ASC 606 Revenue Recognition for Private Companies: The Five Steps and What Auditors Test

Revenue is usually the largest number in the income statement and, under GAAS, it carries a presumed risk of material misstatement due to fraud. ASC 606, Revenue from Contracts with Customers, applies to private companies. Treating revenue as "invoices issued during the year" works only when the contracts are simple, and the auditor needs evidence that they are.

This guide walks through the five-step model with private-company examples, the practical expedients and disclosure relief available to entities other than public business entities, and the procedures auditors use to test revenue. It paraphrases the Codification and the auditing standards and is not a substitute for them.

The core principle

ASC 606 requires an entity 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. The model applies to contracts with customers, with scope exceptions for items such as leases (ASC 842), insurance contracts, financial instruments and certain nonmonetary exchanges.

The five-step model

Step 1: Identify the contract

A contract exists for ASC 606 purposes when all of these criteria are met:

• the parties have approved the contract (in writing, orally or by customary business practice) and are committed to perform
• each party's rights regarding the goods or services can be identified
• the payment terms can be identified
• the contract has commercial substance
• it is probable that the entity will collect substantially all of the consideration to which it will be entitled

Contracts can be combined when they are entered into at or near the same time with the same customer and meet certain criteria. Contract modifications, such as change orders, are accounted for as a separate contract, as a termination and new contract, or as part of the existing contract, depending on whether distinct goods or services are added at their standalone selling prices.

Example: a construction subcontractor starts work on an unsigned change order. If the change is approved by customary practice and enforceable, it may be a contract modification even before the paperwork is signed.

Step 2: Identify the performance obligations

A performance obligation is a promise to transfer a good or service (or bundle) that is distinct, or a series of distinct goods or services that are substantially the same and have the same pattern of transfer. A good or service is distinct if the customer can benefit from it on its own or with readily available resources, and the promise is separately identifiable from other promises in the contract.

Example: a software company sells a license, installation and one year of support. Installation that any third party could perform is likely distinct; customization that significantly modifies the software may not be.

Step 3: Determine the transaction price

The transaction price is the consideration the entity expects to be entitled to, considering:

• variable consideration (discounts, rebates, refunds, credits, incentives, performance bonuses, penalties), estimated using the expected value or most likely amount method and subject to the constraint: include it only to the extent that it is probable that a significant reversal of cumulative revenue will not occur
• significant financing components
• noncash consideration
• consideration payable to the customer, such as slotting fees or coupons

Step 4: Allocate the transaction price

The transaction price is allocated to each performance obligation based on relative standalone selling prices (SSP). If SSP is not observable, it is estimated using an approach such as adjusted market assessment, expected cost plus a margin, or, in limited cases, a residual approach. Discounts and variable consideration may be allocated to specific obligations if criteria are met.

Step 5: Recognize revenue when (or as) obligations are satisfied

A performance obligation is satisfied over time if one of three criteria is met:

1. the customer simultaneously receives and consumes the benefits as the entity performs (many services)
2. the entity's performance creates or enhances an asset the customer controls as it is created (for example, construction on the customer's land)
3. the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date

Otherwise, revenue is recognized at a point in time, when control transfers. Indicators include a present right to payment, legal title, physical possession, transfer of significant risks and rewards, and customer acceptance.

For over-time obligations, the entity selects a method to measure progress, either an output method (units delivered, milestones) or an input method (costs incurred, labor hours), and applies it consistently.

Practical expedients and private company relief

ASC 606 includes several practical expedients available to all entities, and private companies commonly use them:

• Significant financing component: no adjustment if the period between transfer and payment is expected to be one year or less.
• Incremental costs of obtaining a contract (ASC 340-40): may be expensed as incurred if the amortization period would be one year or less.
• Shipping and handling after control transfers may be treated as a fulfillment activity rather than a promised service.
• Sales taxes collected from customers may be excluded from the transaction price.
• Portfolio approach for contracts with similar characteristics, when the result would not differ materially.
• Right to invoice: when the entity has a right to consideration in an amount that corresponds directly with the value of performance to date, it may recognize revenue in that amount.
• Immaterial promised goods or services in the context of the contract need not be assessed as performance obligations.

Entities other than public business entities also have disclosure relief. For example, they can elect not to provide certain quantitative disaggregation disclosures, some contract balance reconciliations, and certain remaining performance obligation disclosures, subject to minimum disclosures. There is also a franchisor practical expedient for pre-opening services (ASU 2021-02). The specific elections are set out in ASC 606-10-50.

Contract balances

• Contract asset: the entity's right to consideration in exchange for goods or services transferred, when that right is conditional on something other than the passage of time (for example, unbilled revenue on a milestone contract).
• Receivable: an unconditional right to consideration.
• Contract liability: an obligation to transfer goods or services for which the entity has received consideration or an amount is due (deferred revenue).

