A Global Reach with a Local Perspective University of North Alabama 19th Annual Decosimo Accounting Forum July 22, 2011 www.decosimo.comRevenue Recognition Exposure DraftJENNIFER GOODMAN, CPAAssurance Principal
Agenda Overview and scope of the exposure draft Current revenue recognition standards Five steps to the revenue recognition process in the exposure draft Overview of key provision of each step Comparisons to current GAAP Examples Other items in proposal Preparing for new revenue recognition standard
Exposure draft overview June 2010 FASB and IASB each issued exposure drafts entitled “Revenue from Contracts with Customers” Benefits: Remove inconsistencies in existing standards Provides a more robust framework Improve comparability across companies, industries and capital markets Simplify the preparation of financial statements by reducing the number of requirements Applies to ALL entities except for rate-regulated entities Comment period June 24 – October 22, 2010, almost 1,000 letters received
Exposure draft status Redeliberations were substantially completed at the June 13-15, 2011 meeting Numerous revised tentative decisions Announced IASB and FASB will re-expose proposals in Q3 2011 for 120 day comment period Effective date – not yet determined Why are we talking about the exposure draft now? It will affect EVERYBODY Currently the standard would be applied on a retrospective basis. The board is allowing certain relief provisions
Current GAAP: core principlesCore principle: Revenue is recognized when earned and realized or realizable.Primary criteria: Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The sellers price to the buyer is fixed or determinable, and Collectability is reasonably assured.
Exposure draft: core principlesCore principle: An entity will recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.Primary criteria: Identification of contract Identification of performance obligations Determine transaction price Allocate transaction price to performance obligations Recognition of revenue on satisfaction of performance obligation(s)
5 Distinct revenue recognition steps1. Identify the contract or contracts with the customer.2. Identify the separate performance obligations in the contract.3. Determine the transaction price.4. Allocate transaction price to the separate performance obligations.5. Recognize the allocated revenue when the entity satisfies each performance obligation.
Step 1 – Identify the contract(s) with thecustomerKey provision: An entity should apply the proposed guidance to each contract identified.Contract definition – an agreement between two or more parties that creates enforceable rights.
Step 1 – Contract existenceFor a contract to exist: It must have commercial substance The parties must approve the contract and be committed to satisfying respective obligations The entity must be able to identify each party’s rights regarding the goods or services to be transferred, and The entity must be able to identify the terms and manner of payment for the goods or services.Additional points: Contracts need not be written If party can terminate contract before performance occurs, contract does not exist for revenue recognition purposes
Step 1 – Comparison to current GAAP EXPOSURE DRAFT CURRENT GAAP TOPIC (incorporates tentative decisions thru June 15 2011) Persuasive evidence of an Contract An entity obtains rights to receive arrangement must exist existence consideration from the customer and assumes obligations to transfer goods or services to the customer Presumption that separate Combining Contracts entered into at or near contracts with the same contracts the same time with the same entity or related parties customer (or related entity) shall entered into at or near the be combined if certain criteria are same time should be met evaluated as a single arrangement
Step 1 – Comparison to current GAAP EXPOSURE DRAFT CURRENT GAAP TOPIC (incorporates tentative decisions thru June 15 2011) Components of one contract Segmenting No requirement to segment should be accounted for contracts contracts into two or more. separately if each is proposed and negotiated separately and cost and revenues with each can be identified. GAAP provides very little Contract Determine if modification guidance on modifications modifications results in separate with the result being that performance obligation diversity in practice as to when modifications are recognized.
Step 1 – Combining contractsAn entity would combine and account for as singlecontract, multiple contracts entered into at or near thesame time with same customer (or related entity) if oneor more criteria are met: The contracts are negotiated as a package with a single commercial objective The amount of consideration in one contract depends on the other contract, or The goods or services in the contracts are interrelated in terms of design, technology or function.
Step 1 – Contract modificationsContract modifications are any change in the scope or priceof a contract. A contract can be modified by either party.Treatment of contract modifications: Account for as separate contract if modification results in the addition of a separate performance obligation at a price that is commensurate with that additional performance obligation. OR Combine the modification with the contract and reevaluate the performance obligation and reallocate the transaction price to each separate performance obligation.
Step 2 – Identify the separate performanceobligations Key provision: An entity shall evaluate the terms of the contract and its customary business practice to identify all promised goods or services and determine whether to account for each as a separate performance obligation. What is a performance obligation? A performance obligation is a promise whether explicit or implicit in a contract with a customer to transfer a good or service to the customer. Can be implied by an entitys business practices, published policies or specific statements.
