FASB Emerging Issues Task Force

Transcription

1 EITF Issue No FASB Emerging Issues Task Force Issue No Title: Accounting for Consideration Given by a Service Provider to Manufacturers or Resellers of Specialized Equipment Necessary for an End-Customer to Receive Service from the Service Provider Document: Issue Summary No. 1 Date prepared: March 1, 2006 FASB Staff: Cosper (ext. 283) / Beswick (ext. 453) EITF Liaison: Jan Hauser Date previously discussed: None Previously distributed EITF materials: None References: EITF Issue No , "Reporting Revenue Gross as a Principal versus Net as an Agent" (Issue 99-19) EITF Issue No , "Revenue Arrangements with Multiple Deliverables" (Issue 00-21) EITF Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products)" (Issue 01-9) The alternative views presented in this Issue Summary are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination and it is ratified by the Board. EITF Issue No Issue Summary No. 1, p. 1

2 Background 1. Certain companies ("service providers") provide services to their customers that require the customers to purchase specialized equipment in order to utilize the service (including service providers that provide consumables to their customers over a specified contract term). The equipment required to use their services is often manufactured and distributed by third-parties and sold to end-customers through resellers without the direct involvement of the service provider (that is, while the service provider has contractual arrangements with third-parties to manufacture the equipment, the service provider does not purchase or take title to the equipment or directly sell the equipment to the purchasers of its services). The contractual arrangement between the service provider and the third-party manufacturer may include terms that detail the equipment specifications, the production volume, and the selling price. The service provider may also mandate to whom the third-party manufacturer may sell the specialized equipment. 2. Accordingly, a service provider may provide certain incentives to third-party manufacturers or resellers to reduce the selling price of the specialized equipment in order to stimulate endcustomer demand and, inherently, increase the demand for the service provider's service. This is particularly common during the initial stage of a service's introduction to the market when the specialized equipment may be cost prohibitive to the end-customer. An incentive may be in the form of cash, equity instruments, technological know-how, key components of the specialized equipment, or tooling, among others. The incentives given by the service provider to the thirdparty manufacturers and resellers are generally made on a per-unit basis. However, the consideration given to third-party manufacturers is made in advance of the initiation of a service contract with an end-customer, and the consideration given to the resellers is triggered only after a contract is initiated between the service provider and the end-customer for service. Issue 01-9 provides guidance on the accounting for consideration given by a vendor to a customer. Paragraph 2 of Issue 01-9 provides guidance on the scope and states: Consideration (including sales incentives) offered by a company (vendor) on either a limited or a continuous basis to a customer may take various forms including discounts, coupons, rebates, and "free" products or services. Issue 01-9 contemplates that vendor consideration may be given to direct or indirect customers of the vendor. For example, a vendor may sell its products to a distributor who in turn resells the products to a retailer. Consideration paid by the EITF Issue No Issue Summary No. 1, p. 2

3 vendor to the retailer in that example is within the scope of this Issue. Issue 01-9 also addresses sales incentives offered by manufacturers to customers of retailers or other distributors. Thus, the scope of Issue 01-9 includes vendor consideration to any purchasers of the vendor's products at any point along the distribution chain, regardless of whether the purchaser receiving the consideration is a direct customer of the vendor. Examples of arrangements within the scope of Issue 01-9 include, but are not limited to, sales incentive offers labeled as discounts, coupons, rebates, and "free" products or services as well as arrangements labeled as slotting fees, cooperative advertising, and buydowns. 3. However, arrangements in which a service provider gives an incentive to third-party manufacturers or resellers for the equipment needed to use the service provider's service (where the service provider is not a vendor of the specialized equipment) have been historically recognized as subscriber acquisition costs and have not been considered within the scope of Issue Some examples of service providers that may use these types of arrangements include cable and satellite television services, satellite radio services, wireless telecom services, digital video recording services (DVR), internet service providers (ISP) and companies that sell consumables or other services that may require the use of specialized equipment (for example, coffee, security, or medical services). The following three illustrations demonstrate how a number of these arrangements are structured. Illustration 1 5. This arrangement is frequently encountered in the technology sector, specifically with respect to satellite radio and satellite television. EITF Issue No Issue Summary No. 1, p. 3

