In 2018, the Accounting Standards Codification (ASC) Topic 606 became effective for all public companies. This major overhaul of revenue recognition has affected almost every industry, and automotive companies are 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 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 selected guides published by the AICPA and the major accounting firms:
- EY: Technical Line – how the new revenue recognition standard affects automotive OEMs
- Deloitte: Automotive Spotlight
- KPMG: Executive Accounting Update – Automotive manufacturers
We will also provide references to other Revenue Hub articles for more detailed explanations of ASC 606 topics. The following are the issues that companies in the automotive industry commonly face:
1. Sales Incentives—Marketing Incentives Versus Free Goods
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.
ASC 606 requires that entities treat 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 incentives are 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.
2. Revenue Recognition for 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 606, it is likely that tooling is 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 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. Then, depending on the determination, the entity will recognize revenue as it transfers control to the customer (the OEM).
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.
Lydall, Inc. designs and manufactures specialty engineered products and materials primarily for the automotive industry. In its 2018 annual report, Lydall described how it treats tooling under ASC 606 as follows:
Pre-production design and development costs — The Company enters into contractual agreements with certain customers to design and develop molds, dies and tools (collectively, “tooling”). All such tooling contracts relate to parts that the Company will supply to customers under long-term supply agreements. Tooling costs are accumulated in work-in process inventory and are charged to operations as the related revenue from the tooling is recognized. With the adoption of ASC 606, Revenue from Contracts with Customers on January 1, 2018, the Company’s revenue recognition policies require the Company to make significant judgments and estimates regarding timing of recognition based on timing of the transfer of control to the customer. The Company analyzes several factors, including but not limited to, the nature of the products being sold and contractual terms and conditions in contracts with customers to help the Company make such judgments about revenue recognition. For tooling revenue recognized over time, the Company’s significant judgments include, but are not limited to, estimated costs to completion, costs incurred to date, and assessments of risks related to changes in estimates of revenues and costs. The Company’s management must make assumptions regarding the work required to fulfill the performance obligations, which is dependent upon the execution by the Company’s subcontractors, among other variables and contract requirements.
Periodically, the Company enters into contractually guaranteed reimbursement arrangements as a mechanism to collect amounts due from customers from tooling sales. Under these arrangements, amounts due from tooling sales are collected as parts are delivered over the part supply arrangement, in accordance with the specific terms of the arrangement. The amounts due from the customer in such transactions are recorded in “Prepaid expenses and other current assets” or “Other assets, net” based upon the expected term of the reimbursement arrangement.
3. Revenue Recognition for Customized Parts
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.
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.
PACCAR, Inc. is one of the largest truck manufacturers in the world. The SEC requested additional details on why PACCAR recognizes revenue from trucks at a point in time rather than over time. PACCAR’s July 2018 analysis and response are as follows:
The vast majority of the Company’s trucks are sold directly to its independent dealers, who resell the products to an end customer. Most trucks are manufactured to end customer specifications based on the option and configuration choices the customer made when the dealer placed the order. Some trucks are manufactured to dealer specifications where the dealer does not have a specific customer order to fill. These option and configuration choices have been engineered by the Company before being offered to customers and are available to all dealers.
When evaluating revenue recognition, the Company considered the following criteria under ASC 606-10-25-27(a) through 27(c):
(a) “The Customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.”
The Company believes this provision primarily relates to service arrangements and does not apply to the Company’s situation. The Company’s contracts are for the delivery of a completed truck. The timeframe from start of product assembly to delivery of the finished truck is almost always within a few days. The benefit is only transferred to the dealer after the truck is fully assembled and all required testing is completed and when control is transferred to the dealer.
(b) “The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.”
The dealer does not have any control over the truck while it is in the production process.
(c) “The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.”
Trucks are built according to dealer specifications but could be redirected to another dealer without incurring significant rework costs or significant economic loss; therefore, the Company’s performance creates an asset with an alternative use.
Based on this analysis, we concluded revenue should be recognized at a point in time. (July 2018 Letter)
However, the SEC requested additional details regarding the analysis of trucks that were manufactured to end customer specifications as opposed to dealer specifications. PACCAR responded with the following analysis:
The dealer is the Company’s customer and places the order. The specifications requested by the dealer will include items such as chassis length, engine type and horsepower, number and type of axles, tires, interior and exterior colors chosen from the options and choices made available by the Company. Trucks are customized based on pre-configured options which are within industry standard specifications. Accordingly, the trucks are not so unique as to not be readily saleable to another dealer. There are no contractual or practical limitations which would prevent the Company from redirecting a truck to another dealer, and any costs incurred (such as changing paint color) would not be significant.
