Presentation of Certain Costs Billed to Customers

- A. C. Sondhi & Scott A. Taub, Miller Revenue Recognition Guide, 2006

Shipping and Handling

Many companies that sell goods that are shipped direct to customers charge customers a "shipping and handling" fee separately identified on the customer invoice. Other companies do not charge such a separate fee, instead advertising "free" shipping. In fact, the companies that normally do charge such a fee may run promotions offering free shipping for purchases over a certain amount, or for purchases made during certain time periods. When a separate shipping and handling charge is included, the method of determining the amount of the charge varies. Some companies merely pass through thirdparty shipping charges, while others attempt to recover a portion of their internal costs as well. Other companies charge shipping and handling on a basis that bears no relation to the costs incurred.

The EITF concluded in EITF 00-10 that amounts billed to a customer related to shipping and handling should be classified as revenue in the income statement. The conclusion is partially based on the fact that a company has the ability to alter its pricing between its product prices and its shipping and handling charge to achieve similar results (EITF 00-10, par. 5).

Furthermore, the EITF also concluded that shipping and handling costs should be classified as an expense. Therefore, it is not appropriate to offset shipping and handling costs incurred and shipping and handling revenue received against one another in the income statement. Rather, the two must each be reported separately (EITF 00-10, par. 6). This conclusion is consistent with the conclusions reached in EITF 99-19 on reporting revenue gross versus net. The seller acts as a principal in purchasing the shipping from the postal service or private shipping company, and acts as a principal in the transaction with the customer, as well. As such, there is no reason to report shipping and handling costs and revenues on a net basis, even if the cost is merely "passed through" to the customer without any markup.

DISCLOSURE ALERT: If shipping and handling costs are classified within cost of sales on the income statement, no disclosure of such costs is required. However, if such costs are significant and are not classified within cost of sales, the amount of shipping and handling costs must be disclosed, and the line item in which they are included must be identified.

EXAMPLES: SHIPPING AND HANDLING COSTS

The Gillette Company Form 10-K—Fiscal Year Ended December 31, 2004

Shipping and Handling Costs

Under generally accepted accounting principles, shipping and handling costs may be reported as a component of either cost of sales or selling, general and administrative expenses. The Company formerly reported all such costs related to outbound freight in the Consolidated Statement of Income as a component of selling, general and administrative expenses.

Beginning in 2004, the Company elected to report the costs related to outbound freight in cost of sales, and this change resulted in reclassifications to the Consolidated Statement of Income. Cost of sales increased, and gross profit and selling, general and administrative expenses were reduced by $189 million and $175 million in 2003 and 2002, respectively. Gross profit was reduced as a percentage of net sales from 59.9% to 57.9% and from 58.5% to 56.4% in 2003 and 2002, respectively. There was no impact on profit from operations, net income, or earnings per share as a result of this reclassification.

Colgate-Palmolive Form 10-K—Fiscal Year Ended December 31, 2004 Shipping and handling costs may be reported as either a component of cost of sales or selling, general and administrative expenses. The Company reports such costs, primarily related to warehousing and outbound freight, in the Consolidated Statements of Income as a component of selling, general and administrative expenses. Accordingly, the Company’s gross profit margin is not comparable with the gross profit margin of those companies that include shipping and handling charges in cost of sales. If such costs had been included in cost of sales, gross profit margin as a percent to sales would have decreased from 55.1% to 47.9% in 2004 with no impact on reported earnings

Out-of-Pocket Expenses

Service providers often incur certain incidental expenses in performing work for their clients. These "out-of-pocket" expenses include travel costs, such as hotel rooms, airline tickets, car rentals, and meals, costs of supplies, printing and copying costs, etc. In many cases, the customer reimburses the service provider for such costs, separate from (in addition to) the agreed-upon service fee. In other cases, the arrangement fee is stated as a single figure intended to cover out-of-pocket costs in addition to the service fee.

Before 2001, there was no specific guidance in the accounting literature on the characterization of out-of-pocket costs and the related reimbursements. Many companies that routinely billed such costs to their customers determined that the appropriate reporting for the reimbursements was to offset them against the expenses. This was felt to be appropriate because it results in gross margins that reflect the service fee and the related direct costs of providing the service, without any gross-up for out-of-pockets. When companies used this accounting policy, some disclosed the amount of out-of-pocket expenses that had been netted against reimbursements, while others did not.

