Getting paid for shipping goods to international customers is top of mind for all exporters. But when it comes to global sales contracts, there’s more to it than simply issuing an invoice.
As co-owner and founder of Exportspark Services Inc., a Canadian company that delivers virtual international trade training and advisory services to businesses and economic development agencies, I was asked to take part in Export Development Canada’s (EDC) March webinar, Understanding the fine print of global contracts.
The webinar focused on the importance of well-written contracts and incorporating the right Incoterms to avoid risk in global business and successfully grow your company. Following the hour-long discussion, we received several questions from the audience about revenue recognition and how it’s impacted by the Incoterms selected. In this article, I share my expertise on the subject.
What are Incoterms?
International commercial terms, or Incoterms, are a set of 11 universal trade terms used in global sales contracts to clearly define the roles and responsibilities of the buyer and seller, transfer of risk and all costs associated with shipping a product outside Canada. Drafted by the International Chamber of Commerce (ICC), Incoterms consist of short phrases and subsequent three-letter acronyms, like Ex Works (EXW) or Delivered at Place (DAP), that help simplify contracts, eliminate confusion and reduce shipping challenges.
Incoterms fall into four categories:
- E term: EXW
- F terms: Free Carrier (FCA), Free Alongside Ship (FAS) and Free on Board (FOB)
- C terms: Carriage Paid To (CPT), Carriage & Insurance Paid To (CIP), Cost & Freight (CFR) and Cost, Insurance & Freight (CIF)
- D terms: DAP, Delivered at Place Unloaded (DPU) and Delivered Duty Paid (DDP).
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How do I know which Incoterm to use?
They’re typically selected based on how much risk or costs a buyer or seller is willing or capable of assuming. But it also depends on how early in the transaction a seller can recognize revenue since a set delivery point and transfer of risk are built into each Incoterm.
What does revenue recognition mean?
Revenue recognition is an accounting principle that determines when revenue is earned. Generally accepted accounting principles (GAAP) allow recognition of revenue at the completion of the sales transaction. If the product requires installation or training, for example, the date of initial delivery to the destination will be different from the date when the sales transaction is completed as stipulated in the contract.
For most products, the transaction is complete when the seller receives confirmation of product delivery from the buyer. The seller can then invoice and collect payment. So, the Incoterm selected will be key to when the seller can officially move forward with invoicing, based on obtaining confirmation from the buyer.
How do the 11 Incoterms differ?
EXW allows the seller to transfer at the exact moment they make the product available to the buyer. This can be when the seller places the product on a loading bay ready for pickup by the buyer’s courier. This allows the seller to invoice almost immediately after the product is taken off the warehouse shelf and made ready for shipping. EXW presents many challenges to buyers, but it’s a popular choice for sellers who want to recognize revenue the same day.
F terms require the seller to load the product and manage the exporting process, as well as produce an accepted document that allows the seller to invoice and recognize revenue. The product risk is transferred at the seller’s location or nearby shipping port early in the shipping process, reducing the obligations of and risk to the buyer. This makes F terms a popular choice because they reduce risk for the buyer and provide the seller with ease of revenue recognition.
C terms assume the seller will pay for carriage (transportation) to the destination, but the seller is also allowed to transfer the risk early by delivering the product to the first carrier on domestic soil. The benefit to the seller is that they can transfer the risk early in the shipping process and obtain a standard shipping document that demonstrates transfer of ownership and allow for revenue recognition, while the buyer has the shipment and cargo insurance paid for by the seller.
D terms put the most onus on the seller, as well as having the longest timeframes for recognizing revenue because the product is the responsibility of the seller all the way to the destination. It may take a month or more if shipped by ocean. Once the buyer has received the goods, the seller can conclude the sales transaction and recognize the revenue.
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Knowledge is key
It goes without saying that the seller will always look to shorten the amount of time from delivery to payment. But the buyer must agree to these terms and can even add conditions to the sales contract that demand more obligations from the seller. In this case, the seller must ensure they understand all contractual obligations above and beyond those required by the selected Incoterm.
One important concept that the finance team needs to take into consideration is the differences between the date the inventory is adjusted, the risk transfer date and any buyer document that shows receipt of the product.
One scenario would be when a seller takes a product out of inventory, the day the product is loaded onto the first carrier and if there’s any delay in the issuance of a bill of lading (legal document issued by a carrier to a shipper that details what’s being shipped, where it’s coming from and where it’s going). If the seller is looking to ship before year-end and the bill of lading is dated for the new fiscal year, this will affect revenue recognition unless an appropriate Incoterm, like EXW, is used.
It’s very important to have your finance and operations team working with the sales and shipping teams to ensure the Incoterm selected and inserted into the contract benefits the company’s revenue recognition needs.
How to avoid delays and unwanted costs
Using the wrong Incoterm or one that’s been in a contract for decades and is unknown could force the company to wait months to finalize a sales contract or even go through a painful process to adjust past financial reports.
“As an EDC advisor, I’ve seen first-hand the impact of not using the proper Incoterms when companies export to global markets. Misunderstandings can result in unexpected costs and delays, which can harm your bottom line,” says Emiliano Introcaso, who’s a Certified International Trade Professional (CITP).
“Many employees in companies dealing with international supply chains lack proper training on Incoterms. This knowledge gap can lead to costly mistakes,” Introcaso says.
“Proper training is an investment in your company’s growth. Don’t leave your success to chance—ensure your team is equipped with the incoterms knowledge they need.”
