You may have heard the saying “Nothing happens until someone sells something,” The reason you started your business is that you thought you had something that would make other people’s lives better, and you could provide it for them.
When you sell your product or service, you would just record it as sales revenue and cash when you sold it. However, as your business matured, you may have discovered that the moment a sale is completed is not always when you get to consider the money you received as revenue.
The New Standard
On May 28, 2014, a joint revenue standard was issued by two of the main standards bodies of accounting, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The standard changes the way in which a company can recognize revenue. What used to happen is that different industries would recognize revenue in different ways. This new standard provides one way for all industries to report revenue. Now you will recognize revenue when the control of the item that you sell passes to the customer.
Effect on Your Small Businesses
David Worrell, co-author of The Entrepreneur’s Guide to Financial Statements and founding partner of Rock Solid Finance, says the standard will mostly speed up when revenue is recognized. It’s a good idea to check the language in your contracts with customers to see how the new standard might affect you. However, he says small businesses that keep their books on a cash basis for tax purposes will most likely not be affected.
But, he adds, if you use generally accepted accounting principles (GAAP), you should look carefully at your revenue-recognition policies, particularly if you deal with any of the following:
- Advance payments
- Long-term contracts
- Employee incentives related to sales
Since the accounting for these types of items will change, there are certain types of industries that will be most affected by this change, including:
- Aerospace and defense companies
- Construction and real-estate firms
- Technology and software companies
- Life sciences companies
- Retail stores
- Media and entertainment companies
- Telecommunications firms
So, how will things be changing? There are a few areas you need to keep in mind as the standard goes into effect.
- Performance obligations. You may have some contracts in which you provide multiple products or services to customers, and have previously recognized the revenue from the contract all at once. Now, you will recognize revenue from each component separately based on when you perform those services or provide those goods to your customer. Take a look at the contracts you have with your customers to determine when you are to provide those services or products. You will recognize revenue when you fulfill those obligations.
- Contract modifications. The new rules changed when contract modifications can be recognized and whether the original transaction price is adjusted or the modification represents a separate performance obligation. Make sure your contract language is clear on when modifications can occur, and when you can bill the client for them.
- Variable contract prices. If you have any cost-plus or unit-priced contracts, or have any with performance incentives, the revenue from these contracts is recognized when there is no longer the chance that there will not be any downward adjustments on the amount you charge the customer. You will have to be satisfied, and be able to prove, that the billing for work will not have to be reduced before you can recognize the revenue. Make sure your contracts specify the period during which customers can ask for these adjustments.
- If you are in the construction industry and use the percentage-of-completion method to account for contract revenue, you will still be able to recognize revenue over the course of performing the services listed in the contract. However, you can only recognize the revenue to the extent that control of goods or services have been transferred to the customer. Your contracts will need to define when control transfers to the customer, or you may be forced to recognize revenue at a much later date than originally determined.
If you are unsure of how the new revenue-recognition standard will affect your financials, talk to your accountant to see what changes, if any, you need to make in how you operate.