Accounting Issues for Captives and Parents A captive s financing and bundling programs may impact the parent s revenue recognition and financial statement presentation. When a manufacturer s finance company is wholly owned or consolidated (captive), certain accounting issues must be addressed to ensure proper financial reporting, especially in leasing situations. This article will outline general business issues and address significant accounting issues related to captive finance companies. Business Issues A few of the benefits of a captive are to n provide integrated product, service and financing or a one-stop solution n allow equipment pricing and financing to be tailored to specific customer needs n simplify sales financing program administration Generally, the parent is interested in recognizing revenue as early as possible. If the sale is financed through or equipment is leased from a related company, the timing of the revenue recognition may be impacted. 18 June 2006
n provide an additional source of income to the manufacturer/parent from financing activities n provide an additional source of funding and liquidity for the parent. In addition, as pointed out in the April 2006 Financial Watch article, captives can also provide economic advantages through tax deductions for manufacturers, gross profit tax deferrals, and like-kind exchanges. When evaluating if a captive is the best alternative for providing sales financing and leasing, certain issues need to be considered, including n the significant capital, both debt and equity, necessary to fund the receivable portfolio, n developing or hiring the organizational expertise to market, make effective credit decisions, and service the portfolio, n providing for the healthy organizational tension between the sales, manufacturing and credit organizations so that prudent lending and pricing decisions are made while sales potential is maximized, and n the impact the captive may have on the overall credit rating of the consolidated entity. Accounting Issues Revenue Recognition Generally, the manufacturer/ parent is interested in recognizing revenue as early as possible. The Securities and Exchange Commission Staff Assumptions Accounting Bulletin SAB 104, Revenue Recognition, states that revenue is realized and can be recognized when the following criteria are met: n Persuasive evidence of an arrangement exists, n Delivery has occurred or services have been rendered, n The seller s price to the buyer is fixed or determinable, and n Collectibility is reasonably assured. If the sale is financed through or equipment is leased from a related captive, the timing of the revenue recognition may be impacted. If the equipment sale is financed through an installment or conditional sales contract, generally revenue recognition will occur when the criteria in SAB 104 are satisfied. When the equipment is financed through a lease, a number of accounting pronouncements must be reviewed to ensure appropriate financial reporting treatment. The analysis should begin with Financial Accounting Standard No. 13, Accounting for Leases, (SFAS13). If the retail value of the equipment is more or less than the carrying cost of the equipment and the lease agreement is classified as direct finance according to paragraphs 7 and 8 of (SFAS 13), the lease is a sales-type lease. Paragraphs 7 and 8 are the lease classification criteria, such as a bargain purchase option, economic life and present value of the minimum lease payments. As a sales-type lease, the sale price is the net present value of the minimum lease payments discounted at the interest rate implicit in the lease. The cost of goods sold is determined by reducing the inventory value of the leased property by the present value of the un-guaranteed residual value discounted at the interest rate implicit in the lease. (SFAS 13, paragraph 17c). An example of the gross margin in a direct sale compared to a sale financed by a sales-type lease is shown in the following example: 1. Retail price $ 200,000 2. Inventory carrying value $ 175,000 3. Gross lease payments $ 212,300 4. Present value minimum lease payments $ 188,200 5. Interest rate implicit in the lease 8% 6. Unguaranteed residual $ 15,000 7. Present value of the unguaranteed residual $ 11,800 Direct Sale Sales-Type Lease Sales Revenue $ 200,000 $ 188,200 Cost of goods sold (175,000) (163,200) Gross margin $ 25,000 $ 25,000 June 2006 19
When an operating lease product is offered and sales are deferred, management reporting can be prepared so the parent measures the gross margin as through there were a hypothetical equipment sale from the operating lease. The example illustrates the sales-type lease results in the same gross margin at the time of the sale as the direct sale and also provides $27,300 of finance income over the term of the lease. For this reason, many manufacturer/parents desire to structure the sales financing as either a retail installment contract or a sales-type lease. Although the total revenue recognition will not be impacted, the timing of the revenue recognition will be modified significantly if the transaction is an operating lease. As an operating lease, the inventory is presented on the balance sheet as operating lease equipment near the property, plant and equipment section and is depreciated using the entity s normal depreciation policy. Rental revenue is recognized on a straight-line basis over the lease term. No sale or gross margin is recognized. The gross margin is effectively recognized through lower depreciation expense over the term of the lease. As a result, the majority of the income is shifted from the commencement of the lease to straight line over the lease term. When an operating lease product is offered and sales are deferred, management reporting can be prepared so the manufacturer/parent measures the gross margin as through there were a hypothetical equipment sale from the operating lease. Guaranteed Resale Value If a guaranteed resale value is offered to a purchaser as part of an incentive program, EITF 95-1, Revenue Recognition on Sales with a Guaranteed Minimum Resale Value, provides the accounting guidance. In these situations, the manufacturer sells the equipment and is contractually obligated to reacquire the equipment at a guaranteed price at specified time periods or pay the purchaser for any deficiency between the sales proceeds received for the equipment and the guaranteed minimum resale value. These types of arrangements require the manufacturer treat the arrangement as either a sales-type or operating lease, depending on the terms of the arrangement. Operating Leases Acquired Through a Dealer Network If a manufacturer sells its products through a dealer network and either the manufacturer or the captive repurchases the equipment from the dealer subject to an operating lease, the timing of the revenue can be impacted. EITF 95-4, Revenue Recognition on Equipment Sold and Subsequently Repurchased subject to an Operating