4 Illustration 1 Third-party Manufacturer B Service Provider A C Reseller E F Third-party Microchip Manufacturer D End-Customer 6. In this illustration, the service provider enters into a contractual arrangement with a thirdparty (A) to manufacture the microchips that will be used in the production of the specialized equipment by a third-party manufacturer. The service provider purchases the microchips and capitalizes them into inventory. In some cases, the service provider does not take title to the microchips and they are purchased directly by the third-party equipment manufacturer. The service provider enters into a contractual arrangement with a separate third-party manufacturer (B) to produce the specialized equipment. As discussed previously, the terms of the contract may include the equipment specifications, the production volume, and the selling price. The service provider then either gives or consigns the microchips to the third-party manufacturer for use in making the specialized equipment. The service provider does not purchase or take title to the specialized equipment, but provides a cash incentive on a per-unit basis (B) to the third-party manufacturer. 7. The third-party manufacturer then sells the equipment (C) to a reseller. The equipment is sold at a price that is lower than what the third-party manufacturer would have sold it to the reseller for because of the incentive that was paid by the service provider (based on the terms specified in the contractual arrangement). The reseller sells the equipment (D) to the endcustomer on either a "free" or a discounted basis from the reseller's original cost. The service provider pays a cash incentive (E) to reimburse the reseller for the lost revenue on the sale of the EITF Issue No Issue Summary No. 1, p. 4

5 equipment to the end-customer. The incentive payment is triggered by the initiation of a service contract (F) between the service provider and the end-customer after the expiration of the cancellation period. 8. In this illustration, the service provider recognizes the cash incentives as subscriber acquisition costs when they are paid to the third-party manufacturer and the reseller. The costs of the microchips are also expensed as a subscriber acquisition cost at the time the microchips are given to the third-party manufacturer or, if on consignment, when the third-party manufacturer delivers the specialized equipment to the reseller. Under this structure, the service provider recognizes the incentive payments to the third-party manufacturers in advance of obtaining a service contract with the end-customer. The incentive payment made to the reseller is recognized after the service provider obtains a service contract with the end-customer. 9. The service providers do not believe these payments meet the scope requirements of Issue 01-9 because they believe both the reseller and the third-party manufacturer of the specialized equipment are outside of the distribution chain as contemplated by Issue Illustration In some instances, service providers enter into contractual arrangements with companies to include the specialized equipment in the merchandise being sold to the end-customer. In this arrangement, a car company purchases and installs satellite radios in its cars during the manufacturing process and receives a cash incentive from a service provider to reimburse it for the equipment and installation costs. This arrangement, which is a derivation of the arrangement in Illustration 1, is shown below: EITF Issue No Issue Summary No. 1, p. 5

6 Illustration 2 Third-party Manufacturer Company A D Service Provider Microchip Manufacturer B C End-Customer 11. In this illustration, the service provider pays a cash incentive (A) to reimburse the car company for the equipment and installation costs. The specialized equipment is "activated" or "turned on" as it comes off of the assembly line. The car (which includes the specialized equipment) is sold to the end-customer (B) and the service contract may be prepaid by the endcustomer at the point-of-sale and bundled as part of the purchase price of the car (C). The car company then remits the prepayment for the service by the end-customer to the service provider (D). 12. In this arrangement, the service provider recognizes the cash incentive to reimburse the car company for the equipment and installation costs as subscriber acquisition costs when they are made. Similar to the arrangement in Illustration 1, the service providers do not believe these incentive payments meet the scope requirements of Issue 01-9 because they do not believe that the car company is within the service provider's distribution chain. Illustration This illustration describes a contractual arrangement between an ISP and a hardware manufacturer. EITF Issue No Issue Summary No. 1, p. 6