Contract assets and receivables are in the scope of the credit loss guidance in ASC 326. See our guide to CECL for private companies.

What auditors test

Risk assessment

Under AU-C 240, the auditor presumes there are risks of fraud in revenue recognition and evaluates which types of revenue, revenue transactions or assertions give rise to them. If the auditor concludes the presumption does not apply in the circumstances, the reasons must be documented. Under AU-C 315, the auditor considers the inherent risk factors for each revenue stream: complexity of contract terms, subjectivity in estimates such as variable consideration and progress toward completion, and susceptibility to management bias.

Materiality under AU-C 320 can be based on revenue for entities where users focus on the top line, and auditors may set a lower specific materiality for revenue-related disclosures.

Understanding the revenue streams

Document each significant revenue stream: what is sold, typical contract terms, how each of the five steps is applied, the systems involved, and the controls that address risks. A short accounting memo per stream, prepared by management and reviewed by the auditor, can be carried forward in later years.

Contracts and terms

• Select a sample of contracts and read them, including side letters, amendments and change orders.
• Evaluate whether the five-step analysis was applied correctly: performance obligations identified, variable consideration estimated and constrained, allocation reasonable.
• Look for unusual terms that change the accounting: rights of return, acceptance clauses, bill-and-hold arrangements, consignment, extended payment terms or significant customer discounts.
• For contracts recognized over time, test the measure of progress, such as cost-to-cost calculations, including estimated costs to complete.

Occurrence and accuracy

• Vouch a sample of recorded revenue to contracts, customer purchase orders, shipping documents or evidence of service delivery, and to subsequent cash receipt. Use AU-C 530 for sample design.
• Confirm receivable balances or, in some cases, contract terms with customers under AU-C 505.
• Perform substantive analytical procedures where the data supports a precise expectation, for example revenue by unit volume and price.

Cutoff

Cutoff needs its own testing.

• Select transactions recorded shortly before and after year-end and examine shipping terms, delivery evidence or service completion to confirm the period.
• Examine credit memos and returns issued after year-end that relate to pre-year-end sales.
• Review the timing of large or unusual sales near period-end.

Gross vs net (principal vs agent)

When another party is involved in providing goods or services, the entity determines whether it is a principal (recognizes revenue gross) or an agent (recognizes its fee or commission net). The question is whether the entity controls the specified good or service before it transfers to the customer. Indicators of control include:

• primary responsibility for fulfilling the promise
• inventory risk before or after transfer
• discretion in establishing the price

Common examples in smaller entities include travel and event companies, staffing firms, e-commerce marketplaces, and contractors that pass through materials or subcontractor costs. The auditor reads the contracts and evaluates management's analysis. A gross vs net error does not change net income but can materially misstate revenue and gross margin.

Disclosures

Test that the disclosures required for the entity (with any private company elections) are present and supported: disaggregation, contract balances, performance obligations, significant judgments and practical expedients used.

Gaps to avoid

• Revenue streams documented only as "revenue is recognized when invoiced."
• Variable consideration such as volume rebates accrued on a cash basis.
• Over-time revenue with no testing of estimated costs to complete.
• Cutoff testing limited to the last few invoices before year-end, with nothing after.
• No analysis of principal vs agent for pass-through costs.
• Missing or boilerplate revenue disclosures.

Uncorrected revenue misstatements go on the summary of uncorrected misstatements under AU-C 450, where qualitative factors such as effects on covenants or trends matter.

Frequently asked questions

Does ASC 606 apply to small private companies?

Yes. ASC 606 applies to all entities that report under US GAAP and have contracts with customers, including private companies. Private companies have some practical expedients and disclosure relief, but the recognition model is the same.

What are the five steps of ASC 606?

Identify the contract, identify the performance obligations, determine the transaction price, allocate the transaction price to the performance obligations, and recognize revenue when or as each performance obligation is satisfied.

Why is revenue a presumed fraud risk?

AU-C 240 presumes a risk of material misstatement due to fraud in revenue recognition because revenue is a common target for manipulation. The auditor evaluates which revenue types or assertions give rise to the risk and designs specific responses.

How do auditors test gross vs net revenue?

Auditors read the relevant contracts, evaluate whether the entity controls the good or service before transfer, consider indicators such as fulfillment responsibility, inventory risk and pricing discretion, and assess whether management's conclusion and disclosure are appropriate.

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Sources

• FASB ASC 606-10, Revenue from Contracts with Customers (five-step model, practical expedients, disclosures in 606-10-50)
• FASB ASC 340-40, Other Assets and Deferred Costs, Contracts with Customers
• FASB ASU 2021-02, Franchisors, Revenue From Contracts With Customers (Subtopic 952-606)
• FASB ASC 326, Financial Instruments, Credit Losses
• AICPA, AU-C Section 240 (presumed fraud risk in revenue recognition), 315, 320, 450, 505 and 530

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error