Wholesale Distributors – Lessons Learned from Adoption of Revenue Recognition
In 2018, we published a blog post outlining the new revenue recognition accounting standard (ASC 606) and how it would potentially impact distributors. Now that the standard is effective, let’s take a look back and see what the impact on distributors has actually been. Below are areas we found to be of significant emphasis as distributors were adopting the standard. This comes from discussions we had with industry leaders, assisting clients with adopting the revenue recognition standard, and reviews of public company filings.
For background, ASC 606 put into place a five-step process for recognizing revenue. The goal was to provide a framework for recognizing revenue that would provide consistency across industries. Previous accounting for revenue recognition left a lot open to interpretation and was supplemented by various industry guides, which gave rise to differences in revenue recognition methods by companies in the same industry.
Key Areas that Impacted Distributors
Definition of a Contract
The standard lays out four steps that define a contract. We noticed that orders come in many formats. They can be verbal, taken over the phone, faxed, EDI, emailed, put through a purchasing system, through a signed PO, etc. Orders taken verbally or over the phone often faced an uphill battle in meeting the definition of a contract.
This often resulted in getting legal opinions or looking at the Uniform Commercial Code to determine the enforceability. Absent a contract, revenue isn’t recognized until consideration is received. With this being step one in the revenue recognition process, there was a lot more emphasis on the source of orders than there has ever been.
Allocating Transaction Price to Performance Obligations
Many orders received by distributors are for more than one type of good or product. This typically results in a contract with each good or product capable of being a distinct performance obligation. The challenge then came with those orders that were being shipped in multiple shipments. Revenue is to be recognized for each item as it delivers (assuming that is when control transfers) at the relative standalone selling price.
Where this got challenging was when the distributor would add items to the order to sweeten the deal. These are items being thrown into the order for free or at a heavily discounted price. In the event these items ship and deliver at different times, revenue would need to be recognized based on the standalone selling prices of each good, as each good is a distinct performance obligation.
In the past, distributors likely recognized revenue for items as they delivered based on their price in the invoice or PO. This will continue to be a topic to watch as distributors look to add more revenue through value-added services that go beyond the delivery of a product or good.
Timing of Revenue
Distributors have typically recognized revenue upon shipment or delivery of goods. This may have been based on how the company viewed the transaction and when they were done with their obligation. The standard forced distributors to revisit their shipping terms and conditions. For the majority of distributors, control transferred based on the shipping terms, which then was the point in time that revenue could be recognized. This may be different for each sales channel.
This was an area that got a lot of publicity ahead of the effective date of the standard. Despite guidance on this in the standard, it remains a topic that is subjective and not always a simple determination between principal and agent. While the standard provides indicators for principal versus agent, centered around control of the goods, it notes that no indicator is more important than another and that there may be other indicators not listed. The end result is that principals report revenue gross and agents report revenue net. To illustrate the challenges with this determination consider the examples listed below.
- A third-party logistics provider that never has possession of the goods being shipped.
- A cruise line that sells pre-cruise and post-cruise services like flights, hotels, cars, etc.
- An online coupon company that offers customers the ability to buy discounted gift certificates.
You can see where each has a different set of facts and circumstances to be analyzed. And, it is quite easy for two individuals to reach a different conclusion.
Bill and Hold Arrangements
This was a change in accounting for many distributors as there was previously no guidance for private companies on this. Despite there not being any formal guidance previously, many companies followed SEC staff guidance on this topic, so those companies didn’t see much change with bill and hold arrangements. ASC 606 provided four steps to be met for an entity to conclude that control had transferred and revenue could be recognized.
Returns can be common for distributors. While the accounting for returns was generally the same, there was a change in financial reporting to make sure all companies were accounting for this correctly. Returns are to be recognized as a reduction to sales in the financial statements. In addition, returns are to be shown on the balance sheet as a refund liability and an offsetting asset for the right to recover the product.
Presented above are the significant areas we noted as part of distributors adopting the revenue recognition accounting standard that was effective for years beginning after December 15, 2018. Overall, the standard resulted in a lot more scrutiny and review of the various contracts distributors had with their customers, and it put a greater emphasis on controls around contracts.
From the areas highlighted above, it’s evident the level of detail and analysis involved in addressing the standard. What we’ve presented here is a high-level overview of key areas that got extra scrutiny in practice. It’s important to consider your own facts and circumstances as well as the standard to ensure revenue is being recognized appropriately.
We work with best-in-class distributors and would love to help you with applying the revenue recognition standard, analyzing your contracts, or reviewing your sales cycle. Contact us to set up a free consultation (virtual or in-person). Other resources available free of charge include compensation and benefits benchmarking studies, financial analytics and benchmarking, and our on-demand webinar on the future of distribution.