Revenue Recognition: An Introduction for Small Businesses
How much revenue did your business earn this month? That answer may vary depending on whether you have implemented the new revenue recognition standard or not. If you are looking for investors, a bank loan or even looking to sell your business, the way you record revenue needs to be in line with Generally Accepted Accounting Principles (GAAP) and the new Revenue Recognition Standard.
In May 2014, the Financial Accounting Standards Board (FASB), issued Accounting Standards Codification (ASC) 606, a new set of rules for recognizing revenue from contracts with customers. The old guidance was comprised of broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes resulted in different accounting for economically similar transactions. This lack of standardization in financial reporting made it difficult for investors and other consumers of financial statements to compare results across industries, and even companies within the same industry. ASC 606 eliminates variations in the way businesses across industries handle accounting for similar transactions by replacing the numerous industry and transaction-specific guidelines with a basic, five-step framework. Under the new rule, companies must carry out the following steps:
Step 1: Identify the contract(s) with a customer.
- A valid contract must exist and have commercial substance. The contract must clearly show the goods or services that will be delivered and the payment terms for those goods and services.
Step 2: Identify the performance obligations in the contract.
- If more than one good or service is promised, identify and separate. Also distinguish between the promise or obligation to provide goods and services, and any other obligations to a customer.
Step 3: Determine the transaction price.
- The amount of consideration to which you expect to be entitled to in exchange for transferring goods or services should be clearly reflected in the contract.
Step 4: Allocate the transaction price to the performance obligations in the contract.
- Break down the price of each individual good or service you are delivering. If you do not have an exact price for each good or service, estimate it.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
- Recognize revenue only after you have delivered each good or service you separated and priced out in the steps above, not necessarily when the payment is received.
In other words, the new framework requires entities to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
If your small business is in the retail industry, construction, manufacturing or if you provide subscription services, you may be affected by the new rule. If you deal with warranties, advance payments, rebates and discounts, long-term contracts, employee incentives, tech support, sales incentives, and services that cannot be completed within a year, you may also be affected by the new rule.
All companies that report using U.S. GAAP are required to adapt to the new standard. In May 2020, the FASB met and voted to extend the effective date for nonpublic entities that have not yet issued their financial statements. The effective date was extended to annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020. Early application is permitted.
Read over steps 1-5 of ASC 606 above and make sure you understand how they affect the way you recognize revenue. Implementing ASC 606 will not only impact your accounting and financial departments, but will also impact your IT systems, HR policies and more.
Have you started to analyze the impact of the new standard or taken any steps toward implementation? If your business needs expert help dealing with the new revenue recognition rules or any other aspects of your accounting, CPA by Choice can help. We are available to answer your questions, feel free to call us or send us a message.