7 Illustration 3 Hardware Manufacturer A/E Service Provider (ISP) B/F Reseller D C End-Customer 14. In this illustration, a service provider (ISP) enters into a contractual arrangement with a computer hardware manufacturer (A) to sell low cost computers if the end-customers commits to a three-year service contract with the service provider. The computer hardware manufacturer preloads the computer with the service provider's software (or provides end-customers with the software on a disk) and sells the computer (B) to a reseller. The reseller sells the computer (C) to the end-customer. If the end-customer commits to a three-year service contract with the service provider, the computer will have a reduced selling price. The end-customer enters into a threeyear service contract (D) with the service provider. The service provider then pays a cash incentive (E) to the computer hardware manufacturer who reimburses (F) the reseller for the price reduction of the equipment. 15. In this arrangement, the service provider determined that Issue 01-9 applies and recognized the cash incentive payments to reimburse the computer hardware manufacturer as a reduction of revenue. 16. While similar in structure to the arrangement in Illustration 1, the arrangement in Illustration 3 highlights the potential for diversity in determining the application of the scope of Issue 01-9 and, in addition, raises the question of interchangeability, since the equipment needed to use the services of the service provider is not limited to one particular computer hardware manufacturer. EITF Issue No Issue Summary No. 1, p. 7

8 17. In all of the illustrations described above, the service providers rely on the resellers to provide information to the customers on how to activate the service and, in some cases, the resellers activate the service on behalf of the customers, but neither the resellers nor the thirdparty manufacturers are involved in the ongoing delivery of the services to the end-customers. In most instances, the specialized equipment that is required to utilize the service is not interchangeable with any other service provider. 18. While the distribution chain is not explicitly defined in Issue 01-9, or in other accounting literature, in practice, service providers have consistently interpreted that the payments made to third-party manufacturers or resellers for specialized equipment are outside of the distribution chain and therefore have not applied the guidance within Issue This interpretation is made, in part, because the service providers have not taken title to the specialized equipment inventory (and do not meet the definition of a vendor), although the end-customers have received a benefit from the payments made by the service provider within the "equipment" distribution chain. Accounting Issues and Alternatives Issue 1: Whether the consideration given by a service provider to a manufacturer or a reseller of specialized equipment that reduces the price of the specialized equipment to an end-customer and is necessary for an end-customer to receive a service from the service provider should be accounted for pursuant to Issue The Task Force reached a consensus on Issue 1 of Issue 01-9, that cash consideration (including sales incentives) given by a vendor to a customer is presumed to be a reduction of the selling prices of the vendor's products or services and, therefore, should be characterized as a reduction of revenue in the vendor's income statement unless the vendor receives or will receive an identifiable benefit in exchange for the consideration that is sufficiently separable from the recipient's purchase of the vendor's products and where the fair value of the benefit can be reasonably estimated. If the consideration consists of "free" product or services, or anything other than cash or equity, the Task Force reached a consensus that the cost of the consideration EITF Issue No Issue Summary No. 1, p. 8

9 should be characterized as an expense (as opposed to a reduction of revenue) when recognized in the vendor's income statement. View A: Consideration given by a service provider to a manufacturer or reseller of the specialized equipment that reduces the price of that equipment to an end-customer and is necessary for an end-customer to receive a service from the service provider should be accounted for pursuant to Issue Proponents of View A believe that the fundamental question surrounding this issue is the definition of distribution chain in the context of Issue 01-9, and whether factors can be identified that would provide indicators that the definition should be expanded or clarified to take into consideration today's complex structuring arrangements. Contrary to the way in which some service providers have interpreted Issue 01-9, proponents of View A believe that third-party manufacturers and resellers in the illustrations above are a part of the distribution chain and, as a result, believe that they can be linked to the revenue earned by the service providers on the service contracts. They believe that there are several factors that support this conclusion. Control of Production and Distribution Processes 21. First, service providers, through their contractual arrangements, control a portion of the activities of third-party manufacturers and resellers (where applicable) by influencing the production and distribution processes. That influence may include dictating to third-party manufacturers the equipment specifications, the production volume, and to whom the equipment may be sold. Most importantly, the service provider may have the ability to establish the selling price of the equipment to both the reseller and the end-customer. Under that scenario, the service provider's ability to influence the selling price of the equipment, combined with other aspects of the arrangement that are indicators of control, may be a significant factor in establishing control and linkage of the consideration to the end-customer (linkage is discussed further below). Service providers may also provide third-party manufacturers with the technological "knowhow" of production processes and tangible products such as microchips or specialized equipment "technology," so third-party manufacturers are able to produce the specialized equipment according to the service provider's specifications, which may also be an indicator of control. EITF Issue No Issue Summary No. 1, p. 9

