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Revenue Recognition Accounting

revenue recognition accountingI am looking for help in how to recognize the revenue in the following transaction.

Company A lands an order for $2.5 million dollars of proprietary design hardware from Company B.

Company A locates a substantial third party C with manufacturing facilities and negotiates that they will build enough of A's proprietary design hardware to fulfill A's order with B for a cost of $2 million dollars.

Because A is small, has poor credit ratings, and limited cash, C insists on cash with order, LC, or other form of secure/advance payment so it does not end up taking risk on proprietary parts purchases if the deal falls through, or A does not pay, but A cannot source the working capital on its own.

A approaches B and asks if B will prepay all or part of the order, but for the same credit reason, B declines.

Finally, by negotiation, A arranges for B to issue a PO backed by Letter of credit "LC"  for $2 million to C, payable on delivery, and issues a second and related  PO backed by LC to A for the $.5 million dollar difference between the price quoted by A, and the cost of purchasing the inventory direct from C.

The end result is that B receives its order for the agreed price of $2.5 million, C sells $2.0 million of custom-made product, and A ends up with the margin of $.5 million.

Should A (i) recognize revenue of $2.5 million and COGS of $2.0 million or (ii) recognize $.5 million of arrangement "fee" revenue?


Topic Expert
Mark Sphar
Title: Chief Accounting Officer
Company: Veracity Payment Solutions
(Chief Accounting Officer, Veracity Payment Solutions) |

We run through this issue regularly and the answer is "it depends". My company is in the business of selling our services bundled with 3rd party services, so we take the entire $2.5 to revenue in your example and have $2.0 in COGS. Well written question though. Would definitely run through with your auditors before you book.

Topic Expert
Barrett Peterson
Title: Senior Manager, Actg Stnds & Analysis
Company: TTX
(Senior Manager, Actg Stnds & Analysis, TTX) |

"It depends" is right. If A needs this type of structure all the time, the arrangement fee is appropriate. If this structure is rare, revenue of $2.5 million is appropriate. I assume A will ultimately pay the LC fees, which may hit $50k.

Topic Expert
Keith Perry
Title: Director of Global Accounting
Company: Agrinos, Inc.
(Director of Global Accounting, Agrinos, Inc.) |

I would tend towards revenue of only 0.5M in either case, be it common or uncommon.
My preference here is to characterize the $0.5 PO as a license for the technology. Since A never gets the PO for the $2M, and never gets the cash, I really can't see them taking the revenue.
B is effectively purchasing a license for the tech from A, contracting C to manufacture it, and then compensating A on the event of utilization of said license.
I interpret Mark's case to be one where A (Mark's firm) is under contract for the whole amount...effectively a PO, and perhaps even gets paid the full amount? Whether that $2M goes to employee salaries or 3rd party would be your cogs. Not so, I think, in the example given.

Ken Stumder
Title: Finance Director / Controller
Company: Ken Stumder, CPA
(Finance Director / Controller, Ken Stumder, CPA) |

It may also depend on if A is doing some (substantial) finishing work on the inventory delivered by C or not. A purchase order directly from A to C suggests C is the principle for the $2 million leg of the transaction - especially if A effectively has removed itself from the equation with respect to credit/inventory risk. I am by no means well versed here, so it definitely is one for the auditors after you conclude your own evaluation.

Shawn Parandeh
Title: Director of Finance
Company: Netuitive
(Director of Finance, Netuitive) |

Company "A" has to be creative in recording the revenue and COGS for the $2M since it dose not take possession of the goods as well as it does not pay for them. I would take the conservative approach and record revenue at Net. Your answer is part of your question.

"The end result is that B receives its order for the agreed price of $2.5 million, C SELLS $2.0 million of custom-made product, and A ends up with the margin of $.5 million".

The indicators for Net Revenue reporting are:
1 - The supplier is the primary obligor in the arrangment.
2 - The amount of margin is fixed.
3 - The supplier has a credit risk.

You may look at EITF 99-19: Revenue at gross vs. net for additional guideline. Also, I recommend consulting with your audit firm.

Stephen Turk
Title: Principal
Company: Stephen Turk, CPA
(Principal, Stephen Turk, CPA) |

As Shawn indicates, the relevant GAAP guidance is primarily in EITF 99-19 (codified in ASC 605-45, Revenue Recognition – Principal Agent Considerations). The issue that 99-19 addressed is as follows:
"It is a matter of judgment whether an entity should report revenue based on either of the following:
a. The gross amount billed to a customer because it has earned revenue (as a principal) from the sale of the goods or services.
b. The net amount retained (that is, the amount billed to the customer less the amount paid to a supplier) because it has earned a commission or fee as an agent."
Based on the facts as laid out, Company A invoices Company B for $0.5 million, and Company C invoices B for $2.0 million. I do not see any way that A could recognize revenue in excess of the gross amount it bills (i.e., $0.5).
As suggested by other responses, you should work through the detailed criteria of 605-45 and then consult with your auditors to see if they have any additional insights, but I don't see anything in your description of the transaction, as finally negotiated, that would support recognition of $2.5 million by A.

Simon Westbrook
Title: CFO
Company: Aargo Inc.
( CFO, Aargo Inc.) |

I appreciate the input and will check out 605-45. Since Company A, the organizer of this transaction arranges for Company C to be paid by LC, payable on delivery of the goods to the dock (China) I wonder if there is actually any credit risk, and if not whether that makes a difference.

Topic Expert
Keith Perry
Title: Director of Global Accounting
Company: Agrinos, Inc.
(Director of Global Accounting, Agrinos, Inc.) |


I don't think credit risk is a trump, but it is a factor. PWC has some not-dissimilar examples here:

Per case 21 (p28), A meets all three criteria for Net treatment. However, I'm not clear that you need to get that far unless you can demonstrate that A is actually a party to the $2M portion of the agreement. Right of return, warranty etc may help tip that scale, as would A's name on the LC.

Topic Expert
Doug Thompson
Title: Director of Revenue
Company: Castlight Health
(Director of Revenue, Castlight Health) |

Another way to look at it is what happens if something fails i.e. if they can't build it, or they build it but B rejects etc. Is A at risk of the $2M cost? Answer seems to be no. Since no risk for A, only $0.5M revenue is appropriate.

Konrad Sosnow
Title: Revenue Recognition Guru
Company: Konrad M. Sosnow & Associates
(Revenue Recognition Guru, Konrad M. Sosnow & Associates) |

I always look at the substance of the transaction, that is, the contributions that each party makes to the arrangement. In this case, it appears that A is acting as a broker. A arranges that C will manufacture and ship to B. A does not design, manufacture, take possession,or have inventory risk. Thus, this is clearly a net transaction.

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