Step 2 – What are goods and services?Goods and services include: Goods produced by an entity for sale (manufacturer) Goods purchased by an entity for resale (retailer) Arranging for another party to transfer goods or services Standing ready to provide goods or services Constructing or developing an asset on behalf of a customer Granting licenses, rights to use and options, and Performing a contractually agreed task.
Step 2 – Separate vs. bundle If more than one good or service is provided, the entity will need to make a determination whether to bundle or separate the performance obligation. Account for each promised good or service as a separate performance obligation only if it is distinct. If not distinct, combine good or service with other promised goods or services until the entity identifies a bundle of goods or services that is distinct. In some cases, that would result in an entity accounting for all the goods or services promised in the contract as a single performance obligation.
Step 2 – Comparison to current GAAP EXPOSURE DRAFT CURRENT GAAP TOPIC (incorporates tentative decisions through June 15, 2011) Different models several places in Bundling Bundle if entity provides a GAAP where separating performance service of integrating them deliverables in a multiple- obligations into a single item that the deliverable arrangement is entity provides to the discussed. For example, for customer construction-type contracts combine as one unit and apply percentage completion or completed contract method
Step 2 – Comparison to current GAAP EXPOSURE DRAFT CURRENT GAAP TOPIC (incorporates tentative decisions through June 15, 2011) Within the Scope of ASC 605-25, Separating The pattern of transfer of separate if both 1) delivered item performance the good or service is has standalone value to customer, obligations different from the pattern of and 2) if arrangement includes transfer of other promised general right of return related to goods or services in the the delivered item, delivery or contract, AND the good or performance of the undelivered service has a distinct item(s) is considered probable function and substantially in the control of the vendor.
Step 2 – Distinct performance obligationsDistinct if either: 1. The entity regularly sells the good or service separately, or 2. The customer can use the good or service either on its own or together with resources that are readily available to the customer.Exception: If entity transfers goods or services at the same time, it is not necessary to apply the proposed requirements to each performance obligation separately if accounting for those obligations together would result in the same amount and timing of revenue recognition as if they were accounted for separately.
Step 3 – Determine the transaction priceKey provision: The transaction price is the amount of consideration an entity expects to receive in exchange for transferring goods or services to a customer.To meet that objective, an entity would estimate the transaction price using one of the following methods depending of which is most predictive of the amount of entitled consideration: The probability-weighted amount; or The most likely amount. This amount would be allocated to the separate performance obligations.
Step 3 – Variable considerationMany times the transaction price is readily determinable because the customer promises to pay a fixed amount of consideration and it is made near the time of transfer of good or service, however in some cases, there is variable consideration.Follow these steps when a contract has variable consideration. 1. Determine the transaction price 2. Allocate the transaction price to the separate performance obligations in the contract, and 3. Limit the amount of revenue that may be recognized cumulatively on a contract to amounts that the entity is reasonable assured of being entitled to receive.
Step 3 – Comparison to current GAAP EXPOSURE DRAFT CURRENT GAAP TOPIC (incorporates tentative decisions through June 15, 2011) Recognize revenue when Uncertainty Recognize revenue at the fee is fixed/determinable satisfaction of performance - There is no definition of obligation unless the vendor is fixed or determinable fees, not reasonably assured to be instead, literature provides entitled to that amount examples. In past, entities may have recognized revenue when contingency was met…more restrictive.
Step 3 – Reasonably Assured DETAIL Indications in which the entity is not reasonable assured of payment: Lack of experience with similar type contracts, or The entity has experience but experience is not predictive of the outcome of the contract. Factors that reduce the relevance of an entity’s experience include: Consideration is highly susceptible to factors outside the influence of the entity Uncertainty not expected to be resolved for long time Limited experience with similar types of contracts The contact has a large number of possible consideration amounts
Step 3 – Transaction price other considerationsWhen determining the transaction price, an entity shall consider the effects of: collectability, the time value of money, noncash consideration, and consideration payable to the customer.
Step 3 – Collectability Do not consider effects of credit risk in measurement of transaction price. Standard will not include a requirement to assess the customer’s ability to pay. Recognize an allowance for expected impairment loss from contracts with customers. Present as a contra-revenue account adjacent to revenue line item.Current GAAP: Revenue should not be recognized until collection becomes reasonably assured.
Step 3 – Time value of moneyAn entity should adjust the promised amount of consideration to reflect the time value of money if the contract includes a financing component that is significant to the contract.An entity would not be required to assess whether a contract has a significant financing component if the period between payment by the customer and the transfer of the goods or services is one year or less.