10 Linkage of the Consideration to the End-Customer 22. Secondly, proponents of View A believe that there is linkage between the incentive payments made by service providers to third-party manufacturers or resellers and the revenue earned on the service contract. The incentive payments that are made to third-party manufacturers and resellers are intended to influence and incentivize the end-customer to purchase the equipment and enter into a service contract with the service provider. Because service providers, through their contractual arrangements, have the ability to establish the selling price of the specialized equipment to both the reseller and the end-customer, the end-customer is able to directly benefit from the incentives that are given by service providers to third-party manufacturers and resellers because the sales price has been reduced as a result of these incentives. Since the end-customer who purchases the specialized equipment is the same endcustomer who enters into a service contract with the service provider, and since the specialized equipment that is purchased by the end-customer is not transferable to other service providers (discussed further below), proponents of View A believe that the consideration can be linked between the service provider and the revenue that the service provider earns from the service contract with the end-customer. Interchangeability 23. As observed in the illustrations, a characteristic often found in these types of arrangements is that the specialized equipment cannot be used with any other service provider. As a result, assuming the existence of control and linkage, there is little or no risk that the incentive given by service providers to third-party manufacturers or resellers will be used to promote service contracts with other competitors. Proponents of View A believe that the lack of interchangeability in conjunction with the linkage (discussed above) is a significant factor in determining whether these arrangements should be accounted for under Issue Otherwise, proponents of View A believe, service providers may not be willing to give an incentive that they may not be able to recoup from the service revenue they will earn in future periods. Proponents of View A also believe that because of the linkage and lack of interchangeability, the structure of these arrangements is similar to a service provider giving an incentive directly to the EITF Issue No Issue Summary No. 1, p. 10

11 end-customer and, therefore, believe these arrangements should be subject to the provisions of Issue Other 24. In addition to the factors described above, proponents of View A believe that incentives can be analogized to the definition of buydowns in Issue 01-9, with respect to incentives paid to both third-party manufacturers and resellers in the illustrations above. These incentives reimburse third-party manufacturers and resellers for the losses they have or will incur on the sale of the equipment, and since the equipment lacks interchangeability, as discussed above, the incentives are akin to a reimbursement of a rebate on the service arrangements. Buydowns are defined in the glossary of Issue 01-9 as follows: A vendor agrees to reimburse a reseller or retailer up to a specified amount for shortfalls in the sales price received by the retailer for the vendor's products over a specified period of time. Buydown programs generally involve a vendor agreeing to reimburse, compensate, or issue credit memos to a reseller or retailer for the retailer's decreased revenue per unit for specific products during a specified promotion period. In contrast to cooperative advertising, buydown programs generally require no expenditures by the retailer for advertising or promotion. Other related forms of vendor consideration to a retailer include, but are not limited to, shortfalls, factory incentives, dealer holdbacks, price protection, and factory-todealer incentives. 25. Proponents of View A also point out that Issue 01-9 does not explicitly define distribution chain and they do not believe Issue 01-9 anticipated those types of structured arrangements when originally discussed. Proponents of View A note that in certain arrangements, the service provider purchases and capitalizes into inventory a critical component of the equipment, the microchip for example, before providing it to the third-party manufacturer. Proponents of View A believe that if the service provider has the inventory risk associated with the microchips, the service provider may be considered a vendor (and already subject to Issue 01-9) since the microchip is a critical component of the specialized equipment. However, proponents of View A believe that this argument may not be relevant since these arrangements can be structured without the service provider purchasing the microchip inventory. EITF Issue No Issue Summary No. 1, p. 11

