Payments from a Vendor to a Customer

There are many instances in which a vendor makes a payment to one of its customers. Sometimes, this is merely because the vendor is purchasing a product or service from its customer (i.e., the two parties are customers of one another). In other cases, the payment is a sales incentive, the main purpose of which is to convince the customer to purchase (or continue purchasing) the vendor’s products or services. Payments may take various forms including cash discounts, coupons, rebates, “free” products or services, equity instruments, etc. In some cases, a vendor will make payments to its customer’s customer (an indirect customer of the vendor). For example, the manufacturer of a grocery product may issue coupons that are redeemed by a consumer, even though the manufacturer’s customer is the grocery store.

Other common arrangements that involve payments from vendors to customers include:

• Cooperative advertising arrangements, in which a vendor agrees to make payments to its customer if the customer features the vendor’s products in its advertising.
• Slotting fees, in which a vendor makes a payment to a retailer so that the retailer will stock the manufacturer’s product in its stores, sometimes in a particular location.
• Buydowns, in which a vendor makes a payment to a retailer that makes some amount of purchases at agreed-upon prices.
• Rebates, in which a customer, usually an indirect customer, may send in a form to request a return of a portion of the purchase price of the product or service.

Many other arrangements may exist that result in a company making payments to a customer, including various types of marketing partnerships. The vendor’s and customer’s accounting have been addressed in three separate EITF issues. The vendor’s accounting is addressed in EITF 01-9 and the customer’s accounting is addressed in EITF 02-16. Certain incentive arrangements are addressed in EITF 03-10. Although the models in EITF 01-9 and EITF 02-16 are consistent, each takes into consideration the unique perspective of the entity whose accounting it is addressing. In addition, while EITF 01-9 addresses consideration in the form of cash, equity, and “free” products or services, EITF 02-16 addresses only consideration in the form of cash or equity. Each of the models is discussed in greater detail below.

Vendor Classification

The scope of EITF 01-9 is very broad, and the model developed in that consensus must be applied to any payment made by a company to one of its customers (or an affiliate of that customer), whether the payments are contractually linked to the revenue or not. In addition, the scope of EITF 01-9 contemplates that vendor consideration may be given to direct or indirect customers of the vendor, and that the consideration may be in the form of cash, equity, or a product or service. Furthermore, it applies to payments to customers who will alter the product before reselling it (for example, a cooperative advertising payment from a computer chip manufacturer to one of its PC manufacturer customers). Thus, it encompasses almost every kind of sales incentive arrangement in use that results in consideration being paid by a vendor to its customer.

OBSERVATION: The model in EITF 01-9 is applied to payments to both direct and indirect (i.e., further down the distribution chain) customers to prevent a vendor from having the ability to change the reporting of a sales incentive without changing its substance. Consider that a vendor could achieve essentially the same result by (1) selling its product at a $1 discount to list price, (2) selling the product at list price and providing a $1 rebate to its direct customer, or (3) selling the product at list price and providing a $1 rebate to a customer further down the distribution chain. An approach that provides for revenue reduction in some, but not all, of these arrangements would result in different income statement characterization for sales incentives that are essentially the same.

SEC REGISTRANT ALERT: Round-trip transactions are receiving a significant amount of attention by the SEC staff. Round-trip transactions were an area of focus in the SEC staff’s Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002 (the Section 704 Report), issued in early 2003. In compiling the information in the Section 704 Report, the SEC staff studied enforcement actions filed during the period July 31, 1997, through July 30, 2002. In addition, round-trip transactions have also been a focus in recent SEC staff speeches. The SEC staff characterizes round-trip transactions in the Section 704 Report as transactions that “involve simultaneous pre-arranged sales transactions often of the same product in order to create a false impression of business activity and revenue.” The SEC staff cited a number of enforcement actions in the Section 704 Report where registrants inappropriately used round-trip transactions to boost revenue. Essentially, the types of round-trip transactions identified by the SEC staff in the Section 704 Report should be treated as nonmonetary transactions. Nonmonetary transactions that lack substance should not result in the recognition of revenue. Care should be exercised when analyzing the payment by a vendor to its customer to ensure that the payment is not just one of the legs in a round-trip transaction. See Chapter 8, “Miscellaneous Issues,” for additional discussion regarding nonmonetary transactions.