The Company is only entitled to payment when the truck is fully assembled and the dealer takes control, which generally occurs upon shipment. At this point the Company has met its performance obligation and any further customization to the truck is the dealer’s responsibility. The Company is not entitled to payment for a partially completed truck. Therefore, the Company does not meet the provisions of ASC 606-10-25-27(c) as the Company’s performance creates an asset with an alternative use and it has no enforceable right to payment for a partially completed truck. (August 2018 Letter)
4. 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).
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.
In its correspondence with the SEC, Ford describes in detail how it thinks about guaranteed residual values on automotive sales:
Under legacy U.S. GAAP, our promise of a guaranteed resale value at auction was considered a retention of risk, thus we were precluded from recognizing revenue when we transferred the vehicle to the GAV (guaranteed auction value) customer. Accordingly, we accounted for the transaction as a lease, consistent with Topic 840, “Leases”, paragraph 840-10-55-14. However, ASC 606 amended Topic 840, adding paragraph 840-10-55-14A which states, “a sales incentive program in which an entity (for example, a manufacturer) contractually guarantees that it will pay a purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the guaranteed minimum resale value should be accounted for in accordance with Topic 460 on guarantees and Topic 606 on revenue from contracts with customers.”
The terms of our GAV contracts provide the customer with an unconstrained right to direct the use of and obtain substantially all of the benefits from ownership of, the vehicle in exchange for payment to us. As noted above, the GAV contracts stipulate that legal title of the vehicle transfers to and remains with the customer, the resale of the vehicle is at the sole discretion of the customer, and the customer receives proceeds from the sale to a third-party purchaser directly from the auction company. Accordingly, we have transferred significantly all risks and rewards to the customer. Therefore, consistent with the guidance in ASC Topics 606 and 840, we now recognize revenue for vehicles sold to customers under the terms of the GAV program at the point in time at which the customer obtains control of the GAV vehicle, generally upon shipment from the manufacturing facility. At the same time, we record a liability for the best estimate of the amount we will have to pay under the terms of the guarantee. We disclosed the recorded amount of the guarantee, as well as the maximum potential payment for the guarantee, in our Second Quarter 2017 10-Q Report, Note 16 of the Notes to our Financial Statements.
In contrast, we offer a rental repurchase program, the terms of which differ from the terms of the GAV program in that they provide fleet customers with an unconditional option to sell the vehicle back to us rather than selling the vehicle to a third-party purchaser at auction. We are obligated to repurchase the vehicle at a price determined based on the agreed formula once the fleet customer exercises its option. Paragraph 606-10-55-72 states, “if an entity has an obligation to repurchase the asset at the customer’s request (a put option) at a price that is lower than the original selling price of the asset, the entity should consider at contract inception whether the customer has a significant economic incentive to exercise that right… if the customer has a significant economic incentive to exercise that right, the entity should account for the agreement as a lease in accordance with Topic 840 on leases unless the contract is part of a sale-leaseback transaction.”
Unlike the GAV repurchase, in which we purchase approximately 5% of the vehicles sent to auction by the GAV customer for the reasons stated above, approximately 95% of vehicles sold to fleet customers under the terms of rental repurchase contracts were returned to us and re-titled in our name. Accordingly, we concluded that because the terms of our rental repurchase program provide the fleet customer with both an unconditional option to put the vehicle back to us, and a significant economic incentive to exercise the option (neither of which exist with the GAV repurchase), the rental repurchase arrangement should be accounted for as a lease in accordance with ASC 840.
When differentiating a repurchase obligation from a guaranteed resale value obligation, the FASB observed in paragraph BC431 of the basis for conclusions that “the customer’s ability to control the asset in each case is different. If the customer has a put option that it has significant economic incentive to exercise, the customer is restricted in its ability to consume, modify, or sell the asset. However, when the entity guarantees that the customer will receive a minimum amount of sales proceeds, the customer is not constrained in its ability to direct the use of, and obtain substantially all of the benefits from, the asset.” Although the cash flows under our GAV and rental repurchase programs may be similar, the contractual terms of the conditional repurchase by us under the GAV program does not constrain the customer’s ownership of the vehicle like the contractual terms of the unconditional repurchase by us under our rental repurchase program. (September 2017 Letter)
It is likely that many other issues and questions will continue to arise within the automotive industry as entities apply the revenue recognition standard. This article serves as a base reference point for your research into some of the focal issues experienced by industry experts. Similar industry-specific issues and resources are available on the RevenueHub site for all major industries as identified by the AICPA.