Common ASC 606 Issues: Automotive Entities

Vehicles produced by Automotive Industry, which has specific considerations related to ASC 606 accounts standards.

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.

In this article, we provide a brief explanation of the key issues the automotive industry faces when applying ASC 606, drawing on the following helpful guides published by the major accounting firms:

We will also provide references to other RevenueHub articles for more detailed explanations of ASC 606 topics. Companies in the automotive industry may face the following  issues:

1. Sales Incentives—Marketing Incentives Versus Free Good

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.

Historically, OEMs have accounted for most sales incentives to provide free goods or services as a reduction in revenue, but this will change under ASC 606. 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.

In addition, when OEMs grant dealers and customers the option to acquire additional goods or services, these options are treated as separate performance obligations if they qualify as material rights. Material rights exist when the dealer or customer receives a benefit that would not be received without entering into the contract. For example, the option to acquire additional goods or services at a discount that exceeds normal discounts given to similar dealers or customers represents a material right. Material rights can also exist if an agreement grants the option to purchase additional goods or services at a set price when the goods’ and services’ standalone selling prices are highly likely to significantly increase.

Because these sales incentives can be treated as promises in the contract, OEMs will need to recognize them as a separate revenue performance obligation and apply the five-step guidance for revenue recognition in ASC 606. This could be a major change for many OEMs.

Related RevenueHub Articles:

2. 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 performance obligation or part of a bundled performance obligation, requiring an allocation of the contract’s consideration.

Once an APS has determined that tooling is a promised good in the contract, the entity will apply the guidance in ASC 606 to determine if the tooling is distinct (see our article Distinct within the Context of the Contract). Then, if the tooling is distinct, the entity will recognize revenue as it transfers control of the custom-tooled equipment 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:

3. Cash Sales Incentives and Consideration Payable to a Customer

In the automotive industry, OEMs offer cash incentives to dealers and customers. In some cases, the amount of cash consideration is fixed and non-contingent on future events; such cash incentives are accounted for as a fixed discount. In most cases, however, the amount of cash a customer or dealer will qualify for is unknown to an OEM when it sells cars to a dealer. Under the guidance in ASC 606, these cash incentives are considered variable consideration and will lower the transaction price allocated to the performance obligations.

Similarly, many APSs send one-time cash payments to OEMs to foster positive relationships. This is considered consideration payable to a customer, which results in a reduced transaction price (step four), and, consequently, a reduction in revenue. However, in certain situations, it may be apparent that the OEM is providing a distinct good or service to the supplier in exchange for the cash payment. In this case, the transaction is treated like a regular purchase from a supplier.

Related RevenueHub Articles:

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.

For the custom part 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. Additionally, an APS will need to evaluate if an enforceable right to payment for performance completed to date exists for the custom parts revenue to be recognized over time.

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.

Related RevenueHub Articles:

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:

6. Warranties and Significant Financing Components

OEMs commonly include warranties in their sales agreements with dealers and customers. Often, the purpose of these warranties is to fix defects that were present at the time of sale. These warranties represent assurance-type warranties, which are accounted for as cost accruals. Additionally, many OEMs sell extended warranties, which cover vehicles more comprehensively and for longer periods of time. These extended warranties represent service-type warranties, which are accounted for as separate performance obligations. When determining if a warranty qualifies as assurance-type or service-type, OEMs should consider (a) if the warranty can be purchased separately and (b) if the warranty covers defects in the vehicle that did not exist at the time of sale (which is observed in the length or mileage of the warranty and the breadth of the promised coverage). When warranties meet these two considerations, they qualify as service-type warranties.

Finally, OEMs will often receive prepayment for goods or services provided over a period of time (e.g., extended warranties that are paid for upfront); therefore, OEMs need to determine if these prepayment agreements contain a significant financing component. If the period of time over which the good or service is transferred is less than one year or the prepayment does not provide the OEM with a significant financing benefit, then there will be no significant financing component and no change to the transaction price.

Related RevenueHub Articles:

Conclusion

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.

Author Chapman Ellsworth

Chapman was born and raised in Boise, ID. He is studying accounting and chemistry, and will join L.E.K. Consulting after graduation. Chapman loves pick-up sports, playing the viola, and getting his heart broken by the Arizona Diamondbacks.

More posts by Chapman Ellsworth

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