Synthetic FOB Destination (#205)
/In this podcast episode, we discuss synthetic freight on board destination shipping arrangements. Key points made are noted below.
The Freight on Board Scenario
This situation arises when a seller is selling goods using freight on board shipping point terms, which means that normally the customer takes responsibility for the goods being shipped to it once the goods leave the shipping dock of the seller. Under FOB shipping point terms, the seller recognizes revenue on the goods as soon as the goods leave its premises.
However, the seller is also promising the customer that the seller will replace any goods that are lost or damaged while the shipment is in transit to the customer. This could be standard industry practice. At any rate, it means that the seller is effectively retaining the responsibilities of ownership until the goods reach the customer. So this means there’s a timing delay before the seller can actually recognize revenue.
Revenue Recognition for Freight on Board
The way this has worked in the past is that the seller defers revenue recognition until the estimated date of delivery to the customer. It’s really not practical to verify the actual delivery date for every customer delivery, especially if it’s hard to get a proof of receipt. So instead, the seller does an annual analysis of the actual delivery data provided by its freight carriers, to figure out the average number of delivery days.
For example, if the analysis shows that it takes an average of three days for a delivery to reach a customer, then the seller assumes that all deliveries for the last three days of the month were not received by customers during that month. So, that revenue is recognized in the next month.
The easiest way to make this work is for the accounting staff to include it as a step in the month-end closing process. First, they identify all synthetic FOB destination sales, and then they create a reversing entry that shifts the associated sales and cost of goods sold into the next month. That is how the process has worked in the past.
Impact of the New Revenue Recognition Standard
But what about the new revenue recognition standard? Under this standard, the key issue is when control over the goods changes, not when there’s a transfer of the risks and rewards of ownership. So when does the customer gain control? FOB shipping point terms can give the customer title to the goods as soon as the seller ships the goods, which means that there’s an immediate change of control. Or, maybe the customer has the ability to redirect the goods to its own customers while the goods are in transit. If so, that also implies an immediate change of control.
What this means under the new revenue recognition standard is that we really have two products for which the seller can recognize revenue. One is the goods, and the other is its coverage of the risk of loss during the in-transit period. If so, you need to allocate the selling price to each of these performance obligations. The result would probably be that the bulk of the sale can be recognized at the point of shipment from the seller’s facility. A small part of the sale is linked to the seller’s coverage of the risk of loss during the in-transit period.
To figure out the size of the second part of the revenue recognition, the simplest approach would be to calculate the historical cost of replacing goods that are lost or damaged in transit, and apply this amount to the sale transaction.
What does this mean from the perspective of day-to-day accounting? Nothing at all for individual sale transactions. Just record sales as usual. Then, wait until the month-end close, and follow these steps:
First, take note of all synthetic FOB destination transactions.
Second, for those transactions, calculate the amount of the revenue associated with the risk of loss.
Finally, create a reversing entry that shifts this revenue out of the current month and into the next month.
How does this vary from the method that’s historically been used? Basically, revenue for the bulk of all sales is accelerated to the point of shipment, which means that businesses using synthetic FOB destination terms will experience a one-time bump in sales and profits that’s likely to be fairly small.