4.5.2.5 Accounting for free products under current FASB rules

In this section I will not focus on the current IFRS rules for accounting for free products, because they provide very limited guidance on this issue, as I mentioned in Section 4.1.2.3. In contrast, the current1FASB or US GAAP rules on revenue recognition are detailed and elaborate. There are specific rules for determining how to deal with ‘multiple-deliverable arrangements’ and for separating consideration in those arrangements.2 There are also specific rules for customer payments and incentives.3 Under these rules, a delivered item or delivered items in an arrangement with multiple deliverables shall be considered a separate unit of accounting if both of the following criteria are met:

The amount allocable to the delivered unit or units of accounting is limited to the amount that is not contingent upon the delivery of additional items or meeting other specified performance conditions.5

In an example, taken from the FASB’s ‘Multiple Deliverable Revenue Arrangements’ Section, the application of these rules can be shown as follows:

CellularCo runs a promotion in which new customers who sign a two-year contract receive a free phone. There is a one-time activation fee of $50 and a monthly fee of $40 for the ongoing service. The same monthly fee is charged by CellularCo regardless of whether a free phone is provided. The phone costs CellularCo $100. Further, assume that CellularCo frequently sells the phone separately, for $120. CellularCo is not required to refund any portion of the fees paid for any reason.

Based on the above information, the phone and the service should be accounted for as separate units of accounting, because a) the phone has value on a standalone basis and b) there are no general rights of return in this arrangement.

Without considering whether any portion of the amount allocable to the phone is contingent upon CellularCo’s providing the phone service, CellularCo should allocate the arrangement consideration on a relative selling price basis as follows: $112.22 ($1,010 x ($120 / ($120 + $960))) to the phone and $ 897.78 ($1,010 x ($960 / ($120 + $960))) to the phone service. However, because a free phone is provided in the arrangement and the customer has no obligation to CellularCo if the phone service is not provided, $62.22 (assuming the customer has paid the non-refundable activation fee) is contingent upon CellularCo’s providing the phone service. Therefore, the amount allocable to the phone is limited to $50 ($112.22 – $62.22) and the amount allocable to the phone service is increased to $960.6

It is clear from the above that even though the phone is advertised as ‘free’, from an accounting perspective (under the current rules), part of the consideration paid for the transaction as a whole should be allocated to the phone. However, it seems that if in the above example no activation fee would have been charged, none of the consideration would have been allocated to the phone and then it would have actually been supplied for no consideration. I’ve included another example, from the ‘Customer Payments and Incentives’ Section,7 to illustrate the rules regarding ‘free goods’:

This example is based on the sale of Model R personal computers by Personal Computer Retailer A (Retailer A). The list price of Model R is $2,000 and the cost to Retailer A is $1,400. Retailer A advertises that for each Model R computer purchased, customers will receive at the time of purchase a 27-inch television. The cost of the television to Retailer A is $300.

The marketing incentive would be characterised in the income statement as follows:

* The expense associated with the free product ($300) has been classified as cost of goods sold. The cost of the marketing incentive should be recognised at the time of sale of Model R computers to customers.8

In this second example, the total consideration is not divided between the two supplies but the supply of the ‘free product’ is treated as a ‘discount in kind’,9 which is made clear by the last remark in the example: the cost of the marketing incentive should be recognised at the time of the sale of the main supply. This means that, even though at the time of the sale, the value of the supplied free product decreases the value of the inventory, this is considered a cost. Otherwise the cost of the marketing incentive would have been recognised at the same time as the cost of the main goods that are to be supplied (the inventory).

The question then is: what makes the supply of a free phone with a subscription different from the supply of a free television with a personal computer? Based on the different Sections in the relevant FASB documents in which the examples appear, the FASB seems to not consider the supply of the phone a marketing incentive but rather a deliverable in a multiple-deliverable arrangement, whereas the supply of the free television is considered a marketing incentive rather than a deliverable in its own right. This appears to be a result of the fact that a personal computer retailer normally does not sell televisions. I have not examined this further, because it is not sufficiently relevant for this research.

The above in my view demonstrates that the current FASB accounting rules regarding multiple-element transactions differ from the EU VAT rules on this subject, in a similar way to the proposed rules. This means that even though accounting rules are a reflection of ‘economic reality’, both the current as well as the proposed accounting rules do not correspond with the EU VAT concept of ‘economic and commercial reality’ and therefore they should not be used for determining the VAT treatment of multiple element transactions. This can also be explained from the fact that the different sets of rules (the EU VAT rules and the accounting rules) were designed for different purposes, even though the outcome of the application of all rules should of course reflect the economic and commercial reality of the transactions they are applied to. In the dictionary, accounting is defined as the system of recording and summarizing business and financial transactions and analysing, verifying, and reporting the results.10 The purpose of IFRS accounting standards is to provide a high quality, internationally recognised set of accounting standards that bring transparency, accountability and efficiency to financial markets around the world.11 The purpose of the EU VAT rules is to ensure the taxation of expenditure on local private consumption, as I explained in Section 2.4.4. These different purposes explain the different perspectives from which both sets of rules relate to transactions and the valuation of transactions.

The above means that the rules for determining whether ‘free elements’ of a multiple-element transaction are actually supplied free of charge should be based on the existing VAT rules and CJEU case law, including ‘economic and commercial reality’. Where an element to a multiple-element supply is advertised as ‘free’, that element should be considered to be supplied for free, unless in economic and commercial reality that element is not supplied for free. I will now elaborate on this.