Customer Classification: General Model

- A. C. Sondhi & Scott A. Taub, RevenueRecognition.com

The model used by the customer to account for consideration received from its vendor operates off a presumption that cash or equity consideration received by the customer from its vendor is a reduction of cost of sales when it is recognized in the income statement (prior to recognition in the income statement, the payment would be recognized as a reduction of inventory or prepayments for services). This presumption can only be overcome if the customer can support the fact that the payment relates to either:

1. Assets or services provided by the customer to the vendor (in which case the payment would be treated as revenue when recognized in the income statement) or
2. A reimbursement of costs incurred by the customer to sell the vendor’s products (in which case the payment would be treated as a reduction of the related cost when recognized in the income statement) (EITF 02-16, par. 4).

To support the conclusion that the payment relates to the sale of assets or services by the customer to the vendor, the vendor must receive an identifiable benefit (goods or services) in exchange for the consideration. To be considered an identifiable benefit, the customer should be able to (1) illustrate that it would have entered into an exchange transaction with another (non-vendor) party to provide that benefit and (2) determine the fair value of the benefit it is providing to the vendor. If the amount of the payment from the vendor is greater than the fair value of the identifiable benefit provided to the vendor, the excess should be reflected as a reduction of cost of sales when recognized in the income statement (EITF 02-16, par. 5).

To support the conclusion that the payment relates to the reimbursement of costs incurred by the customer to sell the vendor’s products, the customer must incur an incremental, identifiable cost related to selling the vendor’s products or services. If the amount of the payment from the vendor is greater than the incremental, identifiable cost incurred by the customer, the excess should be reflected as a reduction of cost of sales when recognized in the income statement (EITF 02-16, par. 6).

EXAMPLE: CUSTOMER CLASSIFICATIONS OF PROMOTIONAL ALLOWANCES
Albertson’s Form 10-K—Fiscal Year Ended February 3, 2005

Vendor Funds

The Company receives funds from many of the vendors whose products the Company buys for resale in its stores. These vendor funds are provided to increase the sell-through of the related products. The Company receives funds for a variety of merchandising activities: placement of the vendor’s products in the Company’s advertising; display of the vendor’s products in prominent locations in the Company’s stores; introduction of new products into the Company’s distribution system and retail stores; exclusivity rights in certain categories that have slower-turning products; and to compensate for temporary price reductions offered to customers on products held for sale at retail stores. The Company also receives vendor funds for buying activities, such as volume commitment rebates and credits for purchasing products in advance of their need. As of February 3, 2005, the terms of the Company’s vendor funds arrangements varied in length from short-term arrangements that are to be completed within a quarter to long-term arrangements that are expected to be completed within eight years.

Accounting for vendor funds is discussed in Emerging Issues Task Force “EITF ” Issue 02-16: “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”), which the Company adopted as of the beginning of 2002. As a result of this guidance, the Company began recognizing the vendor funds for merchandising activities as a reduction to cost of sales when the related products are sold as opposed to the previous method of recognizing these credits as a reduction to cost of sales when the merchandising activity was performed in accordance with the underlying agreements. In connection with the implementation of this new accounting method, the Company recorded a charge in 2002 of $94, net of tax benefit of $60.

The amount of vendor funds reducing the Company’s inventory (“inventory offset”) as of February 3, 2005, including those resulting from the acquisitions made during fiscal 2004 (see Note 5 “Business Acquisitions”), was $126, a decrease of $29 from the beginning of 2004. The vendor funds inventory offset as of January 29, 2004 was $155, an increase of $3 from the beginning of 2003. The inventory offset was determined by estimating the average inventory turnover rates by product category for the Company’s grocery, general merchandise and lobby departments (these departments received over three-quarters of the Company’s vendor funds in 2004) and by average inventory turnover rates by department for the Company’s remaining inventory.

Vendor’s Sales Incentives Offered Directly to Consumer

A vendor issues sales incentives that a consumer will present to a reseller for redemption (e.g., manufacturer’s coupons redeemed by retailers when presented by consumers). Resellers facilitate the redemption of these sales incentives by acting as middlemen or agents between the vendor and consumer. If these types of sales incentive arrangements possess the following characteristics, they are not subject to the model in EITF 02-16 (EITF 03-10, par. 5-6):

• The incentive can be presented by a consumer at resellers that accept manufacturer’s incentives in partial (or full) payment of the price charged by the reseller for the vendor’s product.
• The incentive results in the reseller receiving a direct reimbursement from the vendor (or a clearinghouse authorized by the vendor) based on the face amount of the incentive.
• The incentive was not influenced by or negotiated in conjunction with any other incentive arrangements between the vendor and the reseller (i.e., the incentive is between the manufacturer and the consumer).
• The reseller is acting in the capacity of an agent for the vendor (either expressly or implied) in redeeming the incentive presented by the consumer.

These characteristics are intended to identify those sales incentives where a reseller receives a payment from the vendor solely to reimburse it for acting as the vendor’s agent in redeeming a sales incentive that is between the vendor and consumer. Requiring a reseller to record this type of sales incentive as a reduction in cost of sales would not properly reflect the reseller’s role in the transaction or sales incentive.

If a sales incentive possesses all of the characteristics listed above, the reseller should account for its involvement in the redemption of the sales incentive on the balance sheet. The balance sheet treatment would involve recording a receivable, in the amount of the sales incentive, from the vendor at the time of the sale to the consumer, with the full sales price included in revenue. If a sales incentive does not possess all of these characteristics, the reseller should apply the model in EITF 02-16. Applying the EITF 02-16 model to a manufacturer’s coupon lacking one or more of the characteristics discussed above would likely result in the payment from the vendor to the reseller being reflected as a reduction in cost of sales when it is recognized on the reseller’s income statement. It is highly unlikely that such an incentive would meet the criteria in the EITF 02-16 model to be treated as revenue or a selling cost reimbursement when recognized in the reseller’s income statement.

