Don’t Be a Control Freak! Revenue Recognition Criteria (ASC 606)
Who gets into a disagreement with a prospective client about application of accounting at a trade booth? Me, that’s who! But I had a good reason. She was misinterpreting the revenue recognition criteria under U.S. GAAP and IFRS (ASC 606 and IFRS 15) and I had to save her from herself (and her auditors). The future of GAAP depended on it!
When do I recognize revenue? It’s all about control!
The conversation began innocently enough. We were talking about ASU 2016-10 and the new policy election available only within ASC 606 to account for shipping and handling activities that occur after the customer has obtained control of a good as an activity to fulfill the promise to transfer the good rather than as an additional promised service. However, it turned into a conversation about control. Specifically, how the revenue recognition criteria within the new standards focus on transferring control as opposed to transferring risks and rewards.
Her company, we’ll call them ABC, a public company, manufactures products and ships them overseas in giant cargo ships. The goods are shipped “FOB Destination” where ABC is responsible for insuring the products during transit. We agreed that under current GAAP (ASC 605 and IAS 18) ABC is not able to recognize revenue until the goods reach their destination. Why? Because ABC retains the risks and rewards of ownership involving the goods. In addition, ABC has not fulfilled its promises, namely getting the goods to the destination. So far so good!
However, things went downhill after that. She stated that since the new revenue standards focus on control, once adopted, ABC would recognize revenue once the goods were loaded on the ship. Her rationale was that once the goods are loaded onto the ship, presumably along with goods from other companies, ABC no longer controls the goods since it cannot order the ship to turnaround.
Me: “Are the goods still shipped with ‘FOB Destination’ terms?”
Woman: “Yes.”
Me: “If the ship sinks, who incurs the loss?”
Woman: “We do.”
Me: “Do you insure the goods?”
Woman: “Of course.”
Me: “I don’t think you would be allowed to recognized revenue until after the goods reach the destination.”
Woman: “You’re wrong!”
Me: “Let me explain, you see I believe you still control the goods because…”
Woman: “Well, my auditors agree with me so there’s nothing else to talk about.”
She left our booth. What can I say? I am a terrible salesman. Guess I won’t be conducting a training for ABC any time soon. It’s a shame because I think she (and her auditors) could have learned a thing or two about the revenue recognition criteria under ASC 606 and IFRS 15!
Revenue recognition criteria: Control (ASC 606 and IFRS 15)
As we discuss in this post, ASC 606 and IFRS 15 state:
“An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.”
What I wanted to say to that woman was that she was looking at control the wrong way. See, she was focusing on herself, or rather her company, rather than on the customer.
In their Basis of Conclusions, the FASB noted that control should be assessed primarily from the customer’s prospective to minimize the risks of an entity recognizing revenue from activities that do not coincide with the transfer of goods or services to the customer. A customer obtains control of an asset when it has the ability to direct the use of and obtain substantially all of the remaining benefits from that asset.
The FASB further explained the key aspects of the definition of control as follows:
Ability
A customer must have the present right to direct the use of, and obtain substantially all of the remaining benefits from, an asset for an entity to recognize revenue.
Direct the use of
A customer’s ability to direct the use of an asset refers to the customer’s right to deploy or to allow another entity to deploy that asset in its activities or to restrict another entity from deploying that asset.
Obtain the benefits from
The customer must have the ability to obtain substantially all of the remaining benefits from an asset for the customer to obtain control of it. Conceptually, the benefits from a good or service are potential cash flows (either an increase in cash flows or a decrease in cash outflows). A customer can obtain the benefits either directly or indirectly in many ways, such as by using, consuming, disposing of, selling, exchanging, pledging, or holding an asset.
Closing thoughts
I’ll concede, begrudgingly, that ABC no longer controls the goods. However, I stand steadfastly by the fact that, based on the guidance above, the customer does not control the goods while they are in-transit sitting on the cargo ship. I believe they take control, and thus revenue should be recognized, when the goods reach the destination.
Of course, I might not have had all the information. Certainly, the sales agreement, including shipping terms and conditions, need to be further analyzed before making a final conclusion.
I swear I am not a bad guy! We’re just passionate about U.S. GAAP and helping people understand how to apply it to their transactions. Plus, we don’t want you to run afoul with the SEC! If you need help understanding or transitioning to the new revenue standards (ASC 606 or IFRS 15), check out our Revenue Recognition topic page which summarizes the guidance and provides helpful resources. Have a specific question on implementing ASC 606 or IFRS 15, reach out to us to discuss. I swear, we’ll be gentle!
About GAAP Dynamics
We’re a DIFFERENT type of accounting training firm. We view training as an opportunity to empower professionals to make informed decisions at the right time. Whether it’s U.S. GAAP, IFRS, or audit training, we’ve trained thousands of professionals since 2001, including at some of the world’s largest firms. Our promise: Accurate, relevant, engaging, and fun training. Want to know how GAAP Dynamics can help you? Let’s talk!
Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.