Accounting Standards Codification (ASC) 606 places the responsibility on management to recognize revenue in a way that “depict[s] the transfer of promised goods and services to customers in an amount … [they] expect to be entitled,” per ASC 606-10-05-3. For many original equipment manufacturers (OEMs) that sell using a distribution network, a single transaction is likely to require significant judgement. For example, an OEM must determine how to properly account for free add-on services, variable cash rebates, or other incentives that are passed on to the end user. This case study examines the accounting issues OEMs are likely to face as they apply ASC 606 to a typical OEM transaction.
PDMeter Company (PDM) manufactures a volumetric flow meter used at fuel terminals and bulk plants. PDM sells its meters exclusively through a network of third-party distributers, which then sell the meters to end users. PDM’s meter prices are highly variable and negotiated differently from one sale to another. As part of a seasonal marketing promotion, PDM offers end users a free factory tune-up 12 months after the user purchases the meter from a distributor. PDM does not offer maintenance services under any other circumstance.
PDM offers tiered cash rebates to distributors, payable at the end of each year. When distributors move from one tier to another, the new cash rebate is applied retroactively to all meter sales during the year. The tiers are presented in the following table:
PDM enters into a contract on June 1, 2017, with Terminal Equipment Distribution Company (TED), a long-time distribution partner, to sell one meter with a free tune-up for the end user. The total consideration stated in the contract is $4,500. PDM’s cost to provide the tune-up service is $320. Because the tune-up is offered as an incentive, the right to receive the tune-up is transferred with the meter to TED and then to the end user for no additional cost. Both PDM and TED view the free tune-up as an incentive for end users to purchase meters. The direct costs incurred by PDM to manufacture this meter are $1,950. TED sells the June 1 meter to an end user, Bulk Plant Owners LLP, on September 1, 2017. PDM performs the free tune-up for Bulk Plant Owners LLP 12 months later, on September 1, 2018. At the time of the initial transaction, PDM expects TED to reach Tier 1 by the end of the year. However, on November 15, 2017, TED sells its 10,001st meter for the year and is eligible for the $800 rebate on every meter sold in 2017. A summary of case facts are as follows:
|Goods and services in transaction:||(A) Meter and (B) tune-up for end user|
|Transaction/Sale date to Distributor:||June 1, 2017|
|Stated contract price:||$4,500|
|Tune-up cost to PDM:||$320|
|Meter cost to PDM:||$1,950|
|Expected rebate to TED:||$500 as of June 1, 2017|
|Actual rebate to TED:||$800 as of November 15, 2017|
|Meter sold to end user:||September 1, 2017|
|Tune-up Performed:||September 1, 2018|
Step One: Identify the Contract
PDM identifies the transaction as a legitimate contract that falls within the scope of ASC 606. Because of their long-standing relationship, both parties agree to the terms and are expected to fulfill their contractual obligations. PDM intends and expects to deliver the meter and tune-up, and TED intends and expects to make payment. TED’s payment to PDM is not contingent on TED’s later sale to its own customer.
Step Two: Identify the Performance Obligations
To identify the performance obligations, promised goods and services must first be identified. In this case, PDM identifies, respectively, the meter and the tune-up as the good and service in the contract. ASC 606-10-25-16A clarifies that any promised goods or services that are immaterial within the context of the contract are not required to be included in the analysis of performance obligations. PDM determines that the tune-up is a material element of the contract because its value is material to the contract (7-8% of the contract value), and the inclusion of the tune-up in the contract is likely to positively affect a customer’s purchasing decision. In order to be separate performance obligations, per ASC 606-10-25-19 the good and service must be (1) capable of being distinct and (2) distinct within the context of the contract.
Capable of being distinct
The meter is capable of being distinct because it provides benefit to TED on its own as something TED can sell to its own customers. The meter is also of separate value to the end customer regardless of whether they receive a tune-up. The tune-up is also capable of being distinct because a tune-up can be performed on a meter regardless of how that meter was obtained. As a result, both the meter and the tune-up are capable of being distinct, whether from TED’s perspective or from the end customer’s perspective.
Distinct within the context of the contract
Goods and services are not distinct within the context of the contract if they meet any of the following three criteria outlined in ASC 606-10-25-21:
- The entity provides a significant service of integrating multiple goods and services within the contract. This means that when goods and services that are otherwise capable of being distinct are used as inputs to an integrated output, the inputs are not distinct within the contract, but the integrated output is distinct within the context of the contract. A common example is nails, wood, plumbing, and other materials when building a house. The building materials, while otherwise distinct goods, are not distinct within the context of the contract, but the final output of a completed house is distinct within the context of the contract. In the case of PDM, the meter itself is not integrated in any way with the tune-up. As a result, this criterion is not met.
