Revenue Recognition Issues in the Larson Industries Case Study

Introduction

Larson Industries is one of the firm's biggest clients. The company is engaged in the manufacturing of carpentry and other premium handheld and mechanical tools. Larson Industries has entered into an agreement with Dynamic Wholesale, Inc. regarding the sale of the AM300, which is Larson's leading product in the industry. Multiple complex revenue recognition problems face this new contract (McNellis, Barone, and Herbold, 2020).

The purpose of this report is to identify and analyze accounting issues in the Larson-Dynamic contract with respect to revenue recognition and to recommend appropriate accounting treatment. The report draws on the most current implementation of the updated revenue recognition guidance under Topic 606 from the Financial Accounting Standards Board's Accounting Standards Codification, together with IFRS 15 from the International Accounting Standards Board.

Accounting Issue 1: Principal vs. Agent Considerations

As indicated by ASC 606-10-25-2, a contract is described as an agreement or covenant between two or more parties that creates enforceable rights and obligations. One of the critical elements that must be considered within a contract is the specification of the principal and agent roles and how any resulting revenue should be recognized. To promote the success of the agreement, Dynamic organized product demonstrations of the AM300, which Jackson Marketing Services will carry out.

Because Dynamic and Jackson have an ongoing association concerning product demonstrations at the warehouse, Jackson billed Dynamic for costs linked to demonstration services in advance of each event. Consequently, Dynamic gave Larson the option to pay its share of the costs by remitting payment to Dynamic or by paying Jackson directly. Larson designated that the initial payment would be made directly to Jackson (McNellis, Barone, and Herbold, 2020).

In this regard, Jackson — a third party — is involved in rendering product demonstration services to consumers (McNellis, Barone, and Herbold, 2020). Consequently, Larson must determine whether the firm is acting as a principal or an agent. This assessment is necessary in order to examine the performance obligations within the contract effectively. The fundamental distinction between an agent and a principal concerns the nature of the performance obligation being fulfilled. Specifically, the principal has a performance obligation to render the specified goods or services to the end consumer, while the agent arranges for the principal to provide the specified good or service (ASC 606-10-55-36).

Based on this assessment, Dynamic is the principal. Under ASC 606, "an entity is a principal if it controls the specified good or service before that good or service is transferred to a customer" (ASC 606-10-55-37). Jackson is an agent in the transaction, as determined by examining the three factors outlined by the ASC:

1. Responsibility for fulfilling the promise. Jackson is not accountable for providing the AM300. Rather, it facilitates the product's demonstration to aid in the sale of the AM300 to end consumers.

2. Inventory risk. Jackson does not have any control over the inventory before or after the transaction and does not face any financial loss on unsold units of the AM300.

3. Discretion in setting prices. Jackson agrees to demonstrate the AM300 but has no role in selling the product directly or indirectly and does not set or alter its price (McNellis, Barone, and Herbold, 2020).

After determining the agent and principal in the transaction, it becomes possible to ascertain the financial statement reporting effect. The principal should report revenue based on the gross amount billed to the customer. The agent, by contrast, reports revenue based on the net amount retained — that is, the amount billed to the consumer minus the amount paid to the subcontractor.

Accounting Issue 2: Performance Obligations in the Contract

A second issue in the contract between Larson and Dynamic involves the identification of performance obligations. The first step requires identifying the distinct goods and services promised. A contract comprises promises to transfer goods or services to a customer; if such goods or services are deemed distinct, those promises are treated as performance obligations and are accounted for separately (ASC 606-10-05-4). In this case, Larson's promise to ship one million standard AM300 units is clearly present. The contract facilitates the transfer of legal title to Dynamic specifically when the goods are delivered to the warehouse.

To determine performance obligations and recognize revenue properly, the applicable accounting standard requires a determination of whether the goods in question are distinct. A good or service is considered distinct if the customer can benefit from it on its own or together with other readily available resources, and if the entity's promise to transfer that good or service is separately identifiable from other promises within the contract (ASC 606-10-25-14).

In this case, the AM300 satisfies the criteria for being distinct (McNellis, Barone, and Herbold, 2020). Two conditions must be met. First, the good must be capable of being distinct — and the AM300 can be used by the customer on its own. Second, the good must be distinct within the contract — and Larson's promise to transfer one million units of the AM300 is separately identifiable from other promises contained within the contract (ASC 606-10-25-18).