In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every industry, and automotive is no exception. The complex arrangements between automotive original equipment manufacturers (OEMs), automotive parts suppliers (APSs), and car dealers pose some of the most difficult issues for the new standard. Due to various contractual incentives and unique manufacturing agreements that may be involved in a single contract, application of the five-step revenue-recognition model can be complicated.
The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues within ASC 606, and we will draw from the guides they have published as we provide a brief explanation of the key issues the automotive industry faces when applying ASC 606. For more information on any of these issues, see:
- EY: Technical Line – how the new revenue recognition standard affects automotive OEMs
- Deloitte: Automotive
- KPMG: Executive Accounting Update – Automotive manufacturers
We will also provide references to other RevenueHub articles for more detailed explanations of related ASC 606 topics. For general information on the basics of revenue recognition, see our RevenueHub article, The Five-Step Method.
The following are the issues that companies in the automotive industry commonly face:
1. Sales Incentives—reduction in revenue versus OEM purchase from supplier
OEMs often offer free services and sales incentives to dealers to increase sales. These incentives can be directed toward the car dealers themselves or to the end purchaser (i.e. retail customer). For example, an OEM might offer a dealer subsidized perks that can be passed on to retail customers, such as a maintenance package or a free period of roadside assistance.
Under the guidance in ASC 606, these sales incentives are normally treated as a reduction in the transaction price (step four), and, consequently, a reduction in revenue. However, in certain situations, it may be apparent that the customer is providing a distinct good or service to the OEM in exchange for the sales incentive (e.g., a car dealer provides a marketing service to the OEM in exchange for OEM-reimbursed car maintenance packages). In this case, if the OEM can reasonably estimate the fair market value of the good or service provided by the customer, the transaction would be treated like a regular purchase from a supplier.
Related RevenueHub Articles:
2. Sales Incentives—marketing incentives versus free goods
Historically, OEMs have accounted for most sales incentives to provide free or discounted goods or services as marketing incentives designed to attract customers, but under ASC 606, this will likely change. ASC 606 requires that entities treat these sales incentives as promised goods or services, even if the promises are not explicitly stated. For example, as discussed in the EY Technical Line, if a dealer normally provides free maintenance services to the customer that are reimbursed by the OEM, an implied promise exists within the sale of a vehicle, because the customary business practice allows the customer to expect such service.
Because these incentives will now be treated as promises in the contract, OEMs will need to recognize them (even if they are free) as a revenue performance obligation and apply the five-step guidance for revenue recognition in ASC 606. This could be a major change for many OEMs.
3. Tooling equipment
The contracts between APSs and OEMs often involve tooling—an arrangement in which the APS constructs custom equipment to manufacture a customized part (like a steering wheel or air bag for a new car model) for an OEM. These tooling arrangements are normally long-term, and often contain provisions under which the APS will transfer the legal title of the tooling machinery to the OEM after the machine’s construction, even though the APS retains physical possession of the machinery.
Under ASC 605, there is diversity in practice among APSs when accounting for tooling arrangements. Some APSs treat tooling as a revenue element while others do not. However, under ASC 606, it is likely that tooling will be treated as a revenue element (or performance obligation) because the constructed machinery constitutes a deliverable within the contract. Step two of the five-step revenue-recognition method in ASC 606 requires that an entity identify the performance obligations within the contract. Even if the tooling is incidental relative to the other parts of the contract, it would still likely qualify as a transferred good or service and would thus require an allocation of consideration as a separate or bundled performance obligation.
Once an APS has determined that the tooling is part of the performance obligation(s), the entity will apply the guidance in ASC 606 to determine if the tooling is distinct within the context of the contract (see our article Distinct within the Context of the Contract). Then, depending on the determination, the entity will recognize revenue as it transfers control to the customer (the OEM).
The historical treatment of tooling as a non-revenue element is less likely to be acceptable under ASC 606. To consider tooling as a non-revenue element under 606, the APS would need to conclude that the tooling is actually more similar to an administrative task to set up the contract, rather than a good or service. Considering the structure of normal tooling arrangements within the automotive industry, this determination appears unlikely.