- A good or service significantly modifies or customizes another good or service in the contract. In this case, the tune-up is minor routine maintenance and does not significantly modify or customize the meter. Similarly, the meter doesn’t significantly modify the tune-up service. As a result, this criterion is not met.
- A good or service is highly dependent on, or highly interrelated with, other goods or services in the contract. In this case, the meter is clearly not dependent on the tune-up to provide benefit to TED (or the end customer). The tune-up provides a benefit to the end customer at a later date, and thus provides a separate benefit to TED by its inclusion with the meter in the bundled package. While the factory tune-up is eventually performed on the meter, they are not considered highly interrelated. As a result, this criterion is not met.
Because the two elements of the contract do not meet any of the above criteria, they are considered distinct within the context of the contract, and each element will be a separate performance obligation.
When ASC 606 was first issued as Accounting Standards Update (ASU) 2014-09, the basis for conclusions (BC) paragraph 92 clarified a situation similar to this case study:
“for example, when an OEM sells a motor vehicle to its customer (a dealer), the OEM also may promise to provide additional goods or services (such as maintenance) to the dealer’s customer…a promise of a good or service (such as maintenance) that the customer can pass on to its customer would be a performance obligation if the promise could be identified (explicitly or implicitly) in the contract with the customer.”
Similarly, the meter and the tune-up in this case are capable of being distinct and distinct within the context of the contract. Thus, the two PDM performance obligations are:
- Deliver the meter to TED
- Provide factory meter tune-up to TED’s customer 12 months from customer purchase
Step Three: Determine the Transaction Price
The stated contract price is $4,500. However, under ASC 606-10-32-5 and 32-6, cash rebates are considered variable consideration and may reduce the transaction price. ASC 606-10-25-32-8 allows PDM to estimate the variable consideration using the “most likely amount” approach because there are effectively only two possible rebate outcomes: $500 rebate or $800 rebate. On June 1, 2017, PDM expects TED to finish the year in the Tier 1 range, which results in a $500 rebate per meter. Thus, the most likely amount for the overall transaction price is $4,000 ($4,500 contract price less $500 expected cash rebate).
Step Four: Allocate the Transaction Price
To allocate the transaction price, PDM must first determine the standalone selling price (SSP) of each performance obligation.
PDM never sells the tune-up separately, has no observable price on which to rely, and must therefore estimate the SSP of the tune-up. Per ASC 606-10-32-34(b), PDM may utilize a cost-plus-margin approach to estimate the tune-up SSP. The cost of the tune-up to PDM is quite stable at $320, and because PDM views this as an incentive instead of a service activity, PDM believes that an appropriate profit margin for this incentive is $0. Using this rationale, PDM estimates the tune-up SSP at $320.
Although PDM may want to employ this reasoning, we question this approach. Using only the cost or the cost plus a small margin as the estimated SSP does not represent “the price at which an entity would sell a promised good or service separately to a customer,” the definition of SSP in ASC 606-10-32-32. Also, using this estimate would inappropriately result in recognizing more of the total transaction price as revenue up front and deferring a smaller amount of revenue. In situations where the entity, such as PDM, does not offer the good or service separately, the SSP must be estimated. Per ASC 606-10-32-33, the entity must “maximize the use of observable inputs and apply estimation methods consistently in similar circumstances.” It is unlikely that if PDM were to offer the service separately, they would charge a price that only covers the costs of the service. On the contrary, because PDM operates as a for-profit business, all observable evidence suggests that PDM would sell the service for a reasonable profit above its costs in the normal course of business.
An appropriate margin may be difficult to pinpoint, but an entity can estimate this margin in a variety of ways. For example, an appropriate margin may be PDM’s operating profit margin or the average gross margin of all products and services that PDM offers. Another appropriate margin may be the typical profit margin of similar services offered by meter maintenance companies. PDM may also consider a non-cost-based estimation method to better estimate the SSP of the tune-up service, adjusted for other factors. Using this method, PDM calculates that the average customer price of a similar service offered by three repair shops specializing in flow meters is $400. PDM determines that this average should be adjusted upwards to represent the premium that is often charged in many industries for services performed by an original manufacturer. Using this approach, PDM estimates the SSP of the tune-up is $425. How an OEM determines an appropriate SSP for an incentive service will ultimately depend on the facts and circumstance specific to the individual transaction. For purposes of this case, assume that PDM determines that the tune-up SSP will be $425, not $320.
