INCOTERMS, Revenue Recognition and Transfer of Title Thomas A. Cook Managing Director American River International An issue facing companies involved in global supply chains and typically one that always causes confusion is the relationship between INCOTERMS, Revenue Recognition, Transfer of Title, Insurance Risk, Trade Compliance and to a smaller extent … freight and payment terms. To frame the issues ... All companies who export and import have seven areas which are “different but connected” ... that need to be managed by strict SOP’s within the supply chain. They will also have an implication on related matters associated with Global Trade Compliance, Logistics Management, SOX and the FCPA in companies who engage in world trade. They are: • INCOTERMS (Terms of Sale) • Payment Terms • Freight • Insurance • Title • Revenue Recognition • Trade Compliance Management While these areas have certain aspects of “connectivity” and are “related” to one another in an export and import sale or purchase, transfer pricing, revenue earning, etc., they are also very distinct issues that need to be resolved and worked out on their own merit. One must also keep in mind there is the strict interpretation of rules and regulations from the IRS, SEC, IAS, SOX, and many others ... then there is also the functionality of dealing with these rules and regulations, and still operate our supply chains compliantly, securely and cost effectively. Before acting in any regard to the material contained in this article, due diligence dictates that professional consultation with internal and external accounting, financial and legal expertise is accomplished … before making final decisions in any of these areas. Each supply chain operates differently. Each supply chain interprets regulation and practice to be compliant, but to work to their favor. This article establishes a reference point for discussion, not implementation. The purpose of this paper is to frame the issues and create a starting point of dialogue between appropriate corporate personnel for the eventual construction of SOP’s and business process that will protect the company’s interests. INCOTERMS The INCOTERMS primarily addresses a point in time in which responsibilities and liabilities pass between an exporter and an importer located overseas. It does not specifically address freight, title, payment and revenue recognition ... though “by default” ... it may have bearing. The INCOTERM does concern itself with liability for loss and damage. But, depending upon how payment is made, which must be factored in, when looking at “functional” supply chain management issues. The best example of this is when responsibility and liability pass to an importer where credit terms have been extended, such as in a FOB/FCA port of export sale, and 60 day open account terms are also provided. What would happen if the shipment was lost or damaged? How would the exporter protect themselves? There are many options to this question, but they would depend upon how the supply chain operates. Having said that, the point being made is the showing of a conflict between the term of sale and the term of payment where a point in time has passed between seller and buyer, but exposure still exists for the seller. Every international executive should have an INCOTERMS manual on their desk. It is such an important foundation issue in global trade. Go to www.iccbooksusa.com to purchase a copy. Payment Whatever both parties agree to fits in here. Just keep in mind, that receivable exposure may exist and is an area that can be insured and your interests protected. Payment in advance, drafts, open accounts, letters of credit, credit cards are but a few of the options. It is a point of negotiation, irrespective of the INCOTERM. One must be sensitive not to create an INCOTERM and a payment term that causes conflict and exposure without means of mitigation. Freight Whatever both parties agree to fits in here, but the intent of freight payment should coincide with the INCOTERM and built into the cost of goods sold to your foreign buyers and/or to your purchasing group accounted for and line itemed in your purchase order or commercial invoice. Freight also can be prepaid or collect - this will have bearing on potential financial exposures. Demurrage and other ancillary freight expenses can also be made an issue when these are not spelled out clearly in the contract of sale. The INCOTERM tries to clearly spell out who has responsibility to arrange freight to a specific point in time. This will usually dictate then who will pay for the freight. Sellers and buyers be aware, make sure you fully evaluate your landed costs to make sure the chosen INCOTERM provides you with the best logistics and the most competitive priced costs of transportation. Insurance Risk of loss and damage is dictated by the INCOTERM as to who has the responsibility for it. However, circumstances can arise as outlined above that dictate that the payment term can impact risk; therefore creating exposure to an exporter beyond the time outlined in the INCOTERM. It is critical that in each import and export that risk is assessed and a specific decision offered to accept, mitigate or transfer that exposure. We see too many corporations not address risk until a claim has already risen and providing financial exposure. Marine insurance, also known as cargo coverage, is readily available and relatively inexpensive on a transactional basis. In the area of insurance is the concern over “products liability”. Typically, as in the USA, most countries will dictate that the “importer of record” is the “manufacturer of record” and responsible locally for any product liability issues. This then impacts the choice of INCOTERM directly with a company’s liability exposures in the area of product liability. There also may be some exposures within the Foreign Corrupt Practices Act (FCPA) … as a result of the correct choice of INCOTERMS. Typically, the legal department will have some influence or controls in place regarding this. Title Title is not determined by the INCOTERM. It is determined by the sales contract, agreement or what you have in the commercial invoice. It should only pass on an export, once the contract has been satisfied ... meaning you have delivered and they have paid. This needs to be expressly written into your contract of sale or on the commercial invoice. In the INCOTERMS prologue, it specifically states “Although INCOTERMS are extremely important for the implementation of sale, a great number of problems which may occur in such a contract are not dealt with at all, like transfer of ownership and other property rights”. Most companies need to control “title” by additional wording in the contract of sale or the commercial invoice or both … that transfers ownership at a point in time, when both parties have met their obligations … you shipped and they paid! Possession, responsibility for and ownership are three very different issues. Revenue Recognition This is a more complicated area for an export. It is primarily covered and interpreted under GAAP/IAS ... Generally Accepted Accounting Principals. For export revenue to be recognized, as a responsible SOP ... there must be four things in place, which are generally accepted: • An order exists, best evidenced in writing such as through a “Purchase Order”. • The order can be completed … work in process, inventory, etc. • There is a reasonable expectation that funds will be collected. • Delivery has been made. From prior rulings and established precedence ... there is also an onus on the corporation to be “consistent” in their revenue recognition practice. This has a potential major impact on SOX Compliance matters. The more difficult area of the component is “delivery”. In most situations ... this is highly interpretative and subjective. Having said that ... most companies have successfully defined this, as a result of court precedence ... when the goods are either loaded on the international conveyance or handed over to the inland carrier for international transport, or when they have an international bill of lading in their possession. This is where there is a connection to the INCOTERM. Important in this choice is that it be consistent and that documentation exists that an “export’ will happen. Tie in the other two factors ... contract completion and payment ... and a company can meet this standard. An example: Many companies have fallen into trouble with the IRS and the SEC. Where an export has happened, but the nature of the sale is one of goods on consignment or ones that are placed strategically in an overseas warehouse, available for the importer to access, but prior to sale. But, in reality the final sale is specifically not made until a “PO” exists and the goods are removed from local inventory and shipped to the customer locally. The INCOTERM of the sale was FOB port of export and delivery has occurred ... but the nature of the “deal” changes how this sale is really being made. The company takes the sale when the goods are exported, but really should not have done that until the goods have been extracted from inventory. Many companies have had major issues over this type of export where revenue is recognized prematurely. Trade Compliance Management Trade compliance management is a very important bi-product of all this discussion but a necessary component in a “best practices” initiative and to meet the government’s guidelines of: o Due diligence o Reasonable care o Supervision and control … in their global supply chains. In exports we have the USPPI concern - United States Principal Party in Interest. This entity is the company that receives the primary benefit in an export transaction and is responsible for export compliance ... the information passed onto the government, where the goods are shipped and who they are going to and how they will be utilized. The government does not care if the INCOTERM is Ex Works, FOB or FCA ... they will still hold the manufacturer responsible for trade compliance. So then why would a company allow a third party, not under their control, to handle the shipment ... then defacto creating significant compliance exposures? This must be factored in when deciding what INCOTERM to utilize. On imports on a DDP (Delivered Duty Paid) transaction, the U.S. Company is the “ultimate consignee”, but not responsible functionally to manage the import clearance process. This could then make the consignee responsible for trade compliance in the import, such as, but not limited to matters as valuation, origin, HTS, record keeping, payment of duties and taxes, to name a few, but that consignee having a third party appointed by the supplier to manage. Typically, this is not a very diligent option. 2010 Changes INCOTERMS typically change every ten years and in September 2010 they changed with an impact date of January 1st, 2011. Changes are supposed to reflect betterments and simplifications in the INCOTERMS and in some analysis this was accomplished with the new changes. Four INCOTERMS were eliminated: DES, DEF, DEQ and DDU. Two new ones were added : DAT and DAP (Delivered at Terminal and Delivered at Place). Most trade professionals are comfortable with the ones eliminated and most agree that DAP has basically replaced DDU, which was a very commonly utilized trade term. The INCOTERMS book was reorganized into two sections, those terms that are for ocean freight only and those for all modes of transit. The World Academy (www.theworldacademy.com) and The U.S. Council for International Business (www.USCIB.org) runs numerous classes on the 2010 changes, which the author highly recommends for anyone engaging in global trade practices to take as soon as possible. Summary All this dialogue and fuss begins with the choice of the INCOTERM. Hopefully, the reader realizes that that choice has far reaching implications within a company and must be decided as an integrated solution to numerous areas of concern. Sales personnel, along with purchasing managers, must be trained in how best to manage the INCOTERM, not only to reduce risk, but more importantly, how to best take advantage of. Most corporations do not address these seven areas as responsibly and thoroughly as they should, leading to logistics and compliance issues in their global supply chain. To manage successfully, company personnel must get informed, access external expertise, learn regulatory concerns and develop integrated and connected SOP’s that work for all the varied import/export interests a company has. In Global Supply Chains … most corporation attempt to accomplish the following: Safe Shipments Timely Delivered Cost Effective Freight The choice of INCOTERM will impact all these areas and ultimately determine the effectiveness of your logistics operation. For more information … contact the experts at … www.theworldacademy.com.