An institution enters into a number of long-term contracts for services and software, including the 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. This article will discuss factors and principles an institution should consider to properly account for contract incentives.
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 an institution receives $100,000 from a vendor to sign a 7-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.
FASB Concepts Statement No. 6, Elements of Financial Statements, a replacement of FASB Concepts Statement No. 3, discusses that the essence of accrual accounting is to match costs and revenues to measure the performance of the institution. The statement also acknowledges many expenses are not related directly to particular revenues but can be related to a period on the basis of the transactions or events occurring in that period.
Using this concept, it would be appropriate to match all of the cash flows for the contract to the periods in which the services were performed by the vendor. Total cash flows in our example equal $1 million ($13,095 x 84 months - $100,000 = $1 million). Generally, the institution should then recognize 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
This accounting treatment is consistent with the accounting requirements codified in ASC 840-20-25 for lease incentives.
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. The termination fee for the existing contract is properly recognized in the period the contract is terminated, but this generally should 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. Many of these contracts, though, contain provisions that require the institution to meet some criteria, which indicates the payment is in exchange for future performance obligations. In any event, whether the contract incentive is refundable or not, the institution hasn’t done anything to “earn” the incentive payment. The payment represents one of a series of cash flows related to the services the vendor will perform in the future. For instance, the vendor noted in our previous example would likely be willing to forego the $100,000 incentive and reduce the monthly fee to $11,905 (excluding any present value factor). Since the substance of each contract is the same, it is reasonable both contracts should be accounted for in a similar fashion.
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, please contact your Wipfli relationship executive.