
This step involves a few different subtopics to determine the transaction price, including variable considerations, the existence of a significant financing component, non-cash considerations and considerations payable to the customer. In general, an organization should consider all four areas to determine the transaction price in a contract.
For the purposes of this post, I won’t go through the definitions of each topic in this step. But I will address a few considerations in the controls arena. For instance, one topic of controversy is whether the variable considerations a company offers to its customer should be included in the transaction price. The common rules are:
- If the variable considerations are common practice in the industry and often adopted by similar companies, they should be excluded in the transaction price.
- If the variable considerations put a company in a critical competitive advantage position, they usually should be included in the transaction price.
A list of appropriate controls should be able to verify these determinations. Examples may include a comparison study to similar companies in the same industry for related variable considerations, separate P&L statement of products for a specific customer to calculate the financial impacts of the variable considerations, and quantitative measurements of the variable considerations (if applicable) against a company’s profitability in an aggregate level.
Other challenging topics are non-cash considerations and payables to the customer. If any of these two are included in a contract, a company should conduct similar assessments to determine whether they should be included in the transaction price and how to quantify them. Under the current pandemic, some companies have switched to produce totally different products due to disruptions. As a result, they need to quickly establish new contracts and new business relationships for goods or services they may not have offered before. It is critical for these companies to do a proper study and analysis for all the topics required in the process of determining transaction price for their new products, make sure they meet compliance requirements, set up the transaction prices correctly and recognize accurate revenue in their books. A corresponding list of controls for the new production must be available to follow in a timely manner.
Regarding the process of allocating the transaction price to the performance obligations and recognizing revenue when the performance obligations are satisfied, one of the challenges is the estimation of revenue. Under ASC 606, revenues should be included in the financial performance if they can be reasonably estimated, even if the obligations have not been met and transactions are not completed. Although ASC 606 defines the rule, it does not provide specific guidelines and methodologies in how a company estimates its revenue. So, companies need to design their own methodologies and processes to show whether the estimations can be done reasonably and realistically.
The corresponding controls should be specified for a company’s products and processes, and they are usually different from one to another. Some examples are historic revenue data and trends of a customer, current period to date revenue recognized, remaining period duration, contract due dates, weighted average prices for each product and estimated quantity of each product in the remaining period. The revenue estimation process is a final product of science and art, combining solid data with business acumen and common knowledge. Due to current uncertainties created by the pandemic, the estimations of revenue become extremely challenging for many companies. However, using a scenario approach is always better than nothing. When cash is so critical for every company, a best estimation for revenue will give a company a clearer view of how much cash they will need (or extra funds they need to raise) to survive this crisis.
Summing Up Our Thoughts on ASC 606 Controls
ASC 606 controls are very important for any company in any business cycle and are now even more critical for organizations given the current pandemic. When companies implement such controls in their practice, they should not only meet all requirements, but also minimize related costs, improve review efficiency, standardize processes, automate manual procedures, better estimate financials and increase cash collections. Post-ASC 606 implementation, all processes and controls need to be reviewed periodically for changes. The final goal is to improve a company’s profitability and cash position.
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About the Author
Renee has 20+ years of diverse finance, accounting and project management experience in high-tech Software and hardware manufacturing and distribution. She has held various leadership roles and management positions in large global corporations as well as mid-sized companies such as Schneider Electric, Invensys Ltd, BenQ Corporation, and Max Group Corporation. Renee has a board range of experience in Corporate Strategy, Financial Modeling, FP&A, Business Process Improvement, System Implementation, M&A Due Diligence, Post-acquisition Integration and General Financial Reporting & Accounting. Renee holds a Bachelor of Arts in Economics from the University of California Irvine (UCI), an Executive MBA from the University of California Los Angeles (UCLA), and a Business Analytics Certificate from Harvard Business School.