The selling price for meters differs significantly from sale to sale because of fluctuations in customer demand and production costs for the meter. PDM considers these factors when setting the contract price; the meter is what drives PDM’s changes in the total contract price from one sale to another in order to maintain a target profit margin. Therefore, a reasonable estimate of the meter SSP is essentially the remaining, or residual, amount after the tune-up SSP is removed from the transaction price. ASC 606-10-32-34(c) allows use of the residual method when a good or service is sold to different customers near the same time, but at different selling prices, which is the case in this PDM-TED transaction. In this case, the meter’s SSP must be $3,575 ($4,000 less $425).
In summary, $3,575 of the transaction price is allocated to the meter, and $425 is allocated to the tune-up.
Step Five: Recognize Revenue
PDM must identify the points in time at which it transfers control of the promised goods and services to TED (or the end customer). Because control of the meter transfers to TED when it is delivered to TED, the $3,575 allocated to the meter is recognized at the time of sale on June 1, 2017. Because the promised tune-up is provided a year after the end customer purchases the meter, the remaining $425 of revenue attributable to the tune-up is recognized when PDM performs the tune-up for Bulk Plant Owners LLP on September 1, 2018.
Subsequent Changes in Cash Rebate Incentive Amount
On November 15, 2017, when TED’s sales reach Tier 2, an extra $300 cash rebate is awarded to the June 1 transaction between PDM and TED. This further reduces the transaction price to $3,700 ($4,500 – $500 expected rebate – $300 adjustment for actual total rebate). Ordinarily, any subsequent change in transaction price is allocated to all performance obligations based on relative SSPs. However, ASC 606-10-32-40 requires PDM to allocate the variable consideration adjustment to a single performance obligation if (a) “the terms of a variable payment relate specifically to… a specific outcome [of one of] the performance obligation[s]” and (b) such allocation “is consistent with the allocation objective.” The allocation objective, per ASC 606-10-32-28, is “to allocate the transaction price to each performance obligation … in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.”
The additional $300 rebate should only adjust the allocated transaction price for the meter performance obligation because the terms of the cash rebate were based on total meter sales, not just meter sales in conjunction with the tune-up promotion; this is consistent with the allocation objective. Also, from TED’s perspective, this rebate is a reduction in the price of the meter because the free tune-up service should not be further discounted when a residual approach for estimating the meter’s SSP was used. This allocation is consistent with the allocation PDM would have reached if they had originally estimated the transaction price to be $3,700. The portion of the total transaction price allocated to the tune-up continues to be its SSP of $425. The full amount of the additional $300 reduction is allocated to only the meter, resulting in $3,275 total revenue for that meter. Because revenue from the meter was previously recognized on June 1, the $300 revenue reduction is recognized immediately, on November 15.
The following journal entries should be recorded by PDM to properly account for the transaction under ASC 606.
June 1, 2017: PDM sells TED the meter
………..Revenue (meter) …………………,,……..3,575
………..Tune-up obligation ………………………-425
………..Rebates Payable …………………………500
Cost of Goods Sold…………………….. 1,950
………..Meter Inventory …………………………..1,950
September 1, 2017: TED sells the meter to Bulk Plant Owners LLP
No booked entry for PDM
November 15, 2017: TED reaches Tier 2 and becomes eligible for additional retroactive rebates
………..Rebates Payable …………………………300
December 31, 2017: PDM issues TED the cash rebate associated with the June 1 sale
September 1, 2018: PDM performs 12-month factory tune-up for Bulk Plant Owners LLP
………..Revenue (tune-up) ………………………300
………..Wages / Supplies Payable ………………320
Comparison to 605
Under ASC 605, OEMs do not have to account for all goods and services promised to a distributor’s customer as performance obligations in the transaction. However, under ASC 606, OEMs typically do account for these promised goods and services as performance obligations.
The determination of transaction price may also be different between ASC 605 and ASC 606. Under ASC 605, variable cash rebates like those in this case are typically treated as fees that are not fixed or determinable, and entities can only recognize the portion of revenue that is fixed or determinable if rebates can be reasonably estimated. Under ASC 605, PDM may determine that the full $800 rebate is extremely unlikely, but the $500 rebate is nearly certain; PDM would then argue that a transaction price of $4,000 is fixed or determinable. Alternatively, PDM may determine that only $3,700 is initially fixed or determinable, despite the fact that the full $800 rebate is highly unlikely. Therefore, PDM would only recognize the remaining $300 of revenue once it determines that certain cash rebates will not occur. ASC 606 treats these cash rebates as variable consideration, and entities may estimate the variable consideration to which the entity expects to be entitled so that amount can be included in the overall transaction price. As shown above, PDM determines that the most likely amount is $4,000, which becomes the initial transaction price under ASC 606.
