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Revenue recognition for the Automotive industry
Efficient recognition and measurement of revenue is essential for the well being, progress and prosperity of any company or individual engaging in business transactions. As the financial markets have become more and more globalized, the need for standardized procedures has increased. That is why the new standard guidelines have been developed with the aim of streamlining the process of keeping accurate financial records and preparing financial statements.
The Five Step Principle
The main principle of measuring and recognizing revenue and cash flows is that an entity receives and records the appropriate amount from customers as a result of the services or goods the entity provides. The following five steps can be applied in order to achieve this principle:
- Establish an agreement or contract with a customer
- Agree on the exact outcomes that are identified in the contract
- Determine the amount that will be paid by the customer
- Assign the amount to the outcomes in the contract
- Recognize the revenue when the entity achieves the outcomes
The outcomes or performance obligations which are required by both automotive part suppliers and original equipment manufacturers may need to be enhanced and increased.
With regard to the timing of revenue recognition, automotive part suppliers who supply customized parts may need to make some changes. These custom made parts are of no other use to the automotive company as they have been specifically supplied at the request of the client, so the company should receive payment as and when the parts are provided, and the revenue recognition would occur over time.
A thorough evaluation or reassessment of the revenue accounting methods which are currently being used is necessary. This will clarify whether and where the automotive entity may need to make adjustments.
The new standard also requires entities to declare information to a greater extent regarding the quality and quantity of their services. This information would include the following:
- Details about contracts with customers relating to the price, the timeframe and the uncertainty of revenue and corresponding cash flows.
- How judgements have been implemented and changed to fit in with the five step process.
- Which assets have been recognized from costs when making contracts
Regarding contract costs, automotive companies would be required to decide whether to expense the costs of goods and services as they are incurred, or to capitalize and amortize the costs when the customer receives the transfer.
When there is a repurchase right within the contract, the automotive entity has to ascertain the correct method of accounting for this. Such a case would be necessary when the customer has the option of returning the product, and this may be recorded alternatively as a lease or a sale with a right of return. If the automotive company is obligated to repurchase the asset, either as a forward or at the customer’s request, this may be at a lower rate than the original price. This will require careful consideration so that the revenue is recognized correctly.
There are a number of variable elements which may occur in the contracts of companies in the automotive industry. These may include varying contract prices, penalties or incentive bonuses as well as discounts, rebates or credits which may be payable to the customer. In order to estimate these variable elements and include them in the contract price, the entities would need to take into consideration all pertinent information such as expectations for projected sales and records of past history.