Revenue Recognition Consideration for Distributors: Drop Shipments
Last Updated: January 29, 2021
With the Financial Accounting Standards Board’s (FASB) new revenue recognition standard, generally effective for 2019 or 2020 year ends, much attention has been given to the basic principles of the standard, and many have observed that certain industries will be more heavily impacted than others. Distributors generally have a simple revenue recognition pattern: revenue is typically recognized when product is shipped, which coincides with when title and risk of loss pass from the seller to the buyer. This may require an understanding of the shipping terms, such as FOB shipping point or FOB destination, but the main revenue recognition concept is straightforward.
At first glance, many accountants expected very little impact of the new standard to distributors. Even under the new standard, this pattern of recognizing revenue when the goods are shipped, which is when the seller has completed its performance obligation, appears to be legitimate. And in many cases, this will be true.
However, the decision is a bit more complicated in the scenario of drop shipments. In these cases, a distributor generally does not physically hold the inventory, but instead directs a supplier to directly ship to the customer. Historically, these types of sales by a distributor have been recognized in the same manner as sales in that the distributor ships its own inventory to customers; but under the new standard, this requires a closer look.
Upcoming Changes
The new revenue recognition standard differentiates between a principal and an agent in a transaction and results in different treatment. A principal, such as a distributor obligated to provide its own inventory to a customer, should record revenue from the transaction at the gross amount (sales price). An agent, however, such as a distributor who simply directs a supplier to provide product to its customer, may be precluded from recording revenue at the gross amount. This is because the new standard focuses on control of the product. In other words, the distributor must have control of the product before selling to the customer, in order to be considered a principal rather than an agent.
This will require a subjective determination based on facts and circumstances. Points to consider include whether the distributor bears a risk of loss in transit; whether the distributor can change shipping instructions at any point; whether the distributor handles any customer complaints or returns related to drop shipments and whether the distributor takes legal title to the product (the rules note that momentary possession of title does not necessarily indicate control). Other observations in a specific fact pattern may be relevant as well. This is not always a simple determination.
Impact on You
If you are considered an agent, rather than a principal in a transaction, then revenue must be recorded at the net amount rather than gross. Thus, only the gross profit from the sale will be included in top-line sales revenue. This is a significant change from current practice and for distributors that utilize a large number of drop shipments, this could have a large impact on top-line sales revenue.
If you are concerned about how this will impact you, please contact us and we will be happy to assist you.