For more information about the custom parts that are produced after tooling, see point 4 in this article.
Related RevenueHub Articles:
- Identifying Promised Goods & Services
- Distinct within the Context of the Contract
- Measuring Progress with Multiple Goods or Services in a Single Performance Obligation
4. Customized parts—revenue recognition at a point in time versus over time
As part of their continuous contractual arrangements, APS entities frequently agree to produce customized parts for their OEM customers. These parts are designed specifically for a particular car make and model being produced by the OEM. In these arrangements, APSs will need to assess if the custom part(s) constitute a separate performance obligation under ASC 606, or if they should be grouped with the other parts supplied as part of the contract.
To qualify as a separate performance obligation, the APS must conclude that the custom part is distinct. Per ASC 606-10-25-19, a good or service is distinct if it (a) is capable of being distinct and (b) is distinct within the context of the contract. For more information about this determination, see our article Distinct within the Context of the Contract.
After the APS entity has determined whether providing the custom part is a separate performance obligation, it must determine if the obligation should be recognized over time or at a point in time. Revenue should be recognized as control of the product is substantively transferred to the customer. To understand this transfer of control, the APS entity will need to use significant judgment to determine if the custom parts produced have a viable alternative use, and if an enforceable right to payment exists.
If the custom parts being made for the OEM are highly customized, it is unlikely that the APS could redirect them to another customer—placing a practical constraint on alternative uses. (Some after-market suppliers may be willing to purchase custom goods, but often at a significant discount relative to the price charged to the OEM—therefore, a practical limitation still exists.) Additionally, there may be contractual restrictions on the APS’s use of the custom products outside of the transfer to the contract-forming OEM. When these contractual or practical constraints exist, revenue recognition over time is likely more appropriate; however, APSs will also need to evaluate if an enforceable right to payment for performance completed to date exists.
An enforceable right to payment exists if the APS’s contract dictates that the OEM will pay for performance completed to the date that the contract is terminated. If the APS finds that the custom parts produced do not have an alternative use and that an enforceable right to payment for performance completed to date exists, revenue would appropriately be recognized over time, rather than at a point in time. For some APS entities, this guidance under ASC 606 could create a significant change in the timing of their revenue recognition.
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5. Repurchase options and residual value guarantees
OEMs frequently execute contracts with repurchase options or provisions to guarantee a certain level of value (residual value guarantees). Historically, these contractual arrangements were accounted for as leases under ASC 840, Leases, but they will need to be reassessed under ASC 606 to see if they qualify as a sale, lease, or financing arrangement.
In accordance with ASC 606-10-55-72, if the OEM entity is required to repurchase the cars or other assets at a price less than the original selling price (a put option), it will need to determine whether the customer has “a significant economic incentive to exercise that right.” If the customer does have significant incentive, the OEM should account for the agreement as a lease under ASC 840, unless the contract is part of a sale-leaseback transaction. If the OEM finds that the contract is part of a sale-leaseback transaction, it “should account for the contract as a financing arrangement and not as a sale-leaseback in accordance with Subtopic 840-40.”
Comparatively, per ASC 606-10-55-74, if the customer does not have a significant economic incentive to exercise its right to return product at a price lower than the original selling price, the agreement should be treated as a product sale with a right of return.
Similar to the put options discussed above, OEMs also execute residual value guarantees in which they guarantee the resale value of vehicles sold—a guaranteed minimum resale value. In these situations, the OEM should recognize revenue from the vehicle sale under ASC 606, but look to the guidance for guarantees under ASC 460, Guarantees to understand the proper treatment of the guarantee within the contract.
Related RevenueHub Articles:
It is likely that many other issues and questions will arise within the automotive industry as entities transition to the new revenue recognition standard. This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues discussions and resources are available on the RevenueHub site for all major industries as identified by the AICPA.