ASC 606 is effective for public entities for fiscal years beginning after Dec. 15, 2017, and for interim periods therein. Nonpublic entities are required to adopt the standard for fiscal years beginning after Dec. 15, 2018, and interim periods within fiscal years beginning after Dec. 15, 2019.
There are several areas, however, that have proven challenging for automotive entities when adopting ASC 606:
What is the contract?
Auto suppliers have long-term relationships with their customers. Often, there are multiple documents that define the scope of a relationship with a customer, including:
- Award letters–Identify that the customer has selected the supplier to provide the parts; identify certain terms and conditions that will govern the ongoing relationship
- Blanket purchase orders (POs)–Provides further definition of terms and conditions, and establishes a price; typically, the PO is for a period of one year, but can be for a period of five years
- Release–Identifies the quantity that the customer has determined and is contractually committed to providing
While these documents outline terms of the arrangement, the quantity of goods to be purchased is not known until the release. Auto suppliers have generally determined that a contract is formed upon release, whereby the quantity agreed to by the customer is identified and the suppliers become contractually committed to fulfilling.
The contract term, the period in which enforceable rights and obligations exist, may be affected by termination provisions in the contract. For example, an entity may apply the standard to only a portion of a contract with a stated term when the contract allows either party to terminate it at any time without penalty. Significant judgment will be required to determine the effect of termination provisions on the contract term. The contract term to which the standard is applied may affect the number of performance obligations identified and the determination of the transaction price. It may also affect the amounts disclosed in some of the required disclosures.
A careful evaluation of the facts and circumstances should be used to determine when a contract exists and how long the contract term is.
Performance obligations within the contract
As part of arrangements with the customer, auto parts suppliers often provide at least the following three items:
- Customer-owned tooling
- Pre-production engineering and design work
Auto suppliers must evaluate each of the promises in the contract to determine if they represent promises for distinct goods or services that should be accounted for as performance obligations. Historically, suppliers have often not considered preproduction activities to be revenue generating activities under ASC 605 and therefore have generally accounted for the reimbursement of preproduction activities—such as customer-owned tooling and preproduction engineering and design work—as an offset to related costs. Generally, entities that currently account for pre-production and tooling activities as non-revenue-generating activities under ASC 605 can be expected to conclude that the activities are not in the scope of ASC 606. However, entities that account for these as deliverables under ASC 605 will need to further evaluate whether they represent performance obligations under ASC 606.
In addition, a supplier will need to evaluate any sales incentives offered in the form of free goods. While many of the free goods that suppliers offer as sales incentives are ultimately used by the retail consumer after he or she buys from a retailer, they may represent promises the supplier makes to the retailer if those rights existed when they parts were sold to the retailer. This applies to both explicit or implicit rights and promises. As a result, suppliers need to evaluate free goods and services to determine whether they are promised goods in their contracts. If the supplier determines that the free goods are distinct, and therefore separate, performance obligations, the supplier will allocate a portion of the transaction price to these items.
Many agreements may also contain options to purchase additional goods, including additional purchases at volume-discounts. Any contract options must be evaluated to determine if they provide the customer with a material right (i.e. an incremental benefit only received as a result of a prior purchase) and therefore, must be accounted for as separate performance obligations.Consideration payable to a customer, including upfront payments
Consideration payable to a customer, including upfront payments
Occasionally, certain automotive parts customers require upfront payments in exchange for a future program or award, sometimes known as “pay-to-play” payments. Some automotive parts suppliers expense these upfront payments, while others defer recognition of them. There is diversity in practice as suppliers interpret how directly the upfront payment is tied to future business compared to payments made to customers for many different reasons (e.g., a negotiated supplier credit related to past business paid to an OEM). This diversity in practice is expected to continue under ASC 606. However, there is no diversity in practice regarding classification: Payments made by a supplier to a customer that are not in exchange for the receipt of a distinct good or service are recorded as a reduction of revenue.
The Financial Accounting Standards Board’s Transition Resource Group (FASB TRG) explains this in Paper 59 as follows:
“In the staff’s view, an important first step in evaluating the accounting for an upfront payment is understanding the reasons for the payment, the rights and obligations resulting from the payment (if any), the nature of the promise(s) in the contract (if any), and other relevant facts and circumstances. Understanding this rationale can be instructive when determining the accounting and in particular, understanding whether and how the entity expects to obtain future benefits as a result of the payment. In addition, this rationale can be helpful in deciding what information about the arrangement should be disclosed to financial statement users.”
How directly the upfront payment is tied to future business is critical in determining a company’s accounting. FASB TRG members generally agreed that an entity will need to apply the view that best reflects the substance and economics of the payment to the customer and won’t be able to make an accounting policy election.
As the automotive industry is migrating to a pay-to-play environment, auto suppliers may capitalize certain upfront payments for new customers or new volume agreements in line with historical practices within the industry and under ASC 606 where the entity expects to generate future revenue associated with the payment. Auto parts suppliers will record an asset for upfront payments to customers and amortize the asset over the life of the agreement. Entities would determine the amortization period based on facts and circumstances and would assess the asset for recoverability using the principles in other asset impairment models in US GAAP.
The above highlighted industry impacts are not all-inclusive and careful evaluation of each of the five steps under ASC 606 is required in order to determine proper accounting for an entity’s contracts with its customers. The following are some additional key areas for consideration:
- Evaluation of variable consideration, including retroactive volume discounts, stock rotation provisions and return rights
- Product warranties, including assessment of length of warranty and other factors to determine if represents an assurance-type (cost accrual model under ASC 460) or service-type warranty (performance obligation under ASC 606)
- Any repurchase rights and related provisions, including impacts on timing of transfer of control
It is important to keep in mind that ASC 606 requires a careful evaluation of the facts and circumstances in reaching conclusions. In addition, careful evaluation of any other consideration payable to a customer is required to determine the accounting for such consideration.