EXAMPLE: VENDOR’S SALES INCENTIVES
BJ’s Wholesale Club Form 10-K—Fiscal Year Ended January 29, 2005

Manufacturer’s Incentives Tendered by Consumers

At the beginning of 2004, we adopted the provisions of EITF Issue No. 03- 10, “Application of EITF Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers” (“EITF 03-10”), which provides guidance for the reporting of vendor consideration received by a reseller as it relates to manufacturers’ incentives (such as rebates or coupons) tendered by consumers. We include such vendor consideration in revenues only if all of the criteria defined in EITF 03-10 are met. Otherwise, such consideration is recorded as a decrease in cost of sales. As permitted by the transition provisions of EITF 03-10, we have reclassified 2003’s sales and cost of sales for comparative purposes. Implementation of EITF 03-10 has no effect on gross margin dollars, net income or cash flows, but certain vendor coupons or rebates which had been recorded in sales in the past are being recognized as a reduction of cost of sales. The implementation of EITF 03-10 resulted in decreases in both sales and cost of sales of $45.6 million in 2004 and $30.9 million in 2003.

Application to Certain Common Arrangements
The guidance in EITF 01-9 and 02-16 applies to any situation in which payments are made from a vendor to a customer. This situation occurs in a wide variety of arrangements, some of which are extremely common. Application of the models in EITF 01-9 and 02- 16 to several common types of arrangements is discussed below.

Cooperative Advertising Arrangements

In a cooperative advertising arrangement, a vendor makes a payment to its customer, intended to compensate the customer for including the vendor’s products in its advertisement.

Vendor classification Given the nature of cooperative advertising arrangements, it would seem reasonable that they would meet the first criterion of the model in EITF 01-9. Since the vendor could have purchased advertising on its own from a newspaper, magazine, radio station, etc., a cooperative advertising arrangement would appear to include an identifiable benefit that could have been received from a party other than the customer. However, the substance of some cooperative advertising arrangements makes it questionable as to what the identifiable benefit is. Certain arrangements do not specify the amount or type of advertising the customer must purchase to qualify for the cooperative payment, while in other arrangements, the amount of the payment is linked to the amount of purchases made by the customer, making the arrangement appear similar to a volume discount or a rebate. Thus, cooperative advertising arrangements should be analyzed to determine their substance before concluding that an identifiable benefit has been received.

For a cooperative advertising arrangement to meet the second criterion of the model in EITF 01-9 (reasonable estimate of fair value of the benefit received), it would generally be necessary for the arrangement to specify the type and volume of advertising to be provided. Without that information, determining the fair value of the benefit would likely be impossible. If both of the criteria in the EITF 01-9 model are met, the vendor’s payment should be reflected as a cost incurred when it is recognized in the income statement, to the extent it does not exceed the estimated fair value of the advertising received. If the amount of the vendor’s payment exceeds the estimated fair value of the advertising received, then (a) the estimated fair value of the advertising received should be reflected as a cost incurred and (b) the excess of the vendor’s payment over the estimated fair value of the advertising received should be reflected as a reduction of revenue when they are recognized in the income statement.

EXAMPLE: COOPERATIVE ADVERTISING AND BUYDOWN PROGRAMS
Helen of Troy Limited Form 10-K—Fiscal Year Ended February 28, 2005

Consideration Paid to Customers

We offer our customers certain incentives in the form of cooperative advertising arrangements, volume rebates, product markdown allowances, trade discounts, cash discounts and slotting fees.We account for these incentives in accordance with Emerging Issues Task Force Issue No. 01-9, “Accounting for Consideration Given By a Vendor to a Customer” (“EITF 01-9”). In instances where the customer is required to provide us with proof of performance, reductions in amounts received from customers as a result of cooperative advertising programs are included in our consolidated statement of income on the line entitled “Selling, general and administrative expenses” (“SG&A”). Other reductions in amounts received from customers as a result of cooperative advertising programs are recorded as reductions of net sales. Markdown allowances, slotting fees, trade discounts, cash discounts, and volume rebates are all recorded as reductions of net sales. Customer incentives included in SG&A were $13,869,000, $16,603,000, and $14,942,000, for the fiscal years 2005, 2004, and 2003, respectively.

Customer classification Given the nature of cooperative advertising arrangements, the customer may be able to support the fact that the payment relates to the reimbursement of advertising costs. To do so under the model in EITF 02-16, however, the customer must be able to illustrate that it has incurred an incremental, identifiable cost related to selling the vendor’s products or services. If the customer has documentation to support the incremental and identifiable nature of the cost, the vendor’s payment should be reflected as a reduction of that cost, when it is recognized in the income statement, to the extent of that cost (any excess of the vendor’s payment over the reimbursed cost should be reflected as a reduction of cost of sales when it is recognized in the income statement). In the case of cooperative advertising arrangements, the cost reimbursement reduction would most likely be reflected in the sales and marketing expense (or similar) line item on the income statement. If the customer does not have documentation to support the incremental and identifiable nature of the cost, it must recognize the vendor’s payment as a reduction of cost of sales when recognized in the income statement. As discussed previously under “Vendor Classification,” careful consideration should be given to the nature and substance of cooperative advertising arrangements.

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