By Saloni Madhok, Marketing Manager at Zuora
The new revenue recognition standard is more principle-based than current revenue guidance. For automotive entities, this means more judgement than required in the past. Original equipment manufacturers and automotive parts suppliers may identify more performance obligations than what is done today. Automotive parts suppliers may be required to change the timing of revenue recognition for contracts to supply customized parts. The new standard is effective for public entities for fiscal years beginning after December 15, 2016, including interim periods within those years, and for non-public entities in years beginning after December 15, 2017.
Ernst and Young Technical Line reports suggest a key issue for automotive entities will be the identification of performance obligations.
Automotive entities may need to change certain revenue recognition practices as a result of the new revenue recognition standard jointly issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the boards). The guidance also provides a model for the measurement and recognition of gains and losses on the sale of certain nonfinancial assets, such as property and equipment, including real estate.
We’ll touch on some key areas of consideration here to give you an idea of how the new #RevRec standards are going to affect the automotive industry. To apply the new standard, original equipment manufacturers (OEMs) will need to change the way they evaluate incentives. Automotive parts suppliers (APSs) will also need to change the way they evaluate long-term supply contracts. Both types of entities may identify separate performance obligations (i.e., unit of account) not done today. The accounting for contracts with repurchase options or residual value guarantees also may change.
OEMs frequently offer sales incentives in contracts to sell vehicles to dealers. These sales incentives can be in the form of a cash rebate bonus or other incentive to dealers and retail customers (who purchase the vehicle from the dealer). These incentives can also include free or heavily discounted goods or services provided to retail customers, such as free satellite radio or free maintenance for a specified period.
Under the new standard, cash incentives (or credits or other items that can be applied against amounts owed to the OEM) paid by the OEM to customers (dealers and retail customers) will generally be accounted for as a reduction in the transaction price, and therefore of revenue.
The boards’ concluded even if such incentives (e.g., free maintenance services performed by a dealer for which the OEM provides reimbursement) are not explicit promises in a contract, they would nonetheless be an implied promise if the OEM has a customary business practice resulting in the retail customer having a valid expectation that the OEM is obligated to provide maintenance services. Therefore, such amounts are considered promises in the contract, and the OEM will be required to account for the free services as a revenue element. OEMs will have to review their processes for estimating rebates and other forms of variable consideration to make sure they fully address the new guidance on estimating the transaction price (and applying the constraint) and appropriately document their conclusions.
Long-term supply contracts
APSs commonly enter into long-term arrangements with OEMs to provide specific parts such as seat belts or steering wheels. An arrangement typically includes the construction of the equipment required to manufacture the part (referred to as tooling) to meet the OEM’s specifications. The boards concluded that incidental goods and services are goods or services for which the customer pays and to which an entity should allocate consideration (i.e., identify as performance obligations) for purposes of revenue recognition.
APSs may be required to change when they recognize revenue for supplying customized parts.
Repurchase options and residual value guarantees
OEMs may sell vehicles with a repurchase option or a residual value guarantee (e.g., when they sell fleets to rental car companies). Under today’s guidance, OEMs account for these vehicle sales as leases in accordance with Accounting Standards Codification (ASC). Under the new standard, arrangement repurchase features must be evaluated to determine whether they represent a sale, lease or financing, based on specified criteria. This evaluation includes considering factors such as the likelihood of a customer exercising a put option or the relationship between the repurchase price and the original selling price.
It is recommended automotive entities carry out a quick preliminary assessment to learn about specific affects of the new guidance as soon as possible. This way, personnel can determine how to prepare to implement this complex new standard. While the effect on entities will vary, it is likely that some may face significant changes in revenue recognition. Entities must aim to evaluate the requirements of the new standard and make sure they have processes and systems in place to collect the necessary information to implement the standard, even if their accounting results won’t change significantly, if at all. The Transition Resource Group (TRG) discussions are an excellent forum to learn about ongoing revenue issues and solutions.