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The growth of e-commerce has enabled buyers and sellers to connect in ways that were previously difficult or impossible. E-commerce is defined as the exchange of goods and services on the internet. A space that was traditionally accessible to only large corporations, e-commerce has enabled entities of all sizes, including freelancers to startups to sell products and services considering the ease of accessibility to customers and suppliers.
E-commerce transactions include everything from buying a t-shirt to hiring a freelancer for your business. It continues to redefine the retail industry and how we shop. However, conducting business via the internet adds complexity to the accounting processes of e-commerce companies.
Adding to this complexity is the new revenue recognition standard that companies must adopt in 2021. ASC 606 requires additional disclosures and transparency around the nature, timing, and amount of revenue from contracts with customers.
Accounting Treatment and revenue recognition for E-Commerce companies
The accounting treatment involves recording entries for cash receipts and deferred revenue, for example. Currently, most retailers recognize revenue when a product reaches a customer’s door. In implementing ASC 606, management will have to reconsider this one-size-fits-all approach to recognizing revenue.
Given the multiple steps in the revenue cycle, analysis is needed to determine when revenue has been earned – such as when a product ships vs. when it’s delivered.
E-commerce companies that sell physical products must perform additional accounting tasks to fully capture the transactions. Entries to record inventory, sales tax, and cost of goods sold must also be recorded.
In a typical e-commerce transaction, sellers receive online payments from customers who place orders for goods. The seller either ships goods from their warehouses to customers or partners with a third-party supplier to deliver products to customers.
Suppose a customer placed an order for $1,000 plus 7% sales tax. The customer pays a total of $1,070: $1,000 for products plus $70 for sales tax.
Unlike service companies, e-commerce companies that sell physical products must collect sales tax from customers. Sales tax is calculated during the checkout process and added to the order total.
In the first scenario, the seller would record the following journal entry to account for the payment received from the customer:
| Account | DR | CR |
|---|---|---|
| Accounts Receivable | $1,070 | |
| Deferred Revenue | $1,000 | |
| Sales Tax Payable | $70 |
The 5-step revenue recognition model directs companies to recognize revenue when earned; in e-commerce, the point of recognition is when the product is shipped. At this point the company records the following journal entries:
| Account | DR | CR |
|---|---|---|
| Deferred Revenue | $1,000 | |
| Revenue | $1,000 |
Some companies currently recognize revenue when a product is shipped, but there are still companies that follow the old accounting standard (ASC 605) and recognize revenue at delivery. The same journal entry applies when a company recognizes revenue at delivery, it would simply be recorded later since delivery would occur after shipping.
Knowing when to record revenue means companies must have a supply chain function that provides real-time data to track orders. The supply chain is essential in that it monitors the steps in the fulfillment process: receipt of the customer’s order, payment, and shipping.
Because physical products are sold, the company must also record an entry for the cost of (1) manufacturing the product shipped to the customer or (2) purchasing products from vendors for resale. This is called Cost of Goods Sold. Continuing with the previous example, assuming the cost of the product is $600, the journal entry would be as follows:
| Account | DR | CR |
|---|---|---|
| Cost of Goods Sold | $600 | |
| Inventory | $600 |
E-Commerce and Third-Party Suppliers
If the seller ships using a third-party supplier, the timing of recognizing revenue depends on the supplier’s shipping process. This method is known as dropshipping and has eliminated barriers to entry in the retail space for small and growing businesses. E-commerce companies must communicate with suppliers to know when orders are shipped since revenue cannot be recognized until then. In many cases, this communication is electronic and part of a larger workflow in the revenue cycle.
For example, a company may integrate its sales order system with a supplier’s inventory system at the warehouse. Once a customer places an order, this notifies the warehouse to fulfill it. Once the order is packaged and ready for shipment, the warehouse system automatically updates the company’s records to show the item is en route to the customer. The e-commerce company then updates its records with the completed order and recognizes revenue in its financial statements.
The journal entries are the same as in scenario 1. The exception is timing since the e-commerce company has no control over shipping times.
Sales Returns
It’s inevitable that customers will return products. E-commerce companies will record a returns reserve as a “cushion” to not overstate revenue. The reserve is based on historical return trends and reviewed to determine if the reserve accurately reflects return activity.
If a customer returns an order, the following journal entries are recorded:
| Account | DR | CR |
|---|---|---|
| Revenue | $1,000 | |
| Sales Tax Payable | $70 | |
| Accounts Receivable | $1,070 |
| Account | DR | CR |
|---|---|---|
| Inventory | $600 | |
| Cost of Goods Sold | $600 |
These journal entries are reversals of the original entries. Since the product was returned, it’s as if a sale never occurred. These entries will adjust the financials to remove all transactions related to the sale.
This sequence of entries speaks to the importance of e-commerce companies understanding the revenue cycle and points at which to record revenue.
While the increased transparency is designed to make reporting simpler, the steps to get there will require companies to evaluate and enhance their finance operations processes and systems to accommodate the requirements of ASC 606.
Additional complexity around E-commerce revenue recognition
Despite the seemingly straightforward nature of E-commerce revenue recognition, there are several challenges that our team has seen arise among our customers. These are caused by:
- Multiple line items where an item will get back ordered or an order will get returned
- Allocating bulk discounts and list prices being completely decoupled by what you actually billed and invoiced customers for
Here are both of these scenarios and their implications explained by Leapfin’s Chief Architect Jason Berwanger.
How revenue recognition for E-commerce companies can get 70% more efficient
One of the biggest issues E-commerce companies face with rev rec is scaling processes efficiently. When dealing with the scenarios described above (rev rec for back orders or refunds for some of the multiple line items in an order, or bulk discounts), revenue recognition turns into an activity that takes up most of your Accounting team’s time.
But it’s more of a “bean counting” activity than a forward-looking, analytical, and value-adding process.
As Jason explains it:
“Once things like back orders or bulk discounts start to happen at a greater scale, that’s usually when someone starts to see how time-intensive it can get. I think the realization from folks that I chat with is that they will probably spend 70% of my time just figuring out what revenue recognition looks like.
People are doing that instead of looking at the performance of certain products on revenues. And, if you’re spending 70% of your time, performing the data analysis and the data scrub and translating that into bookkeeping entries – that’s probably not a great use of your time.
Not to mention the inaccuracies or inconsistencies that sometimes come with some of those processes over time.
And the way that a Finance Data Platform like Leapfin really helps is by connecting to your list price for your standalone selling price as one source. And that’s updated in near real-time. And then you have all of your contracts that e-commerce orders and the line items with them, we connect with those sources as well.
And then Leapfin can apply your custom business logic to your revenue recognition process. When we do that, revenue recognition happens on a daily basis in near real-time. What that manifests itself is that 70% of your time spent on validating data goes to zero. You’re now able to focus on really analyzing how different segments of your business are doing and making the right strategic decisions.”
Further reading on revenue recognition:
- Learn more about revenue recognition for subscription businesses
- An insight into other revenue recognition challenges
- Everything you need to know about cash accounting revenue recognition for subscription businesses
- Some more ASC 606 revenue recognition challenges
- The complexity of revenue recognition gift cards