12 26. Some have countered that the incentives paid to third-party manufacturers or resellers are too similar to the commissions paid in normal agency relationships to be able to differentiate them. For example, service providers may bundle a commission and incentive payment made to a reseller and, in other cases, may allow a reseller to use discretion in identifying what funds, if any, directly benefit the end-customer. In those instances, proponents of View A believe that in an agency relationship, monies are paid as an incentive to an entity to secure a customer for the service provider. Proponents of View A believe that when these payments are bundled and the service provider does not control how the monies are used in the distribution process or is unable to influence how these monies directly benefit the end-customers (who purchase the discounted specialized equipment to use with their services), then it would be unlikely, based on the factors previously discussed, that this scenario would be subject to the provisions of Supporters of View A believe that the factors discussed previously are necessary to determine whether these types of arrangements should be subject to Issue In conclusion, proponents of View A believe that the incentives that are given by the service provider to the third-party manufacturer or reseller (where applicable) are within the service provider's distribution chain because of certain indicating factors: the control the service provider has over the production and distribution processes, the linkage of the incentive payment made by the service provider to the end-customer who enters into the contractual arrangement with the service provider, and/or the lack of interchangeability of the specialized equipment to the services of another service provider. As a result, proponents of View A believe that, while these factors may be subjective in interpretation and based on the facts and circumstances of each of the parties involved (including their contractual relationships), the existence of some or all of these factors is a strong indicator that these arrangements should be subject to the guidance in Issue View B: Consideration given by a service provider to a manufacturer or reseller of the specialized equipment that reduces the price of that equipment to the end-customer and is necessary for an end-customer to receive a service from the service provider should not be accounted for pursuant to Issue EITF Issue No Issue Summary No. 1, p. 12

13 28. Proponents of View B believe that contrary to the opinions expressed in View A, the thirdparty manufacturer or reseller is not within the service provider's distribution chain as discussed in paragraph 2 of Issue Supporters of View B note that the service provider never has title to, nor the risk associated with, the specialized equipment inventory produced by the third-party manufacturer. Additionally, the third-party manufacturer and reseller are not within the service provider's distribution chain because neither is purchasing and then selling the service provider's services. Therefore, these payments are not being made to a "customer" as defined in Issue 01-9: For purposes of this issue, customer includes any purchaser of the vendor's products at any point along the distribution chain, regardless of whether the purchaser acquires the vendor's products directly or indirectly (for example, from a distributor) from the vendor. Since the service provider does not sell the specialized equipment to the end-customer through the third-party manufacturer or retailer, supporters of View B do not believe that the third-party manufacturer or retailer is a "reseller" as contemplated by Issue 01-9 (or that the service provider is a vendor) and, therefore, the service provider is not within the distribution chain as it relates to the sale of the specialized equipment. Supporters of View B contend that these incentive payments are related to obtaining subscribers and should not be accounted for pursuant to Issue Secondly, with respect to the opinions expressed in View A regarding the service provider's control of the distribution and production processes of the third-party manufacturer, proponents of View B analogize to the factors discussed in Issue 99-19, which are interpreted by supporters of View B to be an indicator of the control of the production and distribution processes (and an indicator of gross versus net reporting). Issue states in part these factors in paragraphs 7 14: The company [service provider] is the primary obligor in the arrangement The company [service provider] has general inventory risk (before customer order is placed or upon customer return) The company [service provider] has latitude in establishing price The company [service provider] changes the product or performs part of the service The company [service EITF Issue No Issue Summary No. 1, p. 13