The EITF addressed the income statement classification of reimbursements for out-of-pocket expenses in EITF 01-14, and concluded that such reimbursements should be characterized as revenue, rather than offset against the related expenses. In large part, much the same as the conclusion discussed above regarding shipping and handling costs, the conclusion on out-of-pocket costs and revenues is based on the principles underlying EITF 99-19 on gross versus net revenue reporting. Essentially, the EITF concluded that the service provider is generally acting as a principal with respect to the purchase of travel, supplies and other out-of-pocket costs, not as an agent. Furthermore, the EITF believes that the customer is not purchasing the travel or supplies, but is purchasing the service provided by the service provider. As such, out-of-pocket costs are like any other cost incurred in providing the service; the fact that the arrangement fee varies based on the amount of such costs should not cause the accounting to be any different (EITF 01-14, pars. 4-5).

EXAMPLE: OUT-OF-POCKET EXPENSES

GP Strategies Corporation Form 10-K—Fiscal Year Ended December 31, 2004

As part of General Physics’ on-going operations to provide services to its customers, incidental expenses, which are commonly referred to as "out-ofpocket" expenses, are billed to customers, either directly as a pass-through cost or indirectly as a cost estimated in proposing on fixed-price contracts. Out-of-pocket expenses include expenses such as airfare, mileage, hotel stays, out-of-town meals and telecommunication charges. General Physics’ policy provides for these expenses to be recorded as both revenue and direct cost of services in accordance with the provisions of EITF 01-14, Income Statement Characterization of Reimbursements Received for "Outof- Pocket" Expenses Incurred.

Sales and Excise Taxes

Sales and excise taxes are taxes levied based on sales or purchase activity. Although various names are used, this discussion refers to sales taxes as those that are levied on the purchaser, and excise taxes as those that are levied on the seller. In most jurisdictions, the selling party remits both sales and excise taxes to the government. In the context of sales taxes, the seller acts as a collection agent when it charges the sales tax to the customer and remits the tax to the government. Because sales taxes are taxes on the purchaser, not on the seller, the seller should not record sales tax expense related to customer purchases, nor should the seller record the amount collected for sales tax as revenue. Instead, the collection of sales taxes and their payment on behalf of customers should not be reflected in the income statement at all. Any amounts collected should be immediately reflected as a payable to the government, which payable is relieved upon payment.

Excise taxes, however, are taxes on the seller of goods or services. As such, the seller may reflect these amounts as expenses, generally as part of cost of sales. Alternatively, because these taxes are not discretionary costs and they reduce the amount of revenue that is available to cover the company's expenses, it is also acceptable to show excise taxes that relate directly to sales as reductions of revenue.

EXAMPLES: EXCISE TAXES

Murphy Oil Corporation Form 10-K—Fiscal Year Ended December 31, 2004 Revenue Recognition:

Excise taxes collected on sales of refined products and remitted to governmental agencies are not included in revenues or in costs and expenses.

Sunoco, Inc. Form 10-K—Fiscal Year Ended December 31, 2004 Revenue Recognition:

Consumer excise taxes on sales of refined products and merchandise are included in both revenues and costs and expenses, with no effect on net income.

SEC REQUIRED DISCLOSURE: SEC registrants must disclose the amount of excise taxes included in revenue if that amount exceeds 1% of sales. The classification of the payments of excise taxes should also be disclosed (REG S-X, Rule 5-03).

UNCOLLECTIBLE AMOUNTS AND BAD DEBTS

One of the four conditions that must be met before revenue is recognized is that the arrangement fee must be reasonably assured of collection. In most cases, this criterion is met because the company has policies that prohibit sales to customers whose ability to pay is questionable.

However, if collectibility is not reasonably assured, revenue should not be recognized. When this occurs, it is not acceptable to recognize revenue along with a bad debt expense. Although this would produce the right effect on operating income, it would inappropriately overstate revenue by presenting as revenue amounts that never met all four of the conditions for revenue recognition.

Even when revenue is considered collectible and is therefore recognized when all other criteria have also been met, circumstances may subsequently arise that indicate payment is unlikely. Bad debts may need to be recognized in those situations. Bad debts are distinguished from sales that did not meet the collectibility criterion in that bad debts represent sales that were considered collectible at the time of delivery but became uncollectible sometime thereafter. The classification of bad debt expenses is not specified in GAAP, although the SEC requires them to be presented as expenses (generally a selling or marketing expense), rather than as a reduction of revenue (REG S-X, Rule 5-03(b)(5)).

Readers also should refer to Chapter 3, "General Principles," and the Covad Communications Form 10-K—Fiscal Year Ended December 31, 2004 example on revenue recognition when collectibility is not reasonably assured.

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Copyright 2006 CCH Publishing, a WoltersKluwer business. Excerpted by permission.