Consideration in the Form of Cash or Equity

EITF 01-9 begins with a presumption that a cash or equity payment by a vendor to a customer (as noted above, “customer” includes both direct and indirect customers) should be accounted for as a reduction of revenues. However, the presumption is overcome if both of the following are true (EITF 01-9, par. 9):

1. The vendor receives, or will receive, an identifiable benefit (goods or services) in exchange for the consideration. To meet this condition, the identified benefit must be sufficiently separable from the customer’s purchase of the vendor’s products such that the vendor could have purchased the identified benefit from somebody other than one of its customers.
2. The vendor can reasonably estimate the fair value of the benefit identified under the first condition.

OBSERVATION: The first criterion is meant to ensure that the two transactions (the sale to the customer and the purchase from it) could truly be considered separate events. The second criterion ensures that the net fee can be appropriately allocated to the events, based on fair value. These two criteria are somewhat similar to the criteria necessary to separate deliverables included in a multiple-element arrangement (see Chapter 4, “Multiple-Element Arrangements”).

If both of the criteria are met, the lesser of the amount paid to the customer and the fair value of the benefit received may be classified as an expense when recognized in the income statement, while any amount paid in excess of the fair value of the benefit received must be characterized as a reduction of revenue (EITF 01-9, par. 9). Any amount that can appropriately be characterized as an expense when recognized in the income statement should be included in an expense caption based on the nature of the identifiable benefit received. For example, if the identifiable benefit is advertising, the amount characterized as an expense should be included in a sales and marketing expense (or similar) caption. If either of the two criteria is not met, the entire payment must be characterized as a reduction of revenue. Determining whether the criteria are met requires analysis of all available information (EITF 01-9, par. 9).

PRACTICE POINTER: When the payment from the vendor is in the form of equity instruments, a question is raised about the date to use in valuing the instruments issued. Whether or not the cost of the instruments is to be treated as an expense or a reduction of revenues, the value should be measured based on the guidance of EITF Issue 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

Consideration in the Form of “Free” Products or Services If the sales incentive is a free product or service, the cost of the free product or service should be classified as an expense when recognized in the income statement. When this is the case, the “free” item is considered an additional deliverable in the exchange transaction and not a refund of a portion of the amount charged to the customer. Although the EITF did not reach a consensus on the income statement classification of the cost of the “free” products or services, in most cases this expense should be classified as part of cost of sales (EITF 01-9, par. 10).

SEC REGISTRANT ALERT: Although the Task Force did not reach a consensus on the income statement classification of the expense associated with “free” products or services, the SEC Observer indicated that the SEC staff believes that the expense associated with a “free” product or service delivered at the time of sale of another product or service should be classified as cost of sales.

EXAMPLE: VENDOR CLASSIFICATION OF PROMOTIONAL ALLOWANCES

The Boston Beer Company Form 10-K—Fiscal Year Ended December 25, 2004

Advertising and Sales Promotions

The Company reimburses its wholesalers and retailers for promotional discounts, samples and certain advertising and promotional activities used in the promotion of the Company’s products. The accounting treatment for the reimbursements for samples and discounts to wholesalers results in a reduction in the net revenue line item. Reimbursements to wholesalers and retailers for certain advertising and promotional activities are included in the advertising, promotional and selling expenses line item.

The Company also has sales incentive arrangements with its wholesalers based upon performance of certain marketing and advertising activities by the wholesalers. Depending on what may be allowable by state laws and regulations, these activities promoting the Company’s products would include, but are not limited to, the following: point-of-sale merchandise placement in retailer locations, product displays in retailer locations and promotional programs at retail locations. The costs incurred by the Company for these sales incentive arrangements and promotional activities are included within the advertising, promotional and selling expenses line item. The costs associated with advertising and sales promotional programs are charged to expense during the period in which they are incurred. Total advertising and sales promotional expenditures included within the advertising, promotional and selling expenses income statement line item for the years ended December 25, 2004, December 27, 2003 and December 28, 2002, were $56.5 million, $55.4 million and $62.2 million, respectively.

The total amount of sales incentives, samples and other promotional discounts included within the advertising, promotional and selling line item in the accompanying consolidated statements of income was $4.4 million, $4.6 million and $4.2 million for the years ended December 25, 2004, December 27, 2003 and December 28, 2002, respectively.

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