14 provider] has discretion in supplier selection The company [service provider] is involved in the determination of product or service specifications The company [service provider] has physical loss inventory risk (after customer order or during shipping) The company [service provider] has credit risk. Proponents of View B believe that in analogizing to the factors described above, inventory risk should be considered a significant factor in determining whether these types of arrangements are subject to Issue 01-9 since inventory risk provides evidence that the service provider may meet the definition of a vendor. In addition, proponents of View B argue that the service providers in the arrangements described previously in Illustrations 1 3 do not have a majority of the factors described in paragraphs 7 14 of Issue 99-19, and that when analogized, believe that the service providers do not control the production and distribution processes of the third-party manufacturer. 30. Proponents of View B note that the end-customer may not be aware that incentive payments are made to the third-party manufacturers or resellers, or that the end-customer has benefited from these payments. In Illustration 2, the equipment cost may be bundled with other equipment purchased and included in the overall price of the car. In that sense, supporters of View B claim that it is difficult to establish linkage between the payments made to the third-party manufacturers and from the benefits derived by the end-customers. 31. Lastly, proponents of View B believe that while contracts between service providers and the end-customers have varying terms, it is often the case that the penalties associated with terminating these contractual arrangements either have no monetary penalty (or none above the commitment required by the service contract) or only a discretionary penalty. Proponents of View B believe that unless the service provider requires the end-customer to repay the incentive it provided to the third-party manufacturer or reseller (in the form of a monetary penalty) for terminating the contractual relationship, proponents of View B do not believe that there is linkage between the incentive given and the revenue earned on the service contract. 32. In conclusion, proponents of View B believe these types of arrangements should not be subject to the provisions of Issue Proponents of View B argue that the manufacturer or EITF Issue No Issue Summary No. 1, p. 14

15 reseller is not within the service provider's distribution chain with respect to the sale of specialized equipment, or that the service provider does not control the production and distribution processes of the third-party manufacturer and reseller. Proponent's of View B do not believe there is linkage of the incentive payment to the end-customer since the end-customer may be unaware of the influence or payments made by the service provider and because the endcustomer, in certain arrangements, may have the ability to terminate the service contract with little monetary penalty. Lastly, proponents of View B believe that in analogizing to the factors in Issue it can be argued that without inventory risk, the service provider does not meet the definition of a vendor and therefore should not be considered to be within the scope of Issue Transition and Effective Date 33. The FASB staff believes that entities should recognize the consensus on this Issue as a change in accounting principle through retrospective application to all prior periods. That should include the recognition of: a. The cumulative effect of the change to the new accounting principle on periods prior to those presented reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented. b. An offsetting adjustment, if any, made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period. c. Adjustments to financial statements for each individual prior period presented to reflect the period-specific effects of applying the new accounting principle. 34. If the cumulative effect of applying the change in accounting principle to all prior periods can be determined but it is impracticable to determine the period-specific effects of that change on all prior periods presented, the cumulative effect of the change to the new accounting principle shall be applied to the carrying amounts of assets and liabilities as of the beginning of the earliest period to which the new accounting principle can be applied. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other EITF Issue No Issue Summary No. 1, p. 15

16 appropriate components of equity or net assets in the statement of financial position) for that period. 35. The consensus on this Issue shall be effective for the first annual reporting period beginning after December 15, Early adoption is encouraged. The FASB staff believes that the application of this consensus may result in a significant change in accounting and financial reporting for certain entities that have not accounted for incentives in a manner that is consistent with the consensus on this Issue. Accordingly, the FASB staff believes that the timing of the recommended effective date would allow entities ample time to prepare for the implementation of this consensus. Disclosure 36. Upon application of this consensus, the FASB staff believes that the following disclosures should be made: a. A description of the prior-period information that has been retrospectively adjusted, if any. b. The effect of the change on revenue, cost of sales, income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), any other affected financial statement line item, and any affected per-share amounts for the current period and any prior periods retrospectively adjusted. c. The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented. 37. Upon adoption of the consensus, financial information reported for interim periods after the date of adoption shall disclose the effect of the change on revenue, cost of sales, income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), and related per-share amounts, if applicable, for those postchange interim periods. EITF Issue No Issue Summary No. 1, p. 16