Step 3 – Time value of money example3 year $30,000 service contract whereby services are performed monthly assuming interest rate is 5% Inception Debit cash, credit contract liability for $30,000 Month 1 Debit interest expense, credit contract liability for $125 Debit contract liability, credit revenue $775
Example of variable consideration Jan 1, entity enters into contract to provide fund management services for one year Customer pays fixed quarterly amounts plus 10% of any increase in the fund’s value relative to an observable index at the end of the year The entity has entered into many similar contracts, however circumstances surrounding these types of contracts can change significantly
Example of variable consideration The variable consideration is highly susceptible to external factors i.e. market risk The uncertainty cannot be resolved until the end of the year There are a large number of possible outcomesConclusion – transaction price would be limited to fixed amount until the end of the year.
Step 4 – Allocate the transaction price Key provision: An entity should allocate the transaction price to all separate performance obligations in proportion to the standalone selling price of the good or service underlying each performance obligation at contract inception. The best evidence of a standalone selling price would be the observable price of a good or service when the vendor sells it separately.
Step 4 – Allocate the transaction price When estimating standalone prices, maximize the use of observable inputs and apply estimation methods consistently for goods or services and customers with similar characteristics. Suitable methods: Expected cost plus a margin (forecast), and Adjusted market assessment approach (evaluate market).
Step 4 – Comparison to current GAAP EXPOSURE DRAFT CURRENT GAAP TOPIC (incorporates tentative decisions through June 15, 2011) 1) Entity-specific Standalone selling Best: observable price of a good or objective evidence 2) price service when the vendor sells it third-party evidence separately OK: estimate. 3) estimate New guidance is more flexible. Generally not Residual method Allowed allowed
Example – Allocating Transaction Price An entity enters into a contract to sell Product A for $100 Entity gives customer a 40% discount voucher for future purchases in next 30 days up to $100 Entity intends to offer a 10% discount on all sales during the next 30 days as part of seasonal promotion Discount voucher is a separate performance obligation The standalone price of Product A is $100
Example – Allocating Transaction Price Entity estimates an 80% likelihood that customer will redeem the voucher and purchase on average $50 of additional products. Because the entity intends to offer a 10% discount to all customers as part of seasonal promotion, the 40% discount needs to be reduced by 10% to 30% to reflect the incremental value of the discount to the customer.Conclusion: the entity’s estimated standalone selling price of the voucher is $12 ($50 x 30% X 80%). The entity allocates $10.7 ($100 x (12/ ($12 + $100)) of the $100 transaction price to the discount voucher.
Step 5 – Recognize revenue when performanceobligation satisfied Key provision: Recognize revenue when a performance obligation is satisfied. In order to transfer a good or service, the customer must obtain control. Indications the customer has taken control: Customer has unconditional obligation to pay Customer has legal title Customer has physical possession; exceptions allowed for consignments and bill and holds. Risks and rewards of ownership has passed
Step 5 – Bill and holds Still allowed but will now be a part of the guidance Very similar to current SEC guidance Fixed schedule of delivery requirement probably eliminated Reduce requirements to 4 rules
Step 5 – Performance obligation satisfied EXPOSURE DRAFT (incorporates tentative decisions TOPIC through June 15, 2011) Satisfaction of Determine if satisfaction occurs at a point in time or over performance time. obligations Control is Board will describe rather than define. See examples. transferred Continuous model Output, input and passage of time methods should be methods used to recognize revenue over time.
Step 5 – Point in time or over time Identify each performance obligation within a contract and determine if performance obligation is satisfied: At a point in time, or Recognize revenue when control is asset is transferred to customer. Over time. Recognize revenue as performance obligation is satisfied.
Step 5 – Recognize over timeRecognize a performance obligation over time if: The entity’s performance creates or enhances an asset that the customer controls as the asset is being created, or The entity’s performance does not create an asset with an alternative use to the entity and at least one of the following: Customer receives a benefit as the entity performs each task; Another entity would not need to re-perform the tasks performed to date by the entity if that other entity where to fulfill the remaining obligation to the customer, or The entity has a right to payment for performance to date even if the customer could cancel the contract for convenience.
