Customer Classification: Buydowns

Buydowns
Buydown programs generally involve a vendor agreeing to compensate a retailer for the retailer’s decreased revenue per unit for specific products during a specified period. In turn, the retailer agrees to run some sort of promotion for the vendor’s product involving a reduced selling price, a rebate, or some other discount. In contrast to cooperative advertising, buydown programs generally require no expenditures by the retailer for advertising or promotion. Buydowns are known by different names in various industries. For example, the “factory to dealer incentives” often mentioned in automobile advertisements are a form of buydown program.

Vendor classification Much like a coupon or rebate, payments under a buydown program could never qualify to be characterized as an expense rather than a reduction of revenue, because there is no identifiable benefit received from the customer as required by the model in EITF 01-9.

Customer classification Much like a coupon or rebate where only the vendor and consumer are involved, payments under a buydown program could never qualify to be characterized as anything other than a cost of sales reduction under the model in EITF 02-16 because no products or services are being provided by the customer to the vendor and because the payment does not relate to reimbursement of any particular cost.

ILLUSTRATION: CLASSIFICATION OF PAYMENTS FROM VENDORS TO CUSTOMERS
EXAMPLE 1
Facts: Company Z markets and sells a popular brand of peanuts. One of Company Z’s contracts makes it the exclusive peanut supplier for a major airline. Company Z sells its peanuts to the airline at discounted prices. In addition, Company Z agrees to purchase a minimum amount of airline tickets from the airline to be used for travel by Company Z’s personnel. If Company Z does not purchase the minimum amount of travel by the end of any year of the contract, it must make an additional payment for the shortfall. The prices Company Z pays for plane tickets are comparable to those available to the general public.

Vendor Classification Discussion: With respect to the air travel, Company Z is receiving an identifiable benefit from the airline. That benefit is sufficiently separable from the airline’s purchase of Company Z’s peanuts because Company Z could have used any other airline for its corporate travel. Therefore, the first condition of the EITF 01-9 model is met. The second condition of the EITF 01-9 model is met because the fair value of the plane tickets can be determined based on the prices paid by the general public for similar tickets. Since Company Z pays those same amounts, as long as Company Z actually uses at least the minimum purchase requirement for corporate travel, all of the payments to the airline may be characterized as expenses. If Company Z is required to make a payment at year-end due to a shortfall in travel purchases, the amount of the shortfall payment would be characterized as a reduction of revenue, as it would represent a payment that is over and above the fair value of the benefit received.

Company Z may also believe it is obtaining other benefits from the airline, such as exclusivity and visibility to a captive audience, but these benefits are not separable from the sales arrangement, nor could their fair value be determined. As such, no amount of the shortfall payment could be classified as an expense based on this rationale.

Customer Classification Discussion: With respect to the air travel, the airline is providing a service that it would provide to other, non-vendor customers. In addition, the airline is providing this service to Company Z at prices comparable to those available to the general public. As such, if Company Z actually uses at least the minimum purchase requirement for corporate travel, all of the payments to the airline may be classified as revenue by the airline based on the model in EITF 02-16. To the extent Company Z is required to make a payment at year-end due to a shortfall in travel purchases, the amount of the shortfall payment would be characterized as a reduction of cost of the peanuts.

EXAMPLE 2
Facts: Company Y makes frozen desserts, and sells them through grocery and warehouse stores. As part of an arrangement to sell a large quantity of products to a large grocery store chain, Company Y agrees to reimburse the chain for special display freezers that are intended to be used to display Company Y’s products. The freezers will include Company Y’s logo on the outside and will have racking and other components specifically designed to highlight Company Y’s products. The grocery chain will pay an independent third party to design and build the freezers. Company Y and the grocery store chain believe that the new display freezers will increase sales of Company Y products at the chain’s stores. However, the grocery store chain has no obligation to continue purchasing Company Y’s products.

Vendor Classification Discussion: The first condition of the model in EITF 01-9 is not met because Company Y does not receive an identifiable benefit that is sufficiently separable from the arrangement to sell products to the grocery store chain. Company Y could not enter into such an arrangement with anybody other than a reseller of its products. The consideration therefore should be characterized as a reduction of revenue.

Customer Classification Discussion: If the chain has support for the amount it spends to purchase the freezers from the independent third party, such that the cost is identifiable and incremental under the model in EITF 02-16, it should recognize the payment from Company Y as a reduction of the cost of those freezers when recognized in the income statement.

EXAMPLE 3
Facts: Company Y makes frozen desserts, and sells them through grocery and warehouse stores. As part of an arrangement to sell a large quantity of products to a large grocery store chain, Company Y agrees to give special display freezers to the chain, intended to be used to display Company Y’s products. The freezers include Company Y’s logo on the outside and have racking and other components specifically designed to highlight Company Y’s products. Company Y owns the freezers currently, having purchased them from an independent third party and modified them as necessary to effectively display its products. Company Y and the grocery chain believe that the new display freezers will increase sales of Company Y’s products at the chain’s stores. However, the grocery store chain has no obligation to continue purchasing Company Y’s products.

Vendor Classification Discussion: The consideration that Company Y gives to the chain consists of “free” products (the freezers). Consideration in the form of “free” products or services is seen as a deliverable in the arrangement under the model in EITF 01-9, rather than a refund of revenue. Therefore, Company Y should reflect the cost of the freezers as an expense when recognized in its income statement. In addition, a portion of the revenue from the arrangement should be allocated to the freezers.

Customer Classification Discussion: EITF 02-16 does not address situations where the consideration received by the customer is other than cash or equity. As such, judgment should be exercised, and all of the facts and circumstances considered, in determining the customer’s treatment of the “free” freezers.

EXAMPLE 4
Facts: Company G is an auto manufacturer that sells its products to consumers through a network of dealers. Company G plans to run a nationwide promotion in which its dealers will stay open late for a two-week period and purchasers will receive factory rebates on vehicles purchased during the same two-week period. Company G agrees to reimburse its dealers for the extra payroll costs they will incur during the promotion for keeping the dealerships open longer.

Vendor Classification Discussion: The first condition of the model in EITF 01-9 is not met because Company G does not receive an identifiable benefit that is sufficiently separable from Company G’s sale of automobiles to the dealer. The payroll reimbursements therefore should be characterized as a reduction of revenue in Company G’s income statement.

Customer Classification Discussion: If the dealers have support for the payroll costs incurred due to staying open later during the two-week promotion period, such that the cost is identifiable and incremental under the model in EITF 02-16, it should recognize the payment from Company G as a reduction of the payroll costs when recognized in the income statement. The dealers will need to consider the nature of their payroll costs when determining whether those costs are identifiable and incremental. Hourly wages would be considered incremental, while salaries would not be considered incremental. In addition, most benefit-related payroll costs would most likely not be considered incremental. If the amount of the payment from Company G is greater than the amount of identifiable and incremental reimbursed costs as determined based on the model in EITF 02-16, the excess should be reflected as a reduction of cost of sales.

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Copyright 2006 CCH Publishing, a WoltersKluwer business. Excerpted by permission.