What constitutes "control" before goods are sold

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Porus
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Joined: 13 Aug 2020, 20:13

What constitutes "control" before goods are sold

Post by Porus »

A shoe distributor imports shoes from China, and sells the bulk of its inventory through a related party, say "retailer", which has taken stores on rent in 3 malls in Dubai. The distributor does have its own sales also, but the vast majority of sales is done through the retailer. There is a common shareholder, but around 60-65% ownership is different between the two parties.

Let's say the cost of the goods imported by the distributor is 50, the transfer price to the retailer is 75, while the retailer's price to end customer is 200. The retailer gets to keep the major share of the margin, since it spends on store rents, maintenance, salaries of sales personnel, etc.

As far as the end customer is concerned, he has the relationship only with the retailer, and has no clue about the distributor.

Every 15 days, the retailer reports stock movements to the distributor. It is only at this time that the retailer records sales at 200, COS at 75. Distributor records sales at 75 and COS at 50, and clears the inventory from its books. Any unsold inventory, although physically lying at the retailer's stores, lies in the books of the distributor, at any point in time, and in particular, at year end. The retailer does not hold any inventory on its balance sheet.

Based on a review of the arrangement (both written and unwritten) between the distributor and the retailer, the substance of the arrangement is that:

(i) the risk of slow-moving inventory, obsolete and defective goods lies with the distributor, because the retailer has the right to return defective, obsolete and slow-moving goods back to the distributor.

(ii) on the other hand, the distributor can ask the retailer to return the goods to him at anytime - eg. to make up a shortfall in goods at the distributor's own showroom

(iii) the risk of pilferage and any kind of damage (fire, flood, etc) lies with the retailer, which is however covered by insurance.

So, one could say that a major part of the inventory risk is retained by the distributor.

QUESTION: Despite the above facts of the case, is there something in IFRS to support the argument that "control" of the goods passes from the distributor to the retailer a moment before the sale to end customer, thereby enabling three things to happen: (a) the retailer not recording any inventory in its books when it is shipped from the distributor, (b) when the sale to end customer takes place, since control passes a moment before sale to end customer, the inventory momentarily entering the retailer's books, and then being removed from the books the next instant, and (c) the retailer recording the full sale value of 200 and COS of 75 in its books as a "principal".

In seeking an answer to the above question, we looked at how "control" is defined in IFRS (in blue italics)

IFRS 15 Para 33: Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. ....The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by:....(d) selling the asset

IFRS 15 Para B34: When another party is involved in providing goods to a customer, the entity shall determine whether the nature of its promise is a performance obligation to provide the specified goods itself, or to arrange for those goods or services to be provided by the other party.

IFRS 15 Para B34A: To determine the nature of its promise (as described in paragraph B34), the entity shall:....assess whether it controls (as described in paragraph 33) the good before that good is transferred to the customer.

We also looked at US GAAP (Topic 606) guidance in this regard (in blue italics, with responses to questions being in green highlight)

When an entity (the retailer in our case) obtains only flash title to the specified goods, we believe the principal-agent evaluation should focus on whether the retailer obtains control of the specified goods before obtaining flash title and a consideration of the distributor's and retailer's rights prior to the transfer of the goods to the end customer. All facts and circumstances will need to be considered when evaluating the control principle and we believe the following are likely to be the key factors to consider in many circumstances:

— does the retailer have physical possession of the goods ? (one of the point-in-time indicators providing relevant evidence) YES
— could the retailer direct the use of the goods in the same way it could direct the use of other goods for which it had title before a customer purchases the product at the POS. For example:could the retailer control access to the products through its operation of the store ? YES
could the retailer decide in which part of its store the products are placed ? YES
could the retailer decide in which store the products are placed ? NO, distributor ships the goods to a specific store could the retailer decide what price is charged ? NO, distributor controls the pricing
— does the retailer have the ability to obtain substantially all the benefits from the product in the form of the cash flows from the sale with the customer ? YES
— can the distributor constrain the retailer's ability to direct the use of and obtain substantially all of the remaining benefits from the products ? YES. On what basis - see below.

In many shipping arrangements, the distributor is able to require the return of the goods shipped at any time before sale to end customer. Since the definition of control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset, therefore, if a distributor can require the return of the goods, he can prevent the retailer from obtaining the benefits from the goods. In these cases, as long as the distributor can require the return of those goods, notwithstanding the other indicators of control, the retailer does NOT control the goods before obtaining flash title.

Since the retailer does not obtain "control" before sale to end-customer (given the distributor can require the retailer to return those goods at any time), isn't the retailer an "agent" and should therefore record only the margin as its revenue (200-75), while the distributor records the full sale (200) in its books, along with a commission expense (125) and COS (50) ?
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Marek Muc
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Re: What constitutes "control" before goods are sold

Post by Marek Muc »

This is a consignment agreement covered in IFRS 15.B77-B78

It seems that the distributor controls the shoes until they are sold to the final customer, so the current treatment is correct.

You can read more here:

https://ifrscommunity.com/knowledge-bas ... nt-in-time
Porus
Posts: 59
Joined: 13 Aug 2020, 20:13

Re: What constitutes "control" before goods are sold

Post by Porus »

Thanks Marec, Just to reconfirm, the current treatment adopted by the two entities is:

(i) the distributor holds the inventory on his balance sheet, the retailer does not hold any of this inventory on his balance sheet.

(ii) when the end customer buys the shoes from the retailer's stores, the distributor records the sale to retailer at the price at which he transferred the inventory to the retailer (75 in my example), with COS at 50, while the retailer records the sale at the price charged to the end customer (200 in my example), with COS at 75. The retailer in other words records, and discloses in his P&L, the full sale and COS (gross sale 200, gross COS 75), and not a commission income of 125.

Am I right in understanding that this is the correct treatment you refer to ?
Leo
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Re: What constitutes "control" before goods are sold

Post by Leo »

Usually, in such an arrangement, the distributor record the gross sales to clients as revenue, the original purchase costs in COGS, and commissions to retailer as expenses. The consignee record the commissions only as revenue.

Seems like in your case, it's a bit different. But if this is a consignment agreement, consignee should record only the commissions in their revenue as the inventory is in the distributor.
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Marek Muc
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Re: What constitutes "control" before goods are sold

Post by Marek Muc »

(i) yes
(ii) in depends on the principal vs agent considerations, which are a different story, read more:
https://ifrscommunity.com/knowledge-bas ... ss-vs-net/
Tre-Lois
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Re: What constitutes "control" before goods are sold

Post by Tre-Lois »

Can the context of "consignment arrangements" be applied to the selling of services (such as the right to use a physical space). Or does this term typically refer to physical goods that are transferred?
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Marek Muc
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Re: What constitutes "control" before goods are sold

Post by Marek Muc »

Please start a new topic describing the situation you're dealing with.
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