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The Revenue Recognition Standard and Small Businesses

By Evan Scarbrough, CPA
November 1, 2018
1 comments

The newly updated standard is likely to affect small businesses differently depending on which industry they operate in.

 

If your small business follows International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (GAAP), the new accounting rules for revenue recognition, Revenue from Contracts with Customers, could impact your company in a number of ways, including how all transaction prices are allocated, the importance of contracts, and what should be included in future contracts. The new rules go into effect for private companies’ annual reporting periods starting on December 15, 2018, for those following U.S. GAAP or January 1, 2019, for those using IFRS.

 

Essentially, the new standards separate contracts that have multiple components into numerous metrics and allocate the sales price into the various components. If all components of a contract can be completed within a year, then you can recognize revenue at the point of sale.

 

The two new standards—IFRS 15 and Accounting Standards Codification (ASC) 606—were issued by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), respectively. While the two standards do have some differences—for example, ASC 606 allows a retrospective approach applying the new standard to completed contracts whereas IFRS 15 doesn’t—they are nearly identical, so I will be treating them as one new standard.

 

WHICH COMPANIES WILL BE AFFECTED?

 

In my time as an accounting professional, I have used or reviewed various clients’ ledgers for tax return preparation, auditing, and consultation work. This has shown me that a lot of small businesses don’t follow GAAP or IFRS but use another basis of accounting instead, such as cash or tax basis. Those companies won’t have to change anything.

 

If your small business follows U.S. GAAP or IFRS, however, there are a number of yellow flags that might indicate your business may be affected by the new rule, including warranties, advance payments, rebates and discounts, long-term contracts, employee incentives, tech support (or other post-sale service), sales incentives (for example, free oil changes when purchasing a car), and services that can’t be completed within a year (or might have additional work in the future).

 

Small businesses in the following industries will be heavily affected:

 

  1. Retail (warranties and discounts): Under the old standard, you would recognize revenue for a transaction all at once, and it was based on the transaction price. With the new standard, the price is allocated to the different items within the transaction, as well as to warranties and returns—and all these components have different lives. There’s an additional wrinkle in dealing with discounts, where the discount follows the specific item discounted. An example is a discount being given on a love seat when the consumer purchases an entire living room set. The discount isn’t spread across the whole living room set; it’s applied to the love seat specifically.

 

  1. Construction (long-term contracts): The new rules are concerned with who controls the asset or service as part of the contract. For example, who controls the partially finished office building up the street—the contractor or the owner of the property? The owner only controls what the contractor has completed. Due to this, the construction company uses the percentage of completion method to allocate revenue or allocates all the revenue at the end.

 

  1. Electronics/software manufacturers (tech support): For example, a new phone purchase will be divided into the purchase of the device, the service, and tech support. Each of these metrics has a different life cycle and, thus, a different time frame that should be used to recognize the revenue.

 

  1. Custom projects or vehicles (long-term contracts): Consider someone who commissions a painting from an artist with the purchaser’s family member as the subject. But later on, the purchaser doesn’t like the artwork and refuses to take ownership of it. The painting is custom, so it isn’t easily resalable. The new standard allows the artist to recognize the revenue when an artwork is rejected and possibly causes a loss.

 

  1. Tax services: When I worked at an accounting firm, we would prepare a client’s tax return. If the client received a notice from the IRS, we also would draft a response and perform a limited amount of extra work as needed without additional compensation from the client. With the new standard, part of the transaction price would need to be allocated to these extra services and amortized over time.

 

  1. Manufacturers: All incidental contract expenses incurred, whether a contract was obtained or not, are expensed, such as equipment operating manuals in a specific language of a client. That said, any expenses incurred to get a sale, like a commission, are now amortized to coincide with the matching principle.

 

KEY CONSIDERATIONS

 

There are several other areas related to this new standard that can impact small businesses. The first is metrics and performance obligations. The revenue from contracts that provide multiple products or services to customers used to be recognized at one time. Now the company will recognize revenue from each metric separately based on when it performs the particular service or provides the specific goods to the customer.

 

The second area is contract modifications, which can now only be recognized when the original transaction price is adjusted or when there’s an adjustment in the goods or services to be transferred. Thus, it’s imperative that the language in the contract is clear about when modifications can occur and when the price can be changed.

 

The third area is variable contract prices. Revenue is only recognized when there can be no more negative adjustments to the amount billed. This applies to cost-plus or unit-priced contracts or specific performance incentives. Thus, to recognize revenue in these types of contracts, small businesses will have to prove that there will be no more devaluation in billings. It’s a good idea to specify in the contract when adjustments to billings can occur.

 

Finally, the new standard impacts the percentage of completion. In construction, for example, contractors can only recognize the revenue to the extent that control of goods or services has been transferred to the customer, which can be subjective. It’s a good idea to indicate in the contract exactly when the contractor gave control to the client.

 

Applying this new standard requires accountants to use their best judgment based on multiple data points and sources of information. This is where professionals with the CMA® (Certified Management Accountant) certification can shine in the implementation as they have the proven technical knowledge to interpret data to allocate the revenue and expenses.

 

Evan Scarbrough, CPA, is an auditor for the City of Detroit and a member of IMA’s Ann Arbor Chapter. You can reach him at eascarbro@gmail.com.
1 + Show Comments

1 comment.
    Ahmad Wazeer November 16, 2018 AT 12:36 am

    Thanks for your valuable article

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