Revenue Recognition for E-Commerce Companies
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 in E-Commerce
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:
|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:
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:
|Cost of Goods Sold||$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.
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:
|Sales Tax Payable||$70|
|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.