Accounting differences between the two standards also exist when allocating the transaction price and recognizing revenue. Under ASC 605, PDM has a wide variety of options when accounting for certain incentives or “free” add-ons. For example, PDM could recognize some portion of the original contract price as a prepayment for the service performed a year later. Alternatively, PDM may reach the accounting conclusion that these obligations are “perfunctory and inconsequential,” allowing them to write off the costs of the extra services as marketing expenses. In this case, PDM could allocate the full amount of revenue to the meter, recognize the revenue at the time of sale, and recognize the cost of the perfunctory and inconsequential tune-up as a marketing expense when performed. However, under ASC 606, the tune-up service and the meter are distinct performance obligations, and each must be allocated a portion of the transaction price at contract inception, assuming each element is material. As was the case with PDM, this difference may require OEMs to delay revenue recognition for a portion of contract revenues.
Having considered those differences, it is worth noting that Accounting Standards Update (ASU) 2016-10 allows some flexibility in the treatment of immaterial elements of a contract when identifying performance obligations. This update may result in previously perfunctory and inconsequential obligations receiving the same treatment under ASC 606 as they did under ASC 605. ASU 2016-10 allows companies not to assess whether goods and services are performance obligations if those goods and services are “immaterial in the context of the contract,” according to what will be codified as ASC 606-10-25-16A. It is important to note that this is not technically the same as the “perfunctory and inconsequential” qualification under ASC 605; however, many OEMs and other entities will likely determine that certain elements of a contract that were perfunctory and inconsequential under ASC 605 are also immaterial within the context of the contract under ASC 606. In making this determination, the OEM should consider the relative value of the “free” service within the contract and the influence that the service has on customer purchasing decisions, among other things. If an OEM determines that the extra service is not a material element of the contract, then the entire transaction price is allocated to the main good and recognized when the good is sold. In the PDM-TED transaction, PDM determined that the value of the tune-up was material to the contract because the customer’s purchasing decision was significantly influenced by the inclusion of the tune-up in the contract. Because the tune-up is considered material, PDM appropriately designated it as a separate performance obligation.
Basic OEM sales to distributors are usually straightforward, but combining the goods with free services and sales incentives can quickly complicate the accounting. Cash rebates and other incentives will generally decrease the transaction price and overall revenue recognized. As the transaction price is allocated based on actual or estimated SSPs, the portion allocated to the primary good may be determined using the residual method after first determining the SSP of the add-on incentive. The SSP of the add-on incentive should reflect the price the OEM would sell the incentive for on a standalone basis. Any further sales incentives and cash rebates earned during or after the transaction should be allocated to the main good and recognized immediately.
A similar accounting treatment can be applied to many industries that have similar business practices. Examples of potentially acceptable circumstances include:
- An automobile OEM (such as Ford or GM) sells a car (good) to a privately-owned dealership. Included in the sale is a free one-year proprietary navigation subscription (service) to be passed onto the final consumer. The dealership receives a cash incentive to meet its monthly quota of vehicle sales. Because the transaction price of the main good—the vehicle—is relatively high when compared with the price/cost of the navigation subscription, the immaterial analysis mentioned in this article may be relevant.
- A medical device manufacturer sells a state-of-the-art artery stint (good) to a hospital. Included in the transaction are 3 “free” annual ultrasounds to be performed at the manufacturer’s offices (service) to ensure proper stint placement over time. The hospital receives discounted surgical training from the manufacturer when they implant 100 stints in a 12-month period.
- A laptop computer manufacturer sells a computer (good) to a tech retailer with a free 1-year telephone support package (service) for the final consumer. The retailer is reimbursed by the manufacturer when end users apply manufacturer coupons to their purchase.
- Other manufacturers or OEMs that rely on distributors / dealers to sell products to end users. Many of these transactions include “free” services for end users and result in sales incentives awarded to the distributors.
Other RevenueHub Articles Central to Case Analysis
- ASC 606 Revenue from Contracts with Customers
- ASC 605-10 Revenue Recognition, Overall
- ASC 605-25 Revenue Recognition, Multiple Element Arrangements
- ASC 605-50 Revenue Recognition, Customer Payments and Incentives
- SEC Staff Accounting Bulletin (SAB) 13, Revenue Recognition.
- Deloitte Industry Spotlight: “Automotive Spotlight“. August 2014.
- KPMG, Issues In-Depth: “Revenue from Contracts with Customers.” Second Edition May 2016. Section 5 “The Model.”
- FASB TRG Memo 14: “Variable Consideration“. January 26, 2015.
- FASB TRG Memo 31: “Allocation of the Transaction Price for Discounts and Variable Consideration.” March 30, 2015.