There are two big GAAP changes coming up that could have a major impact on small business if decision makers do not start thinking about the issues. These are changes to lease accounting and the new revenue recognition standards. The lease accounting is probably the more challenging of the two, as I will hopefully explain below.
New Lease Standards
The new lease standards will challenge every small business who needs access to capital and where the money people want GAAP financial statements. So, if you are even thinking of going public or taking on substantial bank debt, you need to think about implementing the new lease standards.
The new lease standards now require you to record an asset and a liability as though you bought the asset on a contract. You then amortize (depreciate) the new asset over the lease term. This is substantially different from old GAAP which handled leases off balance sheet – meaning payments were treated as an expense in the period incurred. The commitment for the lease was then reported in the disclosures.
Obviously, the kicker here is that you will now have additional debt on your books which did not exist before. And like all debt, the current portion, that amount due in the next twelve months, is considered a current liability. So businesses with tight current ratios (say 1.1:1.0) and an affirmative covenant to maintain a current ratio of 1.0:1.0 may find themselves out of compliance. Noncompliance is a default condition.
So, if you are thinking about leasing equipment you may want to reconsider this approach IF GAAP statements are a business requirement.
Recognizing Revenue from Service Contracts
This is a major rewrite for GAAP but is probably will not have a huge impact on most small businesses. Yes, conceptually the issue exists, but most small businesses do not have agreements with customers which extend for long periods of time. But, where your business does have an ongoing customer relationship where money is changed hands intermittently and service is on-going, then you will want to start looking at this ASC.
The biggest change is realizing that billing a customer no longer drives revenue. For QuickBooks users, this could cause problems. As an example, lets say your business enters into a maintenance contract which runs for twelve months. You agree that the client gets up to 20 hours of on-call service plus a 5 hour preventative maintenance visit monthly. The on-call hours do not roll-over and you charge $100 per hour for any hours over 20.
Historically, you know that your clients use about 300 hours additional during the year and you anticipate that this new client will be the same. The new ASC, ASC 606, would require you to anticipate this when you recognize revenues.
What is happening is that we are separating out the revenues from what customers are going to pay. This separation is a good thing, even though it may not seem like it. But anyone who has ever worked with contractors and percentage of completion will understand this concept. Billings are the offset to the accounts receivable and costs and gross profit on contracts is the offset to revenues. The separation will make almost all businesses with contractual relationships with customers record revenues similar to contractors.
This is because we are moving into a transfer of control (knowledge, ability, compute cycles, etc.) instead of transfers of products. Stores will likely continue their accounting the way they used to; unless they have after-sale service offerings. Then, this will become a little more complex but still somewhat like what you are already doing. But you need to start analyzing your processes now to see what can remain the same and what you need to change – assuming GAAP is required.
If you have questions or would like to discuss how the new accounting standards might impact your business, make sure you talk with your CPA. Or, if you would like some help understanding what is about to happen, feel free to contact me with your questions. We are here to help.
Have a great day.