How Revenue Recognition Is Impacting Buy Here – Pay Here Dealers
Note: This article originally appeared in The Showroom.
When the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers, it represented perhaps the most extensive changes to accounting standards for revenue recognition ever. Experiencing a number of revisions and amendments since its issuance, the new guidance is effective for calendar years ending Dec. 31, 2018 for public companies and Dec. 31, 2019 for nonpublic companies; however, many have delayed analyzing how significantly the updated standards will impact their business.
The new guidance will impact companies in every industry that recognizes revenues from contracts with customers, and Buy Here – Pay Here (BHPH) is no exception. Lease Here – Pay Here (LHPH) entities generally get a reprieve from the new revenue recognition guidance as leases were not included in the scope of this updated standard. However, leases received their own accounting standard overhaul with an effective date one year following the new revenue recognition guidance. Insurance contracts (such as gap or collateral protection insurance), financial instruments, and some nonmonetary exchanges were also excluded from the scope of the new revenue guidance.
The new guidance says revenue should be recognized as an entity gains control of a good or service in the amount to which it expects to be entitled. An entity will go through a five-step process when applying this core principle of the revenue recognition guidance:
- Identify the contract(s) with a customer.
- Identify each performance obligation within the contract(s).
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies performance obligations.
This may not seem like a dramatic shift from current guidance, but there are significant concepts within the new guidance that may have substantial implications for the BHPH industry.
Step 1: Identify the Contract With a Customer
Most BHPH transactions with customers originate with a signed contract; however, the new guidance determines a contract to be every enforceable contract under which the entity promises a good or service to a customer. As a result, a contract can be written, oral, or implied.
Generally, companies are required to apply the guidelines to each contract with a customer. However, an entity must combine two or more contracts with the same customer if they are entered into at or near the same time and must account for them as a single contract if certain criteria are met.
An example of this would be the sale of a truck and trailer to a single customer; these two sales may be negotiated together, and the price paid on one contract may depend on the price of the other. This concept of combining customer contracts may represent a change from current dealer practices.
Step 2: Identify the Performance Obligations Within the Contract
After determining the contracts with a customer, a dealer must then review the contract to identify the performance obligations within the contract – in other words, each promise to transfer a good or service (or bundle or series of goods or services) to the customer. A key characteristic of a performance obligation is that it is distinct.
This is where BHPH dealers may notice significant differences from current guidance. Currently, when dealers use incentives – such as free oil changes or free maintenance – to entice buyers, they expense the services as incurred. Under the new guidance, each service is viewed as a distinct promise to the customer (a performance obligation), and a portion of the vehicle sale price must be allocated to these services. This affects the amount of revenue dealers recognize and may result in delayed revenue recognition for the portion allocated to services performed over time.
Warranties are also affected under the new guidance. Currently, warranties embedded within contracts are generally accounted for as a liability; the expected claims expense is accrued at inception of the sale and then offset as claims are incurred. Under the new guidance, warranties are distinguished one of two ways:
- A promise that the vehicle or part meets a contract’s specifications. This type of warranty is accounted for as a loss contingency, resulting in an expense accrual.
- A promise of an additional good or service. This type of warranty is accounted for as a performance obligation in which a portion of the transaction price is allocated to the warranty as revenue.
Generally, the guidance would indicate that a warranty is a separate performance obligation (which would result in deferral of revenue) if it has a long duration or many services provided within the warranty (such as roadside assistance, vehicle maintenance, etc.). A single warranty could have multiple performance obligations that would need to be separated; for example, the portion that relates to the promise that the vehicle meets certain contract specifications could be separated from the remaining services provided in the warranty. In order to separate these, the respective obligations must be able to be reasonably estimated, which may take some work from the dealer.
Step 3: Determine the Transaction Price
Simply put, this step requires entities to estimate the amount they will ultimately be paid for the goods and services they deliver to the customer in the contract (net of all estimated discounts, rebates, price concessions, performance bonuses, etc.).
Dealers often charge customers for a variety of fees related to administration, documentation, and preparation. They also collect certain fees to remit to third parties such as license, registration, and title fees. Fees charged to customers must be included in the total consideration to be received by the customer to determine the transaction price. Fees collected on behalf of a third party must be excluded from the transaction price.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
The fourth step requires an entity to allocate the transaction price of the customer contract to all of the performance obligations within the contract by performing the following:
- Determine the standalone selling prices of the goods and services.
- Add all of the standalone selling prices of the goods and services that comprise each performance obligation.
- Calculate allocation ratios based on the totals of the standalone selling prices for each performance obligation.
- Allocate the transaction price to each performance obligation, giving effect to any discount or contingent consideration.
Step 5: Recognize Revenue When (or as) the Entity Satisfies Performance Obligations
BHPH dealers start recognizing revenue in step five. The new revenue guidance states that an entity earns revenue as a customer gains control of the goods and services that constitute the performance obligations. A customer has control only when they can do both of the following:
- Direct the use of the good or service (and prevent others from doing so).
- Obtain substantially all of the remaining benefits from the good or service (and prevent others from doing so).
Generally, the customer gains control either over time or at a point in time.
BHPH dealers will likely be impacted in some way by the new guidance, and dealers should be analyzing the impact of this standard on their business now to ensure they have ample time to educate all stakeholders in their business (lenders, investors, etc.) as to how the financial statements will change.
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