Lease, lists the criteria that must be met in order for a manufacturer to recognize a sale when equipment is sold to and bought back from an independent dealer. The criteria are as follows: n The dealer is a substantive and independent enterprise that transacts business separately with the manufacturer and customers. n The manufacturer has delivered the product to the dealer, and the risks and rewards of ownership have passed to the dealer, including responsibility for the ultimate sale of the product and for insurability, theft, or damage. A customer s failure to enter into a lease with the finance affiliate (or manufacturer) would not allow the dealer to return the product to the manufacturer. n The finance affiliate (or manufacturer) has no legal obligation to provide a lease arrangement to a potential customer of the dealer at the time the product is delivered to the dealer. n The customer has other financing alternatives available from parties unaffiliated with the manufacturer, and the customer is in control of the selection from the financing alternatives. If any of the conditions are not met, the manufacturer is precluded from recording a sale at the time the equipment is sold to the dealer. The profit is then recognized over the term of the operating lease. Providing Bundled Equipment, Services, Financing and Other Products A popular and effective distribution model many companies use is to combine multiple products and services, including the financing, into a single contract for a single price or payment stream. These types of arrangements raise the issue of allocating the revenue to the different components of the transaction. The issue was 20 June 2006
addressed in EITF 00-21, Revenue Arrangements with Multiple Deliverables. The EITF focuses on whether an arrangement should be evaluated by component or separate unit of accounting and how the single price or payment stream should be allocated to the components. The guidance does not address when the revenue should be recognized, but refers to other authoritative literature for recognition. The EITF also does not override specific guidance provided in other literature, such as accounting for franchise fees or computer software arrangements. The EITF states that a transaction with multiple deliverables must be separated into separate units of accounting if the following criteria exist: n The delivered item(s) has value to the customer on a standalone basis. That item(s) has value on a standalone basis if the item is sold separately by any vendor or the customer could resell the delivered item(s) on a standalone basis. An active market in the item is not necessary to meet this criterion. n Objective and reliable information regarding the fair value of the undelivered items is available. n If the arrangement includes a general right of return for a delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. If the criteria above are met, then the consideration for the arrangement must be allocated to the components of the transaction based on the relative fair market values. The guidance states the amounts identified in the contract may not be representative of the fair market val- June 2006 21
Not only does the captive impact an entity s revenue recognition, but also the consolidated financial statement presentation. ues, and therefore, should not be relied on for the revenue allocation without other evidence. The fair market values can be evidenced for purpose of allocating the revenue by establishing i) the fair value of the item when regularly sold on a stand alone basis, ii) for an item not sold separately, the fair value established by management having the relevant authority, or iii) if vendor specific detail is not available, the price charged by competitors for similar products or services. Competitor price information is the least preferred source of evidence. The revenue allocation in these arrangements is extremely important as this ultimately impacts the timing of the revenue recognition and resulting reported earnings. The EITF provides a flowchart and examples to illustrate the guidance outlined on page 19. Statement of Cash Flows Presentation Not only does the captive impact an entity s revenue recognition, but also the consolidated financial statement presentation. A recent issue is the statement of cash flows presentation related to an entity that finances the sale of inventory on its own or through a captive. If the statement of cash flows is prepared using a mechanical approach, focusing on changes in balances only, then the sale of inventory could be shown as a cash inflow from operating activities with a corresponding cash outflow in investing activities related to the receivable due from the customer. Both amounts would be shown without any cash being collected or paid by the consolidated entity. SFAS 95, Statement of Cash Flows, paragraph 22(a) states operating cash flows should include cash receipts from sales of goods or services, including receipts from collection or sale of accounts and both short- and long-term notes receivable from customers arising from those sales SEC staff members presented the following perspective in March 2005: Presenting cash flows between a registrant and its consolidated subsidiaries as an investing cash outflow and an operating cash inflow when there has not been a cash inflow to the registrant on a consolidated basis from the sale of inventory is not in accordance with GAAP. Similarly, presenting cash receipts from receivables generated by 22 June 2006
the sale of inventory as investing activities in the registrant s consolidated statements of cash flows is not in accordance with GAAP. Therefore, in preparing the statement of cash flows, generally, an adjustment is needed from the change in inventory and portfolio balances to properly present the consolidated operating and investing cash flows. A captive can provide many benefits including i) providing integrated product, service and financing solutions, ii) the ability to tailor equipment pricing and financing to specific customer needs, iii) simplified sales financing program administration, iv) providing an additional source of income to the manufacturer/parent, and v) providing a source of liquidity and funding to the parent. A successful captive strategy also requires that complex funding and organizational issues be addressed. Depending on how financing and bundling programs are structured, the consolidated manufacturer/parent s revenue A successful captive strategy also requires that complex funding and organizational issues be addressed. recognition and financial statement presentation can be impacted. The relevant accounting guidance addressed in this article and other guidance related to the specific fact pattern should be reviewed to ensure proper financial reporting. ELT thanks Alan Moose, John Deere Credit, for this month s column. The author thanks James Brzoska, IBM Global Financing, for his editorial comments. June 2006 23