Step 5 – Three continuous transfer methods1. Output methods – Recognize revenue of the basis of units produced or delivered, contract milestones or surveys of goods or services transferred to date relative to the total. Often result in most faithful depiction.2. Input methods – Recognize revenue on basis of efforts expended to date (cost of resources consumed, labor hours expended, machine hours used) relative total efforts to be expended. Entity has to exclude effects of any inputs that do not depict the transfer of a good or service (abnormal wasted material, labor or other resources).
Step 5 – Three continuous transfer methods3. Passage of time method – An entity would recognize revenue on a straight-line basis over the expected duration of the contract if services are transferred evenly over time (licenses). Passage of time method by itself is not appropriate but may be used as a practical way to apply input and output measures.
Construction contract changes Variable consideration - use most likely amount Continuous transfer over time - performance obligations can be estimated using input methods Change orders – determine if entity must account for as separate contract Separate performance obligation – if distinct and has separate pattern of transfer
Example – Construction contract An entity enters into a contract to construct a facility for a customer Requires engineering (design), procurement and construction activities Design is specific to the customer’s requirements and they are involved in specifying major elements The entity procures materials and equipment as they are needed during construction Customer obtains control of materials and equipment as they are installed Construction is expected to take 3 years
Example – Construction contractHow would the entity recognize revenue?(Under current GAAP, combine all activities and apply percentage of completion or completed contract.)
Example – Construction contractDesign services: Distinct? Yes, construction company regularly sells design services separately. When do you recognize? Over time as service is performed - The vendor’s performance does not create an asset with an alternative use to the vendor AND the vendor has a right to payment for performance to date even if the customer could cancel the contract for convenience.
Example – Construction contractProcurement service: Distinct? No, construction company doesn’t regularly provide procurement services. Procurement is an activity that is necessary for the entity to obtain control of the promised materials and equipment. When do you recognize? N/A
Example – Construction contractMaterials and equipment: Distinct? Yes, the customer can use the good or service either on its own or together with resources that are readily available to the customer. When do you recognize? At a point in time, recognize revenue when control is asset is transferred to customer.
Example – Construction ContractConstruction: Distinct? Divide into separate performance obligations if the pattern of transfer of the good or service is different from the pattern of transfer of other promised goods or services in the contract, and the good or service has a distinct function. When do you recognize? Recognize revenue for each performance obligation over time or with the passage of time when it is satisfied.
Other significant items in exposure draft Onerous contracts If the costs outweigh the contract price at any time during the contract then the contract is considered onerous. Once an entity determines a contract is onerous, a liability should be recorded for the onerous portion.
Other significant items in exposure draft Contract costs Obtainment – recognize asset for the incremental costs of obtaining a long-term contract that is expected to be recovered. Recognize separately on the balance sheet Fulfillment – cost incurred in fulfilling a contract do not give rise to an asset unless: Recoverable Generate or enhance resources Related directly to the contract
Other significant items in exposure draft Warranties If purchased separately, the warranty is considered its own performance obligation. If not purchased separately, the warranty considered a cost accrual.
Other significant items in exposure draft Breakage revenue When a pattern of breakage can be estimated recognize revenue on a proportionate basis. When a pattern cannot be estimated, recognize revenue only when the customer’s likelihood of exercise becomes remote.
Presentation and Disclosure Presentation: When either party to a contract has performed, the entity shall present the contract as a contract asset or a contract liability depending on the relationship between the entity’s performance and the customer’s performance. Disclosure: To help users of financial statements understand the amount, timing, and uncertainty of revenue and cash flows arising from contracts, an entity shall disclose qualitative and quantitative information about: its contracts with customers; and the significant judgments, and changes in judgments, made in applying the proposed
WHAT YOU NEED TO DO Apply the proposed standard to your specific customer contracts to determine the impact. It will be challenging to truly know the impact of this proposed guidance without applying it directly to your contracts and working through each of the principles. Are your current internal controls and operating systems sufficient? Remember retroactive application Will the new standard impact debt covenants? Discuss with your tax preparer.
RESOURCES FASB Proposed Accounting Standards Update – Revenue Recognition (Topic 605) FASB In Focus –short 2-page summary of proposal FASB website – technical plan and project updates tab AICPA Accounting and Auditing Brief June 16, 2011 - good information on redeliberation impact on exposure draft Revenue Recognition Guide – Chapter 13 Future Expectations – Short 13-page summary of exposure draft however redeliberation impact is not incorporated
CONNECT WITH ME Jennifer Goodman, CPA Assurance Principal 423.756.7100 email@example.com On LinkedIn: http://www.linkedin.com/pub/jennife r-goodman/25/7b1/49a Disclaimer: The contents of this presentation are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals or specific situations.