Accounting for contract incentives
An institution enters into a number of long-term contracts for services and software, including its core processing system and debit and credit card payment systems.
To obtain these contracts, vendors may provide various incentives such as an upfront payment to the institution or reduced or no payments for a certain period of time.
But what factors and principles should your institution consider to properly account for contract incentives?
Matching
When an institution receives an incentive payment in advance, the first question usually asked is, “Can I recognize the incentive as income immediately?”
To answer this question, let’s assume the institution receives $100,000 from a vendor to sign a seven-year contract with the vendor. During the contract, the vendor will provide certain services in exchange for a $13,095 monthly payment from the institution.
ASC 705-20-25 discusses the accounting for consideration from a vendor. Consideration may consist of cash amounts received or to be received, credit or other items the institution can apply against the amounts owed to the vendor. Paragraph 25-1 says any consideration from a vendor is accounted for as a reduction of the purchase price of the goods or services acquired from the vendor (except when the consideration is tied directly to other transactions as outlined in the paragraph).
Based on this guidance, the incentive received from the vendor should be recognized over the contract period. Total cash flows in the example equal $1 million ($13,095 x 84 months - $100,000 = $1 million). Generally, the institution should then recognize an expense of $11,905 per month for the services it receives ($1 million ÷ 84 months).
To do this, the institution would defer the initial $100,000 incentive payment and amortize this over the 84 months as an offset to the expense recognized for the monthly payments as follows:
Entry to record contract incentive:
Dr Cash 100,000
Cr Deferred contract incentive 100,000
Entry to record first monthly contract payment:
Dr Expense 11,905
Dr Deferred contract incentive 1,190
Cr Cash 13,095
Other considerations
In certain instances, the vendors provide these incentive payments to the institution to offset costs for terminating an existing contract. Some believe the incentive payment should be recognized in the same period as the termination costs. However, these are two separate contracts, and each contract should be accounted for individually.
ASC 420-10-25-12 states that “a liability for costs to terminate a contract before the end of its term shall be recognized when the institution terminates the contract in accordance with the contract terms.” The termination fee for the existing contract is properly recognized in the period the contract is terminated, but this does not affect the expense recognition principles for the new contract discussed above.
Some have suggested the contract incentive may be recognized immediately if it is nonrefundable to the vendor. However, ASC 705-20-25-1 does differentiate between refundable and nonrefundable payments from vendors.
How Wipfli can help
Whatever contract incentive is received, institutions should carefully consider the contract and applicable accounting principles to determine the appropriate method of accounting for the incentive payment.
If you have questions about a contract incentive, contact us. Our audit and accounting professionals specialize in the financial institutions industry and can assist you with accounting for contract incentives.
