Revenue Recognition in Dropshipping a Brief Guide

The Financial Accounting Standards Board (FASB), has released a new revenue recognition standard. It is generally effective for the 2019 and 2020 years. Many have noticed that some industries will be more affected than others. Distributors have a straightforward revenue recognition model. Revenue is usually recognized when the product is shipped. This coincides with the time title and risk of losing pass from the seller. Although this may require some knowledge of shipping terms such as FOB shipping points or FOB destination, the principle behind revenue recognition is simple.

Many accountants anticipated very little from the new standard for distributors at first glance. This new standard allows for the recognition of revenue at the time the goods are shipped. This is the seller’s fulfillment obligation. This will likely be true in most cases.

Drop shipments are a different situation. However, this decision can be more difficult. Drop shipments are where a distributor does not hold inventory but directs the supplier to ship directly to the customer. These types of sales by distributors have historically been recognised in the same way as sales, in that the distributor ships its inventory directly to customers. However, the new standard requires us to look closer.

Coming Changes

The new revenue recognition standard distinguishes between an agent and a principal in a transaction. This results in different treatment. Revenue from a transaction should be recorded at the gross amount (sales value) by a principal such as a distributor that is obligated to supply its own inventory to customers. However, an agent who directs a supplier in providing product to its customer may not be able to record revenue at the gross amount. The new standard is focused on controlling the product. To be considered a principal, a distributor must have full control over the product before it is sold to customers.

This subjective decision will be made based on facts and conditions. Considerations to be made include: whether the distributor is at risk of losing the product in transit; whether the distributor has the ability to change shipping instructions at any time; how the distributor handles customer complaints and returns related to dropped shipments; and whether the distributor holds legal title to the product. (The rules state that mere possession does not necessarily mean control). You may also find relevant other observations within a particular fact pattern. It is not always easy to determine.

Your Impact

If you are a principal or agent in a transaction, revenue must be reported at the net amount and not at the gross. Top-line sales revenue will only include the gross profit. This is a major change from the current practice. Distributors that use a lot of drop shipping could see a big impact on their top-line sales revenue.

E-commerce has made it possible for buyers and sellers to communicate in new ways. Ecommerce refers to the online exchange of goods or services. E-commerce is a space that was previously only accessible to large corporations. However, it has allowed entities of all sizes, from freelancers to startups, to sell products or services because of the ease of access to customers and suppliers.

E-commerce transactions can include everything, from purchasing a tee-shirt to hiring freelancers for your business. E-commerce continues to revolutionize the retail industry as well as how we shop. The accounting process for e-commerce businesses is complicated because of the complexity of conducting business online.

This complexity is further exacerbated by the new revenue recognition standard companies will have to adopt in 2021. ASC 606 requires that additional information and transparency be provided about the nature, timing and amount of revenue generated from customer contracts.

E-Commerce Dropshipping Accounting

Accounting involves, for example, recording cash receipts or deferred revenues. Most retailers currently recognize revenue when a product arrives at a customer’s doorstep. Management will need to reconsider the one-size-fits all approach to revenue recognition when ASC 606 is implemented.

Due to the many steps involved in the revenue cycle analysis is required to determine when revenue was earned. For example, when a product ships and when it’s delivered.

To fully capture transactions, e-commerce dropshipping businesses that sell physical products need to perform additional accounting tasks. Also, it is necessary to keep track of inventory, sales tax, as well as the cost of goods sold.

Customers place orders and send money to sellers online. This is a typical ecommerce transaction. Either the seller ships products from their warehouses to customers, or they partner with a third party supplier to deliver them.

Let’s say a customer orders $1,000 and pays 7% sales tax. The total cost of the customer’s order is $1,070. $1,000 for the products and $70 for sales tax.

E-commerce dropshipping businesses that sell physical products have to collect sales tax, unlike service companies. The sales tax is added to the total order amount and calculated during checkout.

Companies should recognize revenue as earned in dropshipping. The point of recognition for revenue is when the product has been shipped. The company then records the following journal entries.

While some companies recognize revenue when a product ships, others still follow the old accounting standards (ASC 605) or recognize revenue at shipment. It is the same journal entry that applies to revenue recognition at delivery. This would be recorded later, as delivery occurs after shipping.

Companies must have a supply-chain function that tracks orders and provides real-time information to determine when revenue should be recorded. It monitors all steps of fulfillment, including receipt, payment, and shipping.

Physical products can be sold. The company must record an entry detailing the costs of (1) manufacturing the product and (2) purchasing the products from vendors for resale.

E-Commerce and Third-Party Supply

The timing of recognising revenue is affected by the shipping process used by the third-party supplier if the seller ships using them. This is dropshipping, which has removed barriers to entry for growing and small businesses in the retail sector. E-commerce dropshipping companies need to communicate with suppliers in order to find out when orders have been shipped. Revenue cannot be recognized until that time. This communication is often electronic and part of larger workflows in the revenue cycle.

A company might, for example, integrate its sales order system and a supplier’s inventory at the warehouse. The warehouse is notified when a customer places an online order. The warehouse system updates its records automatically once the order has been packed and shipped. The warehouse system updates the company’s records with the order. Revenue is then recognized in its financial statements.

The journal entries are identical to scenario 1. Timing is the exception, as the e-commerce company does not have control over shipping times.

Sales Returns

Customers will return products. It is a given. Dropshipping E-commerce companies will keep a reserves reserve to ensure that they don’t overstate their revenue. The reserve is calculated based on historical returns trends and then reviewed to verify that it accurately reflects actual return activity.

These journal entries reverse the original entries. It’s almost as though the sale never took place since the product was returned. These entries will correct the financials to eliminate all transactions related.

This is a good example of the importance of ecommerce companies understanding the revenue cycle.

The increased transparency is intended to simplify reporting, but companies will need to assess and improve their financial operations systems and processes to meet ASC 606.