Revenue Recognition Accounting

We run through this issue regularly and the answer is "it depends". My company is in the business of selling our services bundled with 3rd party services, so we take the entire $2.5 to revenue in your example and have $2.0 in COGS. Well written question though. Would definitely run through with your auditors before you book.

"It depends" is right. If A needs this type of structure all the time, the arrangement fee is appropriate. If this structure is rare, revenue of $2.5 million is appropriate. I assume A will ultimately pay the LC fees, which may hit $50k.

I would tend towards revenue of only 0.5M in either case, be it common or uncommon.
My preference here is to characterize the $0.5 PO as a license for the technology. Since A never gets the PO for the $2M, and never gets the cash, I really can't see them taking the revenue.
B is effectively purchasing a license for the tech from A, contracting C to manufacture it, and then compensating A on the event of utilization of said license.
I interpret Mark's case to be one where A (Mark's firm) is under contract for the whole amount...effectively a PO, and perhaps even gets paid the full amount? Whether that $2M goes to employee salaries or 3rd party services....it would be your cogs. Not so, I think, in the example given.

It may also depend on if A is doing some (substantial) finishing work on the inventory delivered by C or not. A purchase order directly from A to C suggests C is the principle for the $2 million leg of the transaction - especially if A effectively has removed itself from the equation with respect to credit/inventory risk. I am by no means well versed here, so it definitely is one for the auditors after you conclude your own evaluation.

Company "A" has to be creative in recording the revenue and COGS for the $2M since it dose not take possession of the goods as well as it does not pay for them. I would take the conservative approach and record revenue at Net. Your answer is part of your question.

"The end result is that B receives its order for the agreed price of $2.5 million, C SELLS $2.0 million of custom-made product, and A ends up with the margin of $.5 million".

The indicators for Net Revenue reporting are:
1 - The supplier is the primary obligor in the arrangment.
2 - The amount of margin is fixed.
3 - The supplier has a credit risk.

You may look at EITF 99-19: Revenue at gross vs. net for additional guideline. Also, I recommend consulting with your audit firm.

As Shawn indicates, the relevant GAAP guidance is primarily in EITF 99-19 (codified in ASC 605-45, Revenue Recognition – Principal Agent Considerations). The issue that 99-19 addressed is as follows:
"It is a matter of judgment whether an entity should report revenue based on either of the following:
a. The gross amount billed to a customer because it has earned revenue (as a principal) from the sale of the goods or services.
b. The net amount retained (that is, the amount billed to the customer less the amount paid to a supplier) because it has earned a commission or fee as an agent."
Based on the facts as laid out, Company A invoices Company B for $0.5 million, and Company C invoices B for $2.0 million. I do not see any way that A could recognize revenue in excess of the gross amount it bills (i.e., $0.5).
As suggested by other responses, you should work through the detailed criteria of 605-45 and then consult with your auditors to see if they have any additional insights, but I don't see anything in your description of the transaction, as finally negotiated, that would support recognition of $2.5 million by A.

I appreciate the input and will check out 605-45. Since Company A, the organizer of this transaction arranges for Company C to be paid by LC, payable on delivery of the goods to the dock (China) I wonder if there is actually any credit risk, and if not whether that makes a difference.

Simon,

I don't think credit risk is a trump, but it is a factor. PWC has some not-dissimilar examples here: http://www.pwc.com/en_GX/gx/pharma-life-sciences/pdf/med-tech-us_gaap-booklet.pdf

Per case 21 (p28), A meets all three criteria for Net treatment. However, I'm not clear that you need to get that far unless you can demonstrate that A is actually a party to the $2M portion of the agreement. Right of return, warranty etc may help tip that scale, as would A's name on the LC.

Another way to look at it is what happens if something fails i.e. if they can't build it, or they build it but B rejects etc. Is A at risk of the $2M cost? Answer seems to be no. Since no risk for A, only $0